Afull understanding of how countries benefit from trading in international

3 EXPANDED GAINS FROM TRADE WITH RESOURCE MOVEMENTS Afull understanding of how countries benefit from trading in international markets requires us to consider production changes and resource reallocations stimulated by new trading opportunities. Two new sources of gain are now added to those described in the preceding account of commodity exchange: (1) Trade encourages nations to concentrate productive efforts in those activities that each performs relatively well. This reflects the famous doctrine of comparative advantage. (2) In addition, exposing producers in each country to a wider world market may encourage a reorganization of productive activities, and such reorganization may lead to gains from expanded production runs and larger scales of output than are possible in a smaller national market. The concluding section of this chapter brings together supply and demand behavior in order to expose the several ways in which a country s demand for imports is sensitive to changes in the terms of trade. 3.1 THE PRODUCTION POSSIBILITIES SCHEDULE AND AUTARKY EQUILIBRIUM No community can produce all the goods and services it desires. That it cannot do so reflects both the basic limitation of resources, natural and manufactured, and the quality of technological knowledge that guides the transformation of resources into final commodities. The production possibilities schedule (or transformation schedule) shows the maximum amount of one commodity that can be produced, given the quantities of all other commodities produced. A stark representation of such a schedule was shown by the TET right-angled box for the home country in Figure 2.3. Here a more general illustration of such a schedule is the TT curve in Figure 3.1, which depicts again a simple economy capable of producing only two commodities, food and clothing. For example, if clothing output is distance 0G, the maximum amount of food that can be produced is AG. Figure 3.1 illustrates several properties of production: (i) Some points of production (e.g., D) are beyond the productive capacity of this community. If the resource base expands with time, or if better production techniques are developed, then point D eventually could be produced. 31

32 CHAPTER 3 EXPANDED GAINS FROM TRADE WITH RESOURCE MOVEMENTS Figure 3.1 The Production Possibilities Schedule The bowed-out curve TT shows the maximum amount of food that can be produced for each amount of clothing, subject to the constraints of technological knowledge and a fixed resource base.the slope shows the opportunity costs of producing clothing, which increase as more clothing is produced. Food T I F E D H B C A J 0 G T Clothing (ii) The TT schedule is negatively sloped. To produce more food than indicated by point A on curve TT, some current production of clothing must be sacrificed to release resources from clothing into the food industry. (iii) A point such as C is possible. For example, during the depression of the 1930s, most industrial countries faced severe unemployment of labor and capital equipment. Perhaps less obvious is the possibility that the combination of production shown by C can occur even with full employment of all resources. Point C might represent the outcome of an arbitrary across-the-board decision by a central planning authority to employ exactly 68 percent of every factor of production in the clothing industry, with the remaining 32 percent producing food. Such a decision would not take into account the fact that some resources are especially productive in one sector and not in the other, or more generally, the fact that techniques of producing clothing are qualitatively different from those of producing food. An economic answer lurks behind the question of allocating the community s resources most efficiently, and one of the strong arguments in favor of using the price system and competitive markets is that it causes society s production of commodities to be efficient, lying along the production possibilities curve. (iv) The TT schedule bows out from the origin, reflecting the so-called law of increasing costs. That is, this shape embodies the assumption that the opportunity costs of obtaining an additional unit of a commodity increase as more of that commodity is produced. Consider clothing production, as shown initially at point F. The slope of the TT curve at F shows the sacrifice in food production required to produce an additional unit of clothing. This is clothing s opportunity cost; that is, the cost of an extra unit of clothing, not in dollars, labor, or material costs, but in terms of the quantity of the other, desired final commodity, food, that must be forgone in order to release the resources required by the unit expansion in the

