BA 187 – International Trade
Standard Trade Model and Gains
from Trade
1
Standard Trade Model

Technology
– Two countries produce two goods, X & Y using two factors of
production, labor, L and capital, K. (2 x 2 x 2 model)
– Prod’n function exhibits constant returns to scale, diminishing
marginal returns to a factor.
– Economies have different endowments of the factors of prod’n.

Tastes
– Economy’s preferences can be represented by community
indifference curves.
– Assume away distortions like taxes, subsidies, imperfect
competition.
2
Technology & Country PPF

Y
PPF: Shape shows
diminishing marg. returns
to factors of prod’n.

Iso-value lines
Iso-Value Lines: For
given set of relative
prices, px, shows prod’n
points with equal value.

Perfect
Competition:
Nation chooses highest
iso-value line given its
PPF.
Prod’n Possibilities
X
3
Trade and Relative Prices

Begin with country in autarkic equilibrium:
– relative price (PX/PY)A & consump/prod’n at point A.

Opening country to trade changes relative price.
– Assume Home exports Good X, then new price will be
steeper than in autarchy (PX/PY)T > (PX/PY)A.
– Home consumes at point C, produces at point Q
Increases prod’n of Good X (which it exports).
 Increases consumption of Good Y (which it imports).

– As in Classical Model, opening trade leads to gains to
both economies. You should be able to show that
Foreign will also benefit, using a similar diagram.
4
Effects of Trade on a Country
U’H
Y
UH
Home
Imports,
CY - QY
CH
A
Prod’n Possibilities
(PX/PY)A
QH
(PX/PY)T
X
Home Exports, QX - CX
5
% Change in U.S. Employment Resulting
from Foreign Trade, 1970-1980
Industry
Percent Change
Footwear
-15.9
Motor Vehicles & equipment
-11.1
Electrical components
-7.8
Leather Products
-6.3
Apparel
-6.3
Service industry machines
5.7
Misc. machinery
8.0
Aircraft & parts
12.8
Office & computing machines
16.1
Engines & turbines
17.8
Construction machinery
19.9
Source: R.Z. Lawrence, Can America Compete?
6
Sources of Gains from Trade

Can break a country’s gains from trade into two
distinct parts.
– Gains from Exchange (Consumption Gains)
Assume trade changes the relative price but the country
continues to produce at the autarchy equilib. Point A.
 Nation still experiences a gain in welfare due to price change
measured by move from point A to C1.

– Gains from Specialization (Production Gains)
The change in relative price leads the country to change
production from Point A to Point Q1.
 Nation experiences an additional gain in welfare due to prod’n
specialization measured by move from point C1 to C2.


This is similar to the substitution/wealth effect analysis of
a price change in microeconomics.
7
Sources of Gains from Trade
Y
C2
C1
Prod’n Possibilities
A1
(PX/PY)
1
Q2
(PX/PY)
2
X
8
Sources of the Basis for Trade
9
The Basis for Trade

Mutual gains from trade arise in the Standard
model of trade in essentially two ways:

Differences in Production Possibilities
– PPF’s may differ across countries in ways that give rise
to trade due to:
 Differences in Technology
 Differences in Factor Endowments

Differences in Tastes
– Utility curves across countries can differ in ways that
give rise to trade even when PPF’s are identical.

Illustrate trade possibilities in these two situations
10
Differing Technology/Endowments
Assuming identical utility function for Home & Foreign
Y
Home & Foreign PPF’s differ due to differences in
technology or factor endowments.
QF
AF
Autarky Equilibrium at AH and AF
C*
Opening trade changes relative prices
New equilib. consumption at C*.
Each country has different prod’n ;point.
AH
QH
(PX/PY)
PPFF
PPFH
*
X
11
Differing Utility Functions
UF
Y
U’F
Assuming identical PPF’s for Home & Foreign.
Utility curves differ across countries,
autarchy prices differ based on utility.
CF
U’H
AF
Open trade, equalizes relative prices,
both countries produce at point Q.
UH
Each consumes at different point,
both countries gain from trade.
Q*
AH
CH
(PX/PY)
*
X
12
Revealed Comparative Advantage
Composition of Exports & Imports of the U.S.,
Europe, and Japan in 1990
U.S.
% of Total
Europe
% of Total
Japan
% of Total
Exports
Imports
Exports
Imports
Exports
Imports
(21.2)
(24.1)
(18.4)
(26.8)
(2.5)
(54.8)
Food
10.8
5.8
10.4
10.7
0.6
14.5
Fuel
3.1
13.3
3.7
8.8
0.4
24.5
(73.9)
(75.5)
(79.7)
(71.0)
(95.9)
(42.6)
Autos
9.0
15.2
11.7
9.2
23.1
3.1
Chemicals
10.0
4.6
12.0
10.0
5.5
6.5
Telecomm
13.1
12.3
6.1
8.2
23.3
4.8
Textiles
1.9
6.5
6.3
6.8
2.2
5.5
Commodities
Manufactures
Source: GATT, International Trade, 1991-1992
13
Determining Trade Equilibrium
14
Trade Equilibrium

In equilibrium, terms of trade adjust to ensure
balanced trade between the two countries.
– Current account = 0 in Standard Trade Model equilib.

