International Economics

1
International Economics

• Lecture 4. The Standard Trade Model

2
Outline

• A Standard Model of a Trading Economy
• Introduction
• Building the Model from four key relationships
• Using the Standard Trade Model
• Effects of economic growth
• Effects of international transfers of income
• Effects of import tariffs and export subsidies

3
Introduction

• The standard trade model is a general model of
  trade that admits previous models as special
  cases.
• It is built on four key relationships
• Production possibilities and the relative supply
  curve.
• Relative prices and relative demand.
• Terms of trade and national welfare.
• Relative prices determined by relative world
  supply and relative world demand.

4
1. Production Possibilities and Relative Supply

• Assumptions
• Each country produces two goods, food (F) and
  cloth (C)
• Each countrys production possibility frontier is
  a smooth curve (TT)
• The point on the production possibility frontier
  at which an economy actually produces depends on
  the price of cloth relative to food, PC/PF.
• Isovalue lines
• Lines along which the market value of output is
  constant

5
How an Increase in the Relative Price of Cloth
Affects Relative Supply
PC/PF ? ? QC/QF ?
VV2(PC/PF)2
TT
6
2. Relative Prices and Relative Demand

• The value of an economy's consumption equals the
  value of its production
• PCQC PFQF PCDC PFDF V
• The economys choice of a point on the isovalue
  line depends on the tastes of its consumers.
• Indifference curve
• Traces a set of combinations of cloth (C) and
  food (F) consumption that leave the individual
  equally well off
• Has the following properties
• 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

7
Production, Consumption, and Trade in the
Standard Model
Indifference curves
8
Relative Prices and Relative Demand (cont.)

• If PC/PF increases, the economys consumption
  choice changes.
• The change reflects two effects
• Income effect
• Increased (decreased) demand for both goods with
  increased (decreased) income (shifting
  indifference curve)
• Substitution effect
• Substitution away from relatively more expensive
  good (sliding along indifference curve)
• The income effect may be so strong that an
  increase in PC/PF leads to an increase in the
  consumption of both goods
• But the ratio of cloth consumption to food
  consumption decreases.

9
Effects of a Rise in the Relative Price of Cloth
PC/PF ? ? DC/DF ? (typically)
10
3. Terms of trade and National Welfare

• Terms of trade is the price of the good a country
  initially exports divided by the price of the
  good it initially imports.
• A rise in the terms of trade increases a
  countrys welfare, while a decline in the terms
  of trade reduces its welfare.
• When t-o-t increases, more imports can be
  exchanged for a given quantity of exports.

11
4. Determining Relative Prices

• Suppose that the world economy consists of two
  countries
• Home (which exports cloth) with t-o-t PC/PF
• Foreign (which exports food) with t-o-t PF/PC
• PC/PF is determined by the intersection of world
  relative supply of cloth (RS) and world relative
  demand (RD).
• RS is upward sloping because an increase in PC/PF
  leads both countries to produce more cloth and
  less food.
• RD is downward sloping because an increase in
  PC/PF leads both countries to shift their
  consumption mix away from cloth toward food.

12
World Relative Supply and Demand
13
Using the Standard Trade Model I Economic Growth

• Is economic growth in other nations good or bad
  for our nation?
• E.g. growth in China
• On the one hand, expansion of export markets.
• On the other, increased competition.
• Is growth in a country more or less valuable when
  it when it is integrated in the world economy?
• Is growth in Sweden more valuable in todays
  globalized world than 50 years ago?
• Depends on to what extent output increases can be
  sold abroad and to what extent growth is passed
  on to foreign consumers.

14
Growth and the Production Possibility Frontier

• Economic growth implies an outward shift of a
  countrys production possibility frontier (TT).
• Biased growth
• Takes place when TT shifts out more in one
  direction than in the other
• Can occur for two reasons
• Technological progress biased towards one sector
  of the economy
• Increase in a countrys relative supply of a
  factor of production

15
Biased Growth
16
Relative Supply and the Terms of Trade

• Export-biased growth
• Disproportionately expands a countrys production
  possibilities in the direction of the good it
  exports
• Worsens a growing countrys terms of trade, to
  the benefit of the rest of the world
• Import-biased growth
• Disproportionately expands a countrys production
  possibilities in the direction of the good it
  imports
• Improves a growing countrys terms of trade at
  the rest of the words expense

17
Growth and Relative Supply
(a) Cloth-biased growth
(b) Food-biased growth
18
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.
• Export-biased growth in our country worsens our
  terms of trade, reducing the direct benefits of
  growth, while import-biased growth leads to an
  improvement of our terms of trade.
• Immiserizing growth
• A situation where export-biased growth worsens
  terms of trade so much that the country is worse
  off than if without growth.
• Requires that strongly export-biased growth is
  combined with very steep RS and RD curves.
• Regarded by most economists as more a theoretical
  point than a real-world issue.

19
Has Growth in Asia Reduced the Welfare of High
Income Countries?

• The standard trade model predicts that
  import-biased growth in China reduces the terms
  of trade and the standard of living in
  industrialized countries.
• Import biased growth for China would occur in
  sectors that compete with exports of
  industrialized countries.
• But this prediction is not supported by data
  there should be negative changes in the terms of
  trade for the US and other high income countries.
• In fact, the terms of trade for high income
  countries have been positive and negative for
  developing Asian countries.