3.1 THE PRODUCTION POSSIBILITIES SCHEDULE AND AUTARKY EQUILIBRIUM 33 clothing industry. Note how this opportunity cost of producing clothing rises when production of clothing expands to the level shown at B on the graph. That is, at B, TT is steeper than at F. What accounts for the general relationship whereby the opportunity cost of any commodity rises as its output increases? Some factors, such as highly skilled labor especially trained to produce clothing, may be employed already in clothing production at F; a further expansion in clothing production will rely on less-skilled labor released from food production. Conversely, when increasing food output at the expense of clothing, the supply of the best grade of fertile land may be used up by the time B is reached, necessitating the use of poorer land for food production in moving to F. Elements of this phenomenon the variability in the aptitude of factors in each occupation are almost always present in the real world to help to account for increasing costs. (A particularly simple case in which some resources simply cannot be transferred from one occupation to another forms the setting for Chapter 6.) Even if each factor has the same potential skills in one occupation as in another, the fact that the two industries may require inputs such as labor and capital in different proportions is sufficient to generate increasing costs. (This more subtle point is picked up in Chapter 7.) Appendix A to this chapter describes how increasing opportunity costs, as reflected in the bowed-out shape of the production possibilities schedule, result even if average production costs in each industry stay constant instead of rising with scale of output. Some productive processes may, at least for a range of outputs, exhibit what is known as increasing returns to scale (or decreasing costs). That is, costs per unit produced may fall as output expands. Here we emphasize that even if such economies of scale prevail, they may not be sufficiently strong to overcome the tendency for opportunity costs to rise as a result of industries requiring different factor proportions and/or the variability of factors aptitudes in different occupations. We continue to assume that the transformation curve for the economy is bowed out. Autarky Equilibrium Our description of equilibrium before international trade is similar to that in Chapter 2, except that consumers now have pretrade choices. If an economy cannot engage in international trade, the production possibilities curve in Figure 3.1 also serves as a consumption possibilities schedule; the community can consume only what it produces. Figure 3.2 again shows the production possibilities curve TT, as well as a pair of indifference curves for the community. Of all points available without trade to the country, point A maximizes satisfaction. Although food and clothing in combination B can be produced, point A is preferred. The slope of the dashed line tangent to the indifference curve at A shows the relative price of clothing (to food) that would lead consumers to demand these items in the proportions shown by point A. This line also is tangent to the production possibilities schedule. Competitive producers respond to price incentives by equating price to marginal cost. The slope of the transformation curve, reflecting the sacrifice of food output to obtain an extra unit of clothing, precisely measures the marginal cost of producing a further clothing unit. This cost is measured now not in dollars

34 CHAPTER 3 EXPANDED GAINS FROM TRADE WITH RESOURCE MOVEMENTS Figure 3.2 The Optimal Production Point for a Closed Economy An economy not engaged in trade can produce and consume anywhere along TT. Point A, where an indifference curve is tangent to the transformation curve, represents a higher level of welfare than any other point (e.g., B).The slope of an indifference curve reflects the marginal rate of substitution.the slope of the transformation curve reflects the relative marginal cost of producing clothing.the slope of the common tangent at A shows the relative price of clothing. Food T A B 0 T Clothing or labor-hours, but in forgone food output. In autarky the community produces and consumes at A, at prices reflected in the common slope of the indifference curve and transformation schedule, that are tangent at point A. 3.2 TRADE AND COMPARATIVE ADVANTAGE Patterns of production in all countries are significantly affected by international trade. Some countries take advantage of trade to pour a relatively large volume of resources into activities for which there is little local demand Zambian copper, Saudi Arabian oil, Greek shipping services. Other countries, such as the United States, have a more balanced productive base, yet certain sectors depend heavily on the export trade. Japan relies on its exports of automobiles and a wide range of consumer durables to finance its great reliance on world markets for oil and other raw materials. The gains alluded to in these examples suggest that international trade allows each country to break out of the constraint imposed by producing only for the local market and to channel its resources into lines more appropriate at world market prices. The following discussion of possible production gains begins by returning to the two-commodity, food-and-clothing example illustrated in Chapter 2, with the discussion first focusing on how a country can augment the gains to consumers by reallocating resources along its production possibilities schedule. The next section explores an alternative route, whereby trading in a world market can benefit a country because the production possibilities schedule itself may expand with trade.

3.2 TRADE AND COMPARATIVE ADVANTAGE 35 Figure 3.3 The Trade Triangle in the Home Country With free-trade prices shown by the slope of line 2, production at home takes place at A and consumption at B. BDA is the trade triangle.the community exports DA units of clothing in exchange for imports of BD units of food. Food F B T 1 y 1 E y 2 2 y 0 D A 0 T Clothing Consider Figure 3.3, which shows the consequence of trade for the home country. If the home country is not allowed to engage in international trade, its consumption possibilities are restricted to points on its transformation schedule, TT ; of these the best is shown by point E, where indifference curve y 0 is tangent to TT. The pretrade relative price of clothing that clears the local market is shown by the slope of line 1. Suppose that with the opening of trade world prices are shown by the slope of line 2. Because clothing is relatively expensive abroad, free trade encourages resources to flow from food production into the clothing industry until local marginal costs equal world prices (at point A). Line 2 shows the new, expanded locus of consumption possibilities, and the most desired consumption bundle along this line is point B. At these prices the community desires to export DA of its clothing output in exchange for BD imports of food. BDA represents the trade triangle. The gains from trade are shown by the increase in real income, moving from curve y 0 to the higher curve, y 1. If resources were frozen into their occupations at point E, the country still would gain from trade with the consumption point moving from E on curve y 0 to F on curve y 2. The movement in consumption from F on y 2 to B on y 1 shows the extra gains provided by trade when production is allowed to change from E to A.

