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Week 5
The Standard
Trade Model
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Introduction
•
We have thus far covered the Ricardian model and
the Heckscher-Ohlin model.
•
The Ricardian model conveys the idea of
comparative advantage but does not allow us to
talk about the distribution of income.
•
The H-O model focuses on resource differences,
with a key implication that trade can affect income
distribution.
•
This chapter covers the standard model of trade in
which the Ricardian and H-O models can be
regarded as special cases.
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5-2
•
The standard trade model takes the common
features from the Ricardian and H-O models.
1. Differences in labor productivity (Ricardian) and resources
(H-O) between countries cause productive differences,
leading to gains from trade.
2. These productive differences are represented as
differences in production possibility frontiers (the
question of “what an economy can produce?”).
3. A country’s PPF determines its relative supply function
(X-axis: Relative Prices; Y-axis: Relative Quantity).
4. National relative supply functions (Home + Foreign)
determine a world relative supply function.
5. World equilibrium is determined by the intersection of
world relative demand and world relative supply functions
(RS = RD).
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Deriving Relative Supply (RS) Curve
•
Assume that Home and Foreign produces 2 goods:
Cloth and Food.
•
In general, each country’s PPF is a smooth line (2
factors of production with factor substitution).
•
Why PPF for Ricardian model is a straight line? It
assumes only one factor of production- labor.
•
But Ricardian model is really an extreme case.
•
PPF describes what an economy can produce.
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Fig. 5-1: The PPF with Factor Substitution
Still, the opportunity cost of cloth
in terms of food rises as the
economy produces more cloth
and less food.
Bowed Shaped
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• To determine what the economy does produce, we
must determine the prices of goods (PC /PF).
• In general, the economy should produce at the point
that maximizes the value of production, V:
V = PCQC + PFQF
 PC is the price of cloth and PF is the price of food.
 When V is constant, the line is defined as isovalue line.
 The slope of the isovalue line equals – (PC /PF)
 If relative prices change, the slope changes. For instance, if
PC increases, the slope becomes steeper (higher value).
 The economy produces at the point that maximizes V, where
PPF touches the highest possible isovalue line.
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Fig. 5-2: What an economy does produce?
Production
choices
(or
relative supply
QC /QF) is
determined by PPF and
relative prices (via the slope
of isovalue line, PC /PF).
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What happen to supply when Pc increases?
•
When PC , PC /PF , implying the slope of isovalue
line will be steeper (now VV2) than before (VV1).
•
The point of production shifts from Q1 to Q2, with
more cloth and less food produced.
•
Hence, when PC , PC /PF , the relative supply of
cloth (QC /QF)  (implying an upward sloping RS
curve).
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Fig. 5-3: Deriving Relative Supply Curve
Upward sloping
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Deriving Relative Demand (RD) Curve
• The value of the economy’s consumption (captured
by the indifference curve) is constrained to equal the
value of the economy’s production (represented by
the isovalue line).
PC DC + PF DF = PC QC + PF QF = V
• Each consumer has his or her own preferences, but
we assume that the preferences of an average
consumer represent all consumers.
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• Consumer
preferences
are
represented
by
indifference curves: combinations of goods that
make consumers equally satisfied (indifferent).
 Indifference curves are downward sloping to represent the
fact that if an average consumer has less cloth, he or she
could have more food and still be equally satisfied.
 Indifference curves farther from the origin represent larger
quantities of food and cloth, and hence a higher level of
satisfaction.
 Indifference curves are flatter when moving to the right to
represent the fact that as more cloth and less food is
consumed, an extra yard of cloth relative to an extra calorie
of food becomes less valuable.
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Fig. 5-4: Consumption Choices and Consumer Preferences
What
the
produce?
economy
does
The economy produces at point Q,
where the PPF is tangent to the
highest possible isovalue line.
What
the
consume?
economy
does
The economy consumes at point D,
where the isovalue line is tangent
to the highest possible indifference
curve.
What
happens
when
consumption is not equal to
production (mix)?
Cloth:
Food:
QC > DC
QF < DF
Export Cloth
Import Food
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What happen to demand when Pc increases?
•
When PC , PC /PF , implying the slope of isovalue
line will be steeper (now VV2) than before (VV1).
•
The point of production shifts from Q1 to Q2, with
more cloth and less food produced.
•
The point of consumption also shifts from D1 to D2,
with the economy moving to a higher indifference
curve (higher level of satisfaction).
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Fig. 5-5: Deriving Relative Demand Curve
At D2, the consumption of
both cloth and food .
However, QC  < QF .
Hence, when PC , PC /PF ,
the relative demand of cloth
(DC /DF)  (implying an
downward
sloping
RD
curve).
