Chapter 5
The Standard Trade Model
1
Introduction

Previous trade theories have emphasized on
specific sources of comparative advantage
which give rise to international trade:



Differences in labor productivity (Ricardian model)
Differences in resources and income distribution
(Heckscher-Ohlin model)
Y=f(x) ----- variables (factors); parameters
2


Real problems requiring a mixture of models. (eg.
1990s newly industrializing economies; income
distribution within a country)
Different models share some features:




Productive capacity
PPF
trade;
Production possibilities
relative supply;
World relative demand & relative supply
World
equilibrium.
The standard trade model is a general model of
trade that admits these models as special cases.
3
Chapter Organization
1.A Standard Model of a Trading Economy
2.Economic Growth: A Shift of the RS Curve
Case Study: Has the Growth of Newly Industrializing Countries Hurt
Advanced Nations?
3.International Transfers of Income: Shifting the
RD Curve (foreign aid, war reparations…)
Case Study: The Transfer Problem and the Asian Crisis
4.Tariffs and Export Subsidies: Simultaneous
Shifts in RS and RD
5.Summary
4
Learning goals

Components of model




Welfare change


supply side - PPF, isovalue line
demand side – indifference curve
pattern of trade
Changes in : TOT, growth (productivity), transfers
Tariffs & subsidies



Trade patterns
Welfares change
Income distribution
5
A Standard Model of a Trading Economy
(1).Production Possibilities and Relative
Supply
(2).Relative Prices and Demand
(3).The Welfare Effect of Changes in the Terms
of Trade
(4).Determining Relative Prices
6
6
A Standard Model of a Trading Economy

The standard trade model is built on four
key relationships:




Production possibility frontier and the relative
supply curve
Relative prices and relative demand
World relative supply and world relative demand
Terms of trade and national welfare
7
(1)Production Possibility and Relative Supply

Production Possibilities and Relative Supply

Assumptions of the model:



Each country produces two goods, food (F) and cloth
(C)
Each country’s production possibility frontier is a
smooth curve (TT)
The point on its production possibility frontier at
which an economy actually produces depends on
the price of cloth relative to food, PC/PF.
8
The Value of Production

Recall that when the economy maximizes its
production possibilities, the value of output V
lies on the PPF.

V = PCQC + PF QF describes the value of output
in a two good model, and when this value is
constant the equation’s line is called isovalue
line.

The slope of any equation’s line equals – (PC / PF), and if
relative prices change the slope changes.
9
9
Figure 5-1: Relative Prices Determine the Economy’s Output
Food production, QF
Isovalue lines
Q
TT
Cloth production, QC
10
Figure 5-2: How an Increase in the Relative Price of Cloth Affects
Relative Supply
Food production, QF
Q1
Q2
TT
VV1(PC/PF)1
VV2(PC/PF)2
Cloth production, QC
11
(2) Relative Price & Demand

The value of an economy's consumption
equals the value of its production:
PCQC + PFQF = PCDC + PFDF = V

Production choices are determined by the
economy’s PPF and the relative prices of
output.
12
Consumer preferences are
represented by indifference
curves: combinations of
goods that make consumers
equally satisfied (indifferent).
Consumer preferences
and prices determine
consumption choices.


What determines consumption choices
(demand)?
The economy’s choice of a point on the isovalue
line depends on the tastes of its consumers, which
can be represented graphically by a series of
indifference curves.
13
13

Indifference curves


Each traces a set of combinations of cloth (C) and
food (F) consumption that leave the individual
equally well off
They have three properties:



Downward sloping
The farther up and to the right each lies, the higher the
level of welfare to which it corresponds
Each gets flatter as we move to the right
14
Figure 5-3: Production, Consumption, and Trade in the Standard Model
Food production, QF
Indifference curves
D
Food
imports
Q
TT
Cloth exports
Cloth production, QC
15
Figure 5-4 Effects of a Rise in the Relative Price of Cloth
Food production, QF
D2
D1
Q1
Q2
VV1(PC/PF)1
TT
VV2(PC/PF)2
Cloth production, QC
16

If the relative price of cloth, PC/PF , increases,
the economy’s consumption choice shifts
from D1 to D2.

The move from D1 to D2 reflects two effects:



Income effect (rise in welfare)
Substitution effect (shifts in consumption)
It is possible that the income effect will be so
strong that when PC/PF rises, consumption of both
goods actually rises, while the ratio of cloth
consumption to food consumption falls.
17

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.
18
(3) The Welfare Effect of Changes in the Terms of Trade


PC / PF change
Terms of trade


The price of the good a country initially exports divided
by the price of the good it initially imports.
A rise in the terms of trade increases a country’s
welfare, while a decline in the terms of trade reduces
its welfare.
19

Determining Relative Prices

Suppose that the world economy consists of two
countries:

Home (which exports cloth)



Its terms of trade are measured by PC/PF
Its quantities of cloth and food produced are QC and QF
Foreign (which exports food)


Its terms of trade are measured by PF/PC
Its quantities of cloth and food produced are Q*C and Q*F
20

To determine PC/PF , one must find the
intersection of world relative supply of cloth
and world relative demand.