36 CHAPTER 3 EXPANDED GAINS FROM TRADE WITH RESOURCE MOVEMENTS World prices are determined by supply and demand in both countries. In a free-trade equilibrium the home country s import demand for food must be matched by the foreign country s willingness to export the same quantity of food. If price line 2 in Figure 3.3 is to reflect an equilibrium price ratio, trade triangle BDA must find its mirror image in the foreign country. That is, production and consumption decisions abroad must show matching amounts, as in Figure 3.4. The foreign country also gains from trade, with the change in consumption from E* to B* entailing a rise in real incomes abroad from level y* 0 to y* 1. Foreign exports of A*D* of food match home imports of BD. The slope of A*B* is, of course, the same as the slope of BA in Figure 3.3. Comparative Advantage A glance at Figures 3.3 and 3.4 reveals the strong bias in the transformation schedules the home country s curve has been drawn flatter than the foreign country s. Figure 3.4 The Trade Triangle in the Foreign Country The slope of line 2 is the same as in Figure 3.3.Trade is balanced as the foreign country s trade triangle, A*D*B*, matches the home country s BDA in Figure 3.3. Food T* 2 A* E* D* B* y 0 * * y 1 0 T* Clothing

3.2 TRADE AND COMPARATIVE ADVANTAGE 37 This (arbitrary) assumption allows us to speak of a production bias toward the home country possessing a comparative advantage in producing clothing (that is, the home country exhibits a lower relative autarky price for clothing than does the foreign country). Note the double comparison involved. It is the pretrade cost ratio (p C /p F ) in one country as opposed to another that is the object of comparison in determining comparative advantage. Figure 3.5 illustrates the production bias found in Figures 3.3 and 3.4. At this stage of the discussion, we deliberately ignore relative country size as a material consideration in affecting relative costs and concentrate on the composition of demand and production by showing how ratios of food to clothing respond to relative prices. Figure 3.5 shows that for any price ratio faced in common by both countries for example, free-trade price ratio 0T the foreign country would, in a competitive market, produce relatively more food at G* than the home country would at G. A vertical comparison of these supply curves shows that if both countries attempt to produce goods in the same proportion, the relative cost of producing food abroad, at A*, would be lower than at home, at A. How about the demand side of the market? If taste patterns were identical and captured by a common downward sloping relative demand curve in Figure 3.5, the autarky price of food at home would have to be higher than that found abroad. However, it is possible to conceive of a situation in which demand patterns differ so much between countries that food is relatively inexpensive at home before trade. Both Figure 3.5 Comparative Advantage The pair of relative supply curves illustrates the production bias in favor of the foreign country possessing a comparative advantage in producing food. If tastes are comparable, positions of comparative advantage and the trade pattern (foreign country exports food) are consistent with the production bias. p F p C A Home s F s C s F * s C Foreign T G G* A* 0 Food/Clothing

