The Standard Trade Model
The text compares different models of international trade within the standard trade
theory framework. Here's a breakdown of the key points:
Trade Models and Their Focus:

The passage highlights three main models used to understand international
trade:
o
Ricardian Model: Focuses on comparative advantage arising from
differences in labor allocation between sectors (e.g., agriculture vs.
manufacturing). This model doesn't explore income distribution within a
country.
o
Specific Factors Model: Introduces multiple factors of production (like
land, labor, capital). Some factors are specific to certain industries (e.g.,
skilled labor for a particular good). This model helps analyze short-term
impacts of trade on income distribution within a country.
o
Heckscher-Ohlin Model: Allows factors of production to move between
sectors within a country. Trade patterns are driven by differences in
resource endowments (availability of factors like labor and capital). This
model explores long-term effects of trade on income distribution.
Choosing the Right Model:

The appropriate model depends on the specific situation being analyzed.

For instance, rapid productivity growth in newly industrialized economies might
be better understood using the Ricardian model's focus on comparative
advantage.

The impact of trade on income distribution within a developed country like the US
might be analyzed using the specific factors model (short-term) or the
Heckscher-Ohlin model (long-term).
Commonalities in Models:

Despite their differences, all these models share some key features:
o
Production Possibility Frontier (PPF): This curve represents the
different combinations of goods a country can produce with its limited
resources. Differences in PPFs between countries create opportunities for
trade.
o
Relative Supply: A country's PPF determines its relative supply schedule,
indicating how much of one good it's willing to export in exchange for
another good.
o
World Equilibrium: Trade establishes a world equilibrium price for goods
based on the aggregate relative demand (from all countries) and the
combined relative supply (from all countries' production possibilities). This
world relative supply curve falls between the individual relative supply
curves of each country.
Standard Trade Model - A Unifying Framework:

The passage proposes a "standard trade model" that encompasses the previous
models as special cases.

This standard model focuses on analyzing how changes in underlying factors
(economic growth, trade policies) affect the global trading system, with less
emphasis on the specific details of individual economies' production structures.
Benefits of the Standard Trade Model:

This broader model allows for studying various international economic issues
without getting bogged down in the specifics of each country's internal supply
mechanisms.

It can be used to analyze the effects of changes like:
o
Economic growth leading to shifts in world supply.
o
Trade policies like tariffs and subsidies influencing both supply and
demand.
In essence, the standard trade model provides a more general framework in
international economics, leveraging insights from previous models while focusing on the
broader impact of various factors on the global trading system.
A Standard Model of a Trading
Economy
Four key relationships form the foundation of the standard trade model in international
economics. Let's break down each relationship:
1. The Relationship between Production Possibility Frontier (PPF) and
Relative Supply Curve:

The PPF represents the limits of what a country can produce given its resources
and technology.

The relative supply curve shows how much of one good a country is willing to
export (give up) in exchange for another good, based on its PPF.

Essentially, the PPF dictates the country's production possibilities, while the
relative supply curve translates those possibilities into trading behavior.
2. The Relationship between Relative Prices and Relative Demand:

Relative prices refer to the price of one good compared to the price of another
good.

Relative demand describes how much of each good consumers are willing to
buy at different relative prices.

As the relative price of a good decreases, consumers tend to demand more of it
(assuming no change in income).
3. The determination of World Equilibrium by Relative Supply and Relative
Demand:

World equilibrium in trade occurs when the world relative supply of goods
matches the world relative demand for those goods.

World relative supply is a combination of individual countries' relative supply
curves.

When supply and demand for both goods balance at a global level, trade is
considered to be in equilibrium.
4. The effects of Terms of Trade on National Welfare:

Terms of trade is a concept that measures the relative price of a country's
exports compared to its imports.

A higher term of trade indicates that a country receives more imports for each
unit of its exports. This is generally considered beneficial for the country.

The standard trade model suggests that the terms of trade can impact a nation's
welfare (economic well-being). Generally, a higher term of trade is associated
with improved welfare.
These four relationships are interconnected and form the core of the standard trade
model. They help us understand how countries make production and trade decisions,
how global trade reaches equilibrium, and how factors like relative prices and terms of
trade influence a nation's economic well-being.
Production Possibilities and Relative Supply
This passage introduces the concept of production possibilities and relative supply in
the context of the standard trade model. Here's a breakdown of the key points:
Assumptions:

Two Goods: The model assumes each country produces two goods, typically
represented by food (F) and cloth (C).

Production Possibility Frontier (PPF): Each country's production capabilities
are represented by a Production Possibility Frontier (PPF) like the curve TT in
Figure 6-1. This curve shows the different combinations of cloth and food a
country can produce with its limited resources.
Production Choices:

The point on the PPF where a country actually produces depends on the relative
price of cloth compared to food (PC/PF).

In a market economy, producers aim to maximize the total value of their output
(production). This value is calculated as:
PC*QC + PF*QF
o
PC is the price of cloth
o
QC is the quantity of cloth produced
o
PF is the price of food
o
QF is the quantity of food produced
Isovalue Lines:

To understand how relative prices influence production choices, the concept of
isovalue lines is introduced. These are lines drawn on a graph with cloth
production on one axis and food production on the other.

Each isovalue line represents a constant total value of output. A higher isovalue
line signifies a higher total output value.

The slope of an isovalue line is determined by the relative price of cloth (PC/PF).
A steeper slope indicates cloth is more valuable compared to food.
Choosing Production Levels:

Producers will choose the point on their PPF (like point Q in Figure 6-1, not
shown here) where the relevant isovalue line is tangent to the frontier. This is the
point that maximizes the total value of their output given the prevailing relative
prices.
The passage sets the stage for the following sections, which will likely explain
how changes in relative prices (like cloth becoming more valuable) can lead to
adjustments in production choices and ultimately influence a country's relative
supply of goods for export.
The figure explain how isovalue lines are used in the standard trade model to determine
a country's optimal production level. Here's a breakdown of the key points:
Isovalue Lines:

These are lines representing a constant value of output (production) for a
country.


The equation PC*QC + PF*QF = V defines isovalue lines, where:
o
PC is the price of cloth
o
QC is the quantity of cloth produced
o
PF is the price of food
o
QF is the quantity of food produced
o
V is the total value (production)
Or by rearranging:
QF = V/PF - (PC/PF)QC
o
The term V/PF represents the total value (V) of production divided by the
price of food (PF). This essentially calculates how much food (in quantity)
the total production value can be exchanged for.
o
Cloth Production (QC): The term (PC/PF)QC represents the "opportunity
cost" of producing cloth (QC) in terms of food production. Here's the
breakdown:

PC/PF: This ratio represents the relative price of cloth compared to
food. A higher value means cloth is more expensive compared to
food.

o
QC: This is the quantity of cloth produced.
Trade-off and Food Production (QF): The entire term -(PC/PF)QC
shows the trade-off between producing cloth and food. When a country
produces more cloth (higher QC), they forgo the opportunity to produce
that much food (because resources are limited). Subtracting this term from
V/PF accounts for the "food sacrificed" for cloth production.
o
Solving for Food Production (QF): The equation essentially solves for
QF, the quantity of food produced. It considers the total production value
(V), the price of food (PF), and the opportunity cost of producing cloth
(QC) in terms of forgone food production.

A higher value (V) for total production results in isovalue lines farther away from
the origin.

The slope of an isovalue line is negative (represented as -PC/PF), indicating the
trade-off between cloth (C) and food (F) production. A steeper slope implies a
higher relative price of cloth (C) compared to food (F).
Production Choice and Isovalue Lines:

The image shows the PPF (TT) representing the different combinations of cloth
and food a country can produce.

Isovalue lines show the possible total value of production achievable with those
combinations.

The country's optimal production point (Q) is where the PPF (TT) is tangent to
the highest attainable isovalue line.

At this point (Q), the country maximizes the value of its output given its
production constraints (PPF).
The figure explain how a change in relative prices (cloth becomes more valuable
compared to food) influences a country's production choices and its relative supply
curve according to the standard trade model.
Impact of Higher Relative Price of Cloth (PC/PF):

If PC/PF (price of cloth relative to food) rises, the isovalue lines become steeper,
then the isovalue lines would be steeper than before.

In Figure 6-2, the highest isovalue line the economy could reach before the
change in PC/PF is shown as VV1 ; the highest line after the price change is VV2
, the point at which the economy produces shifts from Q 1 to Q 2 .

Thus, as we might expect, a rise in the relative price of cloth leads the economy
to produce more cloth and less food. The relative supply of cloth will therefore
rise when the relative price of cloth rises.

This relationship between relative prices and relative production is reflected in
the economy’s relative supply curve shown in Figure 6-2b.
Relative Prices and Demand
Figure 6-3 shows the relationship among production, consumption, and trade in the standard model.

As we pointed out in Chapter 5, the value of a country's consumption must equal the
value of its production. This makes sense because a country cannot consume
more than it produces without external borrowing or aid. This can be shown using
an equation:
PCQC + PFQF = PCDC + PFDF = V

o
PC is the price of cloth
o
QC is the quantity of cloth produced
o
PF is the price of food
o
QF is the quantity of food produced
o
DC is consumption of cloth consumed
o
DF is consumption of cloth food
o
V is the total value (production or consumption)
This equation implies that both production and consumption points must lie on
the same isovalue line (a line representing a constant total value).
The text and image together explain how consumer preferences and indifference curves
influence a country's consumption choices in the standard trade model. Here's a
breakdown of key points:
A country's consumption choices depend on the tastes of its consumers. For our standard
model, we assume the economy’s consumption decisions may be represented as if they were based on
the tastes of a single representative individual. The tastes of an individual can be represented graphically
by a series of indifference curves.
Indifference Curves:

An indifference curve shows various combinations of cloth (C) and food (F) that
provide the same level of satisfaction (utility) to the consumer.

The image shows multiple indifference curves, each representing a different level
of satisfaction. Higher indifference curves represent greater satisfaction.

Indifference curves have three key properties:
1. Downward Slope: If the consumer gets less food (F), they need more
cloth (C) to remain equally satisfied. This reflects a trade-off between the
two goods.
2. Higher Indifference Curve, Higher Welfare: Indifference curves further
from the origin represent higher levels of satisfaction (welfare) for the
consumer. The consumer prefers having more of both goods.
3. Bowed Outward: As you move to the rightward on an indifference curve
(consuming more cloth C and less food F), the curve flattens out. This
indicates a diminishing marginal rate of substitution. The consumer
requires progressively more cloth (C) to compensate for the loss of each
unit of food (F) as they consume less food.
Consumption Choice:
o
As you can see in Figure 6-3, the economy will choose to consume at the
point on the isovalue line that yields the highest possible welfare. This
point is where the isovalue line is tangent to the highest reachable
indifference curve, shown here as point D. Notice that at this point, the
economy exports cloth (the quantity of cloth produced exceeds the
quantity of cloth consumed) and imports food. That means production
occurs at point Q and consumption occurs at point D. As there is excess
cloth after consumption, we export it and there is scarcity of food so we
import it.
o
At point D, the consumer gets the most satisfaction (highest indifference
curve) achievable given the production value (isovalue line).
Now consider the impact of a rising relative price of cloth (PC/PF) on a country's
production, consumption choices, and welfare in the standard trade model. Let's break it
down:
Scenario: The relative price of cloth (PC/PF) increases, meaning cloth becomes more
expensive compared to food.
Panel (a) in Figure 6-4:

Production Shift: Due to the higher price of cloth, producers are incentivized to
switch production from Q1 to Q2 (more cloth, less food).