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.
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.
21
Figure 5-5: World Relative Supply and Demand
Relative price
of cloth, PC/PF
RS
(PC/PF)1
1
RD
Relative quantity
of cloth, QC + Q*C
Q F + Q *F
22

Economic Growth: A Shift of the RS Curve

Is economic growth in other countries good or bad
for our nation?



It may be good for our nation because it means larger
markets for our exports.
It may mean increased competition for our exporters.
Is growth in a country more or less valuable when
that nation is part of a closely integrated world
economy?


It should be more valuable when a country can sell
some of its increased production to the world market.
It is less valuable when the benefits of growth are
passed on to foreigners rather than retained at home. 23

Growth and the Production Possibility Frontier


Economic growth implies an outward shift of a
country’s production possibility frontier (TT).
Biased growth


Takes place when TT shifts out more in one direction
than in the other
Can occur for two reasons:


Technological progress in one sector of the economy
(Ricardian model)
Increase in a country’s supply of a factor of production (H-O
model)
24
Figure 5-6: Biased Growth
Food
production, QF
Food
production, QF
TT1
TT2
Cloth production, QC
(a) Growth biased toward cloth
TT1
TT2
Cloth production, QC
(b) Growth biased toward food 25
Relative Supply and the Terms of Trade
Figure 5-7 Growth and Relative Supply
Relative price
of cloth, PC/PF
Relative price
of cloth, PC/PF
RS1
RS2
RS1
RS2
(PC/PF)1
(PC/PF)2
1
(PC/PF)2
2
(PC/PF)1
RD
Relative quantity
of cloth, QC + Q*C
QF + Q*F
(a) Cloth-biased growth
2
1
RD
Relative quantity
of cloth, QC + Q*C
Q F + Q *F
(b) Food-biased growth
26

Export-biased growth



Disproportionately expands a country’s production
possibilities in the direction of the good it exports
Worsens a growing country’s terms of trade, to the
benefit of the rest of the world
Import-biased growth


Disproportionately expands a country’s production
possibilities in the direction of the good it imports
Improves a growing country’s terms of trade at the
rest of the word’s expense
27

International Effects of Growth


Export-biased growth in the rest of the world
improves our terms of trade, while import-biased
growth abroad worsens our terms of trade.
Export-biased growth in our country worsens our
terms of trade, reducing the direct benefits of
growth, while import-biased growth leads to an
improvement of our terms of trade.
28
International Effects of Growth
Develped Countries
Develping Countries
Immiserizing
growth
29
29
A Standard Model of a
Trading Economy

Immiserizing growth



A situation where export-biased growth by poor
nations can worsen their terms of trade so much that
they would be worse off than if they had not grown at
all
It can occur under extreme conditions: Strongly
export-biased growth must be combined with very
steep RS and RD curves.
It is regarded by most economists as more a
theoretical point than a real-world issue.
30
Case Study
Has the Growth of Newly Industrializing
Countries Hurt Advanced Nations?
31
Table 5-1: Average Annual Percent Changes in Terms of Trade
Figure 5-8 The Terms of Trade of Advanced Countries,1970-1997
115
110
105
100
95
90
85
1970
1975
1985
1980
1990
1995
32
32
International Transfers of Income:
Shifting the RD Curve
(1).The Transfer Problem
(2).Effects of Transfer on the Terms of
Trade
(3).Presumptions about the Terms of Trade
Effects of Transfers
33
33

Relative world demand for goods may shift because
of:





Changes in tastes, prices
Changes in technology (eg. Email, OS)
International transfers of income
International transfers of income (from both
individual and government), such as war reparations
and foreign aid (loans), may affect a country’s terms
of trade by shifting the world relative demand curve.
The Transfer Problem

How international transfers affect the terms of trade?
34
(1).The Transfer Problem

Debates:

Keynes



price adjustment for more ex & less im
reparation payments worsen Germany’s terms of trade
Ohlin


taxes increase or demand for im decrease automatically
reparation payments would not worsen Germany’s
terms of trade
35
35

Effects of a Transfer on the Terms of Trade


Spent changes
When both countries allocate their change in
spending in the same proportions (Ohlin’s point):


The RD curve will not shift, and there will be no terms
of trade effect.
When the two countries do not allocate their
change in spending in the same proportions
(Keynes’s point):

The RD curve will shift and there will be a terms of
trade effect.

The direction of the effect on terms of trade will depend on
the difference in Home and Foreign spending patterns.
36
International Transfers of Income:
Shifting the RD Curve
Figure 5-8: Effects of a Transfer on the Terms of Trade
Relative price
of cloth, PC/PF
Foreign: recipient
RS Home: donor
Home has a higher marginal
propensity to spend on cloth
1
(PC/PF)1
(PC/PF)2
2
RD1
RD2
Relative quantity
of cloth, QC + Q*C
QF + Q*F
37



Are there other possibilities?
Generally, 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. And vice versa.
Does it coincide with the reality?
38

Presumptions about the Terms of Trade Effects of
Transfers


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.
In practice, most countries spend a much higher share of
their income on domestically produced goods than
foreigners do.
 eg. US: 11%-im, 89%-domestical
 This is not necessarily due to differences in taste but rather
to nontradable goods, barriers to trade, natural and artificial.
39

A transfer by the United States to other countries may
lower the price of U.S. exports relative to foreign,
worsening U.S. terms of trade, just as Keynes argued.