38 CHAPTER 3 EXPANDED GAINS FROM TRADE WITH RESOURCE MOVEMENTS demand and supply conditions affect positions of comparative advantage, although we will generally consider supply conditions to be more important. What causes a production bias between countries? Part II develops the rationale along two different lines: The foreign country possesses relatively superior technical knowledge required to produce food, and/or the foreign country is relatively well endowed with those productive factors that are especially well suited for food production. Need every country have a comparative advantage in something? Yes, except for the accidental possibility of a tie. Becoming relatively worse at some activity establishes that the country becomes relatively better at other activities. This is a point frequently misunderstood. For example, Lutz Hoffmann, president of the German Institute of Economic Research, in lamenting the rise in labor costs in eastern Germany in 1990, stated that East Germany is rapidly losing its comparative advantage as a low-wage economy and has no other advantage with which to compensate for this. 1 3.3 SCALE ECONOMIES AND WORLD TRADE Even before David Ricardo (1817) explained the advantages of international trade advantages based on each nation having a certain range of commodities in which it has a comparative advantage Adam Smith expounded on the benefits that accrue from an enlarged scale of operations and the division of labor. Steel, automobiles, many types of manufacturing activity, and production of agricultural commodities all display at least some initial cost-reduction features attributed to larger volumes of production. Countries with large internal markets may exhaust most of these economies of scale even without the opportunity to produce for the world market, whereas smaller countries may find that international trade allows for an expansion of the scale of output of a particular variety of commodity significantly beyond the limits of their national markets. According to Adam Smith, the division of labor is limited by the extent of the market. When comparing production possibilities available to a self-sufficient country with those possible in a world market, it is unrealistic to ignore the influence of economies of scale. In Chapter 2 we discussed the possibility that the kind of clothing found in one country differed from that found in another, and consumers gained by the increase in variety available through trade. Now we expand this scenario by assuming there is a range of types in each industry aggregate produced and consumed within each country before trade. For example, to produce each variety, certain setup or fixed costs may be required, as well as costs incurred per quantity produced. Therefore, expansion of the scale of operations for each variety could entail a reduction in average cost per unit of output. This scenario presupposes a type of competition (monopolistic competition) that we discuss in more detail in Chapter 8. Here it suffices to note that the number of different varieties of clothing (or food) produced and consumed in autarky depends on a balance between consumers interests in having 1As reported in the International Herald Tribune, March 22, 1991.

3.4 SOURCES OF GAINS FROM TRADE:A RECAPITULATION 39 a wide selection from which to choose and the cost savings that accrue to producing larger volumes of only a few varieties. How does the ability to trade in world markets alter the situation for consumers and producers within any given country? Producers now face competition from abroad, but they expand their sales opportunities by finding customers in world markets. Consumers find varieties available abroad that are not produced locally. Indeed, it is assumed that each producer s choice of variety is influenced by the desire to offer a specialty that differs from those of competitors at home and abroad. Of course, how much each country produces of each type depends in part on the extent to which resources are reallocated between the two broad aggregates, and differences between countries encourage each to concentrate on that aggregate in which it has a comparative advantage. Focus now on the disposition of a given bundle of resources to a particular aggregate. The extra competition and opportunities provided by international trade encourage a reduction in the number of varieties produced by any country, matched by a greater volume of output for each variety. Consumers everywhere find a greater total range of items available on world markets, although the spread produced locally is narrowed. A basic property of international trade is that consumption possibilities are freed from local production patterns, and the general effect of trade is to enlarge consumption possibilities while encouraging concentration and greater specialization in production. The changes in production brought about by opening the economy to trade are represented by drawing the nation s transformation schedule linking the two industry aggregates. Figure 3.6 illustrates that the move from autarky to free trade shifts the transformation schedule for these aggregates. To see why this occurs, suppose that quantities of different varieties within each industry are added to obtain an aggregate industry total. For a given bundle of resources, the country with trade produces fewer varieties, each with a longer production run. The outcome is a larger total production for each aggregate. International trade, by making markets more competitive for a nation s producers, allows greater aggregate outputs from a given resource bundle. When European countries first lowered tariff barriers among themselves as members of what is now the European Union, observers expected that some industries in each country would be driven to the wall by the extra competition from their neighbors. Given this expectation, they were surprised at the outcome. The pattern resembled what we have sketched previously: Firms in each country producing different varieties from those of their neighbors could expand into foreign markets. The pattern was one of interpenetration and intra-industry trade. 3.4 SOURCES OF GAINS FROM TRADE: A RECAPITULATION The different sources through which a nation gains from trade are additive. Figure 3.7 helps to tabulate the results. In autarky the economy consumes and produces at point A, with consumption of food and clothing limited to the quantities of aggregate food and clothing produced and the varieties of each type produced nationally before trade.

