The Standard Trade Model
• Ricardian model:
– production possibilities determined by the allocation of
labor between sectors.
– comparative advantage but no distribution of income.
• Heckscher-Ohlin model:
– multiple factors of production;
– differences in resources drive trade patterns;
– trade can affect the distribution of income.
• Standard trade model:
– bring several features into one framework:
– difference in production possibility frontier give rise to trade;
– production possibility determine a country’s relative supply;
– world equilibrium is determined by world relative supply and
demand that lies between national relative supply schedules.
• Standard trade model. More flexible to analyze several important
issues:
– trade effect on industrial structure;
– world price effects on national production, consumption
and welfare; impact of tariffs and other trade policies on the
domestic country;
– impact of growth on welfare;
•
Standard trade model is built on 4 relationship:
1. the relationship between the production possibility
frontier and the relative supply curve;
2. the relationship between relative prices and relative
demand;
3. the determination of world equilibrium by world
relative supply and world relative demand;
4. the effect of the terms of trade—the price of a
country’s exports divided by the price of its imports—
on a nation’s welfare.
• Important concept: the term of trade (TOT)
TOT =
Export Price
Import Price
– TOT changes have an impact on industrial structure,
consumption and welfare;
– Old debate on the TOT of developing countries
– Prebish-Singer thesis: TOT between primary products
and manufactured goods tends to deteriorate over time.
Æ countries that export primary products (developing
countries) would be able to import less and less for a
given level of exports;
Æ developing economies should not focus on producing
primary products but should instead promote the
development of manufacturing industry.
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Important concept: the term of trade (TOT)
1960
2000
Developed country
117
110
Developing country
45
75
Oil producers
21
80
Deterioration of the TOT in
developed countries vs
better TOT for oil exporters
UNCTAD: TOT 1980 base = 100
– A particular aspect of the TOT deterioration: EU Common Agricultural Policy
(CAP)
– Impact of the CAP on developing countries, that have large agricultural sector
– WTO negotiation and “collapse” in Cancun
• Production possibilities and relative supply
V = PC QC + PF QF
⇔ QF =
Each country’s production possibility frontier is
a smooth curve like that illustrated by TT.
V ⎛ PC ⎞
− ⎜ ⎟QC
PF ⎜⎝ PF ⎟⎠
A market economy maximizes the value of
output, V, at given market prices PC QC + PF QF
The economy will produce the highest value of
output it can, which can be achieved by
producing at point Q, where TT is just tangent
to an isovalue line.
Suppose PC PF were to rise. The isovalue lines will
be steeper than before
– 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 VV1;
– the point at which the economy produces
shifts from Q1 to Q².
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.
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• Relative prices and demand
– Autarky equilibrium : QA=DA and QM=DM; the value of
consumption equals the value of its production:
V = PC QC + PF QF = PC DC + PF DF
– Production and consumption MUST lie on the same
isovalue line.
– Production already defined (see last slide)
– Consumption? 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
Curve
Food
Production
An indifference curve traces a set of
combinations of cloth (C) and food (F)
consumption that leave the individual equally
well off.
Properties of indifference curves:
1. downward sloping: If an individual
is offered less F, then to be made equally well
off she must be given more C.
2. The farther up and to the right an
indifference curve lies, the higher the level of
welfare to which it corresponds: on individual
will prefer more of both goods to less.
3. Each indifference curve gets flatter
as we move to the right: The more C and the
less F an individual consumes, the more
valuable a unit of F is at the margin compared
with a unit of C, so more C will have to be
provided to
compensate for any further
reduction in F.
Free Trade:
The economy produces more cloth than it
consumes and therefore exports cloth;
correspondingly, it consumes more food
than it produces and therefore imports
food.
Equilibrium in
Autarky
Cloth
Production
Food
Production
The economy produces at point Q, where
the production possibility frontier is
tangent to the highest possible isovalue
line.
D
Food
imports
It consumes at point D, where that isovalue
line is tangent to the highest possible
indifference curve.
Q=D
Q
Cloth exports
Cloth
Production
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Effects of a rise in the relative price of cloth
Slope of the isovalue lines is equal to minus the
relative price of cloth PC PF , so when that relative
price rises all isovalue lines become steeper.
D1’
In particular, the maximum value line rotates
from VV1 to VV².
– production shifts from Q1 to Q2;
– consumption shifts from D1 to D2. two
effects:
– income effect: the relative price of
cloth rises, country imports more food
for any given volume of exports;
– substitution effect: change in
relative prices leads to a shift along the
indifference curve, toward food and
away from cloth.
