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Externalities and public goods

The supply-and-demand framework can also be used to show imports and exports directly. Figure 2 shows the supply of a good by domestic producers and the demand for that good by domestic buyers. In the absence of any trade, the domestic equilibrium price is Pe and the domestic equilibrium quantity is Qe. If the world price for the good is Pw, then only those domestic producers who can sell at Pw or less will find buyers, so Q1 will be the amount sold by domestic sellers. The quantity demanded at Pw is Q2, which means the distance from Q2 to Q1 (or distance ac) will be the quantity of goods imported. The same analysis can also show the quantity of exports if the world price is above the domestic equilibrium price in the absence of trade.

The supply-and-demand analysis in Figure 2 can also be used to show the benefit of imports, a point often difficult to impress upon students. The social surplus in the absence of trade is the triangle formed above supply and below demand up to Qe. As a result of imports at the world price, consumer surplus is increased and producer surplus is reduced, but the gain to consumers is larger than the loss to producers, resulting in a net gain in social surplus equal to the triangle formed by points a, b, and c. These are the gains from trade. A similar analysis can be used to show the gains from exports when the world price is above the equilibrium domestic price in the absence of trade.