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7.1 Basic Assumptions of the Partial Equilibrium Model

Learning Objective

  1. Identify the basic assumptions of a simple partial equilibrium trade model.

This section analyzes the price and welfare effects of trade policies using a partial equilibrium model under the assumption that markets are perfectly competitive.

  1. Assume there are two countries, the United States and Mexico. The analysis can be generalized by assuming one of the countries is the rest of the world.
  2. Each country has producers and consumers of a tradable good, wheat. The analysis can be generalized by considering broad classes of products, like manufactured goods, or services.
  3. Wheat is a homogeneous good. All wheat from Mexico and the United States is perfectly substitutable in consumption.
  4. The markets are perfectly competitive.
  5. We assume that the two countries are initially trading freely. One country implements a trade policy and there is no response or retaliation by the other country.

The Meaning of Partial Equilibrium

In partial equilibriumAn economic analysis in which the effects are examined only in the markets that are directly affected. Supply and demand curves for the market of interest are typically used in a partial equilibrium analysis. analysis, the effects of policy actions are examined only in the markets that are directly affected. Supply and demand curves are used to depict the price effects of policies. Producer and consumer surplus is used to measure the welfare effects on participants in the market. A partial equilibrium analysis either ignores effects on other industries in the economy or assumes that the sector in question is very, very small and therefore has little if any impact on other sectors of the economy.

In contrast, a general equilibrium analysis incorporates the interaction of import and export sectors and then considers the effects of policies on multiple sectors in the economy. It uses offer curves to depict equilibria and measures welfare with aggregate welfare functions or trade indifference curves.

The Large versus Small Country Assumption

Two cases are considered regarding the size of the policy-setting country in international markets. The effects of policies vary significantly depending on the size of a country in international markets.

If the country is a “large countryA country is large if any change in its trade volume for a product is sufficiently large to affect the price of that product in the rest of the world.” in international markets, then the country’s imports or exports are a significant share in the world market for the product. Whenever a country is large in an international market, domestic trade policies can affect the world price of the good. This occurs if the domestic trade policy affects supply or demand on the world market sufficiently to change the world price of the product.

If the country is a “small countryA country is small if any change in its trade volume for a product is too small to have any effect on the price of that product in the rest of the world.” in international markets, then the policy-setting country has a very small share in the world market for the product—so small that domestic policies are unable to affect the world price of the good. The small country assumption is analogous to the assumption of perfect competition in a domestic goods market. Domestic firms and consumers must take international prices as given because they are too small for their actions to affect the price.

Key Takeaways

  • Partial equilibrium analysis uses supply and demand curves in a particular market and ignores effects that occur beyond these markets.
  • Large countries are those whose trade volume is significant enough such that large changes in trade flows can affect the world price of the good.
  • Small countries are those whose trade volume is not significant enough such that any changes in its trade flows will not affect the world price of the good.

Exercise

  1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”

    1. The term used to describe a country in which domestic policy changes can influence prices in international markets.
    2. The term used to describe a country in which domestic policy changes cannot influence prices in international markets.
    3. The term used to describe the substitutability of a good that is homogeneous.
    4. This type of economic analysis focuses on policy effects within a single market and does not address effects external to the market.