Standard Trade Model

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BA 187 – International Trade

Standard Trade Model and Gains from Trade

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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.

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Prod’n Possibilities

Iso-value lines

Technology & Country PPF

Y

X

PPF: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 Perfect Competition:Competition: Nation chooses highest iso-value line given its PPF.

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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.

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(PX/PY)A

Effects of Trade on a Country

Y

X


A

CH

QH

(PX/PY)T

U’H

UH

Home Exports, QX - CX

Home Imports, CY - QY

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% Change in U.S. Employment Resulting from Foreign Trade, 1970-1980

IndustryIndustry Percent ChangePercent 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?

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Sources of Gains from Trade Can break a country’s gains from trade into two

distinct parts.– Gains from Exchange (Consumption Gains)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)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.

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(PX/PY)1

Sources of Gains from Trade

Y

X

Prod’n PossibilitiesA1

(PX/PY)2

Q2

C2C1

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Sources of the Basis for Trade

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The Basis for Trade Mutual gains from trade arise in the Standard

model of trade in essentially two ways:

Differences in Production PossibilitiesDifferences in Production Possibilities

– PPF’s may differ across countries in ways that give rise to trade due to:

Differences in TechnologyDifferences in Technology Differences in Factor EndowmentsDifferences in Factor Endowments

Differences in TastesDifferences 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

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(PX/PY)*

Opening trade changes relative prices

Assuming identical utility function for Home & Foreign

PPFH

PPFF

Home & Foreign PPF’s differ due to differences intechnology or factor endowments.

Differing Technology/Endowments

Y

X

AH

AF Autarky Equilibrium at AH and AF

QF

QH

C*

New equilib. consumption at C*.Each country has different prod’n ;point.

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Differing Utility Functions

Y

X

AH

UH

CH

U’H

Assuming identical PPF’s for Home & Foreign.

AF

UF

Utility curves differ across countries, autarchy prices differ based on utility.

Q*

(PX/PY)*

Open trade, equalizes relative prices, both countries produce at point Q.

CF

U’F

Each consumes at different point, both countries gain from trade.

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Revealed Comparative Advantage Composition of Exports & Imports of the U.S.,

Europe, and Japan in 1990

U.S.U.S.

% of Total

EuropeEurope

% of Total

JapanJapan

% of Total

ExportsExports ImportsImports ExportsExports ImportsImports ExportsExports Imports Imports

CommoditiesCommodities (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

ManufacturesManufactures (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

Source: GATT, International Trade, 1991-1992

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Determining Trade Equilibrium

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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.

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CF

(PX/PY)*

“Trade Triangles”

AH

Determining Trade Equilibrium

Y

X

PPFH

(PX/PY)*

QH

CH

PPFF

AF CF

(PX/PY)*

QF

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Relative Demand & Supply Alternative, and easier way, to visualize equilibrium

terms of trade is to use relative demand and supply. Relative DemandRelative 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 SupplyRelative 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.

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Deriving Relative Demand & Supply

Y

X

PPF

(PX/PY)1

Q1

C1

(PX/PY)2

Q2

C2 RDRS

PX/PY

Relative Price of X

(qX+ q*X)/(qY + q*Y)Relative Quantity of X

(PX/PY)2

(PX/PY)1

(PX/PY)*

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Terms of Trade for Developing and Developed Countries 1972-1988

YearYear 19721972 19741974 19761976 19781978 19801980 19821982 19841984 19861986 19881988

Developing CountriesDeveloping Countries

Oil Exporters 100 258 259 248 412 456 412 206 192

Other 100 99 94 96 91 84 87 87 92

Developed CountriesDeveloped Countries 100 87 88 89 80 80 81 90 91

Terms of Trade = Export Unit Value ÷ Import Unit Value, 1972 = 100

Source: IMF, International Financial Statistics

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Growth & Trade Equilibrium

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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 butbut– 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 butbut

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.

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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 GrowthExport-biased Growth

– Growth that expands a nation’s PPF more towards its export good.

Import-biased GrowthImport-biased Growth– Growth that expands a nation’s PPF more

towards its import good.

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PPF1

Q1

Export-Biased Growth and Trade

Y

X

PPF0

Q0

RD0

RS0

(PX/PY)0

PX/PY

Relative Price of X

RS1

(PX/PY)1


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PPF1

Import-Biased Growth and Trade

Y

X

PPF0

Q0

RD0

RS0

(PX/PY)0

PX/PY

Relative Price of X

RS1

(PX/PY)1

Q1


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Economic Growth & Welfare Export-biasedExport-biased growth tends to worsenworsen a nation’s

terms of trade benefiting the rest of the world.

Import-biasedImport-biased growth tends to improveimprove a nation’s terms of trade at the rest of the world’s expense.

Immiserizing GrowthImmiserizing 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)

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Trade Policy & Equilibrium

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Trade Policy & Equilibrium

Look at effects of three types of gov’t policies on terms of trade equilibrium.

International Income TransfersInternational Income Transfers– Pure income transfers (aid) or short run effects of

changes in international lending.

Import TariffsImport Tariffs– Taxes levied on nation’s imports

Export SubsidiesExport Subsidies– Payments given to domestic producers of export goods.

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International Income Transfers

RS0


PX/PY

Relative Price of X

(PX/PY)0

RD0

RD1

(PX/PY)1

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.

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Import Tariffs & Terms of Trade

Both tariffs & subsidies drive a wedge between prices of goods internationally (external prices) & domestically (internal prices).

TariffTariff– 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

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Effects of a Import Tariff

RD0

RS0

(PX/PY)0


PX/PY

Relative Price of X

(PX/PY)1

RD1

RS1

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).(RS shifts in).

Home consumes less X & more Y (RD shifts out).(RD shifts out).

Terms of trade improve for Home and worsen for Foreign.

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Effects of a Export Subsidy

(PX/PY)1


PX/PY

Relative Price of X

(PX/PY)0

RD0

RS0

RS1

RD1

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).(RS shifts out).

Home consumes less X & more Y (RD shifts in).(RD shifts in).

Terms of trade worsen for Home and improve for Foreign.

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Summary of Policy Effects International Distribution of Income

– Import TariffImport Tariff Tariff hurts Rest of World by hurting its terms of trade. Improves Home’s terms of trade BUTBUT leads to

distortion in prod’n & consumption (efficiency losses).

– Export SubsidyExport Subsidy Subsidy helps ROW by improving its terms of trade. Hurts Home’s terms of trade ANDAND 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.

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Alternative Method to Determine Trade Equilibrium

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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.

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Deriving An Offer Curve

Y

X


(PX/PY)1

Q1

C1

Q2

(PX/PY)2

C2

Foreign Exports, Q*Y – C*Y

Home Imports, CY – QY

Foreign Imports, C*X – Q*X

Home Exports, Q*X – C*X

(PX/PY)2

(PX/PY)1

Home Country Offer Curve

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Offer Curves & Trade Equilibrium

Foreign Country Offer Curve

Home Country Offer Curve





Equilib. Price Ratio, PX /PY

X

Y

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PPF1

Q1

Export-Biased Growth and Trade II

Y

X

PPF0

Q0





(PX/PY)

OC0

C0

C1

OC1

Home Country Offer Curves

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Export-biased Growth & Trade II

Foreign Country Offer Curve

Home Country OC0





( PX /PY)0

( PX /PY)1

OC1

Standard Trade Model

Business

trade y x prodn possibilities

autarchy p x p y t p

relative price p x p

trade possibilities

foreign trade

trade leads

c y q y

effects of trade