International Trade

1
International Trade

• Week 3 - 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)
• Prodn function exhibits constant returns to
  scale, diminishing marginal returns to a factor.
• Economies have different endowments of the
  factors of prodn.
• Tastes
• Economys preferences can be represented by
  community indifference curves.
• Assume away distortions like taxes, subsidies,
  imperfect competition.

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Technology Country PPF

• PPF Shape shows diminishing marg. returns to
  factors of prodn.
• Iso-Value Lines For given set of relative
  prices, px, shows prodn points with equal value.
• Perfect Competition Nation chooses highest
  iso-value line given its PPF.

Y
X
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Trade and Relative Prices

• Begin with country in autarkic equilibrium
• relative price (PX/PY)A consump/prodn 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 prodn 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.

5
Effects of Trade on a Country
Y
UH
A
(PX/PY)A
Prodn Possibilities
X
6
Change in U.S. Employment Resulting from
Foreign Trade, 1970-1980
Source R.Z. Lawrence, Can America Compete?
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Sources of Gains from Trade

• Can break a countrys gains from trade into two
  distinct parts.
• 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)
• 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 prodn 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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Sources of Gains from Trade
Y
Prodn Possibilities
A1
(PX/PY)1
X
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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 Possibilities
• PPFs may differ across countries in ways that
  give rise to trade due to
• Differences in Technology
• Differences in Factor Endowments
• Differences in Tastes
• Utility curves across countries can differ in
  ways that give rise to trade even when PPFs are
  identical.
• Illustrate trade possibilities in these two
  situations

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Differing Technology/Endowments
Y
X
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Differing Utility Functions
Assuming identical PPFs for Home Foreign.
Y
X
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Revealed Comparative Advantage Composition of
Exports Imports of the U.S., Europe, and Japan
in 1990
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
  PPFs and utility curves for the two countries.
• Both PPFs 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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Determining Trade Equilibrium
Y
PPFH
PPFF
X
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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 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 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 prodn of Good X
  relative to Good Y.

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Deriving Relative Demand Supply
Relative Price of X
Y
PX/PY
PPF
C1
Q1
(PX/PY)1
X
Relative Quantity of X
(qX qX)/(qY qY)
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Terms of Trade for Developing and Developed
Countries 1972-1988
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
  but
• 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 countrys terms-of-trade.
• Our economic growth increases our GDP directly
  but 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 Nations PPF

• Economic growth shifts out a nations PPF.
• Trade effects occur because growth often biased,
  shifts PPF out more in one good than the other.
• Export-biased Growth
• Growth that expands a nations PPF more towards
  its export good.
• Import-biased Growth
• Growth that expands a nations PPF more towards
  its import good.

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Export-Biased Growth and Trade
Relative Price of X
Y
PX/PY
RS0
PPF0
(PX/PY)0
RD0
Q0
X
Relative Quantity of X
(qX qX)/(qY qY)
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Import-Biased Growth and Trade
Relative Price of X
Y
PX/PY
RS0
PPF0
Q0
(PX/PY)0
RD0
X
Relative Quantity of X
(qX qX)/(qY qY)
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Economic Growth Welfare

• Export-biased growth tends to worsen a nations
  terms of trade benefiting the rest of the world.
• Import-biased growth tends to improve a nations
  terms of trade at the rest of the worlds
  expense.
• Immiserizing Growth
• 1950s 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 govt policies
  on terms of trade equilibrium.
• International Income Transfers
• Pure income transfers (aid) or short run effects
  of changes in international lending.
• Import Tariffs
• Taxes levied on nations imports
• Export Subsidies
• Payments given to domestic producers of export
  goods.

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International Income Transfers

• 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.
• Donors terms of trade worsen.

Relative Price of X
PX/PY
RS0
(PX/PY)0
RD0
Relative Quantity of X
(qX qX)/(qY qY)
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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).
• Tariff
• 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)
• Homes 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
Relative Price of X

• 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).
• Home consumes less X more Y (RD shifts out).
• Terms of trade improve for Home and worsen for
  Foreign.

PX/PY
RS0
(PX/PY)0
RD0
Relative Quantity of X
(qX qX)/(qY qY)
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Effects of a Export Subsidy

• 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).
• Home consumes less X more Y (RD shifts in).
• Terms of trade worsen for Home and improve for
  Foreign.

Relative Price of X
RS0
PX/PY
(PX/PY)0
RD0
Relative Quantity of X
(qX qX)/(qY qY)
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Summary of Policy Effects

• International Distribution of Income
• Import Tariff
• Tariff hurts Rest of World by hurting its terms
  of trade.
• Improves Homes terms of trade BUT leads to
  distortion in prodn consumption (efficiency
  losses).
• Export Subsidy
• Subsidy helps ROW by improving its terms of
  trade.
• Hurts Homes terms of trade AND leads to
  distortion in prodn 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
  countrys exports and imports at any terms of
  trade.
• Use PPF/Utility function diagram to generate
  difference between consumption and prodn 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
Home Imports, CY QY
Foreign Exports, QY CY
Y
C1
Q1
(PX/PY)1
Prodn Possibilities
X
Home Exports, QX CX
Foreign Imports, CX QX
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Offer Curves Trade Equilibrium
Home Imports, CY QY
Foreign Exports, QY CY
Home Exports, QX CX
Foreign Imports, CX QX
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Export-Biased Growth and Trade II
Home Imports, CY QY
Foreign Exports, QY CY
Home Country Offer Curves
Y
OC0
OC1
PPF1
C1
PPF0
C0
Q1
Q0
(PX/PY)
X
Home Exports, QX CX
Foreign Imports, CX QX
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Export-biased Growth Trade II
Home Imports, CY QY
Foreign Exports, QY CY
Home Country OC0
( PX /PY)0
OC1
( PX /PY)1
Home Exports, QX CX
Foreign Imports, CX QX