Production and Consumption Efficiency Gains from Free Trade

The aggregate welfare gains from free trade can be decomposed into two separate effects; production efficiency gains and consumption efficiency gains. In the adjoining figure we show the autarky and free trade equilibria for the US. The autarky production and consumption point occurs at the point A with a level of aggregate utility which corresponds to the indifference curve I_Aut. The US production and consumption points in free trade are P and C, respectively. In free trade the US realizes a level of aggregate utility which corresponds to the indifference curve I_FT. The free trade price ratio is given by the slope of the national income line which connects P and C.

The aggregate welfare gains from free trade corresponds to the difference in utility between I_FT and I_Aut. To decompose the aggregate effect we simply introduce a national income line with the same slope as the free trade price ratio and pass it through the original production point A. This income line is tangent to the indifference curve I_C. The utility level at I_C represents the level of aggregate welfare that would be realized if free trade prices prevailed and if there were no changes in domestic production. Thus, the difference between I_C and I_Aut is the increase in welfare that arises solely due to the change in prices. This increase in welfare is the aggregate consumption efficiency gain from free trade.

The remaining gain from free trade corresponds to the difference between utility levels at I_FT and I_C. This increase in welfare arises due to the shift in production from point A to P. This shift represents the aggregate production efficiency gain from free trade.

Thus movements from autarky to free trade result in both aggregate production efficiency gains and aggregate consumption efficiency gains. One can conclude then that both producers and consumers benefit from free trade. This is true, in the aggregate. However, one cannot conclude that every individual producer and consumer will benefit from free trade. The aggregate gains conceal the redistributive effects of the movement to free trade.

International Trade Theory and Policy - Chapter 60-11: Last Updated on 7/31/06