1. Chapter 5 Standard Trade Model

2. Copyright © 2003 Pearson Education, Inc.Slide 5-2 Introduction  Previous trade theories have emphasized specific sources of comparative advantage which give rise to international trade: Differences in labor productivity (Ricardian model) Differences in resources (Heckscher-Ohlin model)  We need more general model of trade that admits the above models as special cases. Based on common features of the above models. Can analyze many important issues, while sacrificing some aspects (on the pattern & gains from trade).

3. Copyright © 2003 Pearson Education, Inc.Slide 5-3 Introduction  The common features of the above models are, – The productive capacity of an economy can be summarized by its production possibility frontier, and differences in the PPFs give rise to trade. – The PPF determines its relative supply schedule, responding to relative prices. – National relative supply curves determine world relative supply, which along with world relative demand determines an equilibrium (relative price) under international trade.

4. Copyright © 2003 Pearson Education, Inc.Slide 5-4 A Standard Model of a Trading Economy  The standard trade model is built on four key relationships, which are the main subjects of this chapter: Production possibility frontier and the relative supply curve Relationship bet. relative prices and relative demand Determination of world equilibrium by world relative supply and world relative demand Effects of ‘terms of trade’ (P exp /P imp ) on a nation’s welfare

5. Copyright © 2003 Pearson Education, Inc.Slide 5-5 A Standard Model: (1) Production Possibilities and Relative Supply  Assumptions of the model: –Each country produces two goods (eg. food and cloth) –Each country’s production possibility frontier is a smooth curve (TT), bowed owtward.  The point on its production possibility frontier at which an economy actually produces depends on the price of cloth relative to food, P C /P F. At the point where the value of output is maximized.  Isovalue lines: Lines along which the market value of output is constant (P c Q c + P f Q f = V) A straight lines with slope of – (P C /P F ).

6. Copyright © 2003 Pearson Education, Inc.Slide 5-6 Figure 5-1: Relative Prices Determine the Economy’s Output Q Isovalue lines TT A Standard Model (1) Production Possibilities and Relative Supply Cloth production, Q C Food production, Q F

7. Copyright © 2003 Pearson Education, Inc.Slide 5-7 Figure 5-2: How an Increase in the Relative Price of Cloth Affects Relative Supply Q1Q1 VV 1 (P C /P F ) 1 Q2Q2 VV 2 (P C /P F ) 2 A Standard Model (1) Production Possibilities and Relative Supply TT Cloth production, Q C Food production, Q F

8. Copyright © 2003 Pearson Education, Inc.Slide 5-8 A Standard Model (1) Production Possibilities and Relative Supply  Now, we can derive upward sloping relative supply (RS) curve from the previous graph. As (P C /P F ) rises, (Q C /Q F ) also increases. The RS curve shows this relations graphically.

9. Copyright © 2003 Pearson Education, Inc.Slide 5-9  The value of an economy's consumption equals the value of its production: (budget constraint or consumption possibility). P C Q C + P F Q F = P C D C + P F D F = V  The economy’s choice of actual consumption point on the budget line (consumption possibility curve, a kind of isovalue line) depends on the tastes of its consumers. –It can be represented graphically by a series of indifference curves. A Standard Model (2) Relative Prices and Demand

10. Copyright © 2003 Pearson Education, Inc.Slide 5-10 Indifference curves –Each indifference curve traces combinations of cloth (C) and food (F) consumption that leave the individual equally well off (the same level of welfare). Three properties of IC: –Downward sloping –The farther up and to the right each lies, the higher the level of welfare to which it corresponds. –Each gets flatter as we move to the right (convex to the origin). –Along an indifference curve, the (absolute) size of slope decreases. A Standard Model (2) Relative Prices and Demand

11. Copyright © 2003 Pearson Education, Inc.Slide 5-11 TT Figure 5-3: Production, Consumption, and Trade in the Standard Model Cloth production, Q C Food production, Q F Q D Indifference curves Food imports Cloth exports A Standard Model (2) Relative Prices and Demand

12. Copyright © 2003 Pearson Education, Inc.Slide 5-12 Figure 5-4: Effects of a Rise in the Relative Price of Cloth

13. Copyright © 2003 Pearson Education, Inc.Slide 5-13 A Standard Model (2) Relative Prices and Demand If the relative price of cloth (P C /P F ) increases, the economy’s consumption choice shifts from D 1 to D 2. The move from D 1 to D 2 reflects two effects: –Substitution effect: (along the same IC) reduce consumption of relatively expensive goods (cloth), while increasing food consumption. –Income effect: as the relative price of its export product rises, it can afford to import more for given amount of exports. –increase both consumption (reaching higher IC).

