Question

Suppose that the current international price of wheat is S6 per bushel and that the United States is currently exporting 30 million bushels per year. If the United States suddenly became a closed economy with respect to wheat, would the domestic price of wheat in the United States end up higher or lower than \(\$ 6 ?\) LO38.3 a. Higher. b. Lower. c. The same.

Short answer

b. Lower.

Step-by-step solution

Understanding Market Equilibrium

In an open economy, the domestic price of wheat is equal to the international price, which is currently $6 per bushel. The U.S. exports wheat at this price because domestic production exceeds domestic consumption.

Analyzing a Closed Economy Scenario

When the U.S. becomes a closed economy, it can no longer export wheat. The supply initially destined for international markets will now be available for domestic consumption.

Effect on Supply and Demand

With additional supply available in the domestic market and no access to international markets, the domestic supply of wheat increases. If demand does not increase correspondingly, this will create a surplus of wheat in the domestic market.

Impact on Domestic Price

The surplus of wheat caused by the closure will lead to a downward pressure on prices. Suppliers will have to reduce prices to balance supply with domestic demand.

Key concepts

Closed Economy

In the world of economics, a closed economy is a system where the country prohibits international trade of goods or services. In other words, no imports or exports take place. This means countries must depend solely on their domestic resources to fulfill their needs. This approach affects various economic factors, including market equilibrium, production, and consumption dynamics.
A closed economy can be self-reliant, fostering domestic industries and mitigating dependencies on foreign markets. However, it also prevents the economy from enjoying the benefits of competitive pricing and product variety available in international trade. These limitations may lead to inefficiencies in resource distribution and slower economic growth. For wheat, this means relying only on domestic production and demand for consumption.

Domestic Price

Domestic price refers to the price level of goods and services within a country's borders, without the influence of international markets. In a closed economy scenario concerning wheat, the lack of export options means the entire production must be consumed domestically. This situation directly impacts the domestic price level of wheat.
With the U.S. shifting from an open to a closed economy, previously exported wheat becomes surplus in the domestic market. Unless domestic demand increases to absorb this surplus, suppliers find themselves in a position where they need to lower prices to sell their stock, resulting in a decrease in domestic wheat prices. The domestic price is thus likely lower than the international market price, which was originally set at $6 per bushel.

Export Impact

Exports play a significant role in a country’s economy, affecting production, consumption, and pricing patterns. In the context of wheat, exports facilitated the United States to sell surplus production on international markets at competitive prices. When these sales routes are cut off in a closed economy, the impact is tangible.
The immediate consequence of halting exports is an abundance of supply within the domestic market. This surplus leads to lower domestic prices as producers lack international buyers. The drop in price is intended to coax local consumers to purchase more wheat, balancing the over-supply with demand. Thus, the absence of export significantly impacts pricing, using domestic dynamics to address the surplus instead.

Supply and Demand Dynamics

Supply and demand dynamics dictate market behavior. In an open economy, these dynamics are influenced broadly by global markets. However, transitioning to a closed economy, as we consider for wheat, shifts focus to internal forces.
In the closed economy scenario for U.S. wheat, supply initially increases as exports cease. If domestic demand remains unchanged, this creates a surplus. The economic principle of supply and demand dictates that an increase in supply, given a stable demand, will reduce prices.
To balance this excess supply, prices will naturally decline, encouraging consumers to increase their consumption until equilibrium is re-established. This interplay between supply and demand continues until domestic needs align with domestic production, establishing a new price point within the country.