Isovalue Lines: The rise in PC/PF rotates the isovalue lines (budget constraint)
upwards. The new relevant isovalue line is VV2.

Consumption Shift: Because the isovalue line changed, the consumption point
also shifts from D1 to D2 on the new highest reachable indifference curve.

The move from D 1 to D 2 reflects two effects of the rise in PC/PF:
1. Income Effect (Higher Welfare): First, the economy has moved to a
higher indifference curve, meaning that it is better off. The reason is that
this economy is an exporter of cloth. When the relative price of cloth rises,
the economy can trade a given amount of cloth for a larger amount of food
imports. Thus, the higher relative price of its export good represents an
advantage.
2. Substitution Effect (Shifting Consumption): Even though the country is
better off, it will adjust its consumption choices within the new budget
constraint (VV2). Cloth has become relatively more expensive, so
consumers will tend to substitute some cloth consumption for food
(movement along the indifference curve from D1 to D2, consuming less C
and more F).

These two effects are familiar from basic economic theory. The rise
in welfare is an income effect; the shift in consumption at any
given level of welfare is a substitution effect. The income effect
tends to increase consumption of both goods, while the substitution
effect acts to make the economy consume less C and more F.
Recap from previous explanations:

A higher relative price of cloth (PC/PF) incentivizes producers to switch
production towards cloth (income effect).

Consumers will also substitute some cloth consumption for food (substitution
effect) because cloth is now relatively more expensive.
Panel (b) of Figure 6-4:

This panel shows the relative supply and demand curves associated with the
production possibility frontier and indifference curve.

The x-axis represents the relative quantity of cloth (quantity of cloth divided by

quantity of food).
The y-axis represents the relative price of cloth (price of cloth divided by price of
food).

RS is the relative supply of cloth (production).

RD is the relative demand for cloth (consumption).

The graph shows how the increase in the relative price of cloth induces an
increase in the relative production of cloth (move from point 1 to 2) because
producers switch to cloth production as well as a decrease in the relative
consumption of cloth (move from point 1′ to 2′) because consumers buy less
cloth as it's more expensive

The graph confirms the substitution effect through the movement from 1' to 2'
(consuming less cloth). Even though the income effect might increase
consumption of both goods (DC and DF both increase), the substitution effect
always leads to a decrease in the relative consumption of the good that has
become relatively more expensive (cloth in this case).

Point 3 shows the consumption and production point if the economy cannot
trade, associated with the relative price (PC/PF) 3
The Welfare Effect of Changes in the Terms of
Trade
The text explain the concept of terms of trade and its impact on a country's welfare in the
standard trade model. Here's a breakdown of key points:
Terms of Trade:

Terms of trade is the price of the good a country initially exports divided by the
price of the good it initially imports.

For instance, if a country exports cloth (C) and imports food (F), the terms of trade
would be PC/PF (price of cloth divided by price of food).
Impact on Welfare:

The passage states that a rise in the terms of trade increases a country's welfare,
and vice versa.

When PC/PF increases, a country that initially exports cloth is made better off, as
illustrated by the movement from D 1 to D 2 in panel (a) of Figure 6-4. Conversely,
if PC/PF were to decline, the country would be made worse off; for example,
consumption might move back from D 2 to D 1.
Exporting Different Goods:

The text clarifies that the direction of the effect depends on what a country export.

If the country were initially an exporter of food instead of cloth, the direction of this
effect would be reversed. An increase in PC/PF would mean a fall in PF/PC and
the country would be worse off: The relative price of the good it exports (food)
would drop.

If a country exports food (F) instead of cloth (C), a decrease in PC/PF (relative
price of cloth falls) would improve their terms of trade because they can import
more cloth with the same food exports.
Terms of Trade

Again, we can say that, we cover all these cases by defining the terms of trade as
the price of the good a country initially exports divided by the price of the good it
initially imports. The general statement, then, is that:
a rise in the terms of trade increases a country’s welfare, while a decline in the terms of
trade reduces its welfare.

Note, however, that changes in a country’s terms of trade can never decrease the
country’s welfare below its welfare level in the absence of trade (represented by
consumption at D3). The gains from trade mentioned in Chapters 3, 4, and 5 still
apply to this more general approach. The same disclaimers previously discussed
also apply: Aggregate gains are rarely evenly distributed, leading to both gains and
losses for individual consumers.
Limits and Gains from Trade:

Note, however, that changes in a country’s terms of trade can never decrease the
country’s welfare below its welfare level in the absence of trade (represented by
consumption at D3). This is because they can still consume at the point on their
production possibility frontier (PPF) even if they cannot trade.

The gains from trade mentioned in Chapters 3, 4, and 5 still apply to this more
general approach. The same disclaimers previously discussed also apply:
Aggregate gains are rarely evenly distributed, leading to both gains and losses for
individual consumers. The passage acknowledges the gains from trade discussed
earlier in the chapter, but emphasizes that these gains might not be evenly
distributed within the country.
Determining Relative Prices
This passage sets the stage for analyzing how relative prices are determined in a twocountry world (Home and Foreign) within the standard trade model. Here's a
breakdown of the key assumptions:
The Countries:

Two countries: Home and Foreign.

Home exports cloth (C) and imports food (F).

Foreign exports food (F) and imports cloth (C).

Terms of trade of home is measured by PC/PF.

Foreign's terms of trade are measured by PC*/PF*.

These trade patterns are likely due to differences in production capabilities
between the two countries.
Production Capabilities (referring to Figure 6-6 (a)):

So, Home and Foreign have different production capabilities, which is reflected in
their relative supply curves. These curves are positioned such that Home's
relative supply curve for cloth is higher than Foreign's, and vice versa for food.

At any given relative price PC/PF, Home will produce quantities of cloth and food
QC and QF, while foreign produces quantities QC * and QF * where QC/QF >
QC*/QF * (It means that home is better at producing cloth and foreign is better at
producing food).

The world's relative supply curve is obtained by summing the quantities of
cloth and food that both countries are willing to supply at each relative price. This
curve is constructed mathematically by taking (QC + QC*) for cloth and (QF +
QF*) for food, and then dividing them (cloth quantity)/(food quantity). By
definition, this world relative supply curve must fall between the individual relative
supply curves of Home and Foreign. This is because the world supply at any
given price is always more than what a single country can supply, and less than
the combined supply of both.

The text clarifies that both countries have the same preferences for cloth and
food. Relative demand for the world also aggregates the demands for cloth and
food across the two countries: (DC + DC*)/ (DF + DF*). Since there are no
differences in preferences across the two countries, the relative demand curve
for the world overlaps with the same relative demand curve for each country.

Equilibrium Price:
o
The intersection point of the world's relative supply curve and the world's
relative demand curve (point 1) determines the equilibrium relative price
of cloth (PC/PF) in the world market.
o
At this equilibrium point, the quantity of cloth demanded by consumers
(both countries combined) exactly matches the quantity of cloth supplied
by producers (both countries combined).
o
This relative price (at equilibrium point) determines how many units of
Home’s cloth exports are exchanged for Foreign’s food exports.
o
At the equilibrium relative price (PC/PF) for cloth (referring to point 1), two
key things happen:

Cloth Trade: Home's desired exports of cloth (QC - DC) exactly
match Foreign's desired imports of cloth (DC* - QC*). This means
the amount of cloth Home wants to sell is exactly what Foreign
wants to buy.

Food Trade: Home's desired imports of food (DF - QF) precisely
match Foreign's desired exports of food (QF* - DF*). Similar to
cloth, the amount of food Home wants to import is the same as
what Foreign wants to export.

Balanced Trade Flows: This matching of desired exports and imports at the
equilibrium price ensures balanced trade flows between Home and Foreign.
There's no excess supply or demand for either cloth or food in the market.
The production possibility frontiers for Home and Foreign, along with the budget
constraints and associated production and consumption choices at the equilibrium
relative price (PC/PF) 1, are illustrated in panel (b).
Explanation of Figures at panel B:

Left graph (Home): In the left graph homes production, consumption, and trade
are shown. The red curve shows home’s production possibilities. home can
produce at any point of this curve. After analyzing their advantage in cloth
production, home has decided to produce more cloth and less food at point Q in
the production possibility curve. So, homes production of cloth is QC and
production of food is QF. But homes total consumption of clothes and food is at
point D. So, home consume less cloth than it produces that's why the extra
amount of cloth is exported. On the other hand, home consume more food than it
produces that's why the extra amount of food is important imported from another
country. This consumption and production point creates the VV1 line, which
indicated total value (production or consumption).
CASE STUDY: Unequal Gains from Trade across the Income Distribution
Economic Growth: A Shift of the RS Curve
The passage dives into the complex relationship between economic growth and
international trade. Here's a breakdown of the key points:
The Debate

The passage highlights two main questions surrounding economic growth in a
globalized world:
1. Impact of growth in other countries: Is economic growth in other
countries good or bad for our nation? Is it beneficial (larger export
markets, lower import prices) or detrimental (increased competition) for
our economy?
2. Value of growth in a global economy: Is growth in a country more or
less valuable when that nation is part of a closely integrated world
economy? Is it more valuable when a country can export its increased
production, or are the benefits diluted by lower export prices?
Common Sense Arguments (Contradictions)

The passage acknowledges seemingly contradictory arguments from a commonsense perspective:
o
Growth abroad can be good (larger markets) or bad (increased
competition).
o
Domestic growth can be beneficial (increased production), but the gains
might be shared with foreign consumers (lower export prices).

Exactly from Book:
o
Means, economic growth in the rest of the world may be good for our
economy because it means larger markets for our exports and lower
prices for our imports.
o
Growth in other countries may mean increased competition for our
exporters and domestic producers, who need to compete with foreign
exporters.
The Contradiction at Home:
We can find similar ambiguities when we look at the effects of growth at Home.

Benefit: Economic growth increases a country's production capacity, allowing it
to produce more goods and potentially sell a surplus in the international market.
This can be beneficial as it brings in foreign currency and expands the market for
domestic producers.

Drawback: Increased production often leads to lower prices for exports. While
consumers in other countries benefit from cheaper imports, the exporting country
might see a decrease in revenue per unit sold. This raises the question of
whether the gains from increased production are fully captured domestically.
The Standard Model of Trade as a Solution:
The passage suggests that the standard model of trade, introduced earlier, can provide
a framework to analyze this contradiction. This model considers factors like supply and
demand, production costs, and international prices to determine the overall impact of
economic growth in a globalized economy.
In simpler terms, the standard model of trade can help us understand how:

Increased production due to economic growth affects the domestic supply of
goods.

