Chapter 2
How is TOT established

Mill’s Reciprocal Demand Principle

Graph



Autarky
Trade equilibrium
Offer Curve

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
Conception
How to derive offer curve
Trade equilibrium
Chapter 2
Autarky
Price Line
Y
A
K
Y0
I2
I0
O
X0 B
X
I1
Chapter 2
Trade Equilibrium
Chapter 2
Offer Curves are



all combinations of a country’s desired
exports and imports at different terms
of trade
also known as reciprocal demand curves
(J.S. Mills)
measures of willingness to trade
Chapter 2
Y
Y1
Y2
Y
C
P
(PX/PY)1
X1
X2
X
(PX/PY)1
Y5
X5
X
Chapter 2
Y
Y3
(PX/PY)1
Y4
(PX/PY)2
Y
X3
X4
X
(PX/PY)2
(PX/PY)1
Y6
Y5
X5 X6
X
Chapter 2
Y
Y3
(PX/PY)1
Y4
(PX/PY)2
Y
X3
OCA
X4
X
(PX/PY)2
(PX/PY)1
Y6
Y5
X5 X6
X
Chapter 2
Offer Curves



Offer curves represent willingness to
trade at every possible terms of trade
As the relative price of good X rises,
Country A becomes willing to export
more and import more
Offer curves “bow” towards the import
good axis
Chapter 2
Deriving Country B’s Offer
Curve


This will reflect Country B’s willingness
to trade at different terms of trade
B’s offer curve bows towards the axis
with B’s import good on it
Chapter 2
Y
(PX/PY)1
p
Y7
c
Y8
Y
X7
X8
X
(PX/PY)1
Y9
X9
X
Chapter 2
Y
(PX/PY)1
Y10
(PX/PY)2
Y11
Y
X10
X11 X
(PX/PY)1
(PX/PY)2
OCB
Y12
Y9
X9
X12
X
Chapter 2
Terms of Trade Equilibrium


The international terms of trade (that is,
PX/PY) will be the slope of a line passing
through the point where the offer
curves cross.
This equilibrium point takes into
account demand and supply conditions
in both countries
Chapter 2
Terms of Trade Equilibrium
Y
OCA
(PX/PY)E
OCB
If these are the terms of trade,
country A will desire to export
X1 units, and country B will
want to import X1 units;
Y1
X1
country A will desire to import
Y1 units, and country B will
want to export Y1 units
X
Chapter 2
How Do We Know It’s
Equilibrium?

Any terms of trade other than (PX/PY)E
will result in



excess demand for one good
excess supply for the other
Therefore relative prices will adjust until
(PX/PY)E is reached
Chapter 2
Disequilibrium
Y
OCA
(PX/PY)1
Y1
Y2
OCB
At (PX/PY)1, country A wishes
to import Y1 units, but country B
is only interested in exporting Y2
units. That is, there is an excess
demand for good Y.
X
Chapter 2
Disequilibrium
OCA
Y
(PX/PY)1
OCB
At (PX/PY)1, country A wishes
to export X1 units, but country B
is only interested in importing X2
units. That is, there is an excess
supply of good X.
X2
X1
X
Chapter 2
Disequilibrium




Excess demand for Y causes PY to rise
Excess supply of X causes PX to fall
Thus, (PX/PY) falls
In other words, the terms of trade line
gets flatter, moving the countries in the
direction of equilibrium
Chapter 2
Moving Towards Equilibrium
Y
(PX/PY)1
OCA
OCB
X
Chapter 2
Disequilibrium

Terms of trade lines that are flatter than
(PX/PY)E, such as
Y
OCA
(PX/PY)2
OCB
X
Chapter 2
Disequilibrium

Terms of trade lines that are flatter than
(PX/PY)E will results in




an excess demand for good X
an excess supply of good Y, and so
(PX/PY) will rise
That is, the terms of trade line will get
steeper until (PX/PY)E is reached
Chapter 2
Moving Towards Equilibrium
Y
(PX/PY)2
OCA
OCB
X