Can illustrate trade equilibrium using diagram of
PPF’s and utility curves for the two countries.
– Both PPF’s & utility curves differ across countries
initially. Autarchy relative prices differ, leading to
potential gains from trade.
– Trade equalizes relative prices across countries.
– In equilibrium, this relative price adjusts to make trade
triangles for each country identical, i.e. balanced trade.
15
Determining Trade Equilibrium
QF
Y
AF
CF
CH
PPFH
AH
QH
“Trade
Triangles”
PPFF
(PX/PY)
(PX/PY)
*
*
X
16
Relative Demand & Supply
Alternative, and easier way, to visualize equilibrium
terms of trade is to use relative demand and supply.
 Relative Demand

– Increase in PX/PY, relative price of Good X, results in
relative fall in demand for Good X relative to Good Y.
– Corresponds to move from C1 to C2 on next slide.

Relative Supply
– Increase in PX/PY, relative price of Good X, results in
movement along the PPF of each country from Q1 to Q2.
– Result is a relative increase in prod’n of Good X relative
to Good Y.
17
Deriving Relative Demand & Supply
Relative Price of X
Y
PX/PY
C2
RD
RS
PPF
C1
(PX/PY)2
Q1
(PX/PY)1
(PX/PY)*
(PX/PY)1
Q2
(PX/PY)2
X
Relative Quantity of X
(qX+ q*X)/(qY + q*Y)
18
Terms of Trade for Developing and
Developed Countries 1972-1988
Year
1972
1974
1976
1978
1980
1982
1984
1986
1988
Oil Exporters
100
258
259
248
412
456
412
206
192
Other
100
99
94
96
91
84
87
87
92
100
87
88
89
80
80
81
90
91
Developing Countries
Developed Countries
Terms of Trade = Export Unit Value ÷ Import Unit Value, 1972 = 100
Source: IMF, International Financial Statistics
19
Growth & Trade Equilibrium
20
Economic Growth & Trade
How does economic growth both in our country &
in the rest of the world affect trade?
 Ambiguity at “common sense” level

– Our growth means better able to export to world but
– May mean receive lower prices for our exports.
– Similar considerations for growth in rest of world.

We look only at effects of growth on trade,
particularly a country’s terms-of-trade.
– Our economic growth increases our GDP directly but
look at whether effect through trade adds or subtracts
from this benefit of growth.
– Similarly growth in another nation has no direct effect
on us but may benefit or hurt us through effect on trade.
21
Growth and a Nation’s PPF
 Economic
growth shifts out a nation’s PPF.
– Trade effects occur because growth often biased,
shifts PPF out more in one good than the other.
 Export-biased Growth
– Growth that expands a nation’s PPF more towards
its export good.
 Import-biased Growth
– Growth that expands a nation’s PPF more towards
its import good.
22
Export-Biased Growth and Trade
Relative Price of X
Y
PX/PY
PPF1
RS0
RS1
PPF0
(PX/PY)
0
Q0
Q1
(PX/PY)
RD0
1
X
Relative Quantity of X
(qX+ q*X)/(qY + q*Y)
23
Import-Biased Growth and Trade
Relative Price of X
Y
PX/PY
PPF1
RS1
Q1
RS0
PPF0
Q0
(PX/PY)
1
(PX/PY)
0
X
RD0
Relative Quantity of X
(qX+ q*X)/(qY + q*Y)
24
Economic Growth & Welfare

Export-biased growth tends to worsen a nation’s
terms of trade benefiting the rest of the world.

Import-biased growth tends to improve a nation’s
terms of trade at the rest of the world’s expense.

Immiserizing Growth
– 1950’s belief that export-biased growth could
worsen terms of trade so much that nation
worse off than if had not grown at all.
– Requires extreme conditions unlikely to hold in
real world (large shift, steep RS & RD curves)
25
Trade Policy & Equilibrium
26
Trade Policy & Equilibrium

Look at effects of three types of gov’t policies on terms of
trade equilibrium.

International Income Transfers
– Pure income transfers (aid) or short run effects of
changes in international lending.

