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Chapter 5

The Standard Trade Model

Prepared by Iordanis Petsas

To Accompany

International Economics: Theory and Policy, Sixth Edition

by Paul R. Krugman and Maurice Obstfeld

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Chapter Organization

Introduction
A Standard Model of a Trading Economy
International Transfers of Income: Shifting the RD Curve
Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD
Summary
Appendix: Representing International Equilibrium with Offer Curves

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Introduction

Previous trade theories have emphasized specific sources of comparative advantage which give rise to international trade:

Differences in labor productivity (Ricardian model)
Differences in resources (specific factors model and Heckscher-Ohlin model)

The standard trade model is a general model of trade that admits these models as special cases.

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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

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A Standard Model of a �Trading Economy

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, P_C/P_F.
Isovalue lines

Lines along which the market value of output is constant

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A Standard Model of a �Trading Economy

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

Isovalue lines

Cloth production, Q_C

Food production, Q_F

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

Q¹

VV¹(P_C/P_F)¹

Q²

VV²(P_C/P_F)²

A Standard Model of a �Trading Economy

Cloth production, Q_C

Food production, Q_F

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A Standard Model of a �Trading Economy

Relative Prices and Demand

The value of an economy's consumption equals the value of its production:

P_CQ_C+ P_FQ_F= P_CD_C + P_FD_F = V

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.

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A Standard Model of a �Trading Economy

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

Cloth production, Q_C

Food production, Q_F

Indifference curves

Food

imports

Cloth exports

A Standard Model of a �Trading Economy

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If the relative price of cloth, P_C/P_F , increases, the economy’s consumption choice shifts from D¹ to D².

The move from D¹ to D² reflects two effects:

Income effect
Substitution effect

It is possible that the income effect will be so strong that when P_C/P_F rises, consumption of both goods actually rises, while the ratio of cloth consumption to food consumption falls.

A Standard Model of a �Trading Economy

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

Q¹

VV¹(P_C/P_F)¹

Q²

VV²(P_C/P_F)²

D²

D¹

A Standard Model of a �Trading Economy

Cloth production, Q_C

Food production, Q_F

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A Standard Model of a �Trading Economy

The Welfare Effect of Changes in the Terms of Trade

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.

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A Standard Model of a �Trading Economy

Determining Relative Prices

Suppose that the world economy consists of two countries:

Home (which exports cloth)

Its terms of trade are measured by P_C/P_F
Its quantities of cloth and food producedare Q_C and Q_F

Foreign (which exports food)

Its terms of trade are measured by P_F/P_C
Its quantities of cloth and food producedare Q^*_C and Q^*_F

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A Standard Model of a �Trading Economy

To determine P_C/P_F, 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 P_C/P_Fleads both countries to produce more cloth and less food.
The world relative demand curve (RD) is downward sloping because an increase in P_C/P_Fleads both countries to shift their consumption mix away from cloth toward food.

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Figure 5-5: World Relative Supply and Demand

Relative price

of cloth, P_C/P_F

Relative quantity

of cloth, Q_C + Q^*_C

Q_F + Q^*_F

A Standard Model of a �Trading Economy

(P_C/P_F)¹

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A Standard Model of a �Trading Economy

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
Increase in a country’s supply of a factor of production

A Standard Model of a �Trading Economy

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Figure 5-6: Biased Growth

TT¹

TT²

A Standard Model of a �Trading Economy

Cloth production, Q_C

Food

production, Q_F

(a) Growth biased toward cloth

Cloth production, Q_C

Food

production, Q_F

(b) Growth biased toward food

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Relative Supply and the Terms of Trade

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

A Standard Model of a �Trading Economy

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Figure 5-7: Growth and Relative Supply

Relative price

of cloth, P_C/P_F

Relative quantity

of cloth, Q_C + Q^*_C

Q_F + Q^*_F

RS¹

(P_C/P_F)¹

RS²

(P_C/P_F)²

Relative price

of cloth, P_C/P_F

Relative quantity

of cloth, Q_C + Q^*_C

Q_F + Q^*_F

RS²

(P_C/P_F)²

RS¹

(P_C/P_F)¹

(a) Cloth-biased growth

(b) Food-biased growth

A Standard Model of a �Trading Economy

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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.

A Standard Model of a �Trading Economy

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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.

A Standard Model of a �Trading Economy

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

A Standard Model of a �Trading Economy

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International Transfers of Income: Shifting the RD Curve

International transfers of income, such as war reparations and foreign aid, may affect a country’s terms of trade by shifting the world relative demand curve.
Relative world demand for goods may shift because of:

Changes in tastes
Changes in technology
International transfers of income

The Transfer Problem

How international transfers affect the terms of trade

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International Transfers of Income: Shifting the RD Curve

Effects of a Transfer on the Terms of Trade

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

Relative price

of cloth, P_C/P_F

Relative quantity

of cloth, Q_C + Q^*_C

Q_F + Q^*_F

RD²

RD¹

(P_C/P_F)²

(P_C/P_F)¹

International Transfers of Income: Shifting the RD Curve

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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.

This is not necessarily due to differences in taste but rather to barriers to trade, natural and artificial.

International Transfers of Income: Shifting the RD Curve

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Import tariffs and export subsidies affect both relative supply and relative demand.
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).
The terms of trade correspond to external, not internal, prices.

Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD

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Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD

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

Relative price

of cloth, P_C/P_F

Relative quantity

of cloth, Q_C + Q^*_C

Q_F + Q^*_F

RS¹

RD¹

RD²

RS²

(P_C/P_F)¹

(P_C/P_F)²

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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%.
This will lead Home producers to produce more cloth and less food.

A Home export subsidy worsens Home’s terms of trade and improves Foreign’s.

Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD

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Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD

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

Relative price

of cloth, P_C/P_F

Relative quantity

of cloth, Q_C + Q^*_C

Q_F + Q^*_F

RS¹

RD¹

RD²

RS²

(P_C/P_F)¹

(P_C/P_F)²

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Implications of Terms of Trade Effects: Who Gains and Who Loses?

The International Distribution of Income

If Home (a large country) imposes a tariff, its welfare increases as long as the tariff is not too large, while Foreign’s welfare decreases.
If Home offers an export subsidy, its welfare deteriorates, while Foreign’s welfare increases.

The Distribution of Income Within Countries

A tariff (subsidy) has the direct effect of raising the internal relative price of the imported (exported) good.
Tariffs and export subsidies might have perverse effects on internal prices (Metzler paradox).

Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD

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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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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.

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Figure 5A-1: Home’s Desired Trade at a Given Relative Price

Desired

imports

of food

Desired

exports

of cloth

Home’s

imports, D_F - Q_F

Home’s

exports, Q_C - D_C

P_C/P_F

Appendix: Representing International Equilibrium with Offer Curves

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Figure 5A-2: Home’s Offer Curve

T²

T¹

Appendix: Representing International Equilibrium with Offer Curves

Home’s

imports, D_F - Q_F

Home’s

exports, Q_C - D_C

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Figure 5A-3: Foreign’s Offer Curve

Appendix: Representing International Equilibrium with Offer Curves

Foreign’s

exports, Q^*_F – D^*_F

Foreign’s

imports, D^*_C – Q^*_C

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Appendix: Representing International Equilibrium with Offer Curves

Figure 5A-4: Offer Curve Equilibrium

Home’s exports of cloth, Q_C – D_C

Foreign’s imports of cloth, D^*_C – Q^*_C

Home’s imports of food, D_F– Q_F

Foreign’s exports of cloth, Q^*F – D^*_F