International Economics Vienna University of Technology Summer Semester 2006 Lecturer: Walter H. Fisher The Standard Trade Model
Krugman and Obstfeld, Chapter 5, 6th ed: The Standard Trade Model There are 4 major relationships in the standard trade model 1. The relationship between the production possibility frontier and the relative supply curve. 2. The relationship between relative prices and relative demand. 3. The determination of world equilibrium by world relative demand and supply. 4. The e ects of the terms of trade the price of a country s exports divided by its imports on a nation s welfare. Consider an economy without market failures that is e cient in production, so that it seeks to maximize the value of output at any given point of time.
Graphically, we illustrate the value of output, V, with are termed isovalue lines: P C Q C + P F Q F = V ) Q F = V P F P C P F Q C where Q F =food, Q C =clothing, P C =price of clothing, P F =price of food and where the slope of the isovalue line correspond to the (negative) of the relative price of clothing: dq F dq C = P C P F : In Figure 5-1 the highest value of output is attained at point Q. In Figure 5-2 the economy shifts to textile production after an increase in its relative price.
Since the value of an economy s consumption equals the value of its production: P C Q C + P F Q F = P C D C + P F D F = V where D C consumption of clothing and D F consumption of food, the economy s consumption must also lie on the isovalue line. Precisely where on the isovalue line the economy chooses to consume depends on preferences, which are represented by indi erence curves. Indi erence curves illustrate the combinations of clothing and food that make the individual equally well o, i.e., the combinations that yield the same utility.
We can describe an indi erence curve over clothing and food as a function U U (D C ; D F ) with the following partial derivative characteristics @U @D C = U C > 0; @U @D F = U F > 0; @ 2 U = U CC < 0; @ 2 U = U F F < 0; @D 2 C @D 2 F U CC U F F U 2 CF > 0: The latter condition imposes that the (instantaneous) utility function is strictly concave.
Indi erence curves have 3 essential properties 1. Indi erence curves are negatively sloped, since clothing and food are both goods, rather than bads. 2. Since more is preferred to less, indi erence curve lying further to the right correspond to higher levels of welfare, or utility. 3. Diminishing Marginal Rate of Substitution, i.e., the indi erence curve gets atter as the economy chooses more clothing and less food Figure 5-3 illustrates the optimal consumption point D. In this example, the economy exports clothing and imports food.
In Figure 5-4 illustrating the e ects of a rise in the relative price P C =P F the economy: 1. Produces more clothing and less food. 2. The consumption basket shifts from D 1 to D 2. Observe that D 2 is on a higher indi erence curve so that the economy s welfare improves. This is because the economy is an exporter of cloth and because the relative price of clothing rises, the economy can a ord to import more for any given volume of exports. This re ects the income e ect of the change in the relative price.
In addition, the change in the relative price leads to a substitution toward food and away from textiles, which, of course, represents the income e ect. In General A rise in the terms of trade increases a country s welfare, while a decline in the terms of trade reduces its welfare. Figure 5-5 depicts the world equilibrium in terms of the relative supply and demand of clothing. Observe that A rise in P C =P F increases the relative supply, RS, of clothing. A rise in P C =P F decreases the relative demand, RD, of clothing.
Economic Growth Growth and the Production Possibility Frontier This amounts to a shift in the country s production possibility frontier due either to: 1. More resources 2. Better technology Biased Growth Biased growth occurs when the production possibility frontier shifts-out more in one direction than another. For example:
Biased technical change can occur in the Ricardian model An increase in a country s supply of factor of production for example, a rise in the capital stock K will produce a biased expansion in the production possibility frontier.
This bias will then be in the direction of the good for which the factor is speci c or the good whose production is intensive in the factor whose supply has risen. Figure 5-6a: cloth-biased technical change in the production possibility frontier. Figure 5-6b: food-biased technical change in the production possibility frontier. Figure 5-7a: cloth biased technical change causes RS to rise and the relative price P C =P F to fall. Figure 5-7b: food biased technical change causes RS to fall and relative price P C =P F to rise.