Import Tariffs
– Taxes levied on nation’s imports

Export Subsidies
– Payments given to domestic producers of export goods.
27
International Income Transfers

Relative Price of X
PX/PY

RS0

(PX/PY)
0
(PX/PY)
RD0
1
RD1

Relative Quantity of X
(qX+ q*X)/(qY + q*Y)

Income transfer from
Home to Foreign.
Home expenditure falls,
Foreign expenditure rises.
Net result for RD depends
on differences in marg.
prop. to spend on Good X
between Home & Foreign.
Transfer shifts RD back if
donor has higher mps on
its export than recipient.
Donor’s terms of trade
worsen.
28
Import Tariffs & Terms of Trade

Both tariffs & subsidies drive a wedge between prices of goods
internationally (external prices) & domestically (internal
prices).

Tariff
– Makes imported goods more expensive within a nation than
they are outside. This has two effects within nation:
Home producers face lower relative price of Good X & so produce
less X and more Y. (RS falls)
 Home consumers demand less Y and more X. (RD rises)

– Home’s terms of trade improve at expense of Foreign.
– Size of effect depends on how large Home is relative to
ROW. If country is small then little impact on world RD
and RS so correspondingly small effect on terms of trade
29
Effects of a Import Tariff
Relative Price of X
PX/PY

RS1
RS0

(PX/PY)
1

(PX/PY)
0
RD1
RD0


Relative Quantity of X
(qX+ q*X)/(qY + q*Y)
Import tariff decreases
internal relative price of
export good X vs. good Y.
Internal price of export
good X falls.
Home produces less X &
more Y (RS shifts in).
Home consumes less X &
more Y (RD shifts out).
Terms of trade improve
for Home and worsen for
Foreign.
30
Effects of a Export Subsidy
Relative Price of X
PX/PY

RS0
RS1

(PX/PY)
0
(PX/PY)
1
RD0
RD1
Relative Quantity of X
(qX+ q*X)/(qY + q*Y)



Export subsidy has exact
opposite effect on internal
versus external prices to
an import tariff.
Internal price of export
good X rises.
Home produces more X &
less Y (RS shifts out).
Home consumes less X &
more Y (RD shifts in).
Terms of trade worsen for
Home and improve for
Foreign.
31
Summary of Policy Effects
 International
Distribution of Income
– Import Tariff
 Tariff
hurts Rest of World by hurting its terms of trade.
 Improves Home’s terms of trade BUT leads to
distortion in prod’n & consumption (efficiency losses).
– Export Subsidy
 Subsidy
helps ROW by improving its terms of trade.
 Hurts Home’s terms of trade AND leads to distortion in
prod’n & consumption (efficiency losses)

In a multi-commodity world:
– Export subsidies to goods we import, improve our welfare
– Import tariffs on goods we export, hurt our welfare.
32
Alternative Method to
Determine Trade Equilibrium
33
Offer Curves and Trade Equilib.

Offer Curve analysis focuses explicitly on a country’s
exports and imports at any terms of trade.
– Use PPF/Utility function diagram to generate difference
between consumption and prod’n for each good at any
relative price (its trade triangle at each relative price).
– Offer Curve Diagram summarizes these trade triangles with
relative price equal to slope of ray from origin.
Can construct an Offer Curve for each country. Point
at which they cross is where trade is balanced, i.e.
trade triangles are equal.
 Can use to analyze effects of growth or trade policy as
alternative to relative demand/supply approach.

34
Deriving An Offer Curve
Home Imports, CY – QY
Foreign Exports, Q*Y – C*Y
Y
C2
Home Country
Offer Curve
(PX/PY)
2
C1
Q1
(PX/PY)
1
(PX/PY)
Q2
Prod’n Possibilities
1
(PX/PY)
2
X
Home Exports, Q*X –
C*X
Foreign Imports, C*X –
Q*X
35
Offer Curves & Trade Equilibrium
Home Imports, CY – QY
Foreign Exports, Q*Y – C*Y
Home Country
Offer Curve
Y
Equilib. Price
Ratio, PX /PY
Foreign Country
Offer Curve
X
Home Exports, Q*X –
C*X
Foreign Imports, C*X –
Q*X
36
Export-Biased Growth and Trade II
Home Imports, CY – QY
Foreign Exports, Q*Y – C*Y
Y
Home Country Offer Curves
OC0
OC1
PPF1
C1
PPF0
C0
Q0
Q1
(PX/PY)
X
Home Exports, Q*X –
C*X
Foreign Imports, C*X –
Q*X
37
Export-biased Growth & Trade II
Home Imports, CY – QY
Foreign Exports, Q*Y – C*Y
Home Country
OC0
OC1
( PX /PY)0
( PX /PY)1
Foreign Country
Offer Curve
Home Exports, Q*X –
C*X
Foreign Imports, C*X –
Q*X
38