Chapter 2
Basic Theory of International Trade
Demand and Supply, Offer Curves,
and the Terms of Trade
Chapter 4
Salvatore: International Economics, 10th Edition © 2 0 13 Jolm Wiley & Son s, Inc.
Dominick Salvatore
John Wiley & Sons, Inc.
Learning Goals:
• Show how the equilibrium price at which
trade takes place is determined.
• Show how the equilibrium price at which
trade takes place is determined with offer
curves.
• Explain the meaning of the terms of trade and
how they have changed over time for the
United States.
Salvatore: International Economics, 11thEdition © 2 0 13 Jolm Wiley & Sons, Inc.
Introduction
• Relative commodity price differences
between two nations in isolation reflect
comparative advantage, and forms basis for
mutually beneficial trade.
• Can use partial and general equilibrium
analysis to determine equilibrium-relative
commodity price at which trade will take
place.
Salvatore: International Economics, 11th Edition © 2 0 13 Jolm Wiley & Son s, Inc.
Panel A
Px!Py
Nation 1's Market
for Commodity X
PanelS
International Trade
in Commodity X
- - - - - - - - - -A" - - - - - - - - - s
Exports
- A._- - .
v
Imports
0
Dx
A*
0
--
------ --- X
0
--------------- X
0
--------------- X
FIGURE 4-1 The Equilibrium-Relative Commodity Price with Trade
with Partial Equilibrium Analysis.
Salvatore: International Economics, 11th Edition © 2 0 13 Jolm Wiley & Son s, Inc.
The Equilibrium-Relative Commodity Price
with Trade-Partial Equilibrium Analysis
• Figure 4-1:
• At a relative price greater than P11 Nation l ' s excess
supply of X (Panel A) gives rise to Nation 1 's
international supply curve of X (S in Panel B).
• At a relative price lower than P3 , Nation 2's excess
demand for X (Panel C) gives rise to Nation 2's
demand for imports of X (D in Panel B).
• Only at P2 (Panel B) does quantity of imports
demanded equal quantity of exports supplied .
• Thus, P 2 is equilibrium-relative commodity price
with trade.
Salvatore: International Economics, 11th Edition © 2 0 13 Jolm Wiley & Son s, Inc.
Offer Curves
• Offer curves (sometim es called reciprocal demand
curves) introduced to international economics by
M arshall and Edgeworth.
• Show how much of its import commodity a nation
demands for it to be willing to supply various
amounts of its export commodity.
• Can be derived from production possibilities
frontier, indifference map and various
hypothetical relative commodity prices at which
trade could take place.
Salvatore: International Economics, 11th Edition © 2 0 13 Jolm Wiley & Son s, Inc.
y
y
Nation 1
Ill
100
"
Offer curve of
Nation 1
80
P8
60
45
40
G
1
20
PF= 2
c
20
P =1
8
---L-- ---- ---- -------L -- X
0
10
30
50
t
70
95
130
0
20
40
60
55
FIGURE 4-3 Derivation of the Offer Curve of Nation 1.
Salvatore: International Economics, 11th Edition © 2 0 13 Jolm Wiley & Son s, Inc.
=1
y
140
Nation2
120
y
PA•=4
85
P8 ·= 1
60
60
C'
45
40
Ill'
G'
offercurve
40
A'
20
PF•=2
0
20
40
65 80
100
20
40
60
FIGURE 4-4 Derivation of the Offer Curve of Nation 2.
Sah·atore: International Economics, lith Edition 2 0 13 Jolm \Vtley & Sons, Inc.
X
The Equilibrium-Relative Commodity Price
with Trade-General Equilibrium Analysis
• Equilibrium-relative commodity price with trade
found at intersection of offer curves for two
nations.
• Only at this equilibrium price will trade be
balanced.
• At any other relative commodity price, quantities
of imports do not equal quantities of exports,
placing pressure on relative commodity price to
move toward equilibrium.
Salvatore: International Economics, 11thEdition © 2 0 13 Jolm Wiley & Sons, Inc.
y
Nation 1
60
P8 =P8 ·= 1
Nation 2
G'
E
50
40
C'
30
1
PF= 2
20
1
PA=4
10
0
10
20
30
40
50
60
FIGURE 4-5 Equilibrium-Relative Commodity Price with Trade.
Salvatore: International Economics, 11thEdition © 2 0 13 Jolm Wiley & Sons, Inc.
Relationship between General and Partial
Equilibrium Analyses
• Both partial equilibrium and general equilibrium
analysis use production frontiers and
indifference maps to find equilibrium trade price.
• Only general equilibrium analysis considers all
markets together, not just the market for
commodity X.
• Changes in the market for X affect other markets,
which possibly impact the market for X.
• General equilibrium analysis is therefore
required for more complete analysis.
Salvatore: International Economics, 11thEdition © 2 0 13 Jolm Wiley & Sons, Inc.
Px!Py
s
1
H'
.!.
2
D
Excess demand
A
1
4
0
20
40
60
80
100
120
Exports of commodity X
FIGURE 4-6 Equilibrium-Relative Commodity Price with Partial
Equilibrium Analysis.
Salvatore: International Economics, 11thEdition © 2 0 13 Jolm Wiley & Sons, Inc.
The Terms of Trade
• Terms of trade= the ratio of the price of a
nation's export commodity to the price of its
import commodity.
