Introduction to International Economics, Summer 2026

Chapter 1
international trade
- Selected Issues in a Standard Trade Model -

Dr. Alexandra Seidel Dr. Alexandra Seidel

 Introduction to International Economics, Summer 2026

Selected Issues in a Standard Model

• We have seen different models to motivate trade:

• Ricardo model: differences in technology  comparative advantage

• Heckscher-Ohlin model: differences in relative abundance of factor inputs

 distributional consequences

• Now: standard model of a world with trading economies

• Readings: Krugman et al (2022): Chapter 6

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Standard Trade Model

• A “standard model” is a model that incorporates all major “standard” features and assumptions that
we use in microeconomic theory – without asking what precisely are the determinants of trade (e.g.,
factor productivity differences as in the Ricardo-world or resource differences as in the Heckscher-
Ohlin-world).

• Definition: Terms of trade are the price of a country’s exports divided by the price of its imports
(in practice, price indices are used)

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Terms of Trade

Source: OECD (2024), Terms of trade (indicator). doi: 10.1787/7722246c-en (Accessed on 1 May 2024); International trade - Terms of trade - OECD Data; “Terms of trade are defined as the ratio between the
index of export prices and the index of import prices. If the export prices increase more than the import prices, a country has a positive terms of trade, as for the same amount of exports, it can purchase more
imports.”

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Standard Trade Model

• We use this model to analyse terms-of-trade effects of growth and trade policies, notably:

(1) biased growth

(2) import tariffs

• There may be also other changes, which can be analysed in their terms-of-trade effects in the
standard model (e.g. subsidies or income transfers).

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Standard Trade Model

Roadmap:

 Production possibility frontier and output mix given relative prices

 Relative supply curve given relative prices
 Indifference curve and representative consumer
 Relative demand curve given relative prices
 Welfare effects of changes in the terms of trade
 World relative supply and demand
 Two examples: biased growth and tariffs

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Standard Trade Model

Set-up

• Two goods, food (F) and cloth (C).

• Each country’s PPF is a smooth curve and determines its relative supply function.

• Differences in labor services, labor skills, physical capital, land, and technology between countries
cause differences in production possibility frontiers.

• National relative supply functions determine a world relative supply function, which along with world
relative demand determines the equilibrium under international trade.

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Standard Trade Model

Set-up

• What a country produces depends on the relative price of cloth to food

PC
PF
.

• An economy chooses its production of cloth and food to maximize the value of its output
given the prices of cloth and food.
P 
• The slope of an isovalue line equals  C
 PF
.


• The country produces at the point where the PPF is tangent to isovalue line.

 Relative prices determine the economy‘s output.

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Relative prices determine economy‘s output

Food production, QF

An economy whose production

Q
possibility frontier is TT will produce
at Q, which is on the highest possible
isovalue line.

TT

Cloth production, QC

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How does an increase in the relative price of cloth affect

relative supply?
Food production, QF
• The isovalue lines become steeper
when the relative price of cloth
rises from (PC/PF)1 to (PC/PF)2, shown
by the rotation from VV1 to VV2.
Q1 • As a result, the economy produces
QF1 VV1(P C/PF)
1 more cloth and less food and the
equilibrium output shifts from Q1 to
Q2.
• The relative supply of cloth to food
QF2 Q2 increases with the relative price of
cloth to food.
VV2(PC/PF)2

TT
QC1 Q C2 Cloth production, QC

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How does an increase in the relative price of cloth affect

relative supply?
The relative supply of
cloth to food
increases with the
relative price of cloth
to food.
Recap

Caution!

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Relative prices and demand

• The value of the economy’s consumption must equal the value of the economy’s production. DC and
DF reflect the consumption of cloth and food.

PC DC  PF DF  PCQC  PF QF  V

• Which point on the isovalue line does the economy choose?

 Outcome depends on tastes of the economy’s consumers.

 Assumption: representative consumer

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Relative prices and demand

Representative consumer

• Assume that the economy’s consumption decisions may be represented as if they were based on the tastes
of a single representative consumer.

• An indifference curve represents combinations of cloth and food that leave the consumer equally well off
(indifferent).

Indifference curves

• are downward sloping—if you have less cloth, then you must have more food to be equally satisfied.

• that lie farther from the origin make consumers more satisfied—they prefer having more of both goods.

• become flatter when they move to the right—with more cloth and less food, an extra yard of cloth becomes
less valuable in terms of how many calories of food you are willing to give up for it.

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Production, Consumption and Trade in the Standard Model

The economy produces at point Q, where the

production possibility frontier is tangent to the
highest possible isovalue line. It consumes at
point D, where that isovalue line is tangent to
the highest possible indifference curve.

 The economy produces more cloth than it

consumes and therefore exports cloth; it
consumes more food than it produces and
therefore imports food.

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Relative prices and demand

• Consumption choice is based on preferences and relative price of goods: Consume at point D where
the isovalue line is tangent to the indifference curve.

• But: Production does not match consumption (D versus Q).

• Thus: Economy exports cloth –the quantity of cloth produced exceeds the quantity of cloth
consumed – and imports food.

 Next step: What happens if relative prices change? How do relative prices and relative demand
relate to each other?

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Effects of a rise in the relative price of cloth and gains

The slope of the isovalue lines is

equal to minus the relative price
of cloth PC/PF, so when that
relative price rises, all isovalue
lines become steeper.

In particular, the maximum-

value line rotates from VV1 to
VV2. Production shifts from Q1 to
Q2, consumption shifts from D1
to D2. If the economy cannot
trade, then it produces and
consumes at point D3.

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Relative prices and demand

• With trade: An economy that exports cloth is better off when the price of cloth rises relative to the price of
food
 the isovalue line becomes steeper and a higher indifference curve can be reached.
 a higher relative price of cloth means that more calories of food can be imported for every yard of
cloth exported.

• If the economy cannot trade:

 The relative price of cloth to food is determined by the intersection of relative demand and relative
supply for that country.
 Consume and produce at point D3 where the indifference curve is tangent to the production
possibilities frontier.

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Effects of a rise in the relative price of cloth and gains

from trade

An increase in relative prices of cloth induces an increase in relative supply of cloth (1

to 2); and a decline in relative consumption of cloth (1‘ to 2‘), which reflects a
substitution effect.

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The Welfare Effects of Changes in the Terms of Trade

• The terms of trade refers to the price of exports relative to the price of imports.

When a country exports cloth and the relative price of cloth increases, the terms of trade rise.

• Because a higher relative price for exports means that the country can afford to buy more imports,
an increase in the terms of trade increases a country’ s welfare.

• A decline in the terms of trade decreases a country’s welfare.

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Determining relative prices

• We assume that there are two countries H (exporting cloth) and F (exporting food) with the same
preferences but differences in their PPF

• To determine the price of cloth relative to the price food, we use relative supply and relative demand.

 World supply of cloth relative to food at each relative price.

 World demand for cloth relative to food at each relative price.
 World quantities are the sum of quantities from the two countries in the world:
Q C  QC   and
D
C  DC  .
Q F  QF   D
F  DF  

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Recap

• What can we conclude from the information of same tastes of consumers in both countries?

• What can we conclude from the assumption that countries differ in their PPF’s?

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World relative supply and demand

The higher PC/PF is, the larger the world

supply of cloth relative to food (RS) and
the lower the world demand for cloth
relative to food (RD).
Equilibrium relative price (here, (PC/PF)1)
is determined by the intersection of the
world relative supply and demand
curves.

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Equilibrium Relative Price with Trade and Associated

Trade Flows

Foreign‘s
food
exports

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International effects of growth

• This model is our starting point for the analysis of changes in economic growth/ trade policies and
welfare effects.

• For example:

 How to evaluate growth in other countries for our nation in a world with trade integration?
 Is growth in a country more or less valuable when it is integrated in the world economy?

The standard trade model gives us an idea what could be possible answers to these questions.

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International effects of growth

• Growth is usually biased: it occurs in one sector more than others, causing relative supply to
change.
 Rapid growth has occurred in U.S. computer industries but relatively little growth has occurred in U.S.
textile industries.

 In the Ricardian model, technological progress in one sector causes biased growth.

 In the Heckscher-Ohlin model, an increase in one factor of production causes biased growth.

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Biased growth – PPF in Home and Foreign

Growth is biased when it
shifts production
possibilities out more
toward one good than
toward another. In both
cases shown, the PPF shifts
out from TT1 to TT2.
In case (a) this shift is
biased toward cloth, in case
(b) toward food.

(Remember the Rybczynski-

Theorem!)

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Biased growth and relative supply

Growth biased toward cloth

shifts the RS curve to the
right (a), while growth
biased toward food shifts it
to the left (b).

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Biased Growth
• Export-biased growth: expands a country’s production possibilities disproportionately in that
country’s export sector.
 Biased growth in the food industry in the foreign country is export-biased growth for the foreign country.

 Export-biased growth reduces a country’s terms of trade, reducing its welfare and increasing the welfare of
the rest of the world.

• Import-biased growth: expands a country’s production possibilities disproportionately in that

country’s import sector.
 Biased growth in cloth production in the foreign country is import-biased growth for the foreign country.

 Import-biased growth increases a country’s terms of trade, increasing its welfare and decreasing the
welfare of the rest of the world.

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Biased Growth
• Conclusion: “biased” growth changes the terms of trade in the direction of the bias, i.e. the good
whose supply becomes more abundant becomes cheaper.

• Welfare implication: how relative prices and terms of trade change depends also on the slope of the
demand curve (price elasticity).
 If the elasticity is low (in absolute terms), the price shift is strong.

 If the elasticity is high (in absolute terms), the price shift is moderate.

• Corner solution: In theory, there could be a case when the price decline is so dramatically strong that
the country that grows is in the end worse off than without growth (immiserizing growth).

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Case Study: Energy prices and Terms of Trade

ECB Economic Bulletin,
Issue 3/2022:
“The recent sharp increase in
natural gas and crude oil
prices has led to a strong
increase in euro area nominal
energy imports.”

Source: [Link]
prices-2021/

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Euro area terms of trade and energy import prices

Source: ECB (2022). Notes: The terms of trade are expressed as a ratio between export and import deflators.

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Case Study: Energy prices and Terms of Trade

ECB Economic Bulletin, Issue 3/2022:

• “The euro area terms of trade deteriorated substantially from the second half of 2021 onwards,
reflecting the surge in energy prices.”

• “The deterioration in the terms of trade generates a negative income effect for the euro area. Given
the rigidity of imported energy demand in the short term, maintaining import volumes at higher
prices results in a transfer of purchasing power from the euro area to the rest of the world.”

Income effect is stronger for euro area than for e.g. the Unites States or United Kingdom.

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Effects of Import Tariffs on the Terms of Trade

Trade policy: Import tariffs are taxes levied on imports

European Union: EU Customs Tariff (TARIC) ([Link])

 Example 1:
 Example 2:

 Trade policies can potentially influence the terms of trade and therefore national welfare.

 Import tariffs drive a wedge between prices in world markets (external prices) and internal prices at
which goods can be purchased in domestic markets.

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Effects of Import Tariffs on the Terms of Trade

Relevance

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Effects of Import Tariffs on the Terms of Trade

• If the home country (mainly exporting cloth and importing food) imposes a tariff on food imports,…

 the price of food relative to the price of cloth rises for domestic consumers.
 the price of cloth relative to the price of food falls for domestic consumers.
• Domestic producers: receive a lower relative price of cloth, and therefore will be more willing to
switch to food production

 relative supply of cloth will decrease.

• Domestic consumers: will pay a lower relative price for cloth, and therefore will be more willing to
switch to cloth consumption

 relative demand for cloth will increase.

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Effects of Import Tariffs on the Terms of Trade

An import tariff on food imposed by

Home both reduces the relative
supply of cloth and increases the
relative demand for the world as a
whole.

As a result, the relative price of cloth

rises.

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Effects of Import Tariffs on the Terms of Trade

• When the home country imposes an import tariff on food, its terms of trade increase and the welfare
of the country may increase.

• The magnitude of this effect depends on the size of the home country relative to the world economy.

 If the country is a small part of the world economy, its tariff (or subsidy) policies will not have
much effect on world relative supply and demand, and thus on the terms of trade.

 But for large countries (e.g. United States), a tariff may maximize national welfare at the
expense of foreign countries.

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Implications of Terms of Trade Effects: Who Gains and Who Loses?

• The standard trade model predicts that an import tariff by the home country can increase domestic
welfare at the expense of the foreign country.

• But: in a world with many goods and many countries, there might be spillovers. E.g. think of EU tariffs
for imported products: resulting changes in relative prices will also affect prices for US exports of
these products and thus the US terms of trade.

• But: other players might respond as well, impose further policies, and gains from trade might shift
again.

 Risk of trade wars!

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Recent research: Climate change risks and trade

• Climate change increases extreme weather events such as flooding or drought all over the globe

• In a highly integrated world, shocks to one country can be felt in interlinked countries.

