Ch. 5: The Standard Trade Model
1
Introduction

The standard trade model combines ideas from the
Ricardian model and the Heckscher-Ohlin model.
1.
Differences in labor, labor skills, physical capital, land and
technology between countries cause productive differences,
leading to gains from trade.
2.
These productive differences are represented as differences in
production possibility frontiers, which represent the productive
capacities of nations.
3.
A country’s PPF determines its relative supply curve.
4.
National relative supply curves determine world relative supply,
which along with world relative demand determines an
equilibrium under international trade.
2
Standard Model
Food
Cloth
3
Indifference Curves

Consumer preferences and prices determine
consumption choices.

Consumer preferences are represented by
indifference curves: combinations of goods
that make consumers equally satisfied
(indifferent).
4
Indifference Curves

Indifference curves are downward sloping to represent
the fact that if a consumer has more cloth he could have
less food and still be equally satisfied.

Indifference curves farther from the origin represent
larger quantities of food and cloth, which should make
consumers more satisfied and better off.

Indifference curves are flatter when moving to the right:
the more cloth and the less food that is consumed, the
more valuable an extra calorie of food becomes relative
to an extra m2 of cloth.
5
Standard Model
Food
-Pc/Pf
Cloth
6
Why The Price Has to Change
Given the high price of cloth and the
relatively low price of food, more cloth is
produced and less food is produced.
 In the absence of trade, the population
wants more food and less cloth.
 Demand will raise the price of food and
lower the price of cloth until the price line,
PPF and indifference curves are all equal
to each other.

7
Standard Model
Food
-Pc/Pf
Qd
Qs Cloth
8
Market for Cloth
Price
S
D
Qd
Qs Quantity
9
Questions
Show the same situation in terms of
Supply and Demand in the Food
Market.
 Using the PPF and indifference curves,
show the amount of food produced and
demanded at the given relative price
line.

10
Market for Food
Price
S
D
Qs
Qd
Quantity
11
Standard Model
Food
-Pc/Pf
-Pc/Pf
Cloth
12
Determining Relative Prices
13
Introducing Trade
Food
-Pc/Pf
Exports
-Pc/Pf
Cloth
14
Welfare Changes

The change in welfare (income) when the price
of one good changes relative to the price of
another is called the income effect.


The income effect is represented graphically by
shifting the indifference curve.
The substitution of one good for another when
the price of the good changes relative to the
other is called the substitution effect.

This substitution effect is represented graphically by a
moving along a given indifference curve.
15
Welfare and the Terms of Trade

The terms of trade refers to the price of
exports relative to the price of imports.

When a country exports cloth and the relative
price of cloth increases, the terms of trade
increase or “improve”.

Because a higher price for exports means that
the country can afford to buy more imports, an
increase in the terms of trade increases a
country’s welfare.

A decrease in the terms of trade decreases a
country’s welfare.
16
Welfare Effect of Terms of
Trade
When a country’s Terms of Trade
improves, i.e., the price of its exports
rise relatively to the price of its imports,
welfare increases.
 Question 3: Show the effect on welfare
when the Terms of Trade worsens.

17
Welfare Effect of Terms of Trade
Food
-Pc/Pf
-Pc/Pf
Exports
Cloth
18
The Effects of Economic Growth

Growth is usually biased: it occurs in one
sector more than others, causing relative
supply to shift.

Rapid growth has occurred in US computer
industries but relatively little growth has occurred in
US textile industries.

According to the Ricardian model, technological
progress in one sector causes biased growth.

According to the Heckscher-Ohlin model, an
increase in one factor of production (e.g., an
increase in the labor force, arable land, or the
capital stock) causes biased growth.
19
20
The Effects of Economic Growth

Biased growth and the resulting shift in relative supply
causes a change in the terms of trade.

Biased growth in the cloth industry (in either the domestic or
foreign country) will lower the relative price of cloth and lower
the terms of trade for cloth exporters.

Biased growth in the food industry (in either the domestic or
foreign country) will raise the relative price of cloth and raise
the terms of trade for cloth exporters.

Suppose that the domestic country exports cloth and
imports food.
21
22
Biased Growth
Y
The growth of the economy
is biased toward X. In the
diagram the relative prices,
Px/Py, are constant. In fact,
the higher relative supply
of X would have lowered
the Px/Py.
X
23
Welfare Effect of Biased Growth
Y
If the bias is in favor of the
exported good X, then the
Terms of Trade change will
be negative (Px down).
The welfare of the citizens
will be lower as the new
indifference curve will be to
the left of the one under
constant Terms of Trade.
X
24
The Effects of Economic Growth
(cont.)

