A Graphic Demonstration

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These points can be shown neatly using a device known as the utility-possibility frontier (or the UPF). This curve shows the outer limit of utilities or satisfactions that an economy can attain.

Such a concept is very similar in spirit to the production-possibility frontier. The major difference is that the UPF places utilities or levels of satisfaction on the two axes, as is shown in Figure 1. The UPF slopes downward to indicate that, on the frontier, as one person's satisfaction increases, the other person's must decrease.

Note that the UPF is drawn somewhat wavy. This shape indicates that the scale of the individual utility measure is arbitrary; however, the inability to measure and compare individual utilities is completely unimportant for analyzing efficiency.

All that matters here is that a person's level of satisfaction rises as the utility index increases. Because of this positive relation between utility and desired levels of consumption, we are guaranteed that each person will want to move out as far as possible on his or her utility axis.

Now comes the important point: An efficient ...
... economy is one that is on the frontier of its utility possibility curve. One such efficient (or Pareto efficient) point is shown at point A in Figure 1.

Why is point A Pareto-efficient? Because there is no feasible economic reorganization that makes anyone better off without making someone else worse off. We can, of course, move to point C.

Such a move would certainly delight Smith, whose consumption and satisfaction are increased. But Smith's gain comes only at Jones' expense. When all possible gains to Smith must come at Jones' expense, the economy is on its UPF and is operating efficiently.

An economy is efficient when it is on the utility possibility frontier.The general principles laid out here can be used to illustrate one of the most important propositions of all economics: the efficiency of free international trade and the harms from tariffs and other trade barriers.

A free-trade system is one in which there are no tariffs, quotas, or other barriers to imports and exports. In a free-trade regime, the costs of importing foreign goods would involve only the true marginal costs and not artificial costs imposed by governments to "protect" domestic firms and workers.

International trade is no different from trade within a nation, which means that in a free-trade situation the world would be on its utility-possibility frontier. The efficiency of free trade is illustrated in Figure 2.

We have divided the world into two countries, America and Japan, and have shown the satisfactions of the consumers of the two countries on the two axes. Point A represents efficient, perfectly competitive, free-trade equilibrium.

Now suppose that an American politician enters and says, "We need to protect our automobile and computer workers from unfair competition. Let's limit imports of cars and computer chips. These measures would distort prices and push the economy inside the world UPF.

If the trade barriers were well crafted, America might improve the economic position of its consumers, say, by moving to point B in Figure 2. This is clearly a "beggar-thy-neighbor" policy in which America wins at the expense of Japan.

More likely is that the measures will end up hurting both countries. A Japanese bureaucrat might respond by saying, "if you feel threatened by our automobile industry, let us ration out the exports among our firms.

The result would be that Japan would in effect exercise market power, raise the prices of its exports, and lower the welfare of American consumers. Another possibility is that Japan might retaliate by putting tariffs on American imports.

Such dismal outcomes would be illustrated by point C, where interferences with free trade have ended up hurting both countries.

We can also use this discussion to illustrate the gains from trade. The basic idea is that isolated communities or nations can improve their consumption possibilities by engaging in trade with others. Without trade, each group can consume only what it produces.

Free international trade allows each country to improve its living standards. The potential improvement in income and consumption from allowing free and open interchange is called the gains from trade.

The reason why countries gain from trade is a simple corollary of the efficiency of competitive markets. Boundaries are irrelevant for the invisible-hand principle.

In the idealized conditions, competitive markets are efficient in Houston, in Texas, in the United States, in North America, and in the world. The maximum consumption possibilities are attained when there are no interferences with the free flow of products.

This point is easily seen in Figure 2. Say that point C is the utilities of the two countries without trade. Then borders are opened to free trade. We know that in a competitive economy, the equilibrium must move to the northeast, such as to point A. The difference between points A and C represents the gains from trade.

Under free trade, the world economy can attain its highest consumption and utility levels. The increase in consumption from opening borders to trade is the gains from trade. Interferences with the free international flow of goods push the economy inside its UPF and lowers potential consumption.