This change in supply, along with global demand, influences the equilibrium price
of those goods in the international market.

The new equilibrium price determines how much revenue the exporting country
earns from its increased production.
By analyzing these factors, the standard model of trade can clarify whether the benefits
of economic growth are retained domestically or passed on to foreign consumers.
Growth and the Production Possibility Frontier
Economic growth signifies an increase in a country's productive capacity. This is
reflected in an outward shift of the PPF. (The outward shift means the country can now
produce more of both goods, or even the same amount of one good with a significant
increase in the other, compared to before.)
Causes of the Shift:

There are two main reasons why a PPF might shift outwards:
o
Increase in Resources: If a country discovers new resources, expands
its workforce, or invests in capital (machinery, technology), it can produce
more from the same amount of effort.
o
Improvements in Efficiency: Even with the same resources, a country
can become more productive through advancements in technology, better
resource management, or a more skilled workforce. This allows them to
produce more output without increasing inputs.
The international trade effects of growth result from the fact that such growth typically has a bias. The
graph perfectly illustrates the concept of biased growth in international trade. Let's
analyze the graph together:
Biased Growth and the Production Possibility Frontier (PPF)

The two panels (a) and (b) depict a country's PPF before and after economic
growth.

The horizontal axis represents the production of cloth (Qc), and the vertical axis
represents the production of food (Qf).

TT1 represents the initial PPF, showing the possible combinations of cloth and
food the country could produce with its initial resources.

Biased Growth: Economic growth typically leads to an outward shift of the PPF,
signifying an increase in productive capacity. However, this shift isn't always
symmetrical.
o
Panel (a): Growth biased toward cloth (TT1 to TT2). The PPF expands
more towards cloth production (Qc) compared to food production (Qf).
This suggests the country has become more efficient in producing cloth,
perhaps due to advancements in textile technology or increased resource
allocation to cloth manufacturing.
o
Panel (b): Growth biased toward food (TT1 to TT3). The PPF expands
more towards food production (Qf) compared to cloth production (Qc).
This indicates a growth focused on the food sector, maybe due to
discoveries in agriculture or increased investment in farmland.
International Trade Effects
The concept of biased growth is crucial in understanding how a country's economic
growth can influence international trade.

A country experiencing biased growth will likely look to export the good it
becomes more efficient in producing (cloth in panel (a), food in panel (b)).

This can lead to:
o
Increased competition in the international market for that good (cloth or
food in this example), potentially driving down prices.
o
The country potentially specializing in producing and exporting that good,
while importing more of the good it becomes relatively less efficient in
producing.
In essence, biased growth can significantly impact a country's trade patterns.
Causes of Biased Growth
Growth may be biased for two main reasons:
1.
Technological Progress (Ricardian Model): If a country experiences a
technological advancement in a specific sector (like textiles in the image), its PPF
will expand more in that direction (cloth production in panel (a) of the image).
This is because the country can now produce more cloth with the same
resources or produce the same amount of cloth with fewer resources, allowing
them to allocate more resources to other goods.
2.
Increase in Factors of Production (Heckscher-Ohlin Model): If a country
experiences an increase in a factor of production (like labor or capital), its PPF
might shift towards goods that intensively use that factor. For instance, an
increase in skilled labor might make the country more efficient in producing
complex goods like machinery (not shown in the image).
Impact of Biased Growth on Relative Supply

Relative Supply Curve: This curve shows the different combinations of two
goods (like cloth and food) a country is willing and able to supply at various
relative prices. The relative price refers to the price of one good in terms of the
other (e.g., price of cloth per unit of food).
The image shows how biased growth can influence a country's relative supply curve:

Panels (a) and (b): These depict strong biased growth scenarios. Even though
total output of both goods increases (outward shift of the PPF), the increase is
uneven.
o
Panel (a): Here, growth is biased toward cloth. Food production (Qf)
actually falls despite the overall growth. (By falls it means food production
increases but less compared to increase in cloth, or it might even slightly
decrease)
o
Panel (b): Growth is biased toward food. Cloth production (Qc) actually
falls despite the overall growth. (By falls it means cloth production
increases but less compared to increase in food, or it might even slightly
decrease)
o
Although growth is not always as strongly biased as it is in these
examples, even growth that is more mildly biased toward cloth will lead,
for any given relative price of cloth, to a rise in the output of cloth relative
to that of food.

Panel (c): This panel shows the relative supply curve.
o
RS1: Represents the initial relative supply curve.
o
RS2: Represents the relative supply curve after biased growth toward
cloth (as shown in panel (a)). The curve shifts to the right because at any
given relative price of cloth, the country is now willing and able to supply
more cloth relative to food.
o
RS3: Represents the relative supply curve after biased growth toward
food (as shown in panel (b)). The curve shifts to the left because at any
given relative price of cloth, the country is now willing and able to supply
less cloth relative to food.
World Relative Supply and the Terms of Trade
The passage and image you sent are explaining how biased growth in one country can
affect the relative price of goods traded between countries (terms of trade) Let's break
down the concepts involved:
Home experiences growth strongly biased toward cloth, so that its output of cloth rises at any given
relative price of cloth, while its output of food declines [as shown in panel (a) of Figure 6-7]. Then the
output of cloth relative to food will rise at any given price for the world as a whole, and the world
relative supply curve will shift to the right, just like the relative supply curve for Home. This shift in the
world relative supply is shown in panel (a) of Figure 6-8 as a shift from RS1 to RS2.
Impact of Biased Growth on World Relative Supply

Panel (a) of Figure 6-8:
o
RS1: Represents the initial relative supply curve.
o
RS2: Represents the relative supply curve after a country experiences
biased growth towards cloth (like in the image's panel (a)).
o
Since this country is now a more efficient producer of cloth, the world
becomes collectively able to supply more cloth relative to food at any
given price. This shift is represented by the movement from RS1 to RS2 to
the right.
Terms of Trade and the Price of Cloth (panel a)
o
Terms of Trade: This refers to the price a country receives for its exports
relative to the price it pays for its imports. A worsening of terms of trade
means a country needs to export more units of its good to import the same
amount of another good.
o
Price of Cloth: The passage explains that a shift in the world relative
supply curve due to biased growth can affect the price of cloth.
o
Impact on Prices: The passage states that the biased growth towards
cloth will lead to a decrease in the relative price of cloth, from (PC/PF)¹ to
(PC/PF)². Here's why:

Due to the shift in world relative supply (RS1 to RS2), there's now
more cloth available globally at any given price.

This increased supply of cloth, relative to food, puts downward
pressure on the price of cloth compared to food.
o
The decrease in the relative price of cloth worsens the terms of trade for
the country that experienced biased growth towards cloth (Home in the
image). This is because: Home exports cloth and imports food. With the
price of cloth falling relative to food, Home needs to export more cloth to
import the same amount of food as before (assuming their import needs
remain the same).
Panel (b) of Figure 6-8:
Notice that the important consideration here is not which economy grows but rather the bias of that
growth. So, it's not just about a country experiencing growth, but the direction of that
growth (biased towards cloth or food production in this case) that matters.

Similar Impact of Foreign's Cloth-Biased Growth: If Foreign (the other
country) had also experienced growth biased towards cloth (like Home in the
previous example), the impact on the world relative supply curve (RS) would be
similar. This means there would be a shift to the right (like RS1 to RS2) and a
decrease in the relative price of cloth, affecting both Home and Foreign's terms of
trade.

Food-Biased Growth and Price Reversal: If either Home or Foreign
experiences growth biased towards food, the world relative supply curve (RS)
would shift to the left (RS1 to RS3). This shift would lead to a rise in the relative
price of cloth compared to food (from (PC/PF) ¹ to (PC/PF) ³). This would be an
improvement in terms of trade for Home (the cloth exporter) and a worsening for
Foreign (the cloth importer).
Types of Biased Growth:
1.
Export-Biased Growth: When a country's economic growth leads to a greater
increase in production of the good it exports. (e.g., Home's growth biased
towards cloth)
2.
Import-Biased Growth: When a country's economic growth leads to a greater
increase in production of the good it imports.

Impact on Terms of Trade of Export-Biased Growth: This typically leads to a
worsening of the growing country's terms of trade. This is because:
o
The increased supply of the exported good (due to biased growth) drives
down its global price relative to the imported good.
o
The country needs to export more units of the good to import the same
amount of the imported good. (e.g., Home might need to export more cloth
to import the same amount of food)

Impact of Terms of Trade of Import-Biased Growth: This typically leads to an
improvement of the growing country's terms of trade. This is because:
o
The increased production of the imported good reduces the country's
reliance on imports.
o
The global price of the imported good might even decrease due to the shift
in global supply.
o
The country might need to export fewer units of its exported good to
import the same amount of the previously imported good.

Our analysis leads to the following general principle:
Export-biased growth tends to worsen a growing country’s terms of trade, to the
benefit of the rest of the world; import-biased growth tends to improve a growing
country’s terms of trade at the rest of the world’s expense.
International Effects of Growth
Using this principle, we are now in a position to resolve our questions about the
international effects of growth.

Is growth in the rest of the world good or bad for our country?

Does the fact that our country is part of a trading world economy increase or
decrease the benefits of growth?
In each case the answer depends on the bias of the growth.

In other countries: Export-biased growth (increased production of exported
goods) in the rest of the world is good for us, improving our terms of trade (we can
import more for the same price of exports), while import-biased growth abroad
worsens our terms of trade (need to export more for the same import). Note: The
thing foreign export is what we import. So increase export production will reduce
price of those good so we can import those good in cheaper price.

In our own country: Export-biased growth in our own country worsens our terms
of trade (need to export more for the same import), reducing the direct benefits of
growth, while import-biased growth leads to an improvement of our terms of trade
(need to export less for the same import), a secondary benefit.
Concerns of Poorer Countries (1950s):
The passage describes the concerns of economists from poorer countries in the 1950s
regarding the potential negative effects of biased growth on their economies. Let's break
it down:

Export Reliance: These countries primarily exported raw materials (commodities)
to developed nations.

Fear of Declining Terms of Trade: They worried that growth in the developed
world would be:
o
Import-Biased: Focused on producing substitutes for their raw materials
(e.g., synthetic fabrics instead of cotton).
o
This would reduce demand for their exports, lowering the relative price of
raw materials compared to manufactured goods.

Export-Biased Growth for Themselves: They believed their own growth would
simply increase their capacity to produce more raw materials (further saturating
the market).

Immiserizing Growth: Some feared this "export-biased growth" could be selfdefeating. They worried that worsening terms of trade would outweigh any benefits
of growth, leaving them worse off than before.

Immiserizing Growth: Theoretical Possibility
o
Economist Jagdish Bhagwati demonstrated that immiserizing growth can
occur in a theoretical model. However, the conditions under which
immiserizing growth can occur are extreme: Very strong export bias in a
country's growth must be combined with very steep supply (RS) and
demand (RD) curves for the traded goods (raw materials and manufactured
goods in this context). This extreme scenario would cause a large enough
decline in terms of trade to outweigh the benefits of growth.