Export-biased growth reduces a country’s terms
of trade, generally reducing its
welfare and increasing the welfare of
foreign countries.

Import-biased growth increases a country’s
terms of trade, generally increasing its
welfare and decreasing the welfare of
foreign countries.
25
The Effects of Economic Growth

Export-biased growth is growth that
expands a country’s PPF disproportionally
in production of that country’s exports.

Import-biased growth is growth that
expands a country’s PPF disproportionally
in production of that country’s imports.
26
27
Welfare Effect of Biased Growth
Y
If the bias is in favor of the
imported good X, then the
Terms of Trade change will
be positive.
The new indifference curve
will be situated northeast of
the old one.
X
28
Immiserizing Growth
Y
Growth in the export sector
reduces the international price
of the export commodity to such
an extend that the country is
worse off than it was before the
growth: the brown indifference
curve is below the white one.
X
29
Has Growth in Asia Reduced
the Welfare of US?

The standard trade model predicts that import biased
growth in China reduces the US terms of trade and the
standard of living in the US.


Import biased growth for China would occur in sectors that
compete with US exports.
But this prediction is not supported by data:
there should be negative changes in the terms of trade
for the US and other high income countries.

In fact, the terms of trade for high income countries have been
positive and negative for developing Asian countries.
30
Has Growth in Asia Reduced the
Welfare of High Income Countries?
31
Income Transfers
If a country were to donate a substantial
amount of its income to the rest of the
world, would its T/T improve or worsen?
 Say, US gave $1 trillion of its income
away. If the marginal propensity to spend
for each good is the same around the
world, then no T/T will take place.


Whatever US has reduced in demand for both
products is matched by the increase in
demand in rest of the world.
32
Income Transfers
Again, suppose US donates income
abroad.
 Suppose marginal propensity to spend for
US exports is larger in US than abroad.
 The demand for products US exports will
fall more due to lower US demand than the
increase due to increase in foreign demand.
 The price for the US export good will fall.
 Terms of trade for US will worsen.

33
Income Transfers
US gives foreign aid.
 Marginal propensity to spend for its
export products is higher abroad.
 Terms of trade improves for US.
 Typically, foreign aid is tied to
purchases from US, i.e. marginal
propensity to spend by foreigners is one
(100%).
 Foreign aid by US improves welfare in
the US.

34
Aid
Feb 19th 2009
From The Economist print edition
http://www.economist.com/markets/indicators/displaystory.cfm?story_id=13145257
35
Income Transfers




Typically, the marginal propensity to spend for
domestic products is larger than that of imports.
US has ¼ of world income; Americans “should”
spend 25% of their income on American goods!
For example, Americans spend 83% of their
income on domestically produced goods and only
17% on imports. Foreigners spend 9% of their
income on US products.
Transfer of income from US without any
restrictions should worsen US terms of trade.
36
Asian Crisis
Loss of confidence in the ability of fast
growing Asian countries to be able to pay
their foreign debts made the investors pull
out their savings.
 Dropping currency values made everyone
shift their savings away.
 Transfer of income outside reduced the
demand for their products; price of their
exports fell and welfare was even more
reduced.

37
Tariffs and Terms of Trade
If a large country imposes an import
tariff, internally, higher price of the
product increases the supply but
decreases the demand.
 International price of the imported good
decreases.
 The large country benefits from an
improvement of terms of trade.

38
Import Tariff and Welfare
Home is exporting cheese and
importing wine.
 Home imposes 50% tariff on imported
wine.
 Internal price of wine has increased.
 Home produces more wine and less
cheese.
 At the world relative prices, the relative
supply of wine is increased if home is a
large country.

39
Import Tariff and Welfare




The higher price of wine at home will
decrease demand for wine but increase
demand for the relatively cheaper cheese.
The relative demand curve for wine will shift
left for a large country.
TT for home (large country) rises;
international Pw down because world
demand is down.
TT for foreign worsens unless foreign
retaliates. If foreign is small, retaliation will
not matter.
40
Import Tariff and Welfare
Pw/Pc
RS1
RS2
RD2
RD1
Wine/Cheese
41
Import Tariff and Welfare for Large Countries
Wine
Pc/Pw
Cheese
42
Import Tariffs and Distribution of
Income Across Countries

If the domestic country imposes a tariff on food imports,
the price of food relative to price of cloth that domestic
citizens face is higher.

