Download barriers to trade

Chapter 5
Standard Trade Model
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 (Heckscher-Ohlin model)
 We need more general model of trade that admits
the above models as special cases.
• Based on common features of the above models.
• Can analyze many important issues, while sacrificing
some aspects (on the pattern & gains from trade).
Copyright © 2003 Pearson Education, Inc.
Slide 5-2
Introduction

The common features of the above models are,
– The productive capacity of an economy can be summarized by
its production possibility frontier, and differences in the PPFs
give rise to trade.
– The PPF determines its relative supply schedule, responding to
relative prices.
– National relative supply curves determine world relative
supply, which along with world relative demand determines an
equilibrium (relative price) under international trade.
Copyright © 2003 Pearson Education, Inc.
Slide 5-3
A Standard Model of a
Trading Economy
 The standard trade model is built on four key
relationships, which are the main subjects of this
chapter:
• Production possibility frontier and the relative supply
curve
• Relationship bet. relative prices and relative demand
• Determination of world equilibrium by world relative
supply and world relative demand
• Effects of ‘terms of trade’ (Pexp/Pimp) on a nation’s
welfare
Copyright © 2003 Pearson Education, Inc.
Slide 5-4
A Standard Model: (1) Production
Possibilities and Relative Supply
 Assumptions of the model:
– Each country produces two goods (eg. food and cloth)
– Each country’s production possibility frontier is a
smooth curve (TT), bowed owtward.
 The point on its production possibility frontier at
which an economy actually produces depends on
the price of cloth relative to food, PC/PF.
• At the point where the value of output is maximized.
 Isovalue lines: Lines along which the market value
of output is constant (PcQc + PfQf = V)
• A straight lines with slope of – (PC /PF).
Copyright © 2003 Pearson Education, Inc.
Slide 5-5
A Standard Model (1) Production
Possibilities and Relative Supply
Figure 5-1: Relative Prices Determine the Economy’s Output
Food production, QF
Isovalue lines
Q
TT
Cloth production, QC
Copyright © 2003 Pearson Education, Inc.
Slide 5-6
A Standard Model (1) Production Possibilities
and Relative Supply
Figure 5-2: How an Increase in the Relative Price of Cloth Affects
Relative Supply
Food production, QF
Q1
Q2
TT
Copyright © 2003 Pearson Education, Inc.
VV1(PC/PF)1
VV2(PC/PF)2
Cloth production, QC
Slide 5-7
A Standard Model (1) Production
Possibilities and Relative Supply
 Now, we can derive upward sloping relative supply
(RS) curve from the previous graph.
• As (PC /PF) rises, (QC /QF) also increases.
• The RS curve shows this relations graphically.
Copyright © 2003 Pearson Education, Inc.
Slide 5-8
A Standard Model (2) Relative
Prices and Demand
 The value of an economy's consumption equals the
value of its production: (budget constraint or
consumption possibility).
PCQC + PFQF = PCDC + PFDF = V
 The economy’s choice of actual consumption point
on the budget line (consumption possibility curve, a
kind of isovalue line) depends on the tastes of its
consumers.
– It can be represented graphically by a series of
indifference curves.
Copyright © 2003 Pearson Education, Inc.
Slide 5-9
A Standard Model (2) Relative
Prices and Demand
• Indifference curves
– Each indifference curve traces combinations of cloth (C)
and food (F) consumption that leave the individual
equally well off (the same level of welfare).
• Three properties of IC:
– 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 (convex to the
origin).
– Along an indifference curve, the (absolute) size of
slope decreases.
Copyright © 2003 Pearson Education, Inc.
Slide 5-10
A Standard Model (2) Relative Prices and Demand
Figure 5-3: Production, Consumption, and Trade in the Standard Model
Food production, QF
Indifference curves
D
Food
imports
Q
TT
Cloth exports
Copyright © 2003 Pearson Education, Inc.
Cloth production, QC
Slide 5-11
Figure 5-4: Effects of a Rise in the
Relative Price of Cloth
Copyright © 2003 Pearson Education, Inc.
Slide 5-12
A Standard Model (2) Relative Prices
and Demand
• 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:
– Substitution effect: (along the same IC) reduce
consumption of relatively expensive goods (cloth),
while increasing food consumption.
