Standard Trade Model (Chapter 5) -- focus on terms of trade
Basics:
start with bowed out PPF
 this drives RS curve:
 production point maximizes GDP (highest iso-GDP line)
equation of iso-GDP line:
PC QC + PF QF = GNP
or
QF = GNP/ PF - [PC/PF] QC
Fig. 5-1
If PC/PF  get steeper iso-GDP lines, choose larger QC,QF combination
Fig. 5-2
This gives upward sloping Relative Supply (RS) curve
Consumers
(1) Consumers are constrained by budget constraint:
PCDC + PFDF = GDP = PCQC + PFQF
(2) Assume can represent collective preferences of a society by a “community
indifference curve” (assumes that income distribution is not important)
(3) Preferences/Indifference Curves has usual properties:
 goods are substitutes to some extent (downward sloping indiff. curves)
 More is better (higher indiff. curves correlate to higher utility)
 Diminishing marginal utility (indiff. curves flatter as move SE, steeper as move NW)
Draw indiff. curves – choose highest one that is tangent to budget constraint.
Fig. 5-3
Note: Since QC > DC country exports cloth, QF < DF country imports food.
Consider that initially:
1) PC/PF = 1
2) Production function is QC2 + QF2 = 1
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3) Indifference curves: U(QC, QF) = k = QC *QF
Solve for production and consumption
Now suppose that the relative price of cloth rises (Fig. 5-4), so that now PC/PF = 2. What
happens? Both the production and consumption choices change.
Solve for production and consumption.
More generally, what happens to quantities demanded/produced if relative prices change?
If PC/PF  then QC  QF 
What about quantities demanded?
Since relative price of cloth is up and country produces more cloth than it consumes,
country’s income is greater.
So even though cloth is relatively more expensive, is possible (although not usual) that
both DF  and DC 
Note that although people may consume more of each good (income effect), will
consume relatively more food than cloth (substitution effect)
Welfare
Note that a change in world relative prices doesn’t always make you better off.
If Pc/PF fell, then value of exports falls. Then income would also fall and country would
be worse off.
Define “terms of trade”: the price of the good a country initially exports divided by the
price of the good it initially imports. (p.97)
Then relationship between price changes and welfare can be summarized as
a rise in the terms of trade increases a country’s welfare, while a decline in the terms of
trade reduces its welfare. (p.97)
Finding equilibrium
Consider model with two countries:
Home
Foreign (*)
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Assume Home exports cloth and Foreign exports food
(then Home’s terms of trade is PC/PF and Foreign’s terms of trade is PF/PC)
World relative supply (RS) is a combination of RS curves of each country.
Same for world relative demand (RD).
World equilibrium price is found where RS = RD
Figure 5-5
Comparative Statics
Is growth always beneficial?
(A) Biased growth – shifts out PPF more along one axis than another:
Figure 5-6, (panel a -- growth biased toward cloth)
Events that cause cloth-biased growth:
(i) technological improvement (Ricardian model aLC )
(ii) increase in endowment of factor used relatively intensively in cloth production
(Rybczynski effect)
At unchanged prices, with growth biased toward cloth would see QC , QF .
This shifts out RS curve of cloth for country and so for whole world:
Fig. 5-7 a
See PC/PF fall.


If Home exports cloth then this cloth-biased growth worsens Home’s terms of trade.
improves Foreign’s terms of trade.
Define
1) Export-biased growth: growth that disproportionately expands a country’s
production possibilities in the direction of the good it exports.
2) Import-biased growth: … of the good it imports. (p.100)
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Result: Export-biased growth tends to worsen a growing country’s terms of trade, to the
benefits 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. (p.100)
Does this improvement in Foreign’s terms of trade make Foreign better off?
Yes:
Food*
PC/PF|old
PC/PF|new
U*new
U*old
Cloth*
Home? Not necessarily.
Food
PC/PF|new
biased
growth
PC/PF|old
Cloth
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Depends on where you were originally consuming:
if originally consumed along here,
then will be worse off because of
worsening terms of trade
Food
PC/PF|new
if originally consumed
along yellow segment,
then will be better
off despite worsening
terms of trade
PC/PF|old
Cloth
If Home originally consuming in pink region, then are worse off from own growth:
example of immiserizing growth.
(Need terms of trade effect to be very strong – i.e. need steep RD curve.)
Theoretical curiosity? Yes, there is little evidence of this occurring in reality.
___________________________________________
What about growth in trading partner’s importing sector?
This can also hurt its trading partner’s terms of trade.
European community argued that economic slump in late 80’s, early 90’s was due to
growth in NIEs.
This explanation can only work if terms of trade of developed countries deteriorated
considerably.
Fig. 5-8
IMF data (Advanced countries): see severe drops during oil crises, but not otherwise.
Can calculate (we won’t) that declining terms of trade over this period responsible for
1.1% drop in real income loss due to NIE growth.
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Offer Curves
Relative Supply (RS) curves not very satisfying -- glosses over issues of aggregation
across countries.
Instead use different tool (offer curves) to solve graphically for international trade
equilibrium.
See Chapter 5, Appendix.
Fig. 5A-1 graphs imports and exports for a given relative price. Point T corresponds to
the situation in Fig. 5-3. Since (DF – QF) = (QC – DC) * (PC/PF), the slope of the line
equals the price ratio. We can do this for different price ratios and trace out the Home
offer curve (Fig. 5A-2). Note that the slope of this curve is always positive.
We can do the same for the Foreign offer curve (Fig. 5A-3). Putting these two together,
we get the international equilibrium shown in Fig. 5A-4. World equilibrium is where the
offer curves intersect.
The Transfer problem
Examples of transfers:
war reparations
foreign aid
(OPEC)
Mechanics of a transfer:
Suppose Home transfers income to Foreign.
If Foreign has lower marginal propensity to consume (mpc) cloth than Home (and so a
higher mpc food), then transfer lowers world RD for cloth.
Fig. 5-9



