Benefits of Free Trade:

In what follows, we use standard cost-benefit apparatus that analyses welfare gains and losses to various economic agents like households (consumers)  and firms  (producers)  to compare alternatives situations  like free trade and autarky.

When Domestic Industry is Perfectly Competitive

We will use a simple diagram (Figure :  Benefits of Free Trade) to illustrate the benefits that accrue  to a country  engaging  in free trade.  

The main assumptions underlying the diagrammatic analysis are (a) perfect competition in the domestic industry;(b) the industry being considered  is a small  part  of the  country's economy (so we can use partial  equilibrium analysis); and (c) the country is a small player in the international market for the product, which means that it.can  import any amount at the world price P_w(it is a price-taker in the world market).

The downward sloping line AD represents the demand curve for the product of  industry X, while the  upward  sloping line BS represents the domestic supply curve of the industry. In  the  absence  of  trade, domestic price of the product of industry X  is P₁.  In  this case total social welfare W  is  the equal  to the  area of  triangle AEB  . You  should  note  that W  = Consumers'  Surplus (Area  of triangle  AP₁E)  + Producers' Surplus (Area  of  triangle BP₁E).

Let  world  price  of  good  X, P_w be below P₁.  This means  the domestic consumers will be better off importing  the good. With free trade, good X will be imported and the price of good X  in the domestic market will be  forced down to P_w.  Obviously, domestic firms  cannot charge a price higher  than P_w,  as nobody would buy  the. good at  a higher price  if cheaper imports are  freely accessible.

With trade, total domestic demand at price P_w is Q,,  which is met in part by domestic supply  (of amount OQ₁) and partly by imports (amounting to Q₁Q₂). You should  note there is a net gain in social welfare in the post-trade situation, amounting to the area C. Consumer surplus  has increased from AP₁E to AP_wG while producers' surplus has fallen from BP₁E to BP_wF,  giving a net gain in welfare of area C.  In principle, the losers (the producers) can be compensated by  the gainers (the consumers). From the diagram  it should  be clear  to you that the extent of gain in social welfare is positively'related to the gap between P₁ and P_w.

Using Figure above we have just carried out a partial equilibrium analysis of  fiee trade  for an  industry.  Here we have not considered the secondary effects of trade on the economy. In particular we have not taken into account the effects of  trade on factor markets, on the terms of trade, or on the Balance of Payments and exchange rates.  However, if  the industry being analysed has considerable weight  in the national economy these secondary effects can be quite important.