1. The Standard Trade Model
Chapter 5
The Standard Trade Model

2. Introduction
Previous trade theories have emphasized on specific sources of comparative advantage which give rise to international trade:
Differences in labor productivity (Ricardian model)
Differences in resources and income distribution (Heckscher-Ohlin model)
Y=f(x) variables (factors); parameters

3. Different models share some features:
Real problems requiring a mixture of models. (eg. 1990s newly industrializing economies; income distribution within a country)
Different models share some features:
Productive capacity PPF trade;
Production possibilities relative supply;
World relative demand & relative supply World equilibrium.
The standard trade model is a general model of trade that admits these models as special cases.

4. Chapter Organization 1.A Standard Model of a Trading Economy
2.Economic Growth: A Shift of the RS Curve
Case Study: Has the Growth of Newly Industrializing Countries Hurt Advanced Nations?
3.International Transfers of Income: Shifting the RD Curve (foreign aid, war reparations…)
Case Study: The Transfer Problem and the Asian Crisis
4.Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD
5.Summary

5. Learning goals Components of model Welfare change Tariffs & subsidies
supply side - PPF, isovalue line
demand side – indifference curve
pattern of trade
Welfare change
Changes in : TOT, growth (productivity), transfers
Tariffs & subsidies
Trade patterns
Welfares change
Income distribution

6. A Standard Model of a Trading Economy
(1).Production Possibilities and Relative Supply
(2).Relative Prices and Demand
(3).The Welfare Effect of Changes in the Terms of Trade
(4).Determining Relative Prices 6

7. A Standard Model of a Trading Economy
The standard trade model is built on four key relationships:
Production possibility frontier and the relative supply curve
Relative prices and relative demand
World relative supply and world relative demand
Terms of trade and national welfare

8. Production Possibilities and Relative Supply
(1)Production Possibility and Relative Supply
Production Possibilities and Relative Supply
Assumptions of the model:
Each country produces two goods, food (F) and cloth (C)
Each country’s production possibility frontier is a smooth curve (TT)
The point on its production possibility frontier at which an economy actually produces depends on the price of cloth relative to food, PC/PF.

9. The Value of Production
Recall that when the economy maximizes its production possibilities, the value of output V lies on the PPF.
V = PCQC + PF QF describes the value of output in a two good model, and when this value is constant the equation’s line is called isovalue line.
The slope of any equation’s line equals – (PC / PF), and if relative prices change the slope changes. 9

10. Figure 5-1: Relative Prices Determine the Economy’s Output
Cloth production, QC
Food production, QF TT
Isovalue lines Q

11. Figure 5-2: How an Increase in the Relative Price of Cloth Affects
Figure 5-2: How an Increase in the Relative Price of Cloth Affects Relative Supply
Cloth production, QC
Food production, QF
VV1(PC/PF)1 Q1 Q2
VV2(PC/PF)2 TT

12. (2) Relative Price & Demand
The value of an economy's consumption equals the value of its production:
PCQC + PFQF = PCDC + PFDF = V
Production choices are determined by the economy’s PPF and the relative prices of output.

13. What determines consumption choices (demand)?
Consumer preferences are represented by indifference curves: combinations of goods that make consumers equally satisfied (indifferent).
Consumer preferences and prices determine consumption choices.
What determines consumption choices (demand)?
The economy’s choice of a point on the isovalue line depends on the tastes of its consumers, which can be represented graphically by a series of indifference curves. 13

14. Indifference curves
Each traces a set of combinations of cloth (C) and food (F) consumption that leave the individual equally well off
They have three properties:
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

15. Figure 5-3: Production, Consumption, and Trade in the Standard Model
Cloth production, QC
Food production, QF
Indifference curves D
Food
imports TT Q
Cloth exports

16. Figure 5-4 Effects of a Rise in the Relative Price of Cloth
Cloth production, QC
Food production, QF D2
VV2(PC/PF)2 D1
VV1(PC/PF)1 TT Q1 Q2

17. If the relative price of cloth, PC/PF , increases, the economy’s consumption choice shifts from D1 to D2.
The move from D1 to D2 reflects two effects:
Income effect (rise in welfare)
Substitution effect (shifts in consumption)
It is possible that the income effect will be so strong that when PC/PF rises, consumption of both goods actually rises, while the ratio of cloth consumption to food consumption falls.

18. The change in welfare (income) when the price of one good changes relative to the price of another is called the income effect.
The income effect is represented graphically by shifting the indifference curve.
The substitution of one good for another when the price of the good changes relative to the other is called the substitution effect.
This substitution effect is represented graphically by a moving along a given indifference curve.

19. (3) The Welfare Effect of Changes in the Terms of Trade
PC / PF change
Terms of trade
The price of the good a country initially exports divided by the price of the good it initially imports.
A rise in the terms of trade increases a country’s welfare, while a decline in the terms of trade reduces its welfare.