14. Copyright © 2003 Pearson Education, Inc.Slide 5-14 A Standard Model (2) Relative Prices and Demand It is possible that the income effect will be so strong that consumption of both goods actually rises when P C /P F rises. Normally (in most situations), however, the ratio of cloth consumption to food consumption (D c /D F ) will fall, that is, the relative demand will decline as relative price increases.

15. Copyright © 2003 Pearson Education, Inc.Slide 5-15  Terms of trade refers to the price of exports relative to the price of imports, namely P exp /P imp.  Determining Relative Prices (‘terms of trade’) Suppose that the world economy consists of two countries: –Home (which exports cloth) –Its terms of trade are measured by P C /P F –Its quantities of cloth and food produced are Q C and Q F –Foreign (which exports food) –Its terms of trade are measured by P F /P C –Its quantities of cloth and food produced are Q * C and Q * F A Standard Model (3) The Welfare Effect of Changes in the Terms of Trade

16. Copyright © 2003 Pearson Education, Inc.Slide 5-16 To determine P C /P F, one must find the intersection of world relative supply and world relative demand of cloth. –The world relative supply curve (RS) is upward sloping because an increase in P C /P F leads both countries to produce more cloth and less food. –The world relative demand curve (RD) is downward sloping because an increase in P C /P F leads both countries to shift their consumption mix away from cloth toward food. A Standard Model (3) The Welfare Effect of Changes in the Terms of Trade

17. Copyright © 2003 Pearson Education, Inc.Slide 5-17 Figure 5-5: World Relative Supply and Demand RS RD Relative price of cloth, P C /P F Relative quantity of cloth, Q C + Q * C Q F + Q * F A Standard Model (3) The Welfare Effect of Changes in the Terms of Trade (P C /P F ) 1 1

18. Copyright © 2003 Pearson Education, Inc.Slide 5-18 A Standard Model (3) The Welfare Effect of Changes in the Terms of Trade  A rise in the terms of trade increases a country’s welfare, while a decline in the terms of trade reduces its welfare. (General statement). When P C /P F increases, a country exporting cloth becomes better off (reach higher indifference curve). –Refer to the Fig. 5-4. –a higher price for exports means that the country can afford to buy more imports When P C /P F decreases, the country become worse off.

19. Copyright © 2003 Pearson Education, Inc.Slide 5-19  Q1. Is economic growth of other countries good or bad for my country? –It may be good for my country because it means larger markets for our exports. –It may mean increased competition for our exporters.  Q2. Is growth of a country more valuable when the country is part of a closely integrated world economy or not? –It would be more valuable when a country can sell some of its increased production to the world market. –It would be less valuable when the benefits of growth are passed on to foreigners thru lower export price. Application of the Model (1) Economic Growth: A Shift of the RS Curve

20. Copyright © 2003 Pearson Education, Inc.Slide 5-20  Growth and the Production Possibility Frontier Economic growth implies an outward shift of a country’s production possibility frontier (TT). The effects of growth on trade result from that growth typically has a bias.  Biased growth Takes place when TT shifts out more in one direction than in the other Can occur for two reasons: –Technological progress in one sector of the economy –Increase in a country’s supply of a factor of production. Application of the Model (1) Economic Growth: A Shift of the RS Curve (cont’d)

21. Copyright © 2003 Pearson Education, Inc.Slide 5-21 Figure 5-6: Biased Growth TT 1 TT 2 Application of the Model (1) Economic Growth: A Shift of the RS Curve (cont’d) Cloth production, Q C Food production, Q F (a) Growth biased toward cloth Cloth production, Q C Food production, Q F (b) Growth biased toward food

22. Copyright © 2003 Pearson Education, Inc.Slide 5-22  Relative Supply and the Terms of Trade Export-biased growth –Disproportionately expands a country’s production possibilities in the direction of its export good. –Shift the RS curve outward direction. –Worsens the growing country’s terms of trade, to the benefit of the rest of the world Import-biased growth –Disproportionately expands a country’s production possibilities in the direction of the good it imports –Shift the RS curve leftward direction. –Improves the growing country’s terms of trade at the expense of the rest of the word. Application of the Model (1) Economic Growth: A Shift of the RS Curve (cont’d)

