"A country can be worse off as a result of free trade in an exported product if there are no policies that force market decision-makers to internalize the external costs associated with the domestic production of this product." Do you agree or disagree with the statement? Illustrate your answer with the help of relevant diagrams.

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE: Consider the case of an industry whose production activity creates substantial pollution in the local rivers, lakes, and groundwater. For example, it is convenient for chemical companies to dump their chemical wastes into nearby lakes and water bodies. This may not impose any cost on the firms. However, the dumping of wastes into the lakes imposes an external cost on other members of society.



In the diagrams above, let's assume that the domestic firms ignore the marginal external costs (MEC, as shown in the lower panel) of their pollution and operate on supply curve Sd (as shown in the upper panel). In the absence of trade, the local price is $1.00, and domestic quantity produced and consumed is 2 billion units (as shown in the upper panel). If this country engages in free trade and the world price is $1.10, the country exports (2.3 - 1.8) = 0.5 billion units.

However, in comparison with no trade, the country may be worse off, since the gain from the triangular area depicted by 'a' may be less than the rectangular Area 'b', which shows the additional external costs resulting from the expansion of domestic production. In the case shown in the diagram above, Area a is $25 million, and Area b is $90 million, so this country is worse off for exporting the product.