• In a two-nation world, the terms of trade of Nation 1
are equal to the reciprocal of the terms of trade of
Nation 2.
• In a w orld of many traded goods, the terms of trade is
the ratio of the export price index to the import price
index, also called commodity or net barter terms of
trade.
• If Nation 1 exports X and imports Y, its terms of trade are
given by P.x/Py, where P = p r ice index.
Salvatore: International Economics, 11thEdition © 2 0 13 Jolm Wiley & Sons, Inc.
Case Study 4-1 Demand, Supply, and the
International Price of Petroleum
Nominal and Real Petroleum Prices. Selected Years. 1972-2011
Year
1972
1973
1974
1978
1979
Petroleum Prices (S/barrel)
2.89
3.24
11.60
13.39
30.21
36.68
27.37
Real Petroleum Prices ($/barrel)
2.89
3.00
9.51
7.70
15.82
17.14
9.34
Year
1986
1990
1998
2000
2005
2008
2011
Petroleum Prices (S/barrel)
14.17
22.99
13.07
28.13
53.40
97.03
140.00
Real Petroleum Prices ($/barrel)
4.69
6.51
2.90
5.73
8.99
14.83
15.80
1980
1985
Sourr:e: Baborated from data in International Monetary Ftmd, Jntet11ll!ional Financial Statistics (Washington, D.C.: IMF.
variousissues).
Salvatore: International Economics, 11thEdition © 2 0 13 Jolm Wiley & Sons, Inc.
Case Study 4-2 The Index of Export to Import
Prices for the United States
130
126
"' 122
8. 118
t :
X
w 114
(f)
---------- --------------
:::) 110
0
·;::;
>
-----------------
106
102
- - - - - -
98
------
a: 94
- - - -
- 4------------------------------
- - - - - - - - - -
-+
90
86
1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 19982000 2002 2004 2006 2008 2010 2012
Years
Figure 4.2 Index of Relative U.S. Export Prices, 1972-2011
(2000=100)
Salvatore: International Economics, 11thEdition © 2 0 13 Jolm Wiley & Sons, Inc.
Case Study 4-3 The Terms of Trade of the G-7
Countries
The Terms of Trade of the G-7 Countries. Selected Years. 1972-2011 (Export Unit
Value ...;- Import Unit Value: 2000 = 100)
197
2
197
4
198
0
1985 199
0
199
5
200
0
2005
United States
127
107
90
103
101
103
100
Canada
Japan
Germany
96
109
118
107
101
109
81
105
82
107
59
98
103
94
97
66
84
94
102
110
101
100
97
115
108
100
107
100
100
100
100
100
United Kingdom
France
Italy
Source:
Elaborated from
data in
106
201
0
201
1
97
97
95
117
120
122
83
68
60
99
19722011
-29
24
-58
-18
-4
103
103 103
100' 100
89
90
111
-r
89
'
80
99
I n t e r n78
a t i o n al78
Monetary
lnremational
(Washington,
D.C.:
94 Fund,96
100 Finandal
101 Statistics
96
-10
IMF,
various
refers toissues).
2008
.
Salvatore: International Economics, 11thEdition © 2 0 13 Jolm Wiley & Sons, Inc.
105
105
X
Change
Case Study 4-4 The Terms of Advanced and
Developing Countries
• TABLE4.3. The Terms of Trade of Advanced and Developing Countries. Selected Years.
1972- 2010 (Export Unit Value -;- Import Unit Value: 2000 = 100)
1972
1974
Industrial countries
110
97
Developing countries
Africa
Asia
Europe
Middle East
61
85
101
112
94
1980
1985
1990
1995
2000
2005
201
0
89
87
100
105
100
101
98
86
107
102
103
107
106
100
100
100
100
100
102
117
103
100
103
69
109
99
118
101
101
75
101
115
101
69
90
98
64
80
68
108
92
102
140
·refers to 2007
Western Hemisphere
39
110
194
189
130
107
100
104
Source: Internat ional Monetary Fund, lntemariona l Flnandal Statistics (Washington, D.C.: IMF, various issues).
Salvatore: International Economics, 11thEdition © 2 0 13 Jolm Wiley & Sons, Inc.
104
95
167
'
92
Open Economies
• Definitions: One that interacts with other
economies in the world
• Conduct trade with other countries
• Exist through international trade agreements
and economic and political union
Closed Economies
• Definitions: One that does not interact with other
economies in the world
• Self-sufficient, no imports are brought in, and no
exports are sent out
• 100% depends on local products and services
Examples of Closed Economy
• Brazil – unusually closed economy
• 27.6% of trade (among lowest figure)
• No. of exporter firms very low
• North Korea
– most goods supplied to China (coals)
• Financial very limited due to repressive economic system
• Squeeze money out of its citizen  send abroad
Gains from Trade
• Allow country to consume beyond its abilities to
produce
• Bring gain to some but also hurt other groups
Export price high= home country gain, vice versa
Import price low= home country gain, vice versa
Effects of free trade
in the short run
In the Malaysia
In the rest of the world
Landowners
Laborers
Landowners
Laborer
Export
In wheat
Gain
Gain
Lose
Lose
Import
In cloth
Lose
Lose
Gain
Gain
How trade affects income in
the long run?
• Examples in Malaysia vs The Rest of the World;
1.
2.
3.
4.
5.
6.
Initial prices
Prices respond to trade
Production responds to prices
National factor markets change
National factor prices respond
Long run results