Likewise, the price of cloth relative to the price of food that
domestic consumers and producers pay is lower.

Domestic producers will receive a lower relative price of cloth,
and therefore will be more willing to switch to food production:
the relative supply curve will shift.

Domestic consumers will pay a lower relative price of cloth, and
therefore be more willing to switch to cloth consumption: the
relative demand curve will shift.
43
Import Tariffs and Distribution of
Income Across Countries
44
Import Tariffs and Distribution of
Income Across Countries

When the domestic country imposes an import tariff, the
terms of trade increases and the welfare of the country
may increase.

The magnitude of this effect depends on the size of the
domestic country relative to the world economy.

If the country is small part of the world economy, its tariff (or
subsidy) policies will not have much effect on world relative
supply and demand, and thus on the terms of trade.

But for large countries, a tariff rate that maximizes national
welfare at the expense of foreign countries may exist.
45
Import Tariff and Welfare
For a small country, world prices will not
change.
 Draw the PPF and world prices,
indicating exports and imports.
 Show the effect of a tariff on imported
wine on internal prices.
 Show the new production point and the
effect on welfare.

46
Import Tariff and Welfare for Small Countries
Wine
Pc/Pw
Cheese
47
Import Tariff and Welfare
48
Export Subsidies and Terms of
Trade for Large Countries



An export subsidy will increase the internal
price and hence the production of the exported
good.
On the other hand, the internal demand for the
exported good will fall because higher priced
good is substituted by the lower priced import.
International price of the exported good will fall
leading to a deterioration of the terms of trade.
49
Export Subsidies and Distribution
of Income Across Countries
Cloth is exported and
Food is imported.
50
Export Subsidy and Welfare
(Large Country)
Cheese
Internal prices
External prices (TT)
Pw/Pc
Wine
51
Export Subsidy and Welfare
(Small Country)
Cheese
Internal prices
External prices (TT)
Pw/Pc
Wine
52
Export Subsidies and Distribution
of Income Across Countries

When the domestic country imposes an export
subsidy, the terms of trade decreases and the
welfare of the country decreases to the benefit of
the foreign country.
53
Distribution of Income Across
Countries

The two country, two good model predicts that

an import tariff by the domestic country can increase
domestic welfare at the expense of the foreign
country.

an export subsidy by the domestic country
reduces domestic welfare to the benefit of the foreign
country.
54
Import Tariffs and Export Subsidies
in Other Countries

A foreign country may subsidize the export of a good
that the US also exports, which will reduce its price in
world markets and decrease the terms of trade for the
US.


The EU subsidizes agricultural exports, which reduce the
price that American farmers receive for their goods in world
markets.
A foreign country may put a tariff on an imported good
that the US also imports, which will reduce its price in
world markets and increase the terms of trade for the
US.
55
Import Tariffs and Export Subsidies
in Other Countries




Export subsidies by foreign countries on goods that the
US imports reduce the world price of US imports and
increase the US terms of trade.
Export subsidies by foreign countries on goods that the
US also exports reduce the world price of US exports
and decrease the US terms of trade.
Import tariffs by foreign countries on goods that the US
exports reduce the world price of US exports and
decrease the US terms of trade.
Import tariffs by foreign countries on goods that the US
also imports reduce the world price of US imports and
increase the US terms of trade.
56
Import Tariffs and Export
Subsidies

Export subsidies on a good decrease the
relative world price of that good by increasing
relative supply of that good and decreasing
relative demand of that good.

Import tariffs on a good decrease the relative
world price of that good (and increase the
relative world price of other goods) by increasing
the relative supply of that good and decreasing
the relative demand of that good.
57
Perverse Policies on Export
Subsidies
Many countries provide export subsidies to
their industries and vigorously oppose
export subsidies by its trading partners.
 Economic logic says just the opposite
should be the case.
 Internal income distribution explains why
governments undertake these
impoverishing measures.

58
Import Tariffs, Export Subsidies and
Distribution of Income Within a Country

Generally, a domestic import tariff increases income for
domestic import-competing producers by allowing the
price of their goods to rise to match increased import
prices, and it shifts resources away from the export
sector.

Generally, a domestic export subsidy increases income
for domestic exporters, and it shifts resources away from
the import-competing sector.
59