– Income effect: as the relative price of its export product
rises, it can afford to import more for given amount of
exports.
– increase both consumption (reaching higher IC).
Copyright © 2003 Pearson Education, Inc.
Slide 5-13
A Standard Model (2) Relative Prices
and Demand
• It is possible that the income effect will be so strong
that consumption of both goods actually rises when
PC/PF rises.
• Normally (in most situations), however, the ratio of
cloth consumption to food consumption (Dc/DF) will
fall, that is, the relative demand will decline as relative
price increases.
Copyright © 2003 Pearson Education, Inc.
Slide 5-14
A Standard Model (3) The Welfare Effect
of Changes in the Terms of Trade
 Terms of trade
• refers to the price of exports relative to the price of
imports, namely Pexp/Pimp.
 Determining Relative Prices (‘terms of trade’)
• 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
Copyright © 2003 Pearson Education, Inc.
Slide 5-15
A Standard Model (3) The Welfare
Effect of Changes in the Terms of Trade
• To determine PC/PF , one must find the intersection of
world relative supply and world relative demand of
cloth.
– 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.
Copyright © 2003 Pearson Education, Inc.
Slide 5-16
A Standard Model (3) The Welfare Effect of Changes in
the Terms of Trade
Figure 5-5: World Relative Supply and Demand
Relative price
of cloth, PC/PF
RS
(PC/PF)1
1
RD
Copyright © 2003 Pearson Education, Inc.
Relative quantity
of cloth, QC + Q*C
Q F + Q *F
Slide 5-17
A Standard Model (3) The Welfare Effect of
Changes in the Terms of Trade
 A rise in the terms of trade increases a country’s
welfare, while a decline in the terms of trade reduces
its welfare. (General statement).
• When PC/PF increases, a country exporting cloth
becomes better off (reach higher indifference curve).
– Refer to the Fig. 5-4.
– a higher price for exports means that the country can
afford to buy more imports
• When PC/PF decreases, the country become worse off.
Copyright © 2003 Pearson Education, Inc.
Slide 5-18
Application of the Model (1) Economic
Growth: A Shift of the RS Curve
 Q1. Is economic growth of other countries good or
bad for my country?
– It may be good for my country because it means larger
markets for our exports.
– It may mean increased competition for our exporters.
 Q2. Is growth of a country more valuable when the
country is part of a closely integrated world economy
or not?
– It would be more valuable when a country can sell some
of its increased production to the world market.
– It would be less valuable when the benefits of growth
are passed on to foreigners thru lower export price.
Copyright © 2003 Pearson Education, Inc.
Slide 5-19
Application of the Model (1) Economic Growth: A Shift of the RS Curve (cont’d)
 Growth and the Production Possibility Frontier
• Economic growth implies an outward shift of a
country’s production possibility frontier (TT).
• The effects of growth on trade result from that growth
typically has a bias.
 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.
Copyright © 2003 Pearson Education, Inc.
Slide 5-20
Application of the Model (1) Economic Growth: A Shift of the RS
Curve (cont’d)
Figure 5-6: Biased Growth
Food
production, QF
Food
production, QF
TT1
TT2
Cloth production, QC
(a) Growth biased toward cloth
Copyright © 2003 Pearson Education, Inc.
TT1
TT2
Cloth production, QC
(b) Growth biased toward food
Slide 5-21
Application of the Model (1) Economic Growth:
A Shift of the RS Curve (cont’d)

Relative Supply and the Terms of Trade
• Export-biased growth
– Disproportionately expands a country’s production possibilities in
the direction of its export good.
– Shift the RS curve outward direction.
– Worsens the 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
– Shift the RS curve leftward direction.
– Improves the growing country’s terms of trade at the expense of
the rest of the word.
Copyright © 2003 Pearson Education, Inc.
Slide 5-22
Application of the Model (1) Economic Growth: A Shift of the RS Curve
(cont’d)
Figure 5-7: Growth and Relative Supply
Relative price
of cloth, PC/PF
Relative price
of cloth, PC/PF
RS1
RS2
RS1
RS2
(PC/PF)1
(PC/PF)2
1
(PC/PF)2
2
(PC/PF)1
2
1
RD
RD
Relative quantity
of cloth, QC + Q*C
QF + Q*F
(a) Cloth-biased growth
Copyright © 2003 Pearson Education, Inc.