40 CHAPTER 3 EXPANDED GAINS FROM TRADE WITH RESOURCE MOVEMENTS Figure 3.6 Trade Shifts the Transformation Schedule If clothing and food are aggregates of a range of types produced locally and the average cost of producing each type diminishes with scale of output, opening the country to a wider world market can increase the aggregate index of all clothing and food that can be produced from any allocation of given resources. The number of varieties produced nationally decreases, although consumers enjoy a wider selection of types in the world market. Food Autarky Trade 0 Clothing 1. Being able to trade at different (world) prices (and assuming food is relatively cheaper on world markets) leads to the consumption choice of aggregate bundle A, if production were to remain frozen at point A. These exchange gains from trade include consumers ability to spread their consumption purchases over an increased variety of food and clothing. The benefits of such intra-industry trade could be captured by relabeling the indifference curve map (not done here) so that each bundle of diversified food and clothing represents a higher level of utility than would be the case for a less-diversified bundle available in autarky with the same industry totals. 2. If resources are kept roughly channeled to the two commodity groups (food and clothing), as in autarky, but a greater aggregate volume of production is possible because the narrower range of varieties produced is combined with a decreasing average cost of producing any variety, the transformation schedule shifts outward. Production at B could support the aggregate consumption bundle at B. 3. Relative to the rest of the world (as reflected in world prices), the country shown in Figure 3.7 has a comparative advantage in producing clothing. The shift of resources from B to C allows further consumption gains to point C on indifference curve y 3. Figure 3.7 does not explicitly reveal the details of the changes in the range of goods produced and consumed within each aggregate. The outward shift in the transformation schedule shows that trade allows a concentration in production, with fewer different varieties within each aggregate group. Similarly, for any given

3.4 SOURCES OF GAINS FROM TRADE: A RECAPITULATION 41 Figure 3.7 Sources of Gains from Trade Autarky consumption and production are shown by point A. International trade brings about an outward shift in the transformation schedule and allows resources to be reallocated according to comparative advantage. Optimal production is at point C, allowing consumption at C. Further gains to consumers follow from the wider variety of food and clothing available at C, compared with autarky bundle A. Food A B y 1 C y 3 y 2 y 0 B A C 0 Clothing aggregate bundle, consumers gain because the world market contains many more varieties than are available at home in autarky. Market structure is also an important characteristic of this description. Consumers are acting competitively as price-takers, as revealed by the tangency between price lines and indifference curves. If pure competition characterized producer behavior, with relative prices accurately measuring marginal opportunity costs, the kind of tangency indicated by point C also would be appropriate. But the presence of activities with fixed costs suggests a type of market structure known as monopolistic competition. Departures from competitive behavior, in particular a lack of correspondence between marginal cost and price, imply that the economy does not achieve the full gains from trade pictured in Figure 3.7. This problem and various other issues concerning international trade and the structure of markets will be discussed later. More Sources of Gains This discussion of the gains that can accrue to a country by opening its markets to trade by no means exhausts the potential possibilities: 1. Production may proceed through a number of stages, making use of raw materials and intermediate products to produce food and clothing. If international trade is allowed in these inputs, as well as in final goods, further gains are available. Indeed, some countries rely heavily on such trade: Norway is a materials exporter, Japan a heavy resource importer. It is important to note two separate sources of

42 CHAPTER 3 EXPANDED GAINS FROM TRADE WITH RESOURCE MOVEMENTS gains from trade in intermediates: Gains accrue both by allowing alterations in the composition of a nation s input supplies and also by allowing net trades of resources for final commodities. 2. International trade allows a country to learn from the rest of the world about new technologies as well as about market possibilities abroad. Indeed these contacts may set off dynamic changes whereby trading possibilities with other countries stimulate investment in both human and physical capital, perhaps aided by foreign investment and international labor flows. 3. Opening up local markets to international trade tends to make them more competitive. Pressure is put on national firms to become more productive in response to challenges from foreign firms. Industries that previously may have been monopolistic become more competitive with resultant gains to local producers. 3.5 FREE TRADE AND THE BEHAVIOR OF IMPORT DEMAND Once a country is embedded in a world trading system, with production taking place on the appropriately enlarged transformation schedule and resources reallocated according to comparative advantage, it becomes appropriate to ask how sensitive import and export volumes are to disturbances in the terms of trade, the relative price of traded goods. The extent of the response in production depends on all the factors that determine the degree to which the transformation schedule is bowed out. Similarly, the consumption response depends in part on the shape of indifference curves. If these are sharply bowed in, any given rise in food s price causes the consumer to purchase less food, but little movement along an indifference curve is required to bring the marginal rate of substitution (slope of the indifference curve) in line with the new price. But more is involved, and this is the tricky part: Any price change affects the real income of a trading community and, through this effect, the demand for all commodities. When analyzing the effect of price changes on demand, it is important to isolate the substitution effect (movements along a given indifference curve) from the income effect (movements from one indifference curve to another). It is perhaps worthwhile to review these concepts here. Substitution and Income Effects in Consumption There are two important aspects of the income effect on demand when price changes: (1) determining how real income is affected by the price change, and (2) determining what the impact of a given change in real income is on demand for importables. The latter reflects only the consumer preference pattern. Revert for the moment to the practice of quoting incomes and prices in dollar units. If income rises by $100 and spending on food (the good being imported) rises by $40, by definition, the marginal propensity to import (food) is 0.4. The answer to (1) depends greatly on the extent of trade. The greater the quantity of food currently imported, the more severely will real incomes be hit by a rise in food s relative price. These points are illustrated in Figure 3.8. Suppose that production is fixed atpoint E, and that initially the home country imports food at the price ratio shown