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PC/PF
Fig. 5-6: The Relative Demand Curve
Downward sloping
RD
QC/QF
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Welfare and the Terms of Trade
• The terms of trade refers to the price of exports
relative to the price of imports.
• When price of exports , it means that the country
can afford to buy more imports, hence an increase in
the terms of trade increases a country’s welfare.
• Assume Home: Export Cloth; Foreign: Export Food.
• When PC , PC /PF  (implying PF /PC )
• Terms of trade (PEX /PIM) for Home , Welfare 
• Terms of trade (PEX /PIM) for Foreign , Welfare 
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5-16
Determining Equilibrium Relative Prices
• To determine the equilibrium price of cloth relative to
the price of food (PC /PF) in the model, we again use
relative supply (RS) and relative demand (RD).
 Relative supply (RS) considers world supply of cloth relative
to that of food at each relative price (RS is upward sloping,
see Slide 9).
 Relative demand (RD) considers world demand of cloth
relative to that of food at each relative price (RD is downward
sloping, see Slide 15).
 In a two-country model, world quantities are the sum of
quantities from Home and Foreign countries.
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Fig. 5-7: World Equilibrium Relative Price
The higher PC /PF is, the
larger the world supply of
cloth relative to food, and
the lower the world
demand of cloth relative to
food.
Equilibrium relative price is
determined
by
the
intersection of the world
RS and RD curves, i.e. at
Point 1.
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Fig. 5-8: Trade Patterns At Equilibrium Relative Price (PC/PF)1
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Effects of Economic Growth: A Shift of the
World RS Curve
• Is economic growth in China good for the standard of
living in the U.S.?
• Is growth in a country more or less valuable when it is
integrated in the world economy?
• The standard trade model gives us precise answers
to these questions.
• Economic growth means an outward shift of PPF.
• But the shift of PPF is biased, expanding
disproportionately in the direction of one good.
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• Growth is usually biased: it occurs in one sector more
than others, causing relative supply (RS) to change.
 For instance, rapid growth has occurred in U.S. computer
industries but relatively little growth has occurred in U.S.
textile industries.
 According to the Ricardian model, technological progress in
one sector causes biased growth.
 According to the Heckscher-Ohlin model, an increase in
resources (e.g., an increase in the labor force, arable land, or
the capital stock) causes biased growth.
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Fig. 5-9: Biased Growth
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• In both figures, the economy is able to produce more
cloth and more food.
• Assuming constant PC /PF (i.e., constant slope for
isovalue line):
 Figure 5-9a: Growth biased toward cloth, QC , QF 
 Figure 5-9b: Growth biased toward food, QF , QC 
How does biased growth shifts the World RS curve?
How does this shift further affect the terms of trade?
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Fig. 5-10a: Cloth-Biased Growth and World RS
If biased growth occurs in the cloth
industry, suppliers are more able and
willing to sell cloth relative to food, so that
the relative supply curve shifts right to
represent an increase in the supply of
cloth relative to the supply of food.
In the new trade equilibrium, the relative
quantity of cloth bought and sold
increases, and the price of cloth relative
to the price of food  from (PC /PF)1 to (PC
/PF)2.
If Home exports cloth and imports food,
the price of exports relative to the price of
imports (PEX /PIM) for Home .
In other words, the terms of trade for
Home .
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Fig. 5-10b: Food-Biased Growth and World RS
If biased growth occurs in the food
industry, suppliers are more able and
willing to sell food relative to cloth, so that
the relative supply curve shifts left to
represent a decrease in the supply of
cloth relative to the supply of food.
In the new trade equilibrium, the relative
quantity of cloth bought and sold
decreases, and the price of cloth relative
to the price of food  from (PC /PF)1 to (PC
/PF)2.
If Home exports cloth and imports food,
the price of exports relative to the price of
imports (PEX /PIM) for Home .
In other words, the terms of trade for
Home .
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5-25
Fig. 5-10c: Summary on Biased Growth and World RS
 Cloth-biased growth:
RS shifts to the right, PC/PF ,
and terms of trade for Home .
 Food-biased growth:
RS shifts to the left, PC/PF , and
terms of trade for Home .
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5-26
In general,
(1) Export-biased growth (growth that expands a country’s PPF
disproportionally in that country’s export sector)
- RS shifts to the right, PEX , Terms of trade (PEX /PIM) 
- Reduce a growing country’s welfare (increase the welfare of the rest
of the world)
(2) Import-biased growth (growth that expands a country’s PPF
disproportionally in that country’s import sector)
- RS shifts to the left, PEX , Terms of trade (PEX /PIM) 
- Improve a growing country’s welfare (reduce the welfare of the rest
of the world)
To relate with slide 26, just look from the perspective of Home.