see PC/PF 
worsens Home’s terms of trade (assume Home is cloth exporter)
improves Foreign’s
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But if Home has lower marginal propensity to consume cloth than Foreign, then the
transfer raises RD for cloth:



see PC/PF 
improves Home’s terms of trade
hurts Foreign’s
Food*
Equation of Budget Constraint with transfer:
DF* = [GDP* + Transfer]/PF – [PC/PF]DC*
PC/PF|old
PC/PF|new
Cloth*
Transfer
PC
Foreign can be made worse off all round:
Food*
PC/PF|old
if originally consumed
along yellow line,
transfer makes
recipient worse off
PC/PF|new
Transfer
PC
Cloth*
In general:
A transfer worsens the donor’s terms of trade if the donor has a higher marginal
propensity to spend on its export good than the recipient. (p.106)
The result that recipient can be made worse off is also viewed as a theoretical curiosity.
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Home Bias in Consumption
Most consumers like to consume domestically produced goods
 patriotism
 attributes reflect local tastes
This alone suggests that the marginal propensity to consume own export goods in US is
higher than in country’s receiving US aid
 US aid likely to hurt US terms of trade.
But non-traded goods also an issue.




If Home spends 1/3 of income on non-traded goods (restaurant meals, haircuts…)
then transfer of $X to Foreign means more resources available to produce imported
and exported goods.
This raises RS of US exported goods. Foreign also increases own spending on own
non-traded goods.
This reduces resources available in Foreign for its export goods.
Together both effects serve to hurt Home’s terms of trade.
Even without Home bias in consumption, even if mpc=mpc*, if there are non-traded
goods then the transfer should still worsen donor's terms of trade.
Tariffs and Export Subsidies
Definitions:
Tariff – a tax levied on imports
 can be specific (measured in $)
 or ad valorem (measured in %)
Export subsidy – a payment given to local producers who export a good
Each can affect a country’s terms of trade.
Example:
 Suppose Foreign imports cloth.
 Applies a 10% ad valorem tariff on cloth imports.
 This reduces Foreign’s demand for cloth for any given relative prices
 shifts in RD curve for cloth (both for Foreign and for World)
 At same time, higher cloth prices in Foreign induce more Foreign production of cloth
 shifts out RS curve for cloth (both for Foreign and for World)
Fig. 5-10
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Outcome:
 lower world relative price of cloth
 worsening of Home’s terms of trade
 improvement in Foreign’s terms of trade!
It is possible that Foreign consumers end up facing lower domestic price for cloth than
without the import tariff.
This called “Metzler Paradox”.
This can’t happen if Foreign is a “small country”, since the terms of trade effect would be
quite small.
Effect of a subsidy
Example:
 Home applies subsidy to cloth exports.
 Raises Home supply of cloth.
 See world RS of cloth shift out.
 Home consumers face higher price (= PC + subsidy)
 then Home consumers face higher relative price for cloth
 Home and World RD curve for cloth shifts in
Fig. 5-11
See PC/PF  -- Home export subsidy hurts Home’s terms of trade.
Implications of Terms of Trade Efffects
Beggar thy neighbor
Since tariffs on US imports improve US terms of trade, why not impose tariffs all the
time?
US tariffs hurt other countries (beggar thy neighbor policy)
If other countries do same (EU), hurts US – no one has better terms of trade, but
everyone loses by distorting prices.
But if other countries can’t retaliate, then US better off to impose small tariffs (optimal
tariff) – will come back to this later in the course.
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Subsidies
As saw in example, Home export subsidies hurt Home terms of trade
 so improve Foreign’s terms of trade
Suggests US should love it when trade partners subsidize goods imported by US.
Paul Krugman proponent of unpopular argument that US should encourage, not penalize,
other countries who “dump” (sell at below cost) goods on US market.
This is an unpopular argument because of income distribution effects.
Summary
Growth in exporting sector hurts a country’s terms of trade.
Growth in importing sector improves terms of trade.
Transfers improve the terms of trade of the donor so long as the donor has lower mpc its
exporting good than the recipient does.
General results:
 import tariffs benefit import competing industry, hurt exporting sector, and benefit
country’s own terms of trade
 export subsidies benefit exporting sector, hurt import competing sector, and hurt
country’s own terms of trade
Paradoxical results
Growth can make you worse off (immiserizing growth)
Aid can make you worse off (transfer problem)
Import tariffs can lower domestic prices of imported goods.
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