3.5 FREE TRADE AND THE BEHAVIOR OF IMPORT DEMAND 43 by line 1, consuming at A. Now let the terms of trade improve. The price reduction for imports is shown by the slope of a steeper line (2 or 3, which are parallel). With the budget line rotating around production point E, consumption of food rises from A to B. This demand change can be broken down into two parts: (1) The move from A to C is the substitution effect; that is, the change in demand if consumption is restricted to the same indifference curve, and (2) the move from C to B is the income effect. A fall in import prices raises real income (from curve y 1 to curve y 2 ). The income effect shows how such an increase in real income at constant prices spills into increased demand for both commodities. Remember that the income effect is strongly influenced by the extent (and direction) of trade. To illustrate, consider the following exercise: In Figure 3.8 suppose that the production point is G instead of point E; that is, suppose imports of food initially are roughly twice the amount illustrated (distance AG is roughly twice the distance AE). Then show, by drawing the new budget line through G, that the drop in food prices raises real income by more than previously shown (indeed, by roughly twice as much). This discussion illustrates an important general point: For a country engaged in trade any price change of traded goods affects real income. If the price of a commodity rises, real income at home goes up if that commodity is exported and falls if it is imported. Furthermore, the extent of the impact of a change in the terms of trade on real income is proportional both to the extent of the price change and to the original volume of trade. These basic points find many applications throughout this book. Figure 3.8 Substitution and Income Effects With point E the production point, consumption is initially at A at terms of trade shown by line 1. A fall in food s import price is shown by steeper lines 2 or 3.The substitution effect is the move from A to C along the initial indifference curve.the income effect is the move from C to B. Food 3 2 B H C y 2 A y 1 E G 1 0 Clothing

44 CHAPTER 3 EXPANDED GAINS FROM TRADE WITH RESOURCE MOVEMENTS Import Demand Elasticity and the Supply of Exports If the price of imports falls (i.e., the terms of trade improve), we now can present the three ingredients that contribute to an increase in import demand: (1) a substitution effect in consumption more of the importables will be demanded (along an indifference curve); (2) an income effect the fall in the price of imports raises real incomes (pushes the consumer onto a higher indifference curve) and thus raises import demand; and (3) a production effect the fall in import price serves to attract resources to other industries. Production of importables falls along the production possibilities schedule. The elasticity of import demand relates the relative extent of import expansion to the initiating price fall. Suppose food import prices fall by 10 percent. By how much will import demand be raised? If the answer is more than 10 percent, import demand is said to be elastic; if the answer is less than 10 percent, import demand is inelastic. These are purely matters of definition, but the distinction between elastic import demand and inelastic import demand is intimately connected to the aggregate volume of exports supplied. Take the elastic case first. Suppose a 10 percent fall in import price causes an expansion of 15 percent in the quantity of imports demanded. Is more or less being paid for imports? Per unit, less is being paid, which is what price reflects. But total payment equals price times quantity, and in the case of elastic import demand the quantity rises relatively more than price falls. Therefore, payments rise as price falls. But how are payments expressed? Recall the budget constraint: Exports must pay for imports. If the demand for imports is elastic, the volume of exports must rise as the relative price of imports falls. The case of inelastic demand for imports reverses this conclusion. If the relative price of food imports falls by 10 percent and the quantity of imports demanded rises by only 4 percent, the country faces a lower overall import bill. That is, the volume of exports required to finance imports at the lower price falls. You may notice something odd about the behavior of export supply for an economy in which import demand is inelastic. For example, an inelastic import demand for clothing in the foreign country implies that a fall in clothing s relative price lowers the quantity of food that country must supply as exports. Stating this in terms of food s relative price, the foreign supply of food exports falls as the relative price of food rises. In Figure 2.6 this would be shown by a stretch of the foreign export supply function that is negatively sloped (or backward bending). 3.6 SUMMARY Both this chapter and the preceding one were designed primarily to identify the sources of gain from engaging in trade. A simple model the basic trade model was developed to illustrate the nature of the gains from trade and how these gains are enhanced if a nation s production patterns also can be realigned to take advantage of trading opportunities. We argued that gains accrue when resources are reallocated in the direction indicated by comparative advantage, and that further gains may well be harnessed if producers take advantage of wider world