In General Export-biased growth tends to worsen a growing country s terms of trade, to the bene t of the rest of the world, which gets cheaper goods. On the other hand, import-biased growth tends to improve a growing economy s terms of trade, to the cost of the rest of the world, which su ers a terms of trade loss.
Immiserizing Growth Can growth ever make a country worse-o on net? This question occupied in the 1950s many economists from poorer nations, who feared that developing countries that exported raw materials would experience declining terms of trade if there were growth in the exporting sectors. In other words, growth in the industrial world would be from the developing country point of view import biased, while in the developing world export biased. The famous trade economist Jagdish Bhagwati showed that immiserizing growth growth that makes you poorer is, at least, a theoretical possibility.
In terms of Figure 5-7a it would, however, require a very steep RS and RD curves, so that the change in the terms of trade is a large enough to o set the positive e ects of an increase in a country s productive capacity. Most economists regard the case of immiserizing growth to be largely a theoretical curiosity. International Transfers of Income Another important phenomenon that can cause changes in trading patters is international transfers of income. Historically, these have often occurred in the aftermath of war Franco-Prussian War, 1871
German reparations, post WW I Marshall plan, post WW II J.M. Keynes believed that the reparations imposed on Germany after WW I would be doubly burdensome, since to pay for the reparations bill, Germany would have to export more, which would require a fall in its terms of trade. B. Ohlin counter-argued that when Germany raised taxes to nance its reparations, its demand for imports would also fall. At the same time, the reparation payments would be distributed to other countries in the form of reduced taxes or increased government spending, some of which would be devoted to buying German exports. Thus, Germany could raise exports and lower imports without at the same time experiencing a deterioration in the terms of trade. In any case, this particular dispute was moot, since Germany in the end paid very little of its reparations bill.
The transfer problem is a purely demand-side issue. Consider the case in which Home transfers income to Foreign. If Foreign raises its spending on clothing and food in the same proportions that Home reduced its spending on cloth and food, then RD does not change (this is Ohlin s point). On the other hand, if Home has a higher marginal propensity to spend on cloth than Foreign, then at any given relative price of cloth the RD curve shifts to the left (see Figure 5-8). This lowers P C =P F, which worsen Home s terms of trade, which is the case Keynes described. There is still another possibility: if Home has a lower marginal propensity to spend on cloth than Foreign, then at any given relative price of cloth the RD curve shifts to the right, which causes Home s terms of trade to improve.
In General A transfer worsens the donor s terms of trade if the donor has a higher marginal propensity to spend on its export good than the recipient. Most economists believe that Keynes was right: due to barriers to trade, which cause domestic residents to buy relatively more domestically produced goods, a transfer of income from the Home country would cause relative demand for domestic goods to fall and result in a decline in the terms of trade.
Tari s and Export Subsidies Import tari s: taxes levied on imports. Export subsidies: payments given to domestic producers who sell a good abroad. Tari s and subsidies drive a wedge between prices at which goods are traded internationally (external prices) and the prices at which they are traded within a country (internal prices). The terms of trade correspond to external, not internal prices. So if Home imposes a 20% tari on food imports, the internal price of food relative to cloth will be 20% higher than the external price of food on the world market.
Equally, the internal relative price of clothing will be 20% lower. The Home producers of textiles facing a lower relative price will produce less cloth and more food. Home consumers will shift their consumption toward clothing and away from textiles. Thus, the relative supply of clothing will fall and the relative demand for clothing will increase, as is illustrated in Figure 5-9. As such, this results in an improvement in Home s terms of trade. The extent of this terms of trade e ect depends on how large the country is in world markets.
Suppose the Home country o ers textile producers a subsidy of 20% on the value of any cloth exported. For any given world prices, this subsidy will raise Home s internal price of textiles relative to food by 20%. This causes Home producers to produce more cloth, while home consumers will substitute food for clothing. As illustrated in Figure 5-10, this results in a rise in the world relative supply of cloth, RS, and a fall in the relative demand for cloth. In sum, a Home export subsidy worsens Home s terms of trade and improves Foreign s.