Most likely, an international transfer of income worsens
the donor’s terms of trade.

Ohlin was right in principle, Keynes was right in practice.
40
40
Case Study: The Transfer Problem and
the Asian Crisis
Asian crisis in 1997 is a classic
illustration of the “excess burden”
Keynes warned about 80 years ago.
41
41
Tariffs and Export Subsidies:
Simultaneous Shifts in RS and RD
(1).Relative Demand and Supply Effects of a
Tariff
(2).Effects of an Export Subsidy
(3).Implications of Terms of Trade Effects: Who
Gains and Who Loses?
42
42
Tariffs and Export Subsidies:
Simultaneous Shifts in RS and RD

Import tariffs and export subsidies affect both
relative supply and relative demand.
(1) Import tariffs are taxes levied on imports
 Tariffs can be classified as:
 Specific tariffs


Taxes that are levied as a fixed charge for each unit of goods
imported
 Example: A specific tariff of $10 on each imported bicycle with
an international price of $100 means that customs officials
collect the fixed sum of $10.
Ad valorem tariffs

Taxes that are levied as a fraction of the value of the imported
goods
 Example: A 20% ad valorem tariff on bicycles generates a $20
payment on each $100 imported bicycle.
43
Tariffs and Export Subsidies:
Simultaneous Shifts in RS and RD

Import tariffs and export subsidies affect
both relative supply and relative demand.
(2) Export subsidies are payments given to
domestic producers that export
(3) Both policies influence the terms of trade and
therefore national welfare
44

Relative Demand and Supply Effects of a
Tariff

Tariffs drive a wedge between the prices at which
goods are traded internationally (external prices)
and the prices at which they are traded within a
country (internal prices).


Tariffs: P(im) increases at home
Subsidies: P(ex) increases at home
45
45
Figure 5-9: Effects of a Tariff on the Terms of Trade
Relative price
of cloth, PC/PF
RS2
Home: 20% tariffs
RS1
(PC/PF)2
2
Country size matters
1
(PC/PF)1
RD2
RD1
Relative quantity
of cloth, QC + Q*C
QF + Q*F
46

Effects of an Import Tariff


A Home Import Tariff improves Home’s terms of trade and
worsens the Foreign’s.
Effects of an Export Subsidy

Tariffs and export subsidies are often treated as similar
policies but they have opposite effects on the terms of trade.
 Example: Suppose that Home offers 20% subsidy on the
value of cloth exported:



This will raise Home’s internal price of cloth relative to food by 20%.
Qc increases, Qf decreases; Dc decreases, Df increases
A Home export subsidy worsens Home’s terms of trade and
improves Foreign’s.
47
Figure 5-10: Effects of a Subsidy on the Terms of Trade
Relative price
of cloth, PC/PF
RS1
RS2
1
(PC/PF)1
(PC/PF)2
2
RD1
RD2
Relative quantity
of cloth, QC + Q*C
QF + Q*F
48

Implications of Terms of Trade Effects: Who
Gains and Who Loses?

The International Distribution of Income

Tariffs



TOT improvement vs. production & consumption incentive
distortions
its welfare increases as long as the tariff is not too large,
while Foreign’s welfare decreases.
Subsidy


TOT deteriorates & distorting policy effect
its welfare deteriorates, while Foreign’s welfare increases
49

Are Home tariffs always beneficial & export
subsidy always a bad thing for it?


Are Foreign tariffs always bad for a country &
foreign subsidy always benifical?



Politics in trade.
Multi-country world.
Subsidies to exports of things Home imports help us,
while tariffs against Home’s exports hurt us.
Are the U.S. Commerce Department’s attitudes
wrong?
50

The Distribution of Income Within Countries

Tariffs and export subsidies might have perverse
effects on internal prices (Metzler paradox).


A tariff (subsidy) has the direct effect of raising the
internal relative price of the imported (exported) good.
Indirect effect on TOT


Tariff - TOT improvement ; Subsidies – TOT deteriation
Policy makers cares about internal prices more.


Tariff – help import-competing industries
Subsidy – help export industries
51
Summary



The standard trade model provides a framework
that can be used to address a wide range of
international issues and admits previous trade
models as special cases.
A country’s terms of trade are determined by the
intersection of the world relative supply and
demand curves.
Economic growth is usually biased. Growth that is
export-biased (import-biased) worsens (improves)
the terms of trade.
52
Summary



International transfers of income may affect a
country’s terms of trade, depending if they shift
the world relative demand curve.
Import tariffs and export subsidies affect both
relative supply and demand.
The terms of trade effects of an export subsidy
hurt the exporting country and benefit the rest of
the world, while those of a tariff do the reverse.

Both trade instruments have strong income distribution
effects within countries.
53