Export-biased growth = Cloth-biased growth
Import-biased growth = Food-biased growth
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Case Study
• Has growth in Asia reduced the welfare of high
income countries?
• The standard trade model predicts that import biased
growth in China reduces the U.S. terms of trade and
the standard of living in the U.S. Is this prediction
supported by the data?
Find out the answers from textbook, page 152-154.
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5-28
International Transfer of Income: A Shift of
the World RD Curve
• World relative demand (RD) for goods may shift due
to changing tastes, technology or international
transfer of income.
• Transfers of income sometimes occur from one
country to another.
 War reparations (e.g. payments demanded of Germany after
World War I) or foreign aid may influence demand of traded
goods and therefore relative demand.
 International loans may also influence relative demand in the
short run, before the loan is paid back.
How do transfer of income shifts the World RD
curve? How does this shift further affect the terms
of trade?
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• The shift in the RD curve (if it occurs) is the only effect
of a transfer of income.
• The RS curve does not shift as long as only income is
being transferred, and not physical resources.
• Thus, the transfer is a purely demand-side issue.
• Assume Home transfers income to Foreign. RD
curve does not shift when:
 Foreign allocates the extra income it receives between cloth
and food in the same proportions that Home reduces its
spending (to generate the transfers)
 World spending on cloth and food will not change
 RD curve will not shift, PC /PF will remain constant, and hence
NO terms of trade effect.
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• If the 2 countries allocate their change in spending
(Home: Reduced spending; Foreign: Increased
spending) in different proportions,
 World spending on cloth and food will change
 RD curve will shift, PC /PF will change, and hence there will
be a terms of trade effect.
 But the shift of RD curve (right or left) depends on the
marginal propensity to consume (MPC) in both countries.
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Illustration
• Assume Transfer = RM1000
MPCcloth(Home) = 0.8
MPCcloth (Foreign) = 0.2
• How much does demand of Cloth decrease in Home
when it reduces its income through a transfer?
 If Home has a higher MPCcloth, demand of its own goods
(Cloth) will fall more than demand of imports (Food)
 Cloth  RM800;
Food  RM200
• How much does demand of Cloth increase in Foreign
when it receives a transfer of income from Home?
 If Foreign has a lower MPCcloth, demand of imports (Cloth)
will rise less than demand of its own goods (Food)
 Cloth  RM200;
Food 
RM800
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• What is the net effect on world relative demand of
cloth?
 Demand for Cloth decreases (Cloth  RM600)
 Demand of Food increases (Food 
RM600)
 The ratio DC /DF  (just check what will happen if the initial
ratio is 1600/1000)
 This means that the RD curve shifts to the left
See Figure 5-11!
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Fig. 5-11: Effect of Income Transfer on RD Curve
If
MPCcloth(Home)
>
MPCcloth(Foreign), a transfer of
income by Home to Foreign shifts
the RD curve to the left.
The equilibrium relative price of
cloth decreases from (PC /PF)1 to
(PC /PF)2.
Since Home exports cloth and
imports food, the price of exports
relative to the price of imports (PEX
/PIM) for Home .
In other words, the terms of trade
for Home  (while improving
Foreign terms of trade).
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If MPCcloth(Home) < MPCcloth(Foreign), what is the
effect of income transfer by Home to Foreign on
terms of trade?
• The RD curve will shift to the right.
• The equilibrium relative price of cloth increases
• Since Home exports cloth and imports food, the price
of exports relative to the price of imports (PEX /PIM) for
Home .
• In other words, the terms of trade for Home  (while
worsening Foreign terms of trade).
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In general,
(1) A transfer worsens the donor’s terms of trade if the
donor has a higher MPC on its export good than the
recipient.
(2) A transfer improves the donor’s terms of trade if the
donor has a lower MPC on its export good than the
recipient.
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Tariffs and Export Subsidies: Simultaneous
Shifts in RS and RD
• Import tariffs are taxes levied on imports.
• Export subsidies are payments given to domestic
producers that export.
• The price changes caused by both policies change
both the RS and RD curves.
• This influence the terms of trade and therefore
national welfare.
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• Import tariffs and export subsidies drive a wedge
between prices in world markets (or external prices)
and prices in domestic markets (or internal prices).
 Since exports and imports are traded in world markets, the
terms of trade measures relative external prices (and not
internal prices).
 We want to know how these policies affect RS and RD as a
function of external prices.
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Import Tariffs
• If Home imposes a tariff on food imports, the internal
price of food relative to the price of cloth (PF /PC) faced
by Home producers and consumers rises (higher than
the external PF /PC on the world market).
 Likewise, the internal price of cloth relative to the price of food
(PC /PF) falls (lower than the external PC /PF on the world
market).