CHAPTER PROBLEMS 45 markets to concentrate on fewer types of a commodity and spread fixed costs over larger volumes. In Part II we explore in more detail the possible patterns of trade that are encouraged by variations among countries in technology, resource endowments, and the degree of scale economies. We also examined more carefully the ways in which a trading economy responds to a change in the terms of trade. In particular, price changes cause production to respond along the production possibilities curve and consumers to substitute for commodities that have risen in price. It is the essence of any trading situation that price changes reallocate real incomes, causing incomes to fall in the country importing the commodity that has risen in price and to rise in the exporting country. Both of these income changes feed back to affect demand for importables and exportables. CHAPTER PROBLEMS 1. The home country in Figure 3.3 is shown to respond to the trading opportunities indicated by line 2 by increasing production of clothing (from E to A) and actually reducing the quantity of clothing consumed. Show why: a. For a country in which production cannot change (e.g., the home country in Figure 2.3), trade must result in a drop in consumption of the good exported. b. If production can respond to new world prices, the quantity of clothing consumed at home could rise. c. In Figure 3.3 reduction in clothing consumption results in an increase in wellbeing, compared with taking advantage of trade to consume more of both commodities. 2. Some consumers have quite rigid taste patterns. Suppose the indifference curves for a community are strictly right-angled, and the corner of each ever-higher indifference curve lies on a ray from the origin. To be precise, suppose that whatever the prices prevailing in the market, two units of food are demanded for each unit of clothing demanded. Furthermore, suppose the transformation schedule shows considerable flexibility in production, so much so that it is a downwardsloping straight line, with a vertical food intercept of 20 units and a horizontal clothing intercept of 40 units. a. If the country cannot engage in trade, how much of each commodity does it consume and produce? b. In the no-trade (autarky) state, what is the relative price of food? c. Suppose world trade is now opened up and the relative price of clothing is double what it was in autarky. Describe what happens to consumption and production. d. Is the country better off with trade? 3. Suppose that in autarky the decomposition of food and clothing aggregates reveals that ten varieties of each are produced, with each variety requiring 200 units of resources for setup costs, regardless of scale of output. In addition, each unit of food of any variety produced requires one unit of resources, and each unit of clothing requires two units of resources. The autarky output levels are 400 units of each variety of clothing and 200 units of each variety of food. With trade,

46 CHAPTER 3 EXPANDED GAINS FROM TRADE WITH RESOURCE MOVEMENTS competition from the world market narrows the number of varieties produced in each industry (food, clothing) to four. If resources are allocated to food and clothing industries exactly as in autarky, by how much has trade allowed each industry aggregate to expand? Why did the number of varieties produced not get cut back to four in each industry before trade? 4. (Answer this problem after reading Appendix A.) In showing why the production possibilities curve in Figure 3.1 bows out, we assumed that techniques used at F to produce food differed from those used at A to produce food. Similarly, we assumed techniques differed in clothing production between F and A. Now suppose this is not so. Suppose that only one all-purpose input is required to produce either food or clothing, and that two units of this input are required per unit of food produced regardless of the scale of output, and that four units are required to produce a unit of clothing. If the community possesses 400 units of this allpurpose input, draw its production possibilities schedule. How sensitive are prices to shifts in demand if the country cannot trade? (Your answer will be useful in Chapter 5.) SUGGESTIONS FOR FURTHER READING Krugman, P. Increasing Returns, Monopolistic Competition and International Trade, Journal of International Economics, 9 (4) (November 1979): 469 479. An early treatment of the benefits of variety and a simple analysis of increasing returns. Leontief, Wassily. The Use of Indifference Curves in the Analysis of Foreign Trade, Quarterly Journal of Economics, 47 (May 1933): 493 503, reprinted in American Economic Association, Readings in the Theory of International Trade (Philadelphia: Blakiston, 1949), Chapter 10. An early exposition showing how to combine transformation schedules and indifference curves to illustrate equilibrium with trade. Meade, James. The Stationary Economy (London: Allen and Unwin, 1965). Chapter 4 gives some simple exercises. APPENDIX A CONSTANT RETURNS TO SCALE AND INCREASING OPPORTUNITY COSTS A simple argument shows that a nation s production possibilities schedule bows out from the origin even if food and clothing production each separately exhibit constant returns to scale. Consider all the inputs required to produce a unit of clothing. If the quantities of all these inputs are expanded by the same proportional amount, constant returns to scale are said to prevail if clothing output also expands by precisely the same proportional amount. Figure 3.1 is used to illustrate the argument. At point F a certain bundle of resources is used to produce food and the remainder of the economy s resources is employed in clothing production. Point I is halfway to the origin relative to F, so