Relative quantity
of cloth, QC + Q*C
Q F + Q *F
(b) Food-biased growth
Slide 5-23
Application of the Model (1) Economic Growth: A Shift of
the RS Curve (cont’d)
 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.
– By shifting the world RS curve accordingly.
• Export-biased growth in our country worsens our
terms of trade, reducing the direct benefits of growth
with the benefit to the rest of the world.
– Import-biased growth leads to an improvement of our
terms of trade, at the rest of the world’s expense.
Copyright © 2003 Pearson Education, Inc.
Slide 5-24
Application of the Model (1) Economic Growth: A Shift of
the RS Curve (cont’d)
• 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 no growth at all.
– can occur under extreme conditions: Strongly exportbiased growth combined with very steep RS, RD curves.
– Mere a theoretical point than a real-world issue.
• Has the growth of NIEs hurt advanced countries?
– Some concern on the “threat” in the advanced countries.
– depends on the direction of bias in the growth of NIEs,
revealed in the change in the terms of trade.
– Not supported by data (see the next slide).
Copyright © 2003 Pearson Education, Inc.
Slide 5-25
A Standard Model of a
Trading Economy
Table 5-1: Average Annual Percent Changes in Terms of Trade
Copyright © 2003 Pearson Education, Inc.
Slide 5-26
Application (2) 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. <cf: international loan- similar in SR.
• World relative demand curve may shift because of
international transfers of income.
• <cf: Changes in technology, Changes in tastes
 The Transfer Problem
• How international transfers affect the terms of trade?
• Again, a controversial issue.
Copyright © 2003 Pearson Education, Inc.
Slide 5-27
International Transfers of Income:
Shifting the RD Curve
 Effects of a Transfer on the Terms of Trade
• Keynes’s point for German War reparation for WWI
– The monetary sum understated the true burden.
– To pay the reparation, Germany would have to export
more and import less, worsening its terms of trade.
• When the two countries (donor & recipient) do not
allocate their change in spending in the same
proportions.
– The RD curve will shift and there will be a terms of
trade effect.
– The direction of effect on terms of trade will depend on
the difference in Home and Foreign spending patterns.
Copyright © 2003 Pearson Education, Inc.
Slide 5-28
International Transfers of Income: Shifting the
RD Curve
 Suppose the Home has a higher marginal propensity
to spend on cloth (its export) than Foreign.
• Home’s transfer payment to Foreign reduce demand
for cloth (relative to demand for food), shifting the RD
curve to the left, worsening Home’s terms of trade.
 When both countries allocate their change in
spending in the same proportions
• Ohlin’s point for German War reparation for WWI.
• The RD curve will not shift, and no terms of trade
effect.
Copyright © 2003 Pearson Education, Inc.
Slide 5-29
International Transfers of Income:
Shifting the RD Curve
Figure 5-8: Effects of a Transfer : When Home (Donor) has higher
marginal propensity to spend on cloth (export) than Foreign (Recipient).
Relative price
of cloth, PC/PF
RS
1
(PC/PF)1
(PC/PF)2
2
RD1
RD2
Copyright © 2003 Pearson Education, Inc.
Relative quantity
of cloth, QC + Q*C
QF + Q*F
Slide 5-30
International Transfers of Income:
Shifting the RD Curve

Presumptions about the Terms of Trade Effects of Transfers
• A transfer will worsen (improve) the donor’s terms of trade
if the donor has a higher (lower) 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 (i.e, export
goods rather than import goods) than foreigners.
– This is not necessarily due to differences in taste but
rather to barriers to trade (natural and artificial).
– The donor’s terms of trade tend to worsen due to its
income transfer to other countries. (Keynes argument is
more convincing.)
Copyright © 2003 Pearson Education, Inc.
Slide 5-31
Application 3:Tariffs and Export SubsidiesSimultaneous Shifts in RS and RD
 Relative Demand and Supply Effects of a Tariff
• Tariff (taxes levied on imports) or export subsidy
(payments to domestic producers that export) influence
the terms of trade and therefore national welfare
• Tariffs drive a wedge between the external
(international) prices and internal (domestic) prices.