Immiserizing Growth: Not a Common Issue
o
Most economists believe immiserizing growth is more of a theoretical
concept than a real-world problem.
o
Growth at home, even with some worsening of terms of trade due to export
bias, generally benefits a country.

Impact of Growth Abroad
o
Growth abroad can also affect a country's terms of trade.
o
Import-biased growth abroad is beneficial as it improves terms of trade
(need to export less for the same import).
o
However, growth abroad can also be export-biased, worsening a country's
terms of trade (need to export more for the same import).
Tariffs and Export Subsidies:
Simultaneous Shifts in RS and RD
The passage explains how import tariffs and export subsidies, while not primarily used to
impact terms of trade, can have unintended consequences on them. Let's break it down:
Main Purpose of Tariffs and Subsidies:
The passage clarifies that import tariffs (taxes on imports) and export subsidies
(payments given to domestic producers who sell a good abroad) are typically not
implemented to directly affect a country's terms of trade. They are used for other
purposes, which will be discussed in later chapters, such as:

Income distribution (e.g., protecting domestic jobs)

Promotion of industries thought to be crucial to the economy

Balance of payments adjustments
Impact on Terms of Trade
Whatever the motive for tariffs and subsidies, however, tariffs and subsidies can still
influence a country's terms of trade through their impact on domestic prices. The
distinctive feature of tariffs and export subsidies is that they create a difference between
prices at which goods are traded on the world market and prices at which those goods
can be purchased within a country.

Import Tariffs: Tariff increase the price of imported goods within the country then
they are outside the country.

Export Subsidies: An export subsidy gives producers an incentive to export. It
will therefore be more profitable to sell abroad than at home unless the price at
home is higher, so such a subsidy raises the prices of exported goods inside a
country.

Note that this is very different from the effects of a production subsidy, which
also lowers domestic prices for the affected goods (since the production subsidy
does not discriminate based on the sales destination of the goods). So production
subsidy lowers the overall production cost for a good, potentially leading to lower
domestic prices for that good (regardless of where it's sold).
Impact on World Market:
When countries are big exporters or importers of a good (relative to the size of the world
market), the price changes caused by tariffs and subsidies change both relative supply
and relative demand on world markets. The result is a shift in the terms of trade, both of
the country imposing the policy change and of the rest of the world.
The passage emphasizes that when a country is a significant exporter or importer (relative
to the global market), these price changes caused by tariffs and subsidies can:

Shift Relative Supply and Demand: The changes in domestic prices due to these
policies can influence how much a country is willing to supply or demand of a good
on the world market.

Shift Terms of Trade: This shift in relative supply and demand on the world market
can ultimately lead to a change in the terms of trade for both the country
implementing the policy and the rest of the world.
Relative Demand and Supply Effects of a Tariff
The passage highlights a crucial point when analyzing the impact of tariffs and
subsidies on terms of trade: the distinction between internal and external prices. Here's
a breakdown:

Internal vs. External Prices:
o
Internal Prices: Prices at which goods are bought and sold within a
country.
o
External Prices: Prices at which goods are traded internationally on the
world market.

Terms of Trade and External Prices:
o
The terms of trade represent the ratio of a country's export price (of one
good) to its import price (of another good). It measure the ratio at which
countries exchange goods; for example, how many units of food can Home import for
each unit of cloth that it exports?
o

This ratio is based on external prices, not internal prices.
Impact Analysis with External Prices:
o
When evaluating how tariffs and subsidies affect terms of trade, we need
to consider how they influence the relative supply and demand of goods
based on external prices.
Why This Matters:
Tariffs and subsidies primarily affect internal prices. For example, a tariff on imports
raises their internal price but doesn't necessarily change the global price (external
price).
Understanding the impact on terms of trade requires analyzing how these policies
change a country's willingness to supply and demand goods based on the world
market prices (external prices), not the potentially altered internal prices.
The passage is explaining the specific effects of a tariff on a country's internal prices
and how it can differ from the external market price. Here's a breakdown:
Scenario: Home country imposes a 20% tariff on food imports.
Impact on Prices:

Internal Price of Food:
o
Increases by 20% compared to the price of domestically produced cloth.
o
This is because the imported food becomes more expensive due to the
tariff.

Internal Price of Cloth (Relative):
o
Effectively becomes cheaper relative to food.
o
Even though the price of cloth itself might not change, the tariff-induced
increase in food price makes cloth seem relatively cheaper domestically.
Key Points:

Tariffs create a wedge between internal and external prices.

A tariff on imports increases the internal price of the imported good relative to
domestically produced goods.

This can make domestically produced goods seem relatively cheaper, even if
their price remains unchanged.
External Market vs. Internal Decisions:

The passage emphasizes that these internal price changes don't necessarily
reflect the external market (world market prices).

Decisions about import/export quantities (which affect terms of trade) are based
on external market prices, not the tariff-inflated internal prices.
The figure perfectly illustrates the concept we've been discussing about how a tariff
imposed by Home (country) on food imports can improve Home's terms of trade.
Key Points from the Passage:

Tariff on Food Imports: Home country imposes a tariff on food imports, making
imported food more expensive domestically.

Internal Prices: This creates a wedge between internal and external prices. The
price of food rises internally (relative to cloth) even though the world market price
(external price) might not change.

Producer Decisions: Home producers face a lower relative price of cloth
domestically (food is more expensive now). This incentivizes them to produce
less cloth and more food.

Consumer Decisions: Home consumers, due to the tariff, see food as relatively
more expensive. They shift their consumption towards cloth (the seemingly
cheaper option).
World Market Effects:

Relative Cloth Supply: As Home producers switch to producing more food, the
global supply of cloth decreases (shifts from RS1 to RS2 in the image).

Relative Cloth Demand: With cloth becoming relatively cheaper domestically,
home consumers demand more cloth, which increases global demand for cloth
(shifts from RD1 to RD2 in the image).

World Price of Cloth: Due to the combined effect of lower supply and higher
demand, the relative price of cloth increases on the world market (from (PC/PF)1
to (PC/PF)2).
Overall Impact:

Home's Terms of Trade Improve: Since Home exports cloth (the good whose
price increased globally), their terms of trade improve (they can import more food
for the same amount of cloth export).

Foreign's Terms of Trade Worsen: Foreign (the country importing cloth)
experiences the opposite effect. Their terms of trade worsen as they need to
export more to afford the same amount of cloth import.
The image visually represents these changes:

Downward Shift of RS curve (RS1 to RS2): Represents a decrease in the
relative supply of cloth due to Home producers switching to food production.

Rightward Shift of RD curve (RD1 to RD2): Represents an increase in the
relative demand for cloth due to Home consumers substituting towards cloth.

Movement from Point A to Point B: Shows how the world relative price of cloth
increases (PC/PF) as a result of the tariff.
In essence, the tariff policy creates a situation where Home benefits at the expense of
Foreign in terms of trade.
The following passage highlights a crucial factor influencing the impact of tariffs on
terms of trade: the size of the country imposing the tariff relative to the global
market.
Key Points:

Tariff Impact Depends on Country Size:
o
A large country imposing a tariff can significantly influence global supply
and demand, leading to a noticeable change in relative prices on the world
market.
o
A small country imposing a tariff has a minimal impact on global markets,
resulting in a negligible change in relative prices.

Example:
o
The US, a large country, imposing a 20% tariff might see its terms of trade
improve by 15% (import prices fall relative to export prices on the world
market).
o
A small country like Luxembourg or Paraguay imposing the same tariff
would have a much smaller (likely unmeasurable) effect on terms of trade.
Explanation:

A large country's tariff can disrupt global markets more significantly because it
can:
o
Reduce the global supply of the good it imports (as its own producers
switch to that good due to the internal price change).
o
Increase the global demand for the good it exports (as its consumers
substitute towards the cheaper good domestically).

These combined effects can push the world market price of the exported good (in
this case, US exports) higher, improving the US terms of trade.

Conversely, a small country's tariff has a minimal impact because its actions
have a negligible influence on global supply and demand, leading to little to no
change in world market prices.
In essence, the effectiveness of a tariff in altering terms of trade depends on the
country's economic clout in the global market.
Effects of an Export Subsidy
The passage and image you sent together explain how an export subsidy, a policy
intended to support domestic producers, can actually worsen a country's terms of trade.
Let's break it down based on the information provided:
Similarities Between Tariffs and Subsidies:

Both influence domestic prices: Tariffs raise import prices, while export subsidies
raise export prices (domestically).
Differences Between Tariffs and Subsidies:

Impact on terms of trade: Tariffs improve the imposing country's terms of trade,
while export subsidies worsen it.
Scenario:

Home country implements a 20% subsidy on the value of exported cloth.
Impact on Domestic Prices:

The subsidy effectively makes cloth production more profitable for domestic
producers.

This raises the internal price of cloth relative to food (by 20% in this case).
Producer Decisions:

Incentivized by the higher relative price of cloth, Home producers switch to
producing more cloth and less food.
Consumer Decisions:

Due to the subsidy-induced rise in cloth prices, Home consumers substitute food
for cloth (opting for the cheaper alternative).
World Market Effects:

Relative Cloth Supply: Increased cloth production by Home producers leads to
a greater global supply of cloth (shifts from RS1 to RS2 in the image).

Relative Cloth Demand: With cloth becoming relatively more expensive
domestically, Home consumers demand less cloth, reducing global demand for
cloth (shifts from RD1 to RD2 in the image).
Overall Impact:

Home's Terms of Trade Worsen: The combined effect of higher supply and
lower demand for cloth on the world market pushes the price of cloth down (from
(PC/PF)1 to (PC/PF)2 in the image).
o
Since Home exports cloth (the good whose price decreased globally), their
terms of trade worsen (they need to export more cloth to import the same
amount of food).

Foreign's Terms of Trade Improve: Foreign (the country importing cloth)
benefits from the lower world price of cloth. They can import more cloth for the
same amount of exports, improving their terms of trade.
Key Takeaways:

Export subsidies can backfire in terms of a country's goal to improve its trade
position.

By altering domestic production and consumption patterns, export subsidies can
influence global supply and demand, ultimately affecting world market prices and
a country's terms of trade.
The image visually represents these changes:

Upward Shift of RS curve (RS1 to RS2): Represents an increase in the relative
supply of cloth due to producers switching to cloth production.

Leftward Shift of RD curve (RD1 to RD2): Represents a decrease in the
relative demand for cloth due to Home consumers substituting towards food.

Movement from Point A to Point B: Shows how the world relative price of cloth
decreases (PC/PF) as a result of the subsidy.
In essence, while an export subsidy might seem to promote domestic production, it can
have unintended consequences, leading to a decline in a country's terms of trade.
Implications of Terms of Trade Effects: Who
Gains and Who Loses?
The passage discusses the winners and losers when it comes to terms of trade
changes caused by tariffs. Let's summarize:
Impact of Tariffs: If home imposes tariff

Home (Tariff Imposing Country):
o
Benefits: Improved terms of trade (can import more for the same export).
o
Costs: Distortions in domestic production and consumption (discussed in
Chapter 9).
o
Overall benefit depends on the tariff size. A "too large" tariff might make
the distortion costs outweigh the terms of trade gains.