20
Has Growth in Asia Reduced the Welfare of High
Income Countries? (cont.)
21
Using the Standard Trade Model II International
Transfers of Income

• Transfers of income sometimes occur from one
  country to another.
• War reparations or foreign aid may influence
  demand for 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 transfers of income across countries
  affect relative demand and the terms of trade?
• The Transfer Problem
• Debate about how international transfers affect
  the terms of trade (Keynes vs. Ohlin)

22
Effects of a Transfer on the Terms of Trade

• Suppose C-exporting Germany pays war reparations
  to the F-exporting UK.
• How does this transfer of income affect welfare
  in Germany?
• Depends on consumption patterns in Germany and
  the UK (on the margin).
• Case 1 Both countries allocate their change in
  spending in the same proportions
• The RD curve will not shift ? no terms of trade
  effect.
• Real income is reduced with the actual transfer.
• Case 2 The countries do not allocate their
  change in spending in the same proportions
• The RD curve will shift ? terms of trade effect.
• The direction of the effect on terms of trade
  will depend on the difference in Home and Foreign
  spending patterns.

23
Effects of International Transfers (cont.)

• Sorting out the direction of the terms-of-trade
  effect in case 2
• How much does demand for German goods increase in
  the UK when it receives a transfer from Germany?
• If the UK has a higher marginal propensity to
  spend on its export good than on imports, demand
  for food will rise more than demand for imports
  of clothes from Germany.
• How much does demand for British goods decrease
  in Germany when it reduces its income through a
  transfer?
• If Germany has a higher marginal propensity to
  spend on its export good than on imports, demand
  for clothes will fall more than demand for
  imports of food from the UK.
• If each country has a higher marginal propensity
  to spend on its own products, the relative demand
  for the donor countrys export good falls.

24
Effects of a Transfer on the Terms of Trade
25
Effects of International Transfers (cont.)

• Countries spend most of their (marginal) income
  on their own products.
• Not necessarily due to differences in taste but
  rather to barriers to trade, natural and
  artificial.
• Income transfers thus predicted to decrease
  terms-of-trade of donor country.
• Moreover, the existence of non-traded goods and
  services may cause relative supply shifts that
  reinforces this tendency.
• Industries that produce non-traded goods and
  services compete for resources with industries
  that produce traded goods.
• A transfer reduces demand for and production of
  non-traded goods in the donor country ? more
  resources used in the export sector.
• It increases demand for and production of
  non-traded goods in recipient countries ? less
  resources used in the export sector.
• The relative supply of the donors exports
  increases.

26
Using the Standard Trade Model III Tariffs and
Export Subsidies

• Import tariffs and export subsidies affect both
  relative supply and relative demand.
• Relative Demand and Supply Effects of a Tariff
• Tariffs drive a wedge between the prices at which
  goods are traded internationally (external
  prices) and the prices at which they are traded
  within a country (internal prices).
• E.g. 10 tariff on food implies a 10 higher
  relative price of food internally than in the
  world market.
• The terms of trade correspond to external, not
  internal, prices.
• Increase in internal relative price of import
  good (in terms of export good)
• Relative supply of export good decreases
• Relative demand for export good increases

27
Effects of a Tariff on the Terms of Trade
28
Effects of a Tariff on the Terms of Trade (cont.)

• Terms of trade increases and welfare may
  increase.
• The magnitude of this effect depends on the size
  of the domestic country relative to the world
  economy.
• If the country is small, its tariff (or subsidy)
  will not have much effect on world relative
  supply and demand, and thus on the terms of
  trade.
• But for large countries, a tariff rate that
  maximizes national welfare at the expense of
  foreign countries may exist.

29
Effects of a Subsidy on the Terms of Trade

• Relative Demand and Supply Effects of an Export
  Subsidy
• Example Suppose that Home offers 20 subsidy on
  the value of cloth exported
• This will raise Homes internal price of cloth
  relative to food by 20 (provided imports of
  cloth is prevented no arbitrage!).
• Increase in internal relative price of export
  good
• Relative supply of export good increases
• Relative demand for export good decreases
• Export subsidy deteriorates terms-of-trade and
  welfare of to the benefit of the foreign country.

30
Effects of a Subsidy on the Terms of Trade
RD2
31
Implications for Income Distribution

• An import tariff can increase domestic welfare at
  the expense of the foreign country.
• An export subsidy reduces domestic welfare to the
  benefit of the foreign country.
• Because of changes in relative prices, import
  tariffs and export subsidies have effects on
  income distribution among producers within a
  country.
• An import tariff increases income for domestic
  import-competing producers and shifts resources
  away from the export sector.
• An export subsidy increases income for domestic
  exporters and shifts resources away from the
  import-competing sector.

32
Summary

• The terms of trade refers to the price of exports
  relative to the price of imports in world
  markets.
• Export-biased growth reduces a countrys terms of
  trade, increasing the welfare of foreign
  countries.
• Import-biased growth increases a countrys terms
  of trade, decreasing the welfare of foreign
  countries.
• The effect of international transfers of income
  depend on the marginal propensity to spend on
  domestic goods, but it will typically lead to a
  decrease in the donors terms of trade.
• An import tariff leads to improved terms of trade
  and may lead to an increase in welfare.
• An export subsidy leads to decreased terms of
  trade and welfare.