1 chapter 5 the standard trade model. 2 introduction previous trade theories have emphasized on...

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Chapter 5

The Standard Trade Model

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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

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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.

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Chapter Organization

1.A Standard Model of a Trading Economy2.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

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Components of model supply side - PPF, isovalue line demand side – indifference curve pattern of trade

Welfare change Changes in : TOT, growth (productivity), transfers

Tariffs & subsidies Trade patterns Welfares change Income distribution

Learning goals

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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

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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

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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.

(1)Production Possibility and Relative Supply

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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.

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Figure 5-1: Relative Prices Determine the Economy’s Output

QIsovalue lines

TT

Cloth production, QC

Food production, QF

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Figure 5-2: How an Increase in the Relative Price of Cloth Affects Relative Supply

Q1

VV1(PC/PF)1

Q2

VV2(PC/PF)2TT


Food production, QF

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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.

(2) Relative Price & Demand

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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.

Consumer preferences and prices determine consumption choices.

Consumer preferences are represented by indifference curves: combinations of goods that make consumers equally satisfied (indifferent).

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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

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TT

Figure 5-3: Production, Consumption, and Trade in the Standard Model


Food production, QF

Q

D

Indifference curves

Food imports

Cloth exports

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TT

Q1

VV1(PC/PF)1Q2

VV2(PC/PF)2

D2

D1


Food production, QF

Figure 5-4 Effects of a Rise in the Relative Price of Cloth

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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.

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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.

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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.

(3) The Welfare Effect of Changes in the Terms of Trade

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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

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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.

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Figure 5-5: World Relative Supply and Demand

RS

RD

Relative priceof cloth, PC/PF

Relative quantityof cloth, QC + Q*

C

QF + Q*F

(PC/PF)11

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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.

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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)

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Figure 5-6: Biased Growth

TT1 TT1TT2 TT2


Food production, QF

(a) Growth biased toward clothCloth production, QC

Food production, QF

(b) Growth biased toward food

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C

QF + Q*F

RS1

RD

1(PC/PF)1

RS2

(PC/PF)22



C

QF + Q*F

RS2

RD

2(PC/PF)2

RS1

(PC/PF)11

(a) Cloth-biased growth (b) Food-biased growth

Relative Supply and the Terms of Trade

Figure 5-7 Growth and Relative Supply

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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

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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.

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International Effects of Growth

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Immiserizing growth

Develped Countries

Develping Countries

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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.


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Case Study

Has the Growth of Newly Industrializing Countries Hurt Advanced Nations?

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115

110

105

100

95

90

851970 1975 1980 199519901985

Figure 5-8 The Terms of Trade of Advanced Countries,1970-1997

Table 5-1: Average Annual Percent Changes in Terms of Trade

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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

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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?

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(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

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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.

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Figure 5-8: Effects of a Transfer on the Terms of Trade



C

QF + Q*F

RS

RD2

RD1

(PC/PF)22

1(PC/PF)1

International Transfers of Income: Shifting the RD Curve

Foreign: recipient

Home: donor

Home has a higher marginal propensity to spend on cloth

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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?

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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.

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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.

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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.

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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?

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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.


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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


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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

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Figure 5-9: Effects of a Tariff on the Terms of Trade



C

QF + Q*F

RS1

RD1

RD2

RS2

(PC/PF)11

(PC/PF)22

Home: 20% tariffs

Country size matters

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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.

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Figure 5-10: Effects of a Subsidy on the Terms of Trade



C

QF + Q*F

RS1

RD1

RD2

RS2

(PC/PF)11

(PC/PF)22

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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

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Are Home tariffs always beneficial & export subsidy always a bad thing for it? Politics in trade.

Are Foreign tariffs always bad for a country & foreign subsidy always benifical? 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?

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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

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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.

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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.

Summary

1 chapter 5 the standard trade model. 2 introduction previous trade theories have emphasized on...

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