20. Determining Relative Prices
Suppose that the world economy consists of two countries:
Home (which exports cloth)
Its terms of trade are measured by PC/PF
Its quantities of cloth and food produced are QC and QF
Foreign (which exports food)
Its terms of trade are measured by PF/PC
Its quantities of cloth and food produced are Q*C and Q*F

21. To determine PC/PF , one must find the intersection of world relative supply of cloth and world relative demand.
The world relative supply curve (RS) is upward sloping because an increase in PC/PF leads both countries to produce more cloth and less food.
The world relative demand curve (RD) is downward sloping because an increase in PC/PF leads both countries to shift their consumption mix away from cloth toward food.

22. Figure 5-5: World Relative Supply and Demand
Relative price
of cloth, PC/PF
Relative quantity
of cloth, QC + Q*C
QF + Q*F RS RD
(PC/PF)1 1

23. Economic Growth: A Shift of the RS Curve
Is economic growth in other countries good or bad for our nation?
It may be good for our nation because it means larger markets for our exports.
It may mean increased competition for our exporters.
Is growth in a country more or less valuable when that nation is part of a closely integrated world economy?
It should be more valuable when a country can sell some of its increased production to the world market.
It is less valuable when the benefits of growth are passed on to foreigners rather than retained at home.

24. Growth and the Production Possibility Frontier
Economic growth implies an outward shift of a country’s production possibility frontier (TT).
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 (Ricardian model)
Increase in a country’s supply of a factor of production (H-O model)

25. Figure 5-6: Biased Growth
Cloth production, QC
Food
production, QF
(a) Growth biased toward cloth
Cloth production, QC
Food
production, QF
(b) Growth biased toward food
TT2
TT2
TT1
TT1

26. Relative Supply and the Terms of Trade
Figure 5-7 Growth and Relative Supply
Relative price
of cloth, PC/PF
Relative quantity
of cloth, QC + Q*C
QF + Q*F
Relative price
of cloth, PC/PF
Relative quantity
of cloth, QC + Q*C
QF + Q*F
RS1
RS2
RS2
RS1 RD RD 1
(PC/PF)1 2
(PC/PF)2
(PC/PF)2 2
(PC/PF)1 1
(a) Cloth-biased growth
(b) Food-biased growth

27. Export-biased growth Import-biased growth
Disproportionately expands a country’s production possibilities in the direction of the good it exports
Worsens a 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
Improves a growing country’s terms of trade at the rest of the word’s expense

28. 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.
Export-biased growth in our country worsens our terms of trade, reducing the direct benefits of growth, while import-biased growth leads to an improvement of our terms of trade.

29. International Effects of Growth
Develped Countries
Develping Countries
Immiserizing growth 29

30. A Standard Model of a Trading Economy
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 if they had not grown at all
It can occur under extreme conditions: Strongly export-biased growth must be combined with very steep RS and RD curves.
It is regarded by most economists as more a theoretical point than a real-world issue.

31. Case Study
Has the Growth of Newly Industrializing Countries Hurt Advanced Nations?

32. Table 5-1: Average Annual Percent Changes in Terms of Trade
Figure 5-8 The Terms of Trade of Advanced Countries,
115
110
105
100 95 90 85
1970
1975
1980
1985
1990
1995 32

33. International Transfers of Income: Shifting the RD Curve
(1).The Transfer Problem
(2).Effects of Transfer on the Terms of Trade
(3).Presumptions about the Terms of Trade Effects of Transfers 33

34. Relative world demand for goods may shift because of:
Changes in tastes, prices
Changes in technology (eg. , OS)
International transfers of income
International transfers of income (from both individual and government), such as war reparations and foreign aid (loans), may affect a country’s terms of trade by shifting the world relative demand curve.
The Transfer Problem
How international transfers affect the terms of trade?

35. (1).The Transfer Problem
Debates:
Keynes
price adjustment for more ex & less im
reparation payments worsen Germany’s terms of trade
Ohlin
taxes increase or demand for im decrease automatically
reparation payments would not worsen Germany’s terms of trade 35

36. Effects of a Transfer on the Terms of Trade
Spent changes
When both countries allocate their change in spending in the same proportions (Ohlin’s point):
The RD curve will not shift, and there will be no terms of trade effect.
When the two countries do not allocate their change in spending in the same proportions (Keynes’s point):
The RD curve will shift and there will be a terms of trade effect.
The direction of the effect on terms of trade will depend on the difference in Home and Foreign spending patterns.

