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"Discuss and illustrate graphically the effects of trade in a small open economy. What are the gains from trade?"

What does small open economy mean?

Is it imports/exports internationally?

Thanks :)

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1 Answer

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When we are told that the economy is small and open, it usually implies that the world market completely dwarfs the small economy's market.

This means that trade will introduce an infinite world supply (very large market) at some world price, pw. This is drawn as a horizontal line at p = pw.

The minimum of the domestic supply curve and the world supply line is known as the effective supply line. Use this supply curve, plus the domestic demand curve to understand the new equilibrium in the economy.

Then, use concepts of welfare/surplus to analyse the "gains from trade". You should find that open trade will improve the welfare of society, hurting producers (obviously, as they face competition), but helping consumers a lot more than the producers lose out (you will gain a new 'triangle' on your graph).

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