Foreign (Country Importing from Home):
o
Loses: Worsened terms of trade (needs to export more for the same
import).

Key Points:
o
Tariffs create winners and losers in terms of trade.
o
The imposing country (Home) benefits from improved terms of trade, but
also faces potential costs due to domestic distortions.
o
The size of the tariff matters. A moderate tariff might yield a net benefit for
the imposing country, while a large tariff could lead to losses due to
domestic distortions outweighing the terms of trade gains.
o
Small countries have minimal impact on global markets, so their optimal
tariff for maximizing net benefit would be close to zero (as their tariff
wouldn't significantly improve terms of trade).
Impact of Export Subsidies:

Home (Subsidy Granting Country):
o
Loses:

Worsened terms of trade (needs to export more for the same
import).


Foreign (Country Importing from Home):
o

Domestic distortions (discussed in Chapter 9).
Benefits: Improved terms of trade (can import more for the same export).
Key Points:
o
Export subsidies harm the subsidizing country by worsening its terms of
trade and creating domestic distortions (similar to tariffs).
o
Unlike tariffs, export subsidies don't benefit the subsidizing country in
terms of trade. They only create clear benefits for the importing country.
o
The passage suggests that using export subsidies rarely makes economic
sense for a country. Their use is often driven by political motives rather
than sound economic logic.

Comparison with Tariffs:
o
Both tariffs and export subsidies distort domestic production and
consumption.
o
However, tariffs can potentially improve the imposing country's terms of
trade (up to a certain point), while export subsidies always worsen the
subsidizing country's terms of trade.
The passage clarifies that the impact of foreign trade policies (tariffs and subsidies) on
the US can be more nuanced in a complex, multi-country world compared to a simple
two-country model. Here's the breakdown:
Limitations of Two-Country Model:

The previous analysis assumed a simplified two-country world where one country
exports what the other imports (and vice versa).

In the real world (with multiple countries), the impact of foreign trade policies can
be more intricate.
Impact Depends on Products:

Foreign Export Subsidy (Competing Good):
o
If a foreign country subsidizes a good that directly competes with US
exports, it worsens the US terms of trade (similar to the two-country
model).
o
This is because the subsidized foreign good becomes more competitive
on the world market, potentially reducing demand for US exports.

Foreign Tariff (Imported Good):
o
If a foreign country imposes a tariff on a good that the US also imports, it
can actually benefit the US.
o
The foreign tariff might lead to a lower world market price for that good,
making it cheaper for the US to import.
Examples:

The passage mentions European subsidies on agricultural exports as an
example of a policy hurting US terms of trade (since the US might compete in
those markets).
Key Takeaways:

The impact of foreign trade policies on the US depends on the specific products
involved.

Subsidies on competing exports and tariffs on imported goods can have opposite
effects on the US terms of trade compared to a simple two-country model.

Analyzing trade policies in a multi-country world requires considering the product
categories and potential competition dynamics.
The passage highlights the complexities of real-world trade policies and their impacts,
sometimes contradicting the predictions of a simple economic model. Here's a
breakdown:
Subsidies on Imported Goods: Not Always Bad for the US

The passage acknowledges that foreign subsidies on goods the US imports can
be beneficial according to the standard economic model.

Lower import prices due to subsidies can stimulate the US economy (assuming
the US is a net importer of that good).
Solar Panel Example:

The passage uses the example of China subsidizing solar panel exports to the
US.

According to the standard model, cheaper solar panels would benefit the US
economy (which imports more solar panels than it exports).
However, the issue is more nuanced:

Some economic models considering imperfect competition and increasing
production returns suggest potential welfare losses from the Chinese subsidy.

The biggest impact might be on income distribution within the US:
o
Most US residents benefit from cheaper solar panels.
o
But US solar panel industry workers and investors are hurt by lower import
prices.
Trade Diversion:

The US imposing tariffs on Chinese solar panels (in response to the subsidy) has
an unintended consequence: trade diversion.

Higher Chinese import prices incentivize solar panel production in other countries
(e.g., Malaysia in this case).

Malaysia's production has boomed, becoming the second-largest import source
for the US (after China).
Key Points:

The impact of foreign trade policies depends on the specific good and economic
factors involved.

A simple economic model might not capture all the complexities.

Subsidies on imported goods can have both positive (lower prices) and negative
(domestic industry job losses) consequences for the US.

Trade policies can lead to unintended consequences, such as trade diversion to
other countries.
International Borrowing and Lending
The passage explains how the standard trade model you've been learning about can be
applied to international borrowing and lending, which involves trading goods across
time. Here's a breakdown:
Standard Trade Model (Review):

This model analyzes how countries trade goods with each other at a specific
point in time (e.g., exchanging cloth for food).
International Borrowing and Lending:

This concept involves a financial aspect (loans, interest rates) but can also be
seen as a type of trade.

Instead of exchanging goods now, countries exchange goods today for goods in
the future.
Intertemporal Trade:

This term refers to the exchange of goods across time, which is what
international borrowing and lending essentially is.

The passage mentions you'll learn more about intertemporal trade later in the
text.
Adapting the Standard Model:

The passage suggests that a variant of the standard trade model with a time
dimension can be used to analyze international borrowing and lending.
Key Points:

International borrowing and lending involve exchanging goods today for goods in
the future.

This concept can be analyzed using a modified version of the standard trade
model you've been studying.

The text promises a more in-depth exploration of intertemporal trade later on.
In essence, the passage is introducing international borrowing and lending as another
facet of international trade, one that involves a time element and financial aspects, but
can still be understood through the lens of the core trade model with some adjustments.
Intertemporal Production Possibilities and Trade
The passage highlights a fundamental economic concept: the trade-off between present
and future consumption. Let's break it down:
Limited Resources:

Economies have a finite amount of resources (labor, land, capital) to produce
goods and services.
Consumption vs. Investment:

These resources can be used for:
o Current Consumption: Producing goods and services for immediate
consumption.
o Investment: Using resources to build productive capacity (machines,
buildings) for future production.
The Trade-Off:

There's a trade-off between consuming everything now (high current
consumption, low investment) and investing for the future (lower current
consumption, higher future production potential).

Investing more today means sacrificing some current consumption, but it allows
the economy to produce more goods and services in the future, leading to
potentially higher future consumption.
Example:


Imagine an economy can produce 100 units of good X.
They can choose to:
o Consume all 100 units now (no investment).
o Consume 80 units now and invest 20 units in building a factory (which will
increase production in the future).
Key Points:



This trade-off exists even without international interactions.
Every economy faces the decision of allocating resources between current
consumption and future production capabilities.
Choosing more investment today signifies a deliberate decision to forgo some
current consumption benefits for the possibility of greater consumption
opportunities in the future.
The passage and image you sent together perfectly illustrate the concept of an
intertemporal production possibility frontier (IPPF) and how it reflects the trade-off
between current and future consumption. Here's a breakdown of the key points:
Limited Resources - Big Decision:

An economy has limited resources to produce goods for consumption.

They face a crucial decision: allocate resources for current consumption or invest
in future production capabilities.
Intertemporal Production Possibility Frontier (IPPF):

This graphical concept depicts the various combinations of current and future
consumption possibilities achievable by an economy given its resource
constraints and technology.

The image shows an IPPF that looks similar to a regular production possibility
frontier (between two goods), but here the "goods" are current consumption on
the vertical axis and future consumption on the horizontal axis.
IPPF Shapes and Biases:

The shape of an IPPF can differ between countries.

Some countries might have an IPPF biased towards current consumption,
meaning they can produce more for current consumption at the expense of future
production potential.

Other countries might lean towards future-oriented IPPFs, sacrificing some
current consumption to invest more for higher future production.
Real-World Biases:

The passage mentions these biases can be due to real factors like:
o
Saving Rates: Countries with higher saving rates tend to have a bias
towards future production.

The text suggests you'll learn more about the reasons behind these biases later.
Two Hypothetical Countries:

The passage introduces Home and Foreign as two hypothetical countries with
contrasting IPPFs.
o
Home (Current Consumption Bias): Can produce more for current
consumption but has a lower future production potential.
o
Foreign (Future Consumption Bias): Can produce less for current
consumption but has a higher future production potential due to more
investment today.
o
So, Home has a bias towards current consumption, while Foreign
prioritizes future production.
Prediction based on Analogy:

Similar to how countries with different production possibilities trade goods, the
passage suggests countries with different IPPFs might "trade" consumption
across time.

Without international borrowing/lending, the passage predicts a higher relative
price of future consumption in Home compared to Foreign (similar to a good
being more expensive in a country that produces less of it). And thus, if we open
the possibility of trade over time, we would expect Home to export current
consumption and import future consumption.
Trading Across Time: The Puzzle

The passage acknowledges the concept of trading consumption across time
might seem puzzling.

It raises questions:
o
How do you define the "relative price of future consumption"?
o
How exactly does borrowing/lending allow countries to "trade"
consumption over time?
The Real Interest Rate
The passage explains how real interest rates play a crucial role in international
borrowing and lending, essentially allowing countries to trade consumption across time.
Here's a breakdown:
Trading Consumption Across Time: The Mechanism

The passage uses borrowing/lending analogies between individuals and
countries.

Borrowing:
o
An individual spends more than their current income by borrowing
(consuming more than production).
o
Later, they repay the loan with interest, meaning they consume less than
their production.
o
In essence, they trade future consumption (lower) for current consumption
(higher).

Lending:
o
Similarly, a lending country prioritizes future consumption by providing
resources now in exchange for a higher return later.

Countries as Borrowers and Lenders:
o
The same logic applies to countries. Borrowing countries consume more
now and repay with interest later (trading future for current consumption).
o
Lending countries prioritize future gains by providing resources now in
exchange for a return.
Real Interest Rates and Relative Price

The passage introduces the concept of the real interest rate (r) as a crucial
factor influencing this "trade."

The real interest rate determines the relative price of future consumption,
which is calculated as 1 / (1 + r).
o
A higher real interest rate signifies a higher relative price of future
consumption.
o
In simpler terms, you need to "pay more" in terms of current consumption
(give up more) to get the same amount of future consumption.
Example: Borrowing Country

Imagine a country with a bias towards current consumption borrows from another
country.

They can consume more now (than their current production allows) but will need
to repay the loan with interest in the future.

This translates to giving up some future consumption (repayment) to enjoy more
consumption now.
Real vs. Nominal Interest Rates (Future Discussion)

The passage acknowledges that things can be more complex in the real world
due to inflation.

This explanation focuses on "real" terms, assuming loan contracts are not
affected by inflation.
o
This simplifies the concept by eliminating the distortion of changing price
levels.

The text suggests that the second half of the book will explore how inflation
affects real interest rates and international borrowing/lending.
The passage dives deeper into the relationship between real interest rates,
intertemporal production possibility frontiers (IPPFs), and the concept of intertemporal
relative demand and supply. Here's a breakdown:
Impact of Real Interest Rates:

The passage reminds us that a higher relative price of future consumption (lower
real interest rate, denoted by r) incentivizes investment.

