1 Ch. 5: The Standard Trade Model 2 Introduction The standard trade model combines ideas from the Ricardian model and the Heckscher-Ohlin model. The.

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Ch. 5: The Standard Trade Model

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IntroductionIntroduction The standard trade model combines ideas from the The standard trade model combines ideas from the

Ricardian model and the Heckscher-Ohlin model.Ricardian model and the Heckscher-Ohlin model.

1.1. Differences in Differences in labor, labor skills, physical capital, land and labor, labor skills, physical capital, land and technologytechnology between countries cause productive differences, between countries cause productive differences, leading to gains from trade.leading to gains from trade.

2.2. These productive differences are represented as differences in These productive differences are represented as differences in production possibility frontiers, which represent the productive production possibility frontiers, which represent the productive capacities of nations.capacities of nations.

3.3. A country’s PPF determines its relative supply curve.A country’s PPF determines its relative supply curve.

4.4. National relative supply curves determine world relative supply, National relative supply curves determine world relative supply, which along with world relative demand determines an which along with world relative demand determines an equilibrium under international trade.equilibrium under international trade.

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Standard ModelStandard ModelFood

Cloth

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Indifference CurvesIndifference Curves

Consumer preferences and prices determine Consumer preferences and prices determine consumption choices.consumption choices.

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

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Indifference CurvesIndifference Curves

Indifference curves are downward sloping to represent Indifference curves are downward sloping to represent the fact that if a consumer has more cloth he could have the fact that if a consumer has more cloth he could have less food and still be equally satisfied.less food and still be equally satisfied.

Indifference curves farther from the origin represent Indifference curves farther from the origin represent larger quantities of food and cloth, which should make larger quantities of food and cloth, which should make consumers more satisfied and better off. consumers more satisfied and better off.

Indifference curves are flatter when moving to the right: Indifference curves are flatter when moving to the right: the more cloth and the less food that is consumed, the the more cloth and the less food that is consumed, the more valuable an extra calorie of food becomes relative more valuable an extra calorie of food becomes relative to an extra mto an extra m22 of cloth. of cloth.

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Cloth

-Pc/Pf

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Why The Price Has to ChangeWhy The Price Has to Change

Given the high price of cloth and the Given the high price of cloth and the relatively low price of food, more cloth is relatively low price of food, more cloth is produced and less food is produced.produced and less food is produced.

In the absence of trade, the population In the absence of trade, the population wants more food and less cloth.wants more food and less cloth.

Demand will raise the price of food and Demand will raise the price of food and lower the price of cloth until the price line, lower the price of cloth until the price line, PPF and indifference curves are all equal PPF and indifference curves are all equal to each other.to each other.

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Cloth

-Pc/Pf

QsQd

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Market for ClothMarket for Cloth

Price

Quantity

S

D

QsQd

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QuestionsQuestions

Show the same situation in terms of Show the same situation in terms of Supply and Demand in the Food Supply and Demand in the Food Market.Market.

Using the PPF and indifference curves, Using the PPF and indifference curves, show the amount of food produced and show the amount of food produced and demanded at the given relative price demanded at the given relative price line.line.

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Market for FoodMarket for Food

Price

Quantity

S

D

Qs Qd

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Cloth

-Pc/Pf-Pc/Pf

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Determining Relative PricesDetermining Relative Prices

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Introducing TradeIntroducing TradeFood

Cloth

-Pc/Pf

-Pc/Pf

Exports

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Welfare ChangesWelfare Changes

The change in welfare (income) when the price The change in welfare (income) when the price of one good changes relative to the price of of one good changes relative to the price of another is called the another is called the income effectincome effect.. The income effect is represented graphically by The income effect is represented graphically by

shifting the indifference curve.shifting the indifference curve.

The substitution of one good for another when The substitution of one good for another when the price of the good changes relative to the the price of the good changes relative to the other is called the other is called the substitution effectsubstitution effect.. This substitution effect is represented graphically by a This substitution effect is represented graphically by a

moving along a given indifference curve.moving along a given indifference curve.

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Welfare and the Terms of TradeWelfare and the Terms of Trade

The The terms of tradeterms of trade refers to the price of refers to the price of exports relative to the price of imports.exports relative to the price of imports. When a country exports cloth and the relative When a country exports cloth and the relative

price of cloth increases, the terms of trade price of cloth increases, the terms of trade increase or “improve”.increase or “improve”.