Welfare effect of a rise in the relative price
of cloth
A country that initially exports cloth is made
better off (see shift from D1 to D2).
A country that initially exports food is made
worse off (see shift from D2 to D1).
Case of developing countries:
– change of industrial structure in favor of
manufacturing (where they do not have
any comparative advantage);
– income
redistribution
towards
manufacturing workers (and not workers
in the agricultural sector.);
– margin reduction and exit of small
enterprises.
A rise in the terms of trade
increases a country’s welfare,
while a decline in the terms of
trade reduces its welfare.
International equilibrium within the RS and RD
framework
The higher PC PF is the larger the world supply of
cloth relative to food (RS) and the lower the world
demand for cloth relative to food (RD). Equilibrium
relative price (here, (PC PF )equi) is determined by the
intersection of the world relative supply and demand
equi
curves.
⎛ PC ⎞
The world relative supply curve (RS) is upward
sloping because an increase in PC PF
leads both
countries to produce more cloth and less food.
⎜⎜ ⎟⎟
⎝ PF ⎠
The world relative demand curve (RD) is downward
sloping because an increase in PC PF leads both
countries to shift their consumption mix away from
cloth toward food.
The intersection of the curves (point 1) determines
the equilibrium relative price
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International equilibrium within offer curves
framework
At the relative price corresponding to
the slope of the line from the origin,
Home makes the offer to trade QC-DC
units of cloth for DF-QF units of food.
Offer curve: tracing out how Home’s
offer varies as PC PF changes.
Same for Foreign (see below)
International equilibrium within offer curves
framework
Equilibrium :
QC − DC = DC* − QC* and
DF − QF = QF* − DF*
Foreign’s offer curve shows how that country’s
desired imports of cloth and exports of food vary
with the relative price.
At the equilibrium point E the relative price of
cloth is equal to the slope of OE.
Home’s exports of cloth, which equal Foreign’s
imports, are OX.
Foreign’s exports of food, which equal Home’s
imports, are OY.
• Economic growth and term of trade
Growth is biased when it shifts production possibilities out more toward one good than
toward another.
In both cases, the production possibility frontier shifts out from TT1 to TT². In case (a)
this shift is biased toward cloth, in case (b) toward food.
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• TOT, distortion and Immiserizing growth
– Is growth good or bad for the domestic country? This
depends on the bias of the growth. Export biased growth is
good for the domestic country because it increases its term
of trade;
– if a country growth results in an increased desired to
trade, growth leads to a deterioration of country’s TOT
unless ROW is growing at the same rate or faster;
– is the deterioration in the TOT so severe that the country
is made worth off? Immiserizing growth (Bhagwati,
1958);
A special case: immiserizing growth: large country with monopoly power
Assume a technical improvement in cloth and
shift from TT1 to TT².
– At the initial price W1, country wan to
trade more, supplying more export and
demanding more import of food;
– this cause the TOT to deteriorate (the
relative price of cloth fall)
– this deterioration is so large that welfare
reduces from D1 to D²; New consumption
and new production sets;
This seems to be paradoxical but since the
country has a monopoly power in trade, it has
an impact on the TOT.
When a country has a monopoly power, free
trade is not the optimal policy
Food
Production
D1
D2
W2
W1
TT1 TT2
Cloth
Production
Growth within the relative supply framework
Growth biased toward cloth
shifts the RS curve to the right
(panel a), while growth biased
toward food shifts it to the left
(panel b)
– 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.
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Example: Has the Growth of Newly Industrializing Countries Hurt Advanced Nations?
Average Annual Percent
Changes in Terms of Trade
Growth in the rest of the world can hurt the
domestic country if it takes place in sectors that
compete with domestic’s exports. (Samuelson,
2004: If China becomes sufficiently good at
producing goods it
currently imports,
comparative advantage disappears and the US
loses the gains from trade.)
19861995
19962005
Advanced
Countries
0.8
-0.4
Developing
Asia
-0.1
-1.1
if this is true, we should see large negative
numbers for the terms of trade of advanced
countries and large positive numbers for the
terms of trade of the new competitors.
Group mainly dominated
by China
The percentage real income effect of a change in
the terms of trade is approximately equal to the
percent change in the terms of trade, multiplied
by the share of imports in income.