Reasoning: When borrowing becomes cheaper (lower r), countries are more
willing to borrow for investment, which increases their future production potential
(shifts the IPPF leftward in Figure 6-12).
Intertemporal Relative Supply:

The passage introduces the concept of an intertemporal relative supply curve
for future consumption.

This curve shows how the supply of future consumption changes relative to
current consumption in response to the relative price of future consumption
(1/(1+r)).

As explained earlier, a lower real interest rate (higher relative price) encourages
investment, increasing future production and supply.

This translates to an upward-sloping intertemporal relative supply curve.
Analogy to Consumer Preferences:

Just like consumers have preferences for different goods (cloth vs. food), they
also have preferences regarding current vs. future consumption.

The passage draws an analogy to how a consumer's preferences for goods are
represented by a relative demand curve.
Intertemporal Relative Demand:

The passage introduces the concept of an intertemporal relative demand
curve.

This curve shows how the demand for future consumption relative to current
consumption changes with the relative price of future consumption (1/(1+r)).

Factors influencing this demand curve could include a country's time preference
(how much they value present vs. future consumption) and future income
expectations.
Overall, the passage highlights how real interest rates act as a price signal that
influences both the supply and demand for future consumption across time,
similar to how relative prices affect the supply and demand for goods in a
traditional market.
The passage and image together explain how international borrowing and lending can
be analyzed using a framework similar to the standard trade model. Here's a breakdown
of the key points:
Standard Trade Model Analogy:

The standard trade model analyzes how countries with different production
possibilities trade goods.

This passage suggests a similar concept can be applied to trade across time
(intertemporal trade) when borrowing and lending are allowed.
World Real Interest Rate:

Borrowing and lending influence the relative price of future consumption, which is
determined by the world real interest rate (r1).
Intertemporal Relative Supply and Demand:

Intertemporal relative supply curve: Shows how much future consumption a
country is willing to supply relative to current consumption, considering the
relative price (1/(1+r)).
o
A lower real interest rate (higher relative price) incentivizes investment,
increasing future supply (upward slope).

Intertemporal relative demand curve: Shows how much future consumption a
country demands relative to current consumption, considering the relative price
(1/(1+r)).
o
Factors affecting demand include time preference (present vs. future
value) and future income expectations.
Global Market Equilibrium:

The world real interest rate is established at the intersection of the global supply
and demand curves for future consumption (similar to how equilibrium prices are
determined in the standard trade model).
The Case of Home and Foreign:

The image depicts the intertemporal relative supply curves for two hypothetical
countries, Home and Foreign.
o
Home (Current Consumption Bias): Higher supply of current consumption
relative to future consumption.
o
Foreign (Future Consumption Bias): Lower supply of current consumption
but higher potential for future production (due to more investment).

At the equilibrium real interest rate (1/(1+r1)), Home exports current consumption
and imports future consumption (borrowing from Foreign).
Essentially, the passage and image use the concepts of intertemporal supply and
demand to show how countries with different production possibilities and time
preferences can "trade" consumption across time through borrowing and
lending. The equilibrium real interest rate emerges from this global market
interaction.
Intertemporal Comparative Advantage
The passage explains the concept of intertemporal comparative advantage, which
applies to a country's relative ability to produce future consumption goods. Here's a
breakdown:
Regular vs. Intertemporal Comparative Advantage

Standard Comparative Advantage: Focuses on a country's ability to produce
current goods and services more efficiently compared to others.

Intertemporal Comparative Advantage: Focuses on a country's ability to
produce future consumption goods more efficiently compared to others.
High Real Interest Rate and Investment:

A country with an intertemporal comparative advantage in future production
would have a low relative price of future consumption (meaning future
consumption is relatively cheap to produce) in the absence of international
borrowing/lending.

This translates to a high real interest rate in that country.

A high real interest rate signifies a high potential return on investment (building
capital goods, etc.) that increases future production capacity.
Borrowing vs. Lending in the International Market:

Countries with high real interest rates (and intertemporal comparative advantage
in future production) tend to borrow in the international market.

This is because they have abundant investment opportunities offering high
returns, making borrowing to invest attractive.

Conversely, countries with low real interest rates (limited high-return investment
options) tend to be lenders in the international market.
o
They lend their resources to countries with a higher potential return on
investment.
Key Points:

Intertemporal comparative advantage is about future production efficiency.

High real interest rates and abundant investment opportunities signal a
comparative advantage in future production.

Countries borrow internationally to capitalize on these high-return investment
opportunities, while lenders provide resources for future production in other
countries.
Looking Ahead:
The passage doesn't explicitly mention what's next, but it suggests international
borrowing and lending can be a way for countries to exploit intertemporal comparative
advantages and potentially benefit from increased future production.
Question and Answer
1. Assume Indonesia and China are trading partners. Indonesia initially exports palm oil to and imports
lubricants from China. Using the standard trade model, explain how an increase in the relative price of
palm oil, in relation to lubricant prices, would affect production and consumption of palm oil for
Indonesia (assuming that the taste for both goods is the same in both countries). If the income effect
of price change of palm oil is greater than the substitution effect, what would happen to palm oil
consumption in Indonesia?
Impact of Increased Palm Oil Price on Indonesia (Standard Trade Model)
Scenario:

Indonesia exports palm oil and imports lubricants from China.

The relative price of palm oil increases compared to lubricants.
Analysis:
1. Export Effects:
o
A higher relative price of palm oil makes it more profitable for Indonesia to export.
o
Indonesian producers will likely increase palm oil production to meet the higher
global demand.
2. Income Effect:
o
Since Indonesia exports palm oil, it earns foreign currency when the price rises.
o
This effectively increases Indonesia's national income.
o
With higher income, Indonesians might choose to:

Consume more palm oil (normal good).

Consume more goods in general (including potentially imported
lubricants).
3. Substitution Effect:
o
Palm oil and lubricants might be substitutes (if they serve similar purposes).
o
With palm oil becoming relatively more expensive, consumers in Indonesia
might:

Substitute some palm oil consumption with lubricants (if possible).

Look for cheaper alternatives to palm oil domestically.
Overall Impact on Palm Oil Consumption:
The net effect on palm oil consumption in Indonesia depends on the relative strengths
of the income and substitution effects:

Income Effect (Likely Stronger): As Indonesia earns more from palm oil exports, their
overall income increases. This might lead to a significant increase in palm oil
consumption (being a normal good).

Substitution Effect (Likely Weaker): If palm oil and lubricants are not close substitutes,
the switch to lubricants might be limited, causing a smaller decrease in palm oil
consumption.
Conclusion:
If the income effect outweighs the substitution effect (which is likely in this case), then
an increase in the relative price of palm oil will lead to an increase in palm oil
consumption in Indonesia despite being an exported good. This might seem
counterintuitive, but it's because the export earnings boost overall income, allowing
Indonesians to afford more palm oil consumption.
2. Due to overfishing, Norway becomes unable to catch the quantity of fish that it could in previous
years. This change causes both a reduction in the potential quantity of fish that can be produced in
Norway and an increase in the relative world price for fish, Pf /Pa .
a. Show how the overfishing problem can result in a decline in welfare for Norway.
b. Also show how it is possible that the overfishing problem could result in an increase in welfare for
Norway.
Impact of Overfishing on Norway's Welfare
Scenario: Due to overfishing, Norway experiences a reduction in fish catch and a rise
in the global price of fish (Pf).
a. Decline in Welfare:
1. Reduced Production and Consumption: Overfishing depletes fish stocks,
lowering the potential quantity of fish Norway can catch (produce) in the future.
This limits the availability of fish for both domestic consumption and export,
potentially leading to:
o
Lower consumption: Norwegians might have less fish to consume, reducing
their overall satisfaction.
o
Lower export revenue: Reduced fish exports mean less foreign currency
earned, potentially decreasing Norway's ability to import other desired goods.
2. Loss of Future Income: Overfishing harms the long-term sustainability of the
fishing industry. Reduced fish stocks might lead to lower catches and export
earnings in the future.
b. Increase in Welfare (Possible, but Less Likely):
1. Short-Term Gain from Price Increase: The global fish price increase (Pf) due
to scarcity might lead to:
o
Higher export revenue: In the short term, Norway might earn more per unit of
fish exported due to the higher price.
o
Increased investment: The temporary revenue boost could be used to invest in
other sectors of the economy, potentially leading to future growth.
2. However, this is a short-sighted approach:
o
Unsustainable: The higher prices and increased catch rates cannot be
maintained if the fish stocks are not allowed to recover.
o
Future Decline: Eventually, depleted fish stocks will lead to a significant decline
in catches and export earnings, negating any short-term gains.
Overall:
While a temporary increase in export revenue is possible due to the price hike, it's far
more likely that overfishing will lead to a decline in Norway's welfare in the long run. The
negative consequences of reduced fish stocks, lower consumption, and potential
collapse of the fishing industry outweigh any short-term gains.
3. In some economies relative supply may be unresponsive to changes in prices. For example, if factors
of production were completely immobile between sectors, the production possibility frontier would
be right-angled, and output of the two goods would not depend on their relative prices. Is it still true
in this case that a rise in the terms of trade increases welfare? Analyze graphically.
Immobile Factors and Right-Angled Production Possibility Frontier (PPF)
The passage describes a scenario where factors of production (labor, land, capital)
cannot move between sectors within an economy. This leads to a right-angled
production possibility frontier (PPF) because:

The economy is stuck producing at fixed quantities of two goods (good X and good Y)
due to the immobility of resources.

Changes in relative prices won't incentivize producers to switch between goods, as they
lack the flexibility to adjust their production methods.
Impact of Terms of Trade on Welfare (Graphical Analysis)
Terms of Trade (ToT): The relative price of a country's exports compared to its imports.
A higher ToT means a country gets more imports for each unit of export.
Right-Angled PPF and ToT:

In this case, even with a higher ToT (improvement in trading conditions), the economy
cannot produce more of the export good (good X) to take advantage of the better price.

They are limited by the fixed production capacity at point A on the PPF (see graph
below).
Graph:
Imagine a right-angled PPF with points A and B representing the two extreme
production possibilities (all good X or all good Y).

Point A: Maximum production of good X and zero production of good Y.

Point B: Maximum production of good Y and zero production of good X.
Analysis:

A higher ToT would normally incentivize a country to shift production towards the export
good (good X) to maximize gains from trade.

However, with a right-angled PPF, such a shift is impossible due to the immobility of
factors.

The economy remains stuck at point A, regardless of the ToT.
Welfare Impact:

In this specific scenario, a change in ToT wouldn't directly affect the total output or
consumption possibilities within the economy.