 At any given external PC /PF, Home producers will receive a
lower relative price of cloth, and therefore will be more willing
to switch to food production: production of cloth QC will
decrease (RS curve shifts to the left, see Figure 5-12).
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5-39
 At any given external PC /PF, Home consumers will pay a
lower relative price of cloth, and therefore will be more willing
to switch to cloth consumption: consumption of cloth will
increase (RD curve shifts to the right, see Figure 5-12).
 At the new equilibrium point where RS2 = RD2 (Point 2, see
Figure 5-12), the external relative price of cloth rises from
(PC/PF)1 to (PC/PF)2.
 Since Home exports cloth and imports food, the price of
exports relative to the price of imports (PEX /PIM) for Home .
 In other words, the terms of trade for Home  (while
worsening Foreign terms of trade).
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5-40
Fig. 5-12: Effect of a Tariff on RS & RD Curves
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5-41
• When Home imposes an import tariff, its terms of
trade increases and the welfare of the country may
increase.
• The magnitude of this terms of trade effect depends
on the size of the domestic country relative to the
world economy.
 If the country is small part of the world economy (like
Luxembourg or Paraguay), its tariff policies will not have
much effect on world relative supply and demand, and thus
minimal effect on the terms of trade.
 But for large countries (like the U.S.), an import tariff rate will
improve its terms of trade at the expense of foreign countries.
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5-42
Export Subsidies
• If Home imposes a subsidy on cloth exports, the
internal price of cloth relative to the price of food (PC
/PF) faced by Home producers and consumers rises
(higher than the external PC /PF on the world market).
 At any given external PC /PF, Home producers will receive a
higher relative price of cloth when they export, and therefore
will be more willing to switch to cloth production for export:
production of cloth QC will increase (RS curve shifts to the
right, see Figure 5-13).
 At any given external PC /PF, Home consumers must pay a
higher relative price of cloth to producers who have the option
of exporting, and therefore will be more willing to switch to
food consumption: consumption of cloth will decrease (RD
curve shifts to the left, see Figure 5-13).
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5-43
 At the new equilibrium point where RS2 = RD2 (Point 2, see
Figure 5-13), the external relative price of cloth decreases
from (PC/PF)1 to (PC/PF)2.
 Since Home exports cloth and imports food, the price of
exports relative to the price of imports (PEX /PIM) for Home .
 In other words, the terms of trade for Home  (while
improving Foreign terms of trade).
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5-44
Fig. 5-13: Effect of a Subsidy on RS & RD Curves
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5-45
Implications of Terms of Trade Effects: Who
Gains and Who Loses?
• The two-country, two-goods model predicts that:
 When Home imposes an import tariff, its terms of trade
increases and the welfare of the country may increase (at the
expense of Foreign).
 When Home imposes an export subsidy, its terms of trade
deteriorates and the welfare of the country may decrease (to
the benefit of Foreign).
In the case of U.S., are foreign tariffs always bad for the
country, and foreign export subsidies always beneficial?
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5-46
• But the model has ignored the effects of tariffs and
subsidies that occur in a world with many countries
and many goods:
 A foreign country may subsidize the export of a good that the
US also exports
• For instance, the EU subsidizes agricultural exports, which
American farmers also export
• According to theory (see slide 47), when EU imposes an export
subsidy, its terms of trade deteriorates to the benefit of Foreign
(in this case, it is beneficial to US)
• In reality, this export subsidy by EU will cause US terms of trade
 (inconsistent with prediction)
• This is because the external price for this agricultural export will
decrease in the world market (see Slides 44-46)
• Since US also exports agricultural good, the price of exports
relative to the price of imports (PEX /PIM) for US 
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5-47
 A foreign country may impose a tariff on an imported good
that the US also imports
• For instance, the EU imposes a tariff on automobile imports,
which American also imports
• According to theory (see slide 47), when EU imposes an import
tariff, its terms of trade improves at the expense of Foreign (in
this case, it is bad for US)
• In reality, this import tariff by EU may instead cause US terms of
trade  (inconsistent with prediction)
• This is because the external price for this import will decrease
in the world market (see slides 40-43)
• Since US also imports automobile, the price of exports relative
to the price of imports (PEX /PIM) for US 
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5-48
To qualify our conclusions from a two-country model, we
have to rephrase Slide 47:
• Export subsidies by foreign countries on goods that
 the U.S. imports reduce the world price of U.S. imports and
increase the terms of trade for the U.S. (theory)
 the U.S. also exports reduce the world price of U.S. exports
and decrease the terms of trade for the U.S. (exception)
• Import tariffs by foreign countries on goods that
 the U.S. exports reduce the world price of U.S. exports and
decrease the terms of trade for the U.S. (theory)
 the U.S. also imports reduce the world price of U.S. imports
and increase the terms of trade for the U.S. (exception)
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