23. Copyright © 2003 Pearson Education, Inc.Slide 5-23 Figure 5-7: Growth and Relative Supply Relative price of cloth, P C /P F Relative quantity of cloth, Q C + Q * C Q F + Q * F RS 1 RD 1 (P C /P F ) 1 RS 2 (P C /P F ) 2 2 Relative price of cloth, P C /P F Relative quantity of cloth, Q C + Q * C Q F + Q * F RS 2 RD 2 (P C /P F ) 2 RS 1 (P C /P F ) 1 1 (a) Cloth-biased growth(b) Food-biased growth Application of the Model (1) Economic Growth: A Shift of the RS Curve (cont’d)

24. Copyright © 2003 Pearson Education, Inc.Slide 5-24  International Effects of Growth Export-biased growth in the rest of the world improves our terms of trade, while import-biased growth abroad worsens our terms of trade. –By shifting the world RS curve accordingly. Export-biased growth in our country worsens our terms of trade, reducing the direct benefits of growth with the benefit to the rest of the world. –Import-biased growth leads to an improvement of our terms of trade, at the rest of the world’s expense. Application of the Model (1) Economic Growth: A Shift of the RS Curve (cont’d)

25. Copyright © 2003 Pearson Education, Inc.Slide 5-25 Immiserizing growth –A situation where export-biased growth by poor nations can worsen their terms of trade so much that they would be worse off than no growth at all. –can occur under extreme conditions: Strongly export- biased growth combined with very steep RS, RD curves. –Mere a theoretical point than a real-world issue. Has the growth of NIEs hurt advanced countries? –Some concern on the “threat” in the advanced countries. –depends on the direction of bias in the growth of NIEs, revealed in the change in the terms of trade. –Not supported by data (see the next slide). Application of the Model (1) Economic Growth: A Shift of the RS Curve (cont’d)

26. Copyright © 2003 Pearson Education, Inc.Slide 5-26 Table 5-1: Average Annual Percent Changes in Terms of Trade A Standard Model of a Trading Economy

27. Copyright © 2003 Pearson Education, Inc.Slide 5-27 Application (2) International Transfers of Income : Shifting the RD Curve  International transfers of income, such as war reparations and foreign aid, may affect a country’s terms of trade by shifting the world relative demand curve. <cf: international loan- similar in SR. World relative demand curve may shift because of international transfers of income. <cf: Changes in technology, Changes in tastes  The Transfer Problem How international transfers affect the terms of trade? Again, a controversial issue.

28. Copyright © 2003 Pearson Education, Inc.Slide 5-28  Effects of a Transfer on the Terms of Trade Keynes’s point for German War reparation for WWI –The monetary sum understated the true burden. –To pay the reparation, Germany would have to export more and import less, worsening its terms of trade. When the two countries (donor & recipient) do not allocate their change in spending in the same proportions. –The RD curve will shift and there will be a terms of trade effect. –The direction of effect on terms of trade will depend on the difference in Home and Foreign spending patterns. International Transfers of Income: Shifting the RD Curve

29. Copyright © 2003 Pearson Education, Inc.Slide 5-29 International Transfers of Income: Shifting the RD Curve  Suppose the Home has a higher marginal propensity to spend on cloth (its export) than Foreign. Home’s transfer payment to Foreign reduce demand for cloth (relative to demand for food), shifting the RD curve to the left, worsening Home’s terms of trade.  When both countries allocate their change in spending in the same proportions Ohlin’s point for German War reparation for WWI. The RD curve will not shift, and no terms of trade effect.

30. Copyright © 2003 Pearson Education, Inc.Slide 5-30 Figure 5-8: Effects of a Transfer : When Home (Donor) has higher marginal propensity to spend on cloth (export) than Foreign (Recipient). Relative price of cloth, P C /P F Relative quantity of cloth, Q C + Q * C Q F + Q * F RS RD 2 RD 1 (P C /P F ) 2 2 1 (P C /P F ) 1 International Transfers of Income: Shifting the RD Curve

31. Copyright © 2003 Pearson Education, Inc.Slide 5-31  Presumptions about the Terms of Trade Effects of Transfers A transfer will worsen (improve) the donor’s terms of trade if the donor has a higher (lower) marginal propensity to spend on its export good than the recipient. In practice, most countries spend a much higher share of their income on domestically produced goods (i.e, export goods rather than import goods) than foreigners. –This is not necessarily due to differences in taste but rather to barriers to trade (natural and artificial). –The donor’s terms of trade tend to worsen due to its income transfer to other countries. (Keynes argument is more convincing.) International Transfers of Income: Shifting the RD Curve