Welfare might improve only if the higher ToT allows the country to import a wider variety
or greater quantities of good Y (assuming it's a desirable good), leading to higher
consumption satisfaction.
Conclusion:
While a higher ToT generally improves welfare by allowing a country to specialize and
benefit from trade, in the case of a right-angled PPF with immobile factors, the impact is
limited. The economy cannot fully exploit the price change due to its production
constraints.
4. The counterpart to immobile factors on the supply side would be lack of substitution on the
demand side. Imagine an economy where consumers always buy goods in rigid proportions—for
example, one yard of cloth for every pound of food—regardless of the prices of the two goods. Show
that an improvement in the terms of trade benefits this economy as well.
Lack of Substitution and Terms of Trade Benefits
The passage presents a scenario where an economy has a fixed consumption ratio
(e.g., 1 yard of cloth for every pound of food) regardless of price changes. This lack of
substitution on the demand side is considered the counterpart to immobile factors on
the supply side.
Terms of Trade (ToT): The relative price of a country's exports compared to its imports.
A higher ToT means a country gets more imports for each unit of export.
Impact of Improved ToT:
Even with a fixed consumption ratio, an improvement in ToT (e.g., the country can now
import more food per yard of cloth exported) can benefit this economy. Here's why:
1. Increased Consumption of Both Goods: With a higher ToT, the country can
import more food for the same amount of exported cloth. This effectively
increases their purchasing power, allowing them to:
o
Maintain the fixed consumption ratio (1 yard cloth : 1 pound food) but with higher
quantities of both goods.
o
Potentially improve their overall consumption level (standard of living).
2. Graphical Explanation:
Imagine a graph with the X-axis representing cloth exports and the Y-axis representing
food imports. The fixed consumption ratio translates to a straight line with a slope of -1
(since the import quantity changes proportionally with the export quantity).

Before the ToT improvement, the line might intersect the axes at points representing the
initial export and import levels.

With a higher ToT, the same line representing the fixed consumption ratio will now
intersect the Y-axis (food imports) at a higher point. This signifies an increase in
affordable food imports for the same cloth exports.
Key Points:

Lack of substitution on the demand side doesn't negate the benefits of improved ToT.

The country can still "buy more" (increased consumption of both goods) due to the
effectively increased purchasing power from the better trade terms.
Limitations:

The benefit might be limited if the fixed consumption ratio leaves little room for
increasing consumption (e.g., if the initial consumption levels were already close to the
maximum affordable quantities).

The lack of substitution could also lead to inefficiencies if there are situations where
consuming more of one good (e.g., food during a famine) would be highly desirable, but
the fixed ratio prevents such adjustments.
Conclusion:
An improvement in Terms of Trade can benefit an economy even with a fixed
consumption ratio due to the increased purchasing power it offers, allowing for higher
consumption levels of both goods within the fixed proportion.
5. The Netherlands primarily exports agricultural products, while importing raw materials such as
natural gas, metal ores, and grains. Analyze the impact of the following events on the Netherland’s
terms of trade:
a. Farm pollution in China is worsening.
b. Egypt is planning to import large quantities of liquefied natural gas.
c. Germany has a sustainable development strategy for raw materials and energy productivity.
d. OPEC’s agreement with Russia cut oil production and pushing oil prices higher.
e. A rise in Netherland’s tariffs on imported iron and steel.
Impact of Events on Netherlands' Terms of Trade (ToT)
Netherlands' Trade Pattern:

Exports: Agricultural products

Imports: Raw materials (natural gas, metal ores, grains)
Terms of Trade (ToT): The relative price of a country's exports compared to its imports.
A higher ToT means a country gets more imports for each unit of export.
Event Analysis:
a. Farm pollution in China worsening:

Impact: Potentially positive for ToT.

Reasoning: China is a major importer of agricultural products. If their farm pollution
reduces domestic production, they might need to import more to meet demand. This
could increase global agricultural product prices, benefiting Dutch exporters (assuming
their production costs don't rise significantly).
b. Egypt planning to import large quantities of liquefied natural gas (LNG):

Impact: Positive for ToT (short-term).

Reasoning: Increased demand for LNG, which the Netherlands might export, could
drive up global LNG prices. This benefits Dutch exporters in the short term. However, the
Netherlands is also an importer of some natural gas, so a long-term price increase could
have mixed effects.
c. Germany has a sustainable development strategy for raw materials and energy
productivity:

Impact: Mixed impact on ToT.

Reasoning: Germany might become less reliant on raw material imports, potentially
lowering global demand and prices for these goods (including those the Netherlands
imports). This could negatively impact Dutch import prices (good for consumers), but
also potentially reduce export opportunities for some raw materials the Netherlands
might supply.
d. OPEC and Russia cutting oil production, pushing oil prices higher:

Impact: Negative for ToT (indirectly).

Reasoning: While the Netherlands doesn't directly export oil, a rise in global oil prices
can lead to generally higher import costs for many goods due to increased transportation
and production expenses. This could reduce the purchasing power of Dutch exports in
the global market, effectively lowering their ToT.
e. A rise in Netherlands' tariffs on imported iron and steel:

Impact: Negative for ToT.

Reasoning: Tariffs make imports more expensive, but they don't directly affect Dutch
exports. This can distort trade patterns and potentially reduce overall trade volumes.
Additionally, retaliation from other countries with tariffs on Dutch exports could further
worsen the ToT.
Overall:
The events will have a mixed impact on the Netherlands' Terms of Trade. Events a and
b have the potential to improve ToT in the short term, while c and d might have negative
consequences. Event e will likely harm the ToT by distorting trade patterns.
6. Access to adequate food is the primary concern for most countries; thus, agriculture is one of the
most important industries in the world. The security and health of population has lowered the price of
manufactured products relative to agricultural products. Brazil is among the top exporters of
agricultural products in the whole world, an area in which the United States had been a major
exporter. Using manufactured goods and agricultural products as tradable goods, create a standard
trade model for the United States and Brazilian economies that show how a decline in relative prices
can reduce welfare in the United States and increase it in Brazil.
Standard Trade Model: US and Brazil (Agricultural vs. Manufactured Goods)
Assumptions:

Two countries: USA (U) and Brazil (B)

Two tradable goods: Manufactured Goods (M) and Agricultural Products (A)

Perfect competition in all markets

Constant opportunity cost (linear PPF)

No transportation costs
Initial Conditions:

USA: Traditionally a major exporter of agricultural products and importer of
manufactured goods.

Brazil: Top exporter of agricultural products.

Global security and health improvements lead to a decline in the relative price of
manufactured goods compared to agricultural products (Pm / Pa falls).
Model:
1. Production Possibility Frontier (PPF):
o
Both USA and Brazil will have PPFs depicting their production possibilities for
manufactured goods (M) and agricultural products (A).
2. Autarky:
o
Initially, both countries operate in autarky (without trade).
o
Each country's consumption point (C) will be located inside their respective
PPFs, representing their autarky consumption levels of both goods.
3. Free Trade:
o
With free trade, both countries specialize and trade.
o
USA, with a comparative advantage in manufactured goods (due to initial
conditions), will export M and import A.
o
Brazil, with a comparative advantage in agricultural products, will export A
and import M.
o
New Consumption Points (C'): Trade will lead to new consumption
points (C') for both countries, located on their respective PPF but beyond
their autarky consumption possibilities. This signifies increased
consumption of both goods for both countries compared to autarky.
Impact of Price Decline:

The decline in the relative price of manufactured goods (Pm / Pa falls) affects the
USA and Brazil differently:
o
USA (Negative Impact):

As a net importer of A, the USA benefits from the price decrease.

However, the USA might also experience a terms of trade decline.

Since they export M (whose price fell) and import A (whose price fell less),
they might need to export more M to import the same amount of A. This
can reduce their overall purchasing power and potentially push their new
consumption point (C') inward, signifying a decrease in welfare
(consumption possibilities) compared to the free trade scenario without
the price decline.
o
Brazil (Positive Impact):

As a net exporter of A, Brazil directly benefits from the price increase of
agricultural products.

Their export earnings increase, potentially allowing them to import more
manufactured goods at the lower price.

This can push their new consumption point (C') outward, signifying an
increase in welfare (consumption possibilities) compared to the free trade
scenario without the price decline.
Conclusion:
The decline in the relative price of manufactured goods can lead to a welfare decline
for the USA (net importer of the good whose price fell) and a welfare increase for
Brazil (net exporter of the good whose price increased). This demonstrates how
changes in global prices can impact different countries based on their comparative
advantage and trading patterns.
7. Countries A and B have two factors of production, capital and labor, with which they produce two
goods, X and Y. Technology is the same in the two countries. X is capital-intensive; A is capitalabundant. Analyze the effects on the terms of trade and on the two countries’ welfare of the
following:
a. An increase in A’s capital stock.
b. An increase in A’s labor supply.
c. An increase in B’s capital stock.
d. An increase in B’s labor supply.
Impact of Events on Terms of Trade and Welfare (A & B)
Assumptions:

Two countries: A and B

Two factors: Capital (K) and Labor (L)

Two goods: X (capital-intensive) and Y

Same technology in both countries
Analysis:
a. Increase in A's Capital Stock:

Impact on A:
o
A becomes more efficient in producing X (capital-intensive good) due to the
increased capital.
o
o
This might lead A to:

Produce more X and potentially less Y.

Export more X.
A's terms of trade (ToT) could improve (get more Y for each X exported) due to
their increased comparative advantage in X.
o

Welfare in A might increase due to higher production and export earnings.
Impact on B:
o
B's ToT could worsen (get less Y for each X imported) as A becomes a more
competitive exporter of X.
o
B's welfare might decrease due to potentially higher import prices for X.
b. Increase in A's Labor Supply:

Impact on A:
o
A's production possibilities expand for both X and Y due to more labor.
o
The effect on the relative production of X and Y depends on the specific factor
intensity of A's new labor force.

If the new labor is more suited for capital-intensive X, A might still export
more X.

If the new labor is more suited for Y, A's comparative advantage in X
might weaken.

o
The impact on ToT depends on the final production decisions.
o
Welfare in A might increase due to the overall production expansion.
Impact on B:
o
The effect on B depends on A's final production choices.

If A continues to export more X, B's ToT worsens, and welfare might
decrease.

If A's comparative advantage in X weakens, B might benefit from a more
balanced trade pattern.
c. Increase in B's Capital Stock:

Impact on B:
o

B becomes more efficient in producing X, potentially:

Increasing their X production.

Making them a more competitive exporter of X.
o
B's ToT could improve (get more Y for each X exported).
o
Welfare in B might increase due to higher production and export earnings.
Impact on A:
o
A's ToT could worsen (get less Y for each X imported) due to B's increased
competitiveness in X.
o
A's welfare might decrease due to potentially higher import prices for X.
d. Increase in B's Labor Supply:

Impact on B:
o
B's production possibilities expand for both X and Y due to more labor.
o
The effect on the relative production of X and Y depends on the specific factor
intensity of B's new labor force.

B might become more competitive in X if the new labor is suited for
capital-intensive production.

B might diversify production more if the new labor is suited for both X and
Y.

o
The impact on ToT depends on the final production decisions.
o
Welfare in B might increase due to the overall production expansion.
Impact on A:
o
The effect on A depends on B's final production choices.

