Supply and demand model with imports

In this post, using supply and demand analysis, I consider what happens to output and prices when a country transitions from a closed economy (i.e, does not trade with the rest of the world) to an open economy (i.e, does trade with the rest of the world).

In a closed economy, the market price for a commodity is determined by the intersection of the supply and demand curves. The equilibrium represents the point where the amount of a good being produced is the same as the quantity being demanded.

In the example below, the equilibrium is at point A where the market price is $5 and the equilibrium quantity is 100 units. As the market is closed and there is not international trade, the 100 units of output is being produced by domestic producers.

Supply and demand model with imports.

I now consider the case where this country opens up to trade. Typically it is assumed that a country faces a horizontal international supply curve. This means that a country can purchase as many units of output at the prevailing world price. This assumption is referred to the 'small country assumption'. The small country assumption assumes that the demand by an individual country is so small compared to global demand that the effect they have on the world demand curve is so minuscule that it won't have any impact on the world price.

In the figure above, it has been assumed that the world price for this commodity is $2. The world supply curve is labelled "World Price" and is illustrated by the straight line which hits the vertical axis at $2.

Quantity of imports

We now wish to calculate the quantity demanded by domestic consumers, the quantity supplied by domestic producers and the quantity of imports.

The quantity demanded by domestic consumers is determined by finding how much is demanded at the price of $2, since domestic consumers can now purchase as much of the commodity as they desire for $2. This point is labelled "C" in the graph above and corresponds to 150 units of demand.

The quantity supplied is now determined at the point where the supply curve equals $2. As local producers now have to compete with international sellers, they will also need to decrease their price to $2 per unit. At the price of $2, they will only produce 50 units of output, which is labelled at point "B" in the graph above.

The quantity of imports are calculated as the difference between the amount demanded by domestic consumers and the quantity supplied by domestic consumers (It is assumed that all the domestic output is sold to the local market). Therefore, we have

\text{Imports} = 150 - 50 = 100

Therefore by opening up to international trade, the domestic consumers now consume 150 units instead of 100; the local producers decrease their production from 100 to 50 and the difference is comprised of 100 imports from the world market.

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