The Standard Trade Model
• Summarizing our findings so far on trade
with the other 3 models:
– Ricardian Model
– Specific Factors
– H-O Model
• What do we do now?
The Standard Trade Model
• Framework for the model:
– Relationship between PPF and relative supply
– Relationship between relative prices and
relative demand
– World equilibrium
– Effects of TERMS OF TRADE!! (Px/Pm) on a
country’s welfare
The Standard Trade Model
• PPF and Relative Supply
– Effects of relative price changes on the level of
production and relative supply.
– We need to maximize the value of production!
– Figures 5-1 and 5-2
1
Food production,
QF
Q1
Q2
TT
VV1(PC/PF)1
VV2(PC/PF)2
Cloth production, QC
The Standard Trade Model
• Relative prices and demand
– The value of consumption must be equal to the value
of production:
PCQC+ PFQF=PCDC +PFDF =V
– In order to pin-point the relative quantity demanded
we need to take into account the isovalue line and the
preferences of consumers (in other words we need
their indifference curves)
Food production, QF
Indifference curves
D
Food
imports
Q
TT
Cloth exports
Cloth production, QC
2
The Standard Trade Model
• Terms of trade and Welfare:
– Terms of Trade: the price of the good a country initially
exports divided by the price of the good it initially
imports.
– Direction of the change in the terms of trade matters for
welfare, why?
“If a country can export at a higher price or import at
a lower price then welfare improves.”
Why?
Food production, QF
D2
D1
Q1
Q2
TT
VV1(PC/PF)1
VV2(PC/PF)2
Cloth production, QC
The Standard Trade Model
• Determining Relative Prices:
– Think of two countries:
• Home (exports cloth)
• Foreign (exports food)
• What are their terms of trade?
– Qc + Qc* / Qf + Qf*
(Relative Quantities Produced)
– RS and RD mark the spot!
3
Relative price
of cloth, PC/PF
RS
1
(PC/PF)1
RD
Relative quantity
of cloth, QC + Q*C
QF + Q*F
The Standard Trade Model
• Now we can analyze different issues like:
– Economic Growth
• Home country growing
– Export sector
– Import sector
• Foreign country growing
– Export sector
– Import sector
– The Transfer Problem
– Being the receiver
– Being the donor
– Tariffs and Export Subsidies
– The usual analysis
– The income distribution effects
The Standard Trade Model
• Economic Growth:
– Biased growth vs proportional growth:
figure 5-6
– The bias can result in two different outcomes:
• Export-biased growth: RS shifts right, worsening the
terms of trade
• Import-biased growth: RS shifts left, improving the
terms of trade
4
The Standard Trade Model
• Real World Facts:
– The case of immiserizing growth
– The case of Latin America during the 60’s –
80’s.
– The South East Asian Tigers
The Standard Trade Model
• The Transfer Problem:
– Spending extra cash may hurt the receiver of the cash!!
– This is a pure demand side issue and depends on the
marginal propensity to spend in imports and exports.
– A transfer will worsen the donor’s terms of trade if the
donor has a higher marginal propensity to spend on its
export good than the recipient
The Standard Trade Model
• Imports tariffs:
– Simply taxes levied on imports
– Tariffs will have effects on RS and RD,
therefore will have an effect on the relative
price of equilibrium. In other words tariffs will
have an effect on the terms of trade.
– Figure 5-9
5
Relative price
of cloth, PC/PF
RS2
RS1
(PC/PF
2
)2
(PC/PF)1
1
RD2
RD1
Relative quantity
of cloth, QC + Q*C
QF + Q*F
The Standard Trade Model
• Export Subsidies:
– Payments given to domestic producers who sell
a good abroad
– Just like tariffs, they will affect the terms of
trade
Relative price
of cloth, PC/PF
RS1
RS2
(PC/PF)1
(PC/PF)2
1
2
RD1
RD2
Relative quantity
of cloth, QC + Q*C
QF + Q*F
6
The Standard Trade Model
• The income distribution effects of changes
in the terms of trade:
– We are dealing with two type of economies,
home and foreign, therefore there are
implications for both economies.
• Implications of Terms of Trade Effects:
Who Gains and Who Loses?
– The International Distribution of Income
• If Home (a large country) imposes a tariff, its welfare increases
as long as the tariff is not too large, while Foreign’s welfare
decreases.
• If Home offers an export subsidy, its welfare deteriorates,
while Foreign’s welfare increases.
– The Distribution of Income Within Countries
• A tariff (subsidy) has the direct effect of raising the internal
relative price of the imported (exported) good.
• Tariffs and export subsidies might have perverse effects on
internal prices (Metzler paradox).
7