If B becomes a strong competitor in X export, A's ToT worsens, and
welfare might decrease.

If B diversifies production, A might benefit from a more balanced trade
pattern.
Overall:
Changes in capital and labor supply in each country affect their comparative advantage
in X and Y. This, in turn, influences their terms of trade and welfare.

A's capital advantage strengthens with more capital (a) or labor suited for X (b),
potentially harming B's ToT.

B's competitiveness in X can improve with more capital (c) or labor suited for X (d),
potentially harming A's ToT.

The specific impact on welfare depends on the production changes, export patterns, and
overall production gains within each country.
8. Economic growth is just as likely to worsen a country’s terms of trade as it is to improve them. Why,
then, do most economists regard immiserizing growth, where growth actually hurts the growing
country, as unlikely in practice?
You're absolutely right. Economic growth can have a double-edged sword effect on a
country's terms of trade (ToT), potentially improving or worsening it. However,
economists generally consider immiserizing growth (where growth actually harms the
country) to be unlikely for a few reasons:
Limited Downside of Lower Export Prices:

Even if economic growth leads to increased production of a country's export
good, causing its price to fall, the overall gains from growth often outweigh this.

Increased production volume typically translates to a significant increase in total
export earnings, despite the lower price per unit.
Technological Advancements Mitigate Negative Effects:

Economic growth often stimulates technological advancements and innovation.

These advancements can improve the efficiency and competitiveness of a
country's exports, even with a slight price decrease.
Demand for Imports Might Increase:

Economic growth usually leads to higher national income.

This can increase demand for imports, which isn't necessarily negative.

A wider variety of imported goods can benefit consumers and potentially improve
their overall well-being.
Overall Welfare Gains Outweigh ToT Fluctuations:

Even if the ToT worsens slightly, the benefits of economic growth in terms of
increased production, consumption, and overall standard of living tend to be
much larger.

Higher national income allows a country to afford a potential decrease in the
purchasing power of exports.
Here's an additional point to consider:

The likelihood of immiserizing growth is higher for a small country with a large
share of global exports in a particular good.

If their production increase significantly impacts the global price of that good, the
negative ToT effects might be more pronounced.
In conclusion:
While economic growth can affect a country's ToT, the overall benefits of growth
(increased production, consumption, and standards of living) usually outweigh the
potential downsides. Additionally, factors like technological advancements and
increased import demand help mitigate the negative impacts of lower export prices. This
is why, despite the theoretical possibility, immiserizing growth is considered unlikely in
practice.
9. Singapore and Korea are somewhat similar in adopting eco-innovation policies: both are highlyinnovative economies, with similar patterns of comparative advantage in producing eco-friendly goods
and services. Korea was the first to adopt instruments for eco-innovation. Singapore is now adopting
its own instruments in this direction. How would you expect this to affect the welfare of Korea? Of the
United States? (Hint: Think of adding a new economy identical to that of Korea to the world economy.)
Impact of Eco-Innovation Policies on Welfare:
Scenario:

Korea and Singapore are highly innovative economies with similar comparative
advantages in eco-friendly goods and services.

Korea was the first mover, adopting eco-innovation policies earlier.

Singapore is now implementing its own eco-innovation policies.
Impact on Korea:

Short-Term Impact (Mixed):
o
Negative Impact: Singapore's entry as a competitor in eco-friendly goods might:

Reduce market share for Korean eco-friendly products in the short term.

Lead to potential price competition, potentially lowering Korean export
earnings.

Long-Term Impact (Potentially Positive):
o
Innovation Spillovers: Competition from Singapore might incentivize Korea to
further invest in eco-innovation, leading to:
o

Development of new, more efficient eco-friendly technologies.

Maintaining a competitive edge in the long run.
Global Market Expansion: Increased global production of eco-friendly goods
can lead to:

Growing global demand for these products.

Potential for both Korea and Singapore to benefit from a larger market
pie.
Impact on United States:

Positive Impact:
o
Increased global production of eco-friendly goods due to Korea and Singapore's
policies can lead to:

Lower global prices for these goods.

Increased accessibility and affordability of eco-friendly products for the
US and other countries.

Potential environmental benefits for the world.
Thinking in terms of Adding an Economy Identical to Korea:

Imagine adding another Korea (economically identical) to the world market.

Initially, there might be a reduction in overall prices for eco-friendly goods due to the
increased supply from both Koreas.

However, in the long run, the increased competition could stimulate further
innovation in both Koreas, potentially leading to:
o
Development of even more advanced eco-friendly technologies.
o
A larger variety and potentially even lower prices for these goods in the long run.
Overall:
Korea's welfare might be negatively affected in the short term due to competition from
Singapore. However, the long-term impact can be positive if Korea leverages
competition to drive further innovation. The United States and other countries are likely
to benefit from lower prices and increased availability of eco-friendly goods due to these
policies.
10. Suppose Country X subsidizes its exports and Country Y imposes a “countervailing” tariff that
offsets the subsidy’s effect, so that in the end, relative prices in Country Y are unchanged. What
happens to the terms of trade? What about welfare in the two countries? Suppose, on the other hand,
that Country Y retaliates with an export subsidy of its own. Contrast the result.
Scenario 1: Countervailing Tariff Offsets Export Subsidy
Country X: Subsidizes exports. Country Y: Imposes a countervailing tariff equal to the
subsidy amount.
Impact on Terms of Trade (ToT):

No Change:
o
The countervailing tariff cancels out the price advantage Country X gained from
the subsidy.
o
Relative prices of imports and exports in Country Y remain the same, so their ToT
is unaffected.
Impact on Welfare:

Country X:
o
The subsidy might distort their production, potentially leading to inefficiencies.
o
Consumers in X might benefit from lower export prices (artificially created by the
subsidy) in the short term.
o
However, the long-term impact depends on how the subsidy is financed (e.g.,
taxes).

Country Y:
o
The countervailing tariff protects their domestic producers from unfair
competition.
o
Consumers in Y might face slightly higher prices due to the tariff, but it prevents a
distortion in their market caused by the subsidy.
Overall:
This scenario essentially negates the effects of both policies, leaving the ToT and
welfare (in the long run) relatively unchanged compared to a situation with no subsidies
or tariffs. However, there might be short-term distortions in production and consumption
patterns in both countries.
Scenario 2: Country Y Retaliates with Export Subsidy
Country X: Subsidizes exports. Country Y: Retaliates with its own export subsidy.
Impact on Terms of Trade:

Uncertain:
o
Both countries are manipulating export prices, making it difficult to predict the
exact impact on their ToT.
o
It depends on the size and effectiveness of each country's subsidy program.
o
In general, a "subsidy war" can lead to:
o

Lower global prices for the subsidized goods.

This could potentially benefit importers in both countries (improved ToT).
However, it can also lead to:

Trade distortions and inefficiencies in both economies.
Impact on Welfare:

Uncertain and Potentially Negative:
o
Both countries are incurring costs associated with the subsidies.
o
Consumers might benefit from lower prices in the short term, but this comes at a
cost to taxpayers or other sources funding the subsidies.
o
There's a risk of a subsidy war escalating, harming both economies in the long
run.
Comparison:
Scenario 1 avoids trade distortions but achieves little overall impact. Scenario 2 might
lead to lower prices for consumers but risks a trade war and potential harm to both
economies. In general, free trade without subsidies and countervailing tariffs is typically
considered the most welfare-enhancing scenario for both countries.
11. Explain the analogy between international borrowing and lending and ordinary international
trade.
Both international borrowing and lending and ordinary international trade involve the
exchange of goods and services between countries, but they differ in terms of what is
being exchanged and the timing.
Ordinary International Trade:

Exchange: Countries exchange physical goods and services.

Timing: The exchange is simultaneous. A country exports goods/services and
receives imports in return at the same time.
International Borrowing and Lending:

Exchange: Countries exchange purchasing power over time.

Borrowing: A country receives financial resources (loans) from another country
today, promising to repay them with interest in the future. They essentially
exchange future goods/services for present goods/services.

Lending: A country provides financial resources (loans) to another country
today, expecting to receive repayment with interest in the future. They essentially
exchange present goods/services for future goods/services (the loan repayment
with interest).
Here's a table summarizing the key differences:
Feature
Ordinary Trade
Borrowing & Lending
Exchanged Value
Goods & Services
Purchasing Power
Timing of Exchange
Simultaneous
Over Time
Flow of Goods/Services
Bi-directional
Uni-directional (Initially)
Future Obligation
No
Repayment with Interest
Analogy:
Imagine two friends, Alice and Bob. In ordinary trade, Alice might trade fresh bread
(good) she baked for some apples (good) Bob harvested. This is a one-time exchange.
In borrowing and lending, Alice might need money (purchasing power) today to buy a
new tool. Bob lends her the money, expecting repayment with some additional interest
in the future. Here, Alice receives something of value now (purchasing power) but owes
Bob something in the future (repayment).
12. Which of the following countries would you expect to have intertemporal production possibilities
biased toward current consumption goods, and which would be biased toward future consumption
goods?
a. A country like Egypt that has discovered large reserves of natural gas that can be exploited with
massive investments.
b. A country like India that is catching up technologically due to massive outsourcing services,
especially from wealthy countries.
c. A country like Germany or the United States where a ban on immigration means a limited inflow of
immigrants.
d. A country like Indonesia that started developing its infrastructure to make industries more
productive and cost-efficient.
e. A country like the Netherlands that aims to reduce energy and gas consumption with low
investment in the use of biofuels.
Here's an analysis of each country and their expected bias in intertemporal production
possibilities:
a. Egypt: Discovering large natural gas reserves presents an opportunity. They can:

Current Bias: Exploit the reserves quickly for immediate consumption benefits.

Future Bias: Invest heavily to develop the resources efficiently, considering
long-term sustainability and maximizing future returns.
Likely Bias: Depends on the chosen exploitation strategy. It could be current-biased if
they prioritize quick extraction, or future-biased if they invest for long-term benefits.
b. India: Catching up technologically signifies investment in:

Future Bias: Building human capital (through education and training) and
technological infrastructure for long-term economic growth.
Likely Bias: Future-biased due to the focus on long-term technological advancements.
c. Germany/US with limited immigration:

Current Bias: A limited workforce might constrain future production possibilities.

Future Bias: Investment in automation and labor-saving technologies could
compensate for the limited workforce.
Likely Bias: The impact is ambiguous. It could be current-biased due to immediate
labor shortage or future-biased if automation is prioritized.
d. Indonesia developing infrastructure:

Future Bias: Infrastructure development improves future productivity and
production capacity.
Likely Bias: Future-biased due to the focus on long-term economic benefits.
e. Netherlands reducing energy consumption:

Current Bias: Lower energy consumption signifies prioritizing present
consumption over potential future economic gains from increased energy
production.
Likely Bias: Current-biased due to the focus on reducing consumption rather than
potential future production.
In conclusion:

Future-biased: India (b), Indonesia (d).

Current-biased (or ambiguous): Egypt (a) depending on exploitation strategy,
Germany/US (c) depending on automation adoption.

Current-biased: Netherlands (e).