37. International Transfers of Income: Shifting the RD Curve
Figure 5-8: Effects of a Transfer on the Terms of Trade
Relative price
of cloth, PC/PF
Relative quantity
of cloth, QC + Q*C
QF + Q*F
Foreign: recipient
Home: donor
Home has a higher marginal propensity to spend on cloth RS
RD1
RD2 1
(PC/PF)1
(PC/PF)2 2

38. Are there other possibilities?
Generally, a transfer worsens the donor’s terms of trade if the donor has a higher marginal propensity to spend on its export good than the recipient. And vice versa.
Does it coincide with the reality?

39. Presumptions about the Terms of Trade Effects of Transfers
A transfer will worsen the donor’s terms of trade if the donor has a higher 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 than foreigners do.
eg. US: 11%-im, 89%-domestical
This is not necessarily due to differences in taste but rather to nontradable goods, barriers to trade, natural and artificial.

40. Ohlin was right in principle, Keynes was right in practice.
A transfer by the United States to other countries may lower the price of U.S. exports relative to foreign, worsening U.S. terms of trade, just as Keynes argued.
Most likely, an international transfer of income worsens the donor’s terms of trade.
Ohlin was right in principle, Keynes was right in practice. 40

41. Case Study: The Transfer Problem and the Asian Crisis
Asian crisis in 1997 is a classic illustration of the “excess burden” Keynes warned about 80 years ago. 41

42. Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD
(1).Relative Demand and Supply Effects of a Tariff
(2).Effects of an Export Subsidy
(3).Implications of Terms of Trade Effects: Who Gains and Who Loses? 42

43. Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD
Import tariffs and export subsidies affect both relative supply and relative demand.
(1) Import tariffs are taxes levied on imports
Tariffs can be classified as:
Specific tariffs
Taxes that are levied as a fixed charge for each unit of goods imported
Example: A specific tariff of $10 on each imported bicycle with an international price of $100 means that customs officials collect the fixed sum of $10.
Ad valorem tariffs
Taxes that are levied as a fraction of the value of the imported goods
Example: A 20% ad valorem tariff on bicycles generates a $20 payment on each $100 imported bicycle.

44. Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD
Import tariffs and export subsidies affect both relative supply and relative demand.
(2) Export subsidies are payments given to domestic producers that export
(3) Both policies influence the terms of trade and therefore national welfare

45. Relative Demand and Supply Effects of a Tariff
Tariffs drive a wedge between the prices at which goods are traded internationally (external prices) and the prices at which they are traded within a country (internal prices).
Tariffs: P(im) increases at home
Subsidies: P(ex) increases at home 45

46. Figure 5-9: Effects of a Tariff on the Terms of Trade
Relative price
of cloth, PC/PF
Relative quantity
of cloth, QC + Q*C
QF + Q*F
RS2
Home: 20% tariffs
RS1
RD2
(PC/PF)2 2
Country size matters
RD1
(PC/PF)1 1

47. Effects of an Import Tariff
A Home Import Tariff improves Home’s terms of trade and worsens the Foreign’s.
Effects of an Export Subsidy
Tariffs and export subsidies are often treated as similar policies but they have opposite effects on the terms of trade.
Example: Suppose that Home offers 20% subsidy on the value of cloth exported:
This will raise Home’s internal price of cloth relative to food by 20%.
Qc increases, Qf decreases; Dc decreases, Df increases
A Home export subsidy worsens Home’s terms of trade and improves Foreign’s.

48. Figure 5-10: Effects of a Subsidy on the Terms of Trade
Relative price
of cloth, PC/PF
Relative quantity
of cloth, QC + Q*C
QF + Q*F
RS1
RS2
RD1
(PC/PF)1 1
(PC/PF)2 2
RD2

49. Implications of Terms of Trade Effects: Who Gains and Who Loses?
The International Distribution of Income
Tariffs
TOT improvement vs. production & consumption incentive distortions
its welfare increases as long as the tariff is not too large, while Foreign’s welfare decreases.
Subsidy
TOT deteriorates & distorting policy effect
its welfare deteriorates, while Foreign’s welfare increases

50. Are the U.S. Commerce Department’s attitudes wrong?
Are Home tariffs always beneficial & export subsidy always a bad thing for it?
Politics in trade.
Are Foreign tariffs always bad for a country & foreign subsidy always benifical?
Multi-country world.
Subsidies to exports of things Home imports help us, while tariffs against Home’s exports hurt us.
Are the U.S. Commerce Department’s attitudes wrong?

51. The Distribution of Income Within Countries
Tariffs and export subsidies might have perverse effects on internal prices (Metzler paradox).
A tariff (subsidy) has the direct effect of raising the internal relative price of the imported (exported) good.
Indirect effect on TOT
Tariff - TOT improvement ; Subsidies – TOT deteriation
Policy makers cares about internal prices more.
Tariff – help import-competing industries
Subsidy – help export industries

52. 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 intersection of 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.

53. Summary
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.