– Tariff make imported goods more expensive inside the
country than outside.
– Note that the terms of trade correspond to external
(international), not internal, prices.
Copyright © 2003 Pearson Education, Inc.
Slide 5-32
Application 3:Tariffs and Export SubsidiesSimultaneous Shifts in RS and RD

Suppose the Home imposes 10% tariff on food import
• Then, for any given world relative price,
• The Home consumers, facing lower relative price (Pc/Pf)
•
•
internally, will shift their consumption toward cloth (export)
away from food (import). (i.e., RD curve shift right-ward.)
The Home producers would face lower relative price (Pc/Pf)
internally, producing less cloth (export) & more food (import)
(lower Qc/Qf). (i.e., RS curve shift left-ward.)
As a result, the new world equilibrium relative price will rise in
favor of Home’s export good (cloth).
Copyright © 2003 Pearson Education, Inc.
Slide 5-33
Tariffs and Export Subsidies:
Simultaneous Shifts in RS and RD
Figure 5-9: Effects of a Tariff (on food import at Home) on the TOT
Relative price
of cloth, PC/PF
RS2
RS1
(PC/PF)2
2
1
(PC/PF)1
RD2
RD1
Copyright © 2003 Pearson Education, Inc.
Relative quantity
of cloth, QC + Q*C
QF + Q*F
Slide 5-34
Tariffs and Export Subsidies:
Simultaneous Shifts in RS and RD
 That is, imposing import tariffs will improve its terms

of trade.
The extent of this effect depend on the size of the
economy relative to the rest of the world.
• A country with small part of the world trade cannot
have much effect on the world relative price.
• A large country with substantial share in the world
trade would have strong effect on the world relative
price (by imposing import tariff).
Copyright © 2003 Pearson Education, Inc.
Slide 5-35
Tariffs and Export Subsidies:
Simultaneous Shifts in RS and RD
 Effects of an Export Subsidy
• Tariffs and export subsidies are often treated as similar
policies (for supporting domestic producer), but they
have opposite effects on the TOT.
– Example: Suppose that Home offers 20% subsidy on the
value of cloth exported:
– This will lead Home producers to produce more cloth and less
food, thereby increasing relative supply for cloth.
– This will raise Home’s internal price of cloth relative to food by
20%, thereby reducing relative demand for cloth.
– A Home export subsidy worsens Home’s terms of trade
and improves Foreign’s.
Copyright © 2003 Pearson Education, Inc.
Slide 5-36
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, PC/PF
RS1
RS2
1
(PC/PF)1
(PC/PF)2
2
RD1
RD2
Copyright © 2003 Pearson Education, Inc.
Relative quantity
of cloth, QC + Q*C
QF + Q*F
Slide 5-37
Tariffs and Export Subsidies:
Simultaneous Shifts in RS and RD
 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 by improving its terms of trade, while
Foreign’s welfare decreases (as long as the tariff is not
too large).
– If Home is a small country, the tariff will not change the terms
of trade.
– If Home offers an export subsidy, its welfare
deteriorates, while Foreign’s welfare increases.
Copyright © 2003 Pearson Education, Inc.
Slide 5-38
Tariffs and Export Subsidies:
Simultaneous Shifts in RS and RD
• The Distribution of Income Within Countries
– A tariff (subsidy) has the direct effect of raising the internal
relative price of the imported (exported) good.
– Tariff help import competing sector, while export subsidy
help export sector.
– However, tariffs and export subsidies might have perverse
effects on internal prices (Metzler paradox).
– A tariff might improve a (large) country’s terms of trade
so much that even after tariff is added, the internal relative
price of imported goods would fall.
– Similar perverse effect may arise for export subsidy.
– Possible in theory, but unlikely to happen in reality.
Copyright © 2003 Pearson Education, Inc.
Slide 5-39
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
world relative supply and demand curves.
Economic growth is usually biased. Growth that is
export-biased (import-biased) worsens (improves) the
terms of trade.
Copyright © 2003 Pearson Education, Inc.
Slide 5-40
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.
Copyright © 2003 Pearson Education, Inc.
Slide 5-41