Example: China (growth ~ 8% in 2005)
4 effects on the term of trade:
– positive: productivity in the import sectors of the
industrialized countries Æ reduction of import price;
– positive: low consumption, high investment rate (40%)
Æ High Chinese demand of machinery and equipment Æ
increase in relative prices of machinery and equipment Æ
TOT improvement (Germany, for example)
– negative: increase of importation of oil and raw material
Æ price of oil increase Æ improvement of TOT of oil
exporters (developing countries) Æ deterioration of TOT
of developed and developing countries that compete with
Chinese consumers;
– negative: increase of the productivity of chinese exports
in in sectors that compete with domestic’s exports Æ
deterioration of TOT (Samuelson’s argument).
• International transfer of income
– Keynes vs Ohlin regarding the Germany’s transfer
payment after WWI. Keynes argue that transfer to the allies
would worsen Germany’s TOT because Germany would
have to make its exports cheaper relative to its imports;
– Asian countries before and after 1998. Before: large
capital flow recipient (~ transfer). After: large outward
transfer. Thus, current account surplus and capital account
deficit. Export prices decreases by 23% in Indonesia, 29%
in South-Korea, 35% in Thailand…
– according to Keynes, this should lead to a large
deterioration of the TOT effect.
– the transfer problem in Asia was masked by other
forces (price of oil, yen/US $ … )
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Effect of a transfer on the TOT
Home makes a transfer of some of its income to
Foreign.
– Home’s income is reduced, and it must
reduce its expenditure.
– Foreign increases its expenditure.
This shift in the national division of world
spending may lead to a shift in world relative
demand and thus affect the terms of trade.
The shift in the RD curve (if it occurs) is the
only effect of a transfer of income. The RS
curve does not shift.
2 cases:
– If the two countries allocate their change in spending in the same proportions Æ
world equilibrium does not change;
– If not, there is a terms of trade effect; the direction of the effect will depend on
the difference in Home and Foreign spending patterns. Assume that Home has a
higher marginal propensity to spend on cloth than Foreign. Then Æ move from
RD1 to RD².
• Tariffs and export subsidies
– Import tariffs are taxes levied on import while export
subsidies are payments given to exporters;
– tariffs and export subsidies is that they create a difference
between prices at which goods are traded on the world
market and their prices within a country;
– direct effect of a tariff: imported goods are more
expensive inside a country than they are outside;
– direct effect of an export subsidy: more profitable to sell
abroad than at home unless the price at home is higher, so
such a subsidy raises the price of exported goods inside a
country;
– price changes caused by tariffs and subsidies change both
relative supply and relative demand Æ shift in the TOT of
the country imposing the policy change and in the TOT of
the rest of the world.
Effect of a tariff on the TOT
Assume home impose an ad-valorem tariff on
imports of food Æ domestic relative price of
cloth is lower than the world relative price
– At any given world relative price of
cloth, then, Home producers face a lower
relative cloth price and therefore produce
less cloth and more food. At the same
time, Home consumers shift their
consumption toward cloth and away from
food.
– Relative supply of cloth fall while the
relative demand for cloth rise (from RD1
to RD²);
– World relative price of cloth rises and
thus Home’s terms of trade improve at
Foreign’s expense.
Impact depends clearly on the size of the
country that imposes tariffs.
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Effect of an export subsidy on the TOT
An export subsidy’s effects are the reverse of
those of a tariff.
Relative supply of cloth rises, while relative
demand falls.
Home’s terms of trade decline as the relative
price of cloth falls from (PC PF )1 to (PC PF )2 .
A Home export subsidy worsens Home’s terms
of trade and improves Foreign’s.
TOT effect: distribution of income BETWEEN countries
– Tariff effect on Home’s welfare
– TOT improvement benefits Home;
– But imposes costs by distorting production and
consumption incentives within Home’s economy. TOT
gains will outweigh the losses from distortion only as long
as the tariff is not too large.Æ optimal tariffs for large
country (makes no sense for small countries)
– export subsidy never make sense (political economy):
– Foreign’s TOT improve at Home’s expense, leaving it
clearly better off.
– Home loses from TOT deterioration and from the
distorting effects of its policy.
TOT effect: distribution of income WITHIN countries
– Trade policies: strong effects on income distribution because
of factor immobility and differences in the factor intensity of
different industries.
– Tariff direct effect: increase in the domestic relative price
of the imported good;
– Export subsidy direct effect: increase in the domestic
relative price of the exported good.
– Indirect effect on TOT: A tariff might improve a
country’s TOT so much that even after the tariff rate is
added, the domestic relative price of the import good falls.
Similarly, an export subsidy might worsen the terms of
trade so much that the domestic relative price of the export
good falls
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