32. Copyright © 2003 Pearson Education, Inc.Slide 5-32  Relative Demand and Supply Effects of a Tariff Tariff (taxes levied on imports) or export subsidy (payments to domestic producers that export) influence the terms of trade and therefore national welfare Tariffs drive a wedge between the external (international) prices and internal (domestic) prices. –Tariff make imported goods more expensive inside the country than outside. –Note that the terms of trade correspond to external (international), not internal, prices. Application 3:Tariffs and Export Subsidies- Simultaneous Shifts in RS and RD

33. Copyright © 2003 Pearson Education, Inc.Slide 5-33 Application 3:Tariffs and Export Subsidies- Simultaneous Shifts in RS and RD  Suppose the Home imposes 10% tariff on food import Then, for any given world relative price, The Home consumers, facing lower relative price (P c /P f ) internally, will shift their consumption toward cloth (export) away from food (import). (i.e., RD curve shift right-ward.) The Home producers would face lower relative price (P c /P f ) internally, producing less cloth (export) & more food (import) (lower Q c /Q f ). (i.e., RS curve shift left-ward.) As a result, the new world equilibrium relative price will rise in favor of Home’s export good (cloth).

34. Copyright © 2003 Pearson Education, Inc.Slide 5-34 Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD Figure 5-9: Effects of a Tariff (on food import at Home) on the TOT Relative price of cloth, P C /P F Relative quantity of cloth, Q C + Q * C Q F + Q * F RS 1 RD 1 RD 2 RS 2 (P C /P F ) 1 1 (P C /P F ) 2 2

35. Copyright © 2003 Pearson Education, Inc.Slide 5-35 Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD  That is, imposing import tariffs will improve its terms of trade.  The extent of this effect depend on the size of the economy relative to the rest of the world. A country with small part of the world trade cannot have much effect on the world relative price. A large country with substantial share in the world trade would have strong effect on the world relative price (by imposing import tariff).

36. Copyright © 2003 Pearson Education, Inc.Slide 5-36  Effects of an Export Subsidy Tariffs and export subsidies are often treated as similar policies (for supporting domestic producer), but they have opposite effects on the TOT. –Example: Suppose that Home offers 20% subsidy on the value of cloth exported: –This will lead Home producers to produce more cloth and less food, thereby increasing relative supply for cloth. –This will raise Home’s internal price of cloth relative to food by 20%, thereby reducing relative demand for cloth. –A Home export subsidy worsens Home’s terms of trade and improves Foreign’s. Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD

37. Copyright © 2003 Pearson Education, Inc.Slide 5-37 Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD Figure 5-10: Effects of a Subsidy on the Terms of Trade Relative price of cloth, P C /P F Relative quantity of cloth, Q C + Q * C Q F + Q * F RS 1 RD 1 RD 2 RS 2 (P C /P F ) 1 1 (P C /P F ) 2 2

38. Copyright © 2003 Pearson Education, Inc.Slide 5-38  Implications of Terms of Trade Effects: Who Gains and Who Loses? The International Distribution of Income –If Home (a large country) imposes a tariff, its welfare increases by improving its terms of trade, while Foreign’s welfare decreases (as long as the tariff is not too large). –If Home is a small country, the tariff will not change the terms of trade. –If Home offers an export subsidy, its welfare deteriorates, while Foreign’s welfare increases. Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD

39. Copyright © 2003 Pearson Education, Inc.Slide 5-39 Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD The Distribution of Income Within Countries –A tariff (subsidy) has the direct effect of raising the internal relative price of the imported (exported) good. –Tariff help import competing sector, while export subsidy help export sector. –However, tariffs and export subsidies might have perverse effects on internal prices (Metzler paradox). –A tariff might improve a (large) country’s terms of trade so much that even after tariff is added, the internal relative price of imported goods would fall. –Similar perverse effect may arise for export subsidy. –Possible in theory, but unlikely to happen in reality.

40. Copyright © 2003 Pearson Education, Inc.Slide 5-40 Summary  The standard trade model provides a framework that can be used to address a wide range of international issues and admits previous trade models as special cases.  A country’s terms of trade are determined by the world relative supply and demand curves.  Economic growth is usually biased. Growth that is export-biased (import-biased) worsens (improves) the terms of trade.

41. Copyright © 2003 Pearson Education, Inc.Slide 5-41  International transfers of income may affect a country’s terms of trade, depending if they shift the world relative demand curve.  Import tariffs and export subsidies affect both relative supply and demand.  The terms of trade effects of an export subsidy hurt the exporting country and benefit the rest of the world, while those of a tariff do the reverse. Both trade instruments have strong income distribution effects within countries. Summary