Free Trade - Consumer and Producer Surplus

Where there is no trade the equilibrium will be at point B - a price level of OC and output level of Q1. When there is free trade the world price is below the domestic equilibrium price and equilibrium will be where the world price is equal to domestic demand. This is at point D - an output level of Q2.

Diagram: Free Trade - Consumer and Producer Surplus

The concepts of consumer and producer surplus can be used to assess the benefits of free trade. The difference between the amount that consumers would be prepared to pay for a good or service rather than go without, and the price that they actually pay is called consumer surplus. It is used as a measure of satisfaction or welfare of consumers. The difference between the price that producers would be prepared to sell their produce at and the price that they actually sell it at is the producer surplus. These two together are a measure of the welfare of the product. In a perfectly competitive market in a closed economy where the equilibrium market price and quantity is Q0 and P0, the consumer surplus is shown by the area ABC. The producer surplus is shown by the area CB0. The total level of welfare would be equal to the area AB0. Following world trade consumer surplus increases to ADPw. The gain in welfare is BGD.

Related diagram: