The Standard Trade Model

How an Increase in the Relative Price of Cloth

Affects Relative Supply
• Isovalue lines
become steeper
when the relative
price of cloth
rises. As a result,
the economy
produces more
cloth and less food
– Upward sloping
relative supply
curve.
What happens when PC/PF increases.
• First, the economy
produces more C and less
F, shifting production
from Q1 to Q2. This
shifts, from VV1 to VV2
the isovalue line on which
consumption must lie.
The economy’s
consumption choice
therefore also shifts, from
D1 to D2. If the economy
cannot trade, then it
produces and consumes
at point D3.
• The move from D1 to D2 reflects two effects of the rise in PC/PF.
• First, the economy has moved to a higher indifference curve, meaning
that it is better off. The reason is that this economy is an exporter of
cloth. When the relative price of cloth rises, the economy can trade a
given amount of cloth for a larger amount of food imports. Thus the
higher relative price of its export good represents an advantage ~
(Income Effect)
• Second, the change in relative prices leads to a shift along the
indifference curve, toward food and away from cloth (since cloth is
now relatively more expensive) ~ (Substitution effect).
• Panel (b) shows the effects of the rise in the relative price of cloth on
relative production (move from 1 to 2) and relative demand (move
from to 1’ to 2’. If the economy cannot trade, then it consumes and
produces at point 3.
The Welfare Effect of Changes in the Terms
of Trade (ToT)
• When relative price of cloth increases, a country that initially exports
cloth is made better off. If the country were initially an exporter of
food instead of cloth, the direction of this effect would be reversed.
An increase in relative price of food would mean a fall in relative price
of cloth and the country would be worse off: The relative price of the
good it exports (food) would drop.
• Defining the terms of trade as 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 country’s welfare, while a
decline in the terms of trade reduces its welfare.
World Relative Supply and the Terms of Trade
• Suppose now that Home
experiences growth
strongly biased toward
cloth, so that its output of
cloth rises at any given
relative price of cloth,
while its output of food
declines,
• The world relative supply
curve will shift to the
right, just like the relative
supply curve for Home.
• It results in a decrease in
the , a worsening of
Home’s terms of trade and
an improvement in
Foreign’s terms of trade.
World Relative Supply and the Terms of Trade

• Growth that disproportionately expands a country’s production

possibilities in the direction of the good it exports (cloth in Home,
food in Foreign) is export-biased growth.
• Similarly, growth biased toward the good a country imports is import-
biased growth.
• Our analysis leads to the following general principle: Export-biased
growth tends to worsen a growing country’s terms of trade, to the
benefit of the rest of the world; import-biased growth tends to
improve a growing country’s terms of trade at the rest of the world’s
expense.
International Effects of Growth
• During the 1950s, many economists from poorer countries believed
that their nations, which primarily exported raw materials, were likely
to experience steadily declining terms of trade over time. They
believed that growth in the industrial world would be marked by an
increasing development of synthetic substitutes for raw materials,
while growth in the poorer nations would take the form of a further
extension of their capacity to produce what they were already
exporting rather than a move toward industrialization. That is, the
growth in the industrial world would be import-biased, while that in
the less-developed world would be export-biased.
• Export-biased growth by poor nations would worsen their terms of
trade so much that they would be worse off than if they had not
grown at all. This situation is known to economists as the case of
immiserizing growth.
Three conditions for immiserizing growth:
• 1. The country’s growth must be strongly biased toward expanding the country’s
supply of exports (increasing its willingness to trade), and the increase in export
supply must be large enough to have a noticeable impact on world prices.
• 2. The foreign demand for the country’s exports must be price inelastic, so that an
expansion in the country’s export supply leads to a large drop in the international
price of the export product.
• 3. Before the growth, the country must be heavily engaged in trade, so that the
welfare loss from the decline in the terms of trade is great enough to offset the
gains from being able to produce more.
Implications of immiserizing growth
• Countries that export a diversified selection of export products do not seem to be
at much risk of experiencing immiserizing growth.
• A developing country that relies on one or a few primary products (agricultural or
mineral products) is more at risk.
• For example, Zambia relies on a mineral (copper) for most of its export revenues.
A discovery that leads to the opening of several new large copper mines would
increase its exports and greatly reduce the international price of copper. As a result
of the decline in the price, the country could be worse off.
• For example, Argentina suffered a 6 percent deterioration in its terms of trade in
1999 (due to declining agricultural prices), which induced a 1.4 percent drop in
GDP. On the other hand, Ecuador enjoyed an 18 percent increase in its terms of
trade in 2000 (due to increases in oil prices), which added 1.6 percent to the GDP
growth rate for that year.
Tariffs and Export Subsidies:
Simultaneous Shifts in RS and RD
• Import tariffs (taxes levied on imports) and export subsidies
(payments given to domestic producers who sell a good abroad).
• The direct effect of a tariff is to make imported goods more expensive
inside a country than they are outside the country. An export subsidy
gives producers an incentive to export. It will therefore be more
profitable to sell abroad than at home unless the price at home is
higher, so such a subsidy raises the prices of exported goods inside a
country.
• When countries are big exporters or importers of a good (relative to
the size of the world market), the price changes caused by tariffs and
subsidies change both relative supply and relative demand on world
markets. The result is a shift in the terms of trade, both of the country
imposing the policy change and of the rest of the world.
Relative DD and SS Effects of a Tariff
• If Home imposes a 20 percent
tariff on the value of food
imports, for example, the
internal price of food relative to
cloth faced by Home producers
and consumers will be 20
percent higher than the external
relative price of food on the
world market.
• At any given world relative price
of cloth, then, Home producers Home’s ToT improves
will face a lower relative cloth at Foreign’s expense.
price and therefore will produce
less cloth and more food. At the
same time, Home consumers
will shift their consumption
toward cloth and away from
food.
Small v/s Large economy
• The extent of this terms of trade effect depends on how large the
country imposing the tariff is relative to the rest of the world: If the
country is only a small part of the world, it cannot have much effect
on world relative supply and demand and therefore cannot have
much effect on relative prices.
• If the United States, a very large country, were to impose a 20 percent
tariff, some estimates suggest that the U.S. terms of trade might rise
by 15 percent. That is, the price of U.S. imports relative to exports
might fall by 15 percent on the world market, while the relative price
of imports would rise only 5 percent inside the United States.
• On the other hand, if Luxembourg or Paraguay were to impose a 20
percent tariff, the terms of trade effect would probably be too small
to measure.
Effects of an Export Subsidy
• Suppose that Home offers a
20 percent subsidy on the
value of any cloth exported.
For any given world prices,
this subsidy will raise
Home’s internal price of
cloth relative to that of
food by 20 percent. The
rise in the relative price of
cloth will lead Home
producers to produce more
cloth and less food, while
leading Home consumers
to substitute food for cloth.
Implications of Terms of Trade Effects:
Who Gains and Who Loses?
• If Home imposes a tariff, it improves its terms of trade at Foreign’s
expense. Thus tariffs hurt the rest of the world. The effect on Home’s
welfare is not quite as clear-cut. The terms of trade improvement
benefits Home; however, a tariff also imposes costs by distorting
production and consumption incentives within Home’s economy. The
terms of trade gains will outweigh the losses from distortion only as
long as the tariff is not too large.
• The effects of an export subsidy are quite clear. Foreign’s terms of
trade improve at Home’s expense, leaving it clearly better off. At the
same time, Home loses from terms of trade deterioration and from
the distorting effects of its policy.
Are foreign tariffs always bad for a country
and foreign export subsidies always beneficial?
• Not necessarily.
• Our model is of a two-country world, where the other country
exports the good we import and vice versa. In the real, multination
world, a foreign government may subsidize the export of a good that
competes with U.S. exports; this foreign subsidy will obviously hurt
the U.S. terms of trade. A good example of this effect is European
subsidies to agricultural exports. Alternatively, a country may impose
a tariff on something the United States also imports, lowering its price
and benefiting the United States.