Results of Trade

An isolated region is usually called a closed economy, and by avoiding trade it is practicing what standard economics calls autarky. Given the inputs available to it, such an economy can produce a specific range of final outputs, incurring specific local input costs.

This is shown in highly simplified form in the following figure.

A closed economy
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A closed economy is the initial situation, prior to the consideration of trade. Apples and strawberries are produced locally at the input costs shown.

This closed economy is capable of producing apples and strawberries with its available inputs. For apples, the input cost of production is 70 health units, while for strawberries it is 90 health units.

The effectual values for the two outputs are not shown because they have no bearing on the initial part of this discussion.

When we open this economy up by permitting trade, two major changes are possible, as shown in the following figure.

An open economy
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When the economy is opened to trade, pineapples can be imported, thus expanding consumption possibilities. As well, the effective input cost of strawberries decreases from 90 to 60 because the local output that is traded for strawberries incurs a lower input cost.

The obvious change here is that imported pineapples have been added to list of outputs. Another but less obvious change is that the input cost of strawberries has decreased from 90 units to 60 units.

This example points to the two important differences that trade can make to a closed economy: it can expand the range of its final outputs, and it can reduce the input cost of existing (locally-produced) final outputs.

There are two reasons why trade can expand the output range.

The first is that another region can produce something that simply cannot be produced given the inputs that are present in the local region. For example, Bangladesh may not have the manufacturing facilities to produce computers. Trade therefore gives the country access to an output that would otherwise be unavailable to it.

The second reason is that an economy may not have access to a necessary intermediate output. Bangladesh may have the required manufacturing facilities for computers, but the rare metals or chemicals required in their production may not be domestically available. In that case, importing the necessary intermediate outputs will permit the country to add computers to its domestic output list.

There are also two reasons, which are parallel to those just cited, why trade can decrease the input cost of an existing final output.

First, the economy may be able to import the same output at an input cost that is lower than its current input cost. It could then replace the locally-produced output with the import.

Second, the economy may be able to import an intermediate output at an input cost that is lower than the one it is currently incurring in production. Substituting this imported intermediate output will again lower the input cost of producing the existing final output.

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