APPENDIX B 47 the food and clothing output bundle at I could be produced with exactly half the economy s resources. Now consider point A. This output combination also uses all the economy s resources, and point J, halfway to the origin, would require exactly half the economy s resources to produce (again, the reason is that both food and clothing exhibit constant returns to scale). Suppose exactly half the economy s resources are used to produce J and the other half to produce I. The resultant production bundle is shown by point H, which lies halfway along the chord connecting points F and A. This argument does not demonstrate that the transformation schedule is flat between F and A. Rather, it shows that any point on chord FA could be produced. However, if techniques used in producing clothing at F differ from those used at A (and similarly for techniques used to produce food at F and A), such a mixture (I, J) entails producing clothing simultaneously with two different techniques. It never pays to do this. There is a single technique that is best. 2 The upshot: A point such as H can be improved on. The production possibilities schedule bows out. 3 APPENDIX B THE OFFER CURVE DIAGRAM All the diagrams used to show free-trade equilibrium and the pattern of trade have illustrated directly how quantities demanded and supplied respond to relative prices. An alternative diagrammatic apparatus, in use in the literature on international trade for more than a century, 4 contrasts directly the quantity of one commodity a country wishes to import against the quantity of the commodity offered in exchange as exports. Retaining the assumption that the home country is an exporter of clothing in a free-trade equilibrium, Figure 3.A.1 illustrates the offer curves for the two countries. Since quantities are shown along the axes, relative prices are indicated in this diagram by the slopes of the rays from the origin. Consider the home country s response to the world relative price of clothing shown by the slope of ray 0A. At this relative price the home country chooses to demand quantity AF of food over and above its local production. In order to obtain this by imports, it must be prepared to export 0F units of clothing, which have an equivalent value. Should the relative price of food fall to the level shown by ray 0B, home demand for imports of food would rise. In this range home import demand is elastic because the quantity of clothing exports it is willing to give up increases from A to B; a rise in total revenue 2In the parlance of Chapter 7, this follows if isoquants are strictly bowed in to the origin. 3It also follows that if production exhibits slightly increasing returns, the production possibilities schedule would still be bowed out (except near the axes). 4Offer curves, or reciprocal demand and supply curves, were used extensively by Alfred Marshall in his Pure Theory of Foreign Trade, London School of Economics and Political Science, 1930, first published in 1879.

48 CHAPTER 3 EXPANDED GAINS FROM TRADE WITH RESOURCE MOVEMENTS Figure 3.A.1 Offer Curves Free-trade equilibrium is shown by point Q, with the equilibrium terms of trade equal to the slope of ray 0 Q. Home imports of food Foreign exports of food G R Q R* B A 0 N F Home exports of clothing Foreign imports of clothing spent on a product when its price falls indicates an elastic demand. 5 By contrast, a further reduction in food s relative price to the ray 0Q shows a reduction in clothing exports. More food imports are demanded at Q than at B, but the fall in food s price is relatively more severe than the increase in quantity demanded, so that total outlay (as measured by clothing exports) has fallen. This inelasticity in import demand reflects a behind-the-scenes conflict between greater production of clothing at Q than at B (because clothing s relative price has risen) coupled with lower local demand for clothing via the substitution effect on the one hand, and a stimulus to local demand for clothing via the income effect on the other. (The rise in clothing s relative price from B to Q raises real incomes for the home clothing-exporting country.) This conflict is won by the income effect in the move from B to Q and by the substitution effects in production and consumption in the move from A to B. The foreign offer curve, 0R*, has (arbitrarily) been drawn as elastic throughout. Decreases in the relative price of the commodity imported abroad (clothing) correspond to steadily rising import demand and export supply as clockwise-moving rays from the origin sweep the curve 0R*. Equilibrium is attained at a price ratio (shown by ray 0Q) at which home demand for imports of food matches foreign supply. This equilibrium point, Q, also reveals that foreign demand for clothing imports matches home export supply. 5The elasticity of demand for imports can be shown by the offer curve in the following manner: At point A draw the line tangent to the offer curve. It will intersect the horizontal axis at N. It can be shown (consider this a useful exercise) that the elasticity of import demand at A is the ratio 0F/0N, which is greater than unity.