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Trading equilibrium and theory of the first best
Opening up to trade offers opportunities to sell products that the world wants: the small open economy can manufacture more cheaply than producers in the rest of the world can. To predict the pattern of trade, compare the country’s underlying production costs before opening up to trade to global goods prices. Cost advantages signal potential exports.
The flip side of knowing what the home country can manufacture more cheaply, however, is identifying the good that should be imported rather than produced domestically. Global relative prices create incentives for productive resources to move into the export sector – but this means moving them out of the import-competing sector.
Trade reshuffles which country produces what, locating production globally where its cost is lowest and so using the world’s inputs most efficiently. Consumers gain from importing things that the world makes more cost effectively than the small open economy can. Because capturing these gains means that the import-competing sector contracts as the export sector expands, it follows that there will be winners and losers from trade.
Although it may be too small for its own output or consumption to affect prevailing global prices, different underlying production relative prices before trade indicate that even a small country has something beneficial to export. Making the most of its comparative advantage creates utility opportunities that are not available without trade. By adjusting its production mix in response to a higher global relative price and taking up the potential to export, consumption off the production possibilities frontier is achievable, with the earnings from exports exactly matching the cost of imports.