Because a higher price for exports means that Because a higher price for exports means that the country can afford to buy more imports, an the country can afford to buy more imports, an increase in the terms of trade increases a increase in the terms of trade increases a country’s welfare.country’s welfare.

A decrease in the terms of trade decreases a A decrease in the terms of trade decreases a country’s welfare.country’s welfare.

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Welfare Effect of Terms of Welfare Effect of Terms of TradeTrade

When a country’s Terms of Trade When a country’s Terms of Trade improves, i.e., the price of its exports improves, i.e., the price of its exports rise relatively to the price of its imports, rise relatively to the price of its imports, welfare increases.welfare increases.

Question 3: Show the effect on welfare Question 3: Show the effect on welfare when the Terms of Trade worsens.when the Terms of Trade worsens.

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Welfare Effect of Terms of TradeWelfare Effect of Terms of TradeFood

Cloth

-Pc/Pf

Exports

-Pc/Pf

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The Effects of Economic GrowthThe Effects of Economic Growth

Growth is usually Growth is usually biasedbiased: it occurs in one : it occurs in one sector more than others, causing relative sector more than others, causing relative supply to shift.supply to shift. Rapid growth has occurred in US computer Rapid growth has occurred in US computer

industries but relatively little growth has occurred in industries but relatively little growth has occurred in US textile industries.US textile industries.

According to the Ricardian model, technological According to the Ricardian model, technological progress in one sector causes biased growth.progress in one sector causes biased growth.

According to the Heckscher-Ohlin model, an According to the Heckscher-Ohlin model, an increase in one factor of production (e.g., an increase in one factor of production (e.g., an increase in the labor force, arable land, or the increase in the labor force, arable land, or the capital stock) causes biased growth.capital stock) causes biased growth.

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Biased growth and the resulting shift in relative supply Biased growth and the resulting shift in relative supply causes a change in the terms of trade.causes a change in the terms of trade. Biased growth in the cloth industry (in either the domestic or Biased growth in the cloth industry (in either the domestic or

foreign country) will lower the relative price of cloth and lower foreign country) will lower the relative price of cloth and lower the terms of trade for cloth exporters. the terms of trade for cloth exporters.

Biased growth in the food industry (in either the domestic or Biased growth in the food industry (in either the domestic or foreign country) will raise the relative price of cloth and raise foreign country) will raise the relative price of cloth and raise the terms of trade for cloth exporters.the terms of trade for cloth exporters.

Suppose that the domestic country exports cloth and Suppose that the domestic country exports cloth and imports food.imports food.

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Biased GrowthBiased GrowthThe 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

Y

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Welfare Effect of Biased GrowthWelfare Effect of Biased Growth

X

YIf 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.

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The Effects of Economic Growth The Effects of Economic Growth (cont.)(cont.)

Export-biased growth reduces a country’s terms Export-biased growth reduces a country’s terms of trade, generally reducing its of trade, generally reducing its welfare and increasing the welfare of welfare and increasing the welfare of foreign countries.foreign countries.

Import-biased growth increases a country’s Import-biased growth increases a country’s terms of trade, generally increasing its terms of trade, generally increasing its welfare and decreasing the welfare of welfare and decreasing the welfare of foreign countries.foreign countries.

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Export-biased growthExport-biased growth is growth that is growth that expands a country’s PPF disproportionally expands a country’s PPF disproportionally in production of that country’s exports.in production of that country’s exports.

Import-biased growthImport-biased growth is growth that is growth that expands a country’s PPF disproportionally expands a country’s PPF disproportionally in production of that country’s imports.in production of that country’s imports.

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Welfare Effect of Biased GrowthWelfare Effect of Biased Growth

X

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.

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Immiserizing GrowthImmiserizing Growth

X

YGrowth 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.

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Has Growth in Asia Reduced Has Growth in Asia Reduced the Welfare of US?the Welfare of US?

The standard trade model predicts that The standard trade model predicts that import import biased biased growth in China reduces the US terms of trade and the growth in China reduces the US terms of trade and the standard of living in the US.standard of living in the US. Import biased growth for China would occur in sectors that Import biased growth for China would occur in sectors that

compete with US exports.compete with US exports.

