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Chapter 7
Perfect Competition
INTERNATIONAL TRADE As noted in Chapter 6, international trade is based on mutually beneficial specialization among countries, that is, on comparative advantage. The final section of this chapter underscores two additional points. First, when free trade is the norm, patterns of trade follow the rules of worldwide supply and demand. If a country’s demand outstrips its available supply, it will make up the difference via imports from the rest of the world. Second, the proposition that competitive markets are efficient applies not only to individual markets within a nation but also to all global markets. Free trade is the basis for worldwide efficient production. When nations erect trade barriers, economic welfare is diminished. To see why perfectly competitive global markets are efficient, we use exactly the same arguments as before. Under free trade, firms from all over the world compete for sales to consumers of different nations. Free competition means that the good in question will sell at a single world price (net of transport costs). Only the most efficient lowest-cost firms will supply the good. Only consumers willing and able to pay the world price will purchase the good. Finally, exactly the right amount of the good will be supplied and consumed worldwide. In competitive equilibrium, global output occurs at a quantity such that P MB MC. The quantity of output is efficient. In a nutshell, this is the efficiency argument for free trade.
Tariffs and Quotas In reality, worldwide trade is far from free. Traditionally, nations have erected trade barriers to limit the quantities of imports from other countries. Most commonly, these import restrictions have taken the form of tariffs, that is, taxes on foreign goods, or direct quotas. The usual rationale for this is to protect particular industries and their workers from foreign competition. Since World War II, the industrialized nations of the world have pushed for reductions in all kinds of trade barriers. Under the General Agreement on Tariffs and Trade (GATT), member nations meet periodically to negotiate reciprocal cuts in tariffs. In the last decade, there has been a rise in protectionist sentiment in the United States, aimed in part at insulating domestic industries from competition and, in part, as retaliation against alleged protectionist policies by Japan and Europe. Although there are a number of strategic reasons why a country might hope to profit from trade barriers, the larger problem is the efficiency harm imposed by these restrictions. To illustrate this point, we return to the digital watch example introduced in Chapter 6. RESTRICTED TRADE IN WATCHES Figure 7.8a depicts hypothetical U.S. demand and supply curves for digital watches. Suppose that the world price is $12.50 per watch (shown in the figure by the horizontal price line at P $12.50).
