1. Slides prepared by Thomas Bishop Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Topic 3 The Standard Trade Model

2. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-2 Preview Measuring the values of production and consumption Welfare and terms of trade Effects of economic growth Effects of international transfers of income Effects of import tariffs and export subsidies Income distribution

3. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-3 Introduction Standard trade model combines ideas from the Ricardian and H-O models. 1.Differences in L services, L skills, K, T, and technology between countries cause productive differences, leading to gains from trade. 2.These productive differences are represented as differences in PPFs. 3.A country’s PPF determines its RS curve. 4.World equilibrium is determined by the intersection of RD and RS which occurs somewhere between national RS curves.

4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-4 The Value of Production When the economy maximizes its production possibilities, the value of output V lies on the PPF. V = P C Q C + P F Q F describes the value of output at market prices,  and when this value is constant the equation’s line is called an isovalue line.  Slope of the isovalue line equals – (P C /P F ), and if ∆(P C /P F ) → ∆slope.

5. Fig. 1: Relative Prices Determine Output As we move farther from the origin, the value of output is increasing. Optimally, the economy produces the highest level of output it can where the PPF is tangent to the isovalue line. 0

6. Fig. 2: How an Increase in the Price of Cloth Affects Output If ↑(P C /P F ) → the isovalue line becomes steeper. As ↑(P C /P F ) → the economy produces more cloth and less food.

7. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-7 The Value of Consumption The value of the economy’s consumption must equal the value of its production.  P C D C + P F D F = P C Q C + P F Q F = V Production and consumption points must lie on the same isovalue line. What determines consumption choices (demand)?

8. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-8 The Value of Consumption (cont.) Consumer tastes and prices determine consumption choices. Consumer preferences are represented by indifference curves: combinations of goods that make consumers equally satisfied (indifferent).  Each consumer has her own preferences, but we assume that we can represent the tastes of an average consumer that represents all consumers. This implies all tastes are identical, as are incomes.

9. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-9 Three Properties of Indifference Curves 1.Indifference curves are downward sloping to represent the fact that if an average consumer has less cloth, she could have more food and still be equally satisfied. 2.Indifference curves farther from the origin represent larger quantities of food and cloth, which should make consumers more satisfied. 3.Indifference curves are flatter when moving to the right to represent the fact that as more cloth and less food is consumed, an extra yard of cloth becomes less valuable.

10. Fig. 3: Production, Consumption, and Trade in the Standard Model Economy produces at pt Q where isovalue line is tangent to the PPF. Economy consumes at pt D where the same isovalue line is tangent to the highest possible indifference curve.

11. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-11 Prices and the Value of Consumption Prices also determine the value of consumption.  When ↑(P C /P F ), the economy is better off when it exports cloth: the isovalue line becomes steeper and a higher indifference curve can be reached.  A higher price for cloth exports means that more food can be imported.  ↑(P C /P F ) makes consumers willing to buy less cloth and more food.

12. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-12 Prices and the Value of Consumption (cont.) The ∆welfare when the P of one good changes relative to the P of another is called the income effect.  The income effect is represented by moving to another indifference curve. The substitution of one good for another when the P of the good changes relative to the other is called the substitution effect.  The substitution effect is represented by moving along a given indifference curve.

13. Fig. 4: Effects of a Rise in the Relative Price of Cloth QCQC QFQF 0 r D1D1 D2D2 I1I1 I2I2 P1P1 P2P2 Q1Q1 Q2Q2 X1X1 X2X2 M1M1 M2M2 Or shows proportionate ↑D C and ↑D F. Points to the left of Or (like D 2 ) represent proportionately greater ↑D F relative to ↑D C. When ↑P C /P F → ↑Q C and ↓Q F and ↑welfare as ↑P X so M F are cheaper. There is an ↑D for both goods but relatively more for food for a given level of utility (I 2 ) because ↑P C /P F. Income effect: D 1 to D' 1. Substitution effect: D' 1 to D 2. D'1D'1

14. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-14 Welfare and the Terms of Trade The terms of trade refers to P X /P M.  When a country exports cloth and ↑P C /P F, the tot have “improved.” Because ↑P X means the country can afford to buy more imports, an ↑tot → ↑ a country’s welfare. A ↓tot → ↓ a country’s welfare.

15. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-15 Determining Relative Prices P C /P F is determined by RS and RD.  RS is world supply of cloth relative to that of food at each relative price.  RD is world demand of cloth relative to that of food at each relative price.  With 2 countries, world quantities are the sum of quantities from the home and foreign countries.

16. Fig. 5: World Relative Supply and Demand RS has a positive slope because ↑P C → both countries to ↑Q C and ↓Q F. RD has a negative slope because ↑P C → both countries to ↓D C and ↑D F.

17. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-17 The Effects of Economic Growth Is economic growth in China good for the standard of living in the U.S.? Is growth in a country more or less valuable when it when it is closely integrated in the world economy? The standard trade model gives us precise answers to these questions.

18. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-18 The Effects of Economic Growth (cont.) Common sense: Growth in NIE may be good for U.S. because this expands our potential export market. However, it may also mean that NIE will begin to compete with our exporters.  As ↑K* and ↑education* → NIE may begin producing computers and software. Growth at home is also controversial: growth means we can produce more goods and sell them abroad. Yet, benefits of growth may be passed onto foreigners if ↑supply of U.S. goods → ↓P X.

19. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-19 The Effects of Economic Growth (cont.) Growth is usually biased: it occurs in one sector more than others, causing ∆RS.  E.g., Rapid growth has occurred in U.S. computer industries but relatively little growth has occurred in U.S. textile industries.  Ricardian model: technological progress in one sector causes biased growth.  H-O model: ↑S of 1 factor of production (e.g., ↑K) causes biased growth in the sector that uses K intensively.

20. Fig. 6: Biased Growth

21. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-21 The Effects of Economic Growth (cont.) Biased growth and the resulting ∆RS causes a ∆tot.  Biased growth in the cloth industry (in either home or foreign) will ↓P C /P F and ↓tot for cloth exporters.  Biased growth in the food industry (in either home or foreign) will ↑P C /P F and ↑tot for cloth exporters.  Assume that home exports cloth and imports food.

22. Fig. 7a: Growth and Relative Supply If either country experiences growth biased toward cloth → RS shifts out on world markets → ↓tot and ↑tot*.

23. Fig. 7b: Growth and Relative Supply If either country experiences growth biased toward food → RS curve shifts in on world markets → ↑tot and ↓tot*.

24. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-24 The Effects of Economic Growth (cont.) Export-biased growth is growth that expands a country’s PPF disproportionately toward that country’s export sector.  Biased growth in the food industry in foreign is export-biased growth for foreign. Import-biased growth is growth that expands a country’s PPF disproportionately toward that country’s import sector.  Biased growth in the cloth industry in foreign is import-biased growth for foreign.

25. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-25 The Effects of Economic Growth (cont.) Export-biased growth tends to worsen a growing country’s tot to the benefit of foreign countries. Import-biased growth tends to improve a growing country’s tot at the expense of foreign countries.

26. Fig. 8a: Export-biased Growth QYQY QXQX Q0Q0 Q1Q1 Q2Q2 D0D0 D2D2 D1D1 I0I0 I1I1 I2I2 r 0 P0P0 P2P2 P 0,1 Overall, welfare is depressed by ↓tot (I 2 I 0. See handout on “Growth and Welfare” for further explanation.

27. Fig. 8b: Import-biased Growth QYQY QXQX Q0Q0 Q1Q1 Q2Q2 D0D0 D2D2 D1D1 I0I0 I1I1 I2I2 r 0 P0P0 P2P2 P 0,1 Overall, welfare increased because of the ↑prod capacity (I 1 > I 0 ) and the ↑tot (I 2 > I 1 ). See handout on “Growth and Welfare” for further explanation.

28. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-28 Has Growth in Asia Reduced the Welfare of High Income Countries? Standard trade model predicts that import biased growth in China ↓tot in U.S. and ↓our standard of living.  Import biased growth for China would occur in sectors that compete with U.S. exports. But this prediction is not supported by data: should see ↓tot for U.S. and other high income countries.  In fact, ↑tot for high income countries and ↓tot* for developing Asian countries.

29. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-29 Table 1: Average Annual Percent Changes in Terms of Trade NIE have experienced export-biased growth which has ↓tot*. E.g., China’s export volume grew by 14% per year from 1992 to 2002. Thus, China’s ↓tot by 13% which shaved 3% off of China’s growth in real income. China’s exports of L-intensive manufactured goods ↑tot in U.S., but ↓tot in Mexico (because they export similar products). Between 1998 and 2003, Chinese-manufactured X to U.S. grew by 15.2% per year which was 2.5X as fast as Mexico’s exports.

30. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-30 The Effects of International Transfers of Income Transfers of income sometimes occur from one country to another.  War reparations or foreign aid may influence demand of traded goods and therefore RD.  International loans may also influence RD in SR, before the loan is paid back. How do transfers of income across countries affect RD and tot?

31. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-31 The Effects of International Transfers of Income (cont.) Income (Y) transferred from home to foreign → ↓Y and ↑Y*, which may shift RD curve.  Note: RS does not shift as long as only money is transferred. If ↑Y* → proportionate ↑D* C and ↑D* F is matched by ↓Y → ↓D C and ↓D F → RD does not shift and tot are unaffected! However, if spending patterns differ between the 2 countries → RD shifts and ∆tot.

32. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-32 The Effects of International Transfers of Income (cont.) If home has a higher marginal propensity to spend on cloth than foreign does → at fixed P C /P F, ↓Y → ↓RD for cloth.  In this case (Fig. 9), an income transfer from home causes ↓tot and ↑tot*. Alternatively, if home has a lower marginal propensity to spend on cloth than foreign does → transfer of income to foreign → ↑RD for cloth → ↑tot and ↓tot*.  In this case, RD curve would shift outward.

33. Fig. 9: One Possible Effect of a Transfer on the Terms of Trade The RD curve will only shift inward when home transfers income to foreign, if home has a higher marginal propensity to spend on cloth than foreign does.

34. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-34 The Effects of International Transfers of Income (cont.) Rule: a transfer worsens the donor’s tot if the donor has a higher marginal propensity to spend on its export good than the recipient. In reality: when examining countries’ spending patterns, each has a preference for its own goods.  E.g., In U.S., imports are only 15% of national income. So we spend 85% of our income on domestically produced goods.  ROW spends 9% of its income on U.S. goods.

35. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-35 The Effects of International Transfers of Income (cont.) Data suggests that if U.S. transferred income to ROW → ↓RD for U.S. goods → ↓tot. We spend income at home because of natural and artificial barriers to trade.  Non-traded goods ensure that the majority of our income is spent on domestic goods (e.g., housing, education, and medical services).

36. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-36 The Effects of International Transfers of Income (cont.) Non-traded and export sectors compete for resources. If U.S. transfers income abroad → ↓D for non- traded goods → releases factors to work in export sector → ↑X → ↓tot.  Recipient’s ↑income → ↑D for non-traded goods → factors move from export to the non-traded goods sector → ↓X* and ↑tot*.

37. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-37 The Effects of International Transfers of Income (cont.) In 1998, several Asian countries were in crisis as investor confidence collapsed in 1997. Countries like South Korea and Thailand saw a sudden reversal of international K flows. Foreign banks that had been lending heavily to these countries, now stopped lending and demanded that the existing loans be repaid. These countries quickly went from receiving large transfers to making large transfers! As predicted, these countries experienced ↓tot which exacerbated the financial crisis.

38. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-38 Import Tariffs and Export Subsidies Import tariffs are taxes levied on imports. Export subsidies are payments given to domestic producers that export. Both policies influence tot and therefore national welfare.

39. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-39 Import Tariffs and Export Subsidies (cont.) Import tariffs and export subsidies drive a wedge between prices in world markets (or external prices) and prices in domestic markets (or internal prices).  Since exports and imports are traded in world markets, tot measures relative external prices.

40. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-40 Import Tariffs If home imposes a tariff on food imports → ↓P C /P F internally.  Home producers: face a lower P C /P F, so they will produce more food and less cloth: RS of cloth shifts in.  Home consumers: face a lower P C /P F, so they will consume more cloth and less food: RD of cloth shifts out.

41. Fig. 10: Effects of a Tariff on the Terms of Trade Note: this graph reflects the world market and world prices. Tot refer to external prices.

42. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-42 Import Tariffs (cont.) When home imposes an import tariff, ↑tot and home’s welfare may increase. The magnitude of this effect depends on the size of the home country relative to the world economy.  If the country is small, its tariff (or subsidy) policies will not have much effect on world RS and RD, and thus on tot.  But for large countries, a tariff rate that maximizes national welfare at the expense of foreign countries may exist.

43. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-43 Export Subsidies If home imposes a subsidy on cloth exports, ↑P C /P F internally.  Domestic producers: face a higher P C /P F when they export, so they produce more cloth and less food: RS of cloth shifts out.  Domestic consumers: face a higher P C /P F, so they consume more food and less cloth: RD of cloth shifts in.

44. Fig. 11: Effects of an Export Subsidy on the Terms of Trade This graph refers to world markets and world prices. Tot will fall if the country is large enough to impact world markets.

45. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-45 Income Distribution Two dimensions: 1.Distribution of income between countries (i.e., international distribution of income) 2.Distribution of income within countries

46. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-46 Import Tariffs and International Distribution of Income Home imposes a tariff → ↑tot and ↓tot* but impact on home’s welfare is not so clear cut.  ↑tot benefits home, but ↑P M → distorts production decisions: encourages home’s producers to use scarce resources to produce a good that home does not have a comparative advantage in.  ↑P M distorts consumer decisions and hurts consumers through a reduction in their purchasing power.

47. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-47 Import Tariffs and International Distribution of Income (cont.) Welfare rises with ↑tot as long as the tariff is not too large and does not substantially distort production and consumption decisions. Later, we will study an optimum tariff for large countries. For a small country, optimum tariff is zero: cannot impact its tot and only distorts producer and consumer decisions.

48. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-48 Export Subsidies and International Distribution of Income Home imposes an export subsidy → ↓tot and ↑tot*. Policy also distorts production and consumption decisions. So home’s ↓welfare. Difficult to justify any export subsidy under any circumstances.

49. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-49 International Distribution of Income with Multiple Countries and Goods Are foreign export subsidies good for U.S.? Yes –in a simple 2 country and 2 good model. But in reality, subsidies to exports of goods the U.S. exports is harmful.  E.g., EU subsidies of agricultural exports hurt U.S. farmers by reducing prices they receive on world markets (i.e., ↓tot).  Alternatively, subsidies to exports of goods the U.S. imports is beneficial!

50. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-50 International Distribution of Income with Multiple Countries and Goods (cont.) Are foreign import tariffs bad for U.S.? Yes –in a simple 2 country and 2 good model. But in reality, foreign tariffs on goods U.S. imports are beneficial.  Why? Foreign tariff lowers world demand for goods we import which raises our tot. Thus, in reality: subsidies to exports of goods U.S. imports is beneficial, while tariffs against U.S. exports is harmful.

51. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-51 Distribution of Income Within Countries View that subsidies of foreign exports of goods that the U.S. imports is beneficial, is not held by G officials.  E.g., When a Commerce Dept. study found EU was subsidizing steel exports to U.S., our G ordered EU to raise its P of steel.  Why? Subsidies of EU exports of steel to the U.S. have an impact on our income distribution. U.S. consumers gain from cheaper steel; as do U.S. exporters who use steel as a factor of production (e.g., Caterpillar and Ford). But, U.S. steel workers and company owners lose!

52. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-52 Distribution of Income Within Countries (cont.) Foreign tariffs and subsidies ∆relative goods prices → ∆factor rewards because of factor immobility and differences in the factor intensity of different industries. In general, a tariff helps the import-competing sector at home while hurting the export sector. 1.Pulls resources out of the export sector. 2.↑P of resources (like steel) that the export sector uses as an input. This ↑costs and ↑P X making our producers less competitive on world markets.  An export subsidy helps the export sector and harms the import-competing sector.