But this prediction is not supported by data: But this prediction is not supported by data: there should be negative changes in the terms of trade there should be negative changes in the terms of trade for the US and other high income countries.for the US and other high income countries. In fact, the terms of trade for high income countries have been In fact, the terms of trade for high income countries have been

positive and negative for developing Asian countries.positive and negative for developing Asian countries.

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Has Growth in Asia Reduced the Has Growth in Asia Reduced the Welfare of High Income Countries? Welfare of High Income Countries?

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Income TransfersIncome Transfers If a country were to donate a substantial If a country were to donate a substantial

amount of its income to the rest of the amount of its income to the rest of the world, would its T/T improve or worsen?world, would its T/T improve or worsen?

Say, US gave $1 trillion of its income Say, US gave $1 trillion of its income away. If the marginal propensity to spend away. If the marginal propensity to spend for each good is the same around the for each good is the same around the world, then no T/T will take place.world, then no T/T will take place.Whatever US has reduced in demand for both Whatever US has reduced in demand for both

products is matched by the increase in products is matched by the increase in demand in rest of the world.demand in rest of the world.

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Income TransfersIncome TransfersAgain, suppose US donates income Again, suppose US donates income

abroad.abroad.Suppose marginal propensity to spend for Suppose marginal propensity to spend for

US exports is larger in US than abroad.US exports is larger in US than abroad.The demand for products US exports will The demand for products US exports will

fall more due to lower US demand than the fall more due to lower US demand than the increase due to increase in foreign demand.increase due to increase in foreign demand.

The price for the US export good will fall.The price for the US export good will fall.Terms of trade for US will worsen.Terms of trade for US will worsen.

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Income TransfersIncome Transfers US gives foreign aid.US gives foreign aid. Marginal propensity to spend for its Marginal propensity to spend for its

export products is higher abroad.export products is higher abroad. Terms of trade improves for US.Terms of trade improves for US. Typically, foreign aid is tied to purchases Typically, foreign aid is tied to purchases

from US, i.e. marginal propensity to from US, i.e. marginal propensity to spend by foreigners is one (100%).spend by foreigners is one (100%).

Foreign aid by US improves welfare in Foreign aid by US improves welfare in the US.the US.

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http://www.economist.com/markets/indicators/displaystory.cfm?story_id=13145257

AidFeb 19th 2009

From The Economist print edition

3636

Income TransfersIncome Transfers Typically, the marginal propensity to spend for Typically, the marginal propensity to spend for

domestic products is larger than that of imports.domestic products is larger than that of imports. US has ¼ of world income; Americans “should” US has ¼ of world income; Americans “should”

spend 25% of their income on American goods!spend 25% of their income on American goods! For example, Americans spend 83% of their For example, Americans spend 83% of their

income on domestically produced goods and only income on domestically produced goods and only 17% on imports. Foreigners spend 9% of their 17% on imports. Foreigners spend 9% of their income on US products.income on US products.

Transfer of income from US without any Transfer of income from US without any restrictions should worsen US terms of trade. restrictions should worsen US terms of trade.

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Asian CrisisAsian CrisisLoss of confidence in the ability of fast Loss of confidence in the ability of fast

growing Asian countries to be able to pay growing Asian countries to be able to pay their foreign debts made the investors pull their foreign debts made the investors pull out their savings.out their savings.

Dropping currency values made everyone Dropping currency values made everyone shift their savings away.shift their savings away.

Transfer of income outside reduced the Transfer of income outside reduced the demand for their products; price of their demand for their products; price of their exports fell and welfare was even more exports fell and welfare was even more reduced.reduced.

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Tariffs and Terms of TradeTariffs and Terms of Trade If a large country imposes an import If a large country imposes an import

tariff, internally, higher price of the tariff, internally, higher price of the product increases the supply but product increases the supply but decreases the demand.decreases the demand.

International price of the imported good International price of the imported good decreases.decreases.

The large country benefits from an The large country benefits from an improvement of terms of trade.improvement of terms of trade.

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Import Tariff and WelfareImport Tariff and Welfare

Home is exporting cheese and Home is exporting cheese and importing wine.importing wine.

Home imposes 50% tariff on imported Home imposes 50% tariff on imported wine.wine.

Internal price of wine has increased.Internal price of wine has increased.Home produces more wine and less Home produces more wine and less

cheese.cheese.At the world relative prices, the relative At the world relative prices, the relative

supply of wine is increased if home is a supply of wine is increased if home is a large country.large country.

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The higher price of wine at home will decrease The higher price of wine at home will decrease demand for wine but increase demand for the demand for wine but increase demand for the relatively cheaper cheese.relatively cheaper cheese.

The relative demand curve for wine will shift The relative demand curve for wine will shift left for a large country.left for a large country.

TT for home (large country) rises; international TT for home (large country) rises; international Pw down because world demand is down.Pw down because world demand is down.

TT for foreign worsens unless foreign TT for foreign worsens unless foreign retaliates. If foreign is small, retaliation will not retaliates. If foreign is small, retaliation will not matter.matter.

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Pw/Pc

Wine/Cheese

RD2 RD1

RS1

RS2

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Import Tariff and Welfare for Large CountriesImport Tariff and Welfare for Large Countries

Wine

Cheese

Pc/Pw

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Import Tariffs and Distribution of Import Tariffs and Distribution of Income Across CountriesIncome Across Countries

If the domestic country imposes a tariff on food imports, If the domestic country imposes a tariff on food imports, the price of food relative to price of cloth that domestic the price of food relative to price of cloth that domestic citizens face is higher.citizens face is higher. Likewise, the price of cloth relative to the price of food that Likewise, the price of cloth relative to the price of food that

domestic consumers and producers pay is lower.domestic consumers and producers pay is lower.

Domestic producers will receive a lower relative price of cloth, Domestic producers will receive a lower relative price of cloth, and therefore will be more willing to switch to food production: and therefore will be more willing to switch to food production: the relative supply curve will shift.the relative supply curve will shift.

Domestic consumers will pay a lower relative price of cloth, and Domestic consumers will pay a lower relative price of cloth, and therefore be more willing to switch to cloth consumption: the therefore be more willing to switch to cloth consumption: the relative demand curve will shift.relative demand curve will shift.

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When the domestic country imposes an import tariff, the When the domestic country imposes an import tariff, the terms of trade increases and the welfare of the country terms of trade increases and the welfare of the country may increase.may increase.

The magnitude of this effect depends on the size of the The magnitude of this effect depends on the size of the domestic country relative to the world economy.domestic country relative to the world economy. If the country is small part of the world economy, its tariff (or If the country is small part of the world economy, its tariff (or

subsidy) policies will not have much effect on world relative subsidy) policies will not have much effect on world relative supply and demand, and thus on the terms of trade.supply and demand, and thus on the terms of trade.

But for large countries, a tariff rate that maximizes national But for large countries, a tariff rate that maximizes national welfare at the expense of foreign countries may exist.welfare at the expense of foreign countries may exist.

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Import Tariff and WelfareImport Tariff and WelfareFor a small country, world prices will not For a small country, world prices will not

change.change.Draw the PPF and world prices, Draw the PPF and world prices,

indicating exports and imports.indicating exports and imports.Show the effect of a tariff on imported Show the effect of a tariff on imported

wine on internal prices.wine on internal prices.Show the new production point and the Show the new production point and the

effect on welfare.effect on welfare.

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Import Tariff and Welfare for Small CountriesImport Tariff and Welfare for Small Countries

Wine

Cheese

Pc/Pw

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Export Subsidies and Terms of Export Subsidies and Terms of Trade for Large CountriesTrade for Large Countries

An export subsidy will increase the internal An export subsidy will increase the internal price and hence the production of the exported price and hence the production of the exported good.good.

On the other hand, the internal demand for the On the other hand, the internal demand for the exported good will fall because higher priced exported good will fall because higher priced good is substituted by the lower priced import.good is substituted by the lower priced import.

International price of the exported good will fall International price of the exported good will fall leading to a deterioration of the terms of trade.leading to a deterioration of the terms of trade.

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Export Subsidies and Distribution of Export Subsidies and Distribution of Income Across CountriesIncome Across Countries

Cloth is exported andFood is imported.

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Export Subsidy and Welfare Export Subsidy and Welfare (Large Country)(Large Country)

Cheese

Wine

Pw/Pc

Internal prices External prices (TT)

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Export Subsidy and Welfare Export Subsidy and Welfare (Small Country)(Small Country)

Cheese

Wine

Pw/Pc

Internal prices

External prices (TT)

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Export Subsidies and Distribution of Export Subsidies and Distribution of Income Across CountriesIncome Across Countries

When the domestic country imposes an export When the domestic country imposes an export subsidy, the terms of trade decreases and the subsidy, the terms of trade decreases and the welfare of the country decreases to the benefit welfare of the country decreases to the benefit of the foreign country.of the foreign country.

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Distribution of Income Across Distribution of Income Across CountriesCountries

The two country, two good model predicts that The two country, two good model predicts that an import tariff by the domestic country can increase an import tariff by the domestic country can increase

domestic welfare at the expense of the foreign domestic welfare at the expense of the foreign country. country.

an export subsidy by the domestic country an export subsidy by the domestic country reduces domestic welfare to the benefit of the foreign reduces domestic welfare to the benefit of the foreign country.country.

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Import Tariffs and Export Subsidies Import Tariffs and Export Subsidies

in Other Countriesin Other Countries A foreign country may subsidize the export of a good A foreign country may subsidize the export of a good

that the US also exports, which will reduce its price in that the US also exports, which will reduce its price in world markets and decrease the terms of trade for the world markets and decrease the terms of trade for the US.US.

The EU subsidizes agricultural exports, which reduce the The EU subsidizes agricultural exports, which reduce the price that American farmers receive for their goods in world price that American farmers receive for their goods in world markets. markets.

A foreign country may put a tariff on an imported good A foreign country may put a tariff on an imported good that the US also imports, which will reduce its price in that the US also imports, which will reduce its price in world markets and increase the terms of trade for the world markets and increase the terms of trade for the US.US.

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Import Tariffs and Export Subsidies Import Tariffs and Export Subsidies

in Other Countriesin Other Countries Export subsidiesExport subsidies by foreign countries on goods that the by foreign countries on goods that the

US imports US imports reduce the world price reduce the world price of US importsof US imports and and increase the US terms of trade.increase the US terms of trade.

Export subsidiesExport subsidies by foreign countries on goods that the by foreign countries on goods that the US also exports US also exports reduce the world price reduce the world price of US exportsof US exports and decrease the US terms of trade.and decrease the US terms of trade.

Import tariffsImport tariffs by foreign countries on goods that the US by foreign countries on goods that the US exports exports reduce the world price reduce the world price of US exportsof US exports and and decrease the US terms of trade.decrease the US terms of trade.

Import tariffs Import tariffs by foreign countries on goods that the US by foreign countries on goods that the US also imports also imports reduce the world price reduce the world price of US importsof US imports and and increase the US terms of trade.increase the US terms of trade.

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Import Tariffs and Export Import Tariffs and Export SubsidiesSubsidies

Export subsidies on a good Export subsidies on a good decrease the decrease the relative world pricerelative world price of that good by increasing of that good by increasing relative supply of that good and decreasing relative supply of that good and decreasing relative demand of that good.relative demand of that good.

Import tariffs on a good Import tariffs on a good decrease the relative decrease the relative world priceworld price of that good (and increase the of that good (and increase the relative world price of other goods) by increasing relative world price of other goods) by increasing the relative supply of that good and decreasing the relative supply of that good and decreasing the relative demand of that good.the relative demand of that good.

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Perverse Policies on Export Perverse Policies on Export SubsidiesSubsidies

Many countries provide export subsidies to Many countries provide export subsidies to their industries and vigorously oppose their industries and vigorously oppose export subsidies by its trading partners.export subsidies by its trading partners.

Economic logic says just the opposite Economic logic says just the opposite should be the case.should be the case.

Internal income distribution explains why Internal income distribution explains why governments undertake these governments undertake these impoverishing measures.impoverishing measures.

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Import Tariffs, Export Subsidies and Import Tariffs, Export Subsidies and Distribution of Income Within a CountryDistribution of Income Within a Country Generally, a domestic import tariff increases income for Generally, a domestic import tariff increases income for

domestic import-competing producers by allowing the domestic import-competing producers by allowing the price of their goods to rise to match increased import price of their goods to rise to match increased import prices, and it shifts resources away from the export prices, and it shifts resources away from the export sector.sector.

Generally, a domestic export subsidy increases income Generally, a domestic export subsidy increases income for domestic exporters, and it shifts resources away from for domestic exporters, and it shifts resources away from the import-competing sector.the import-competing sector.

1 Ch. 5: The Standard Trade Model 2 Introduction The standard trade model combines ideas from the Ricardian model and the Heckscher-Ohlin model. The.

Documents

high price of cloth

low price of food

trade food cloth pcpf

price of exports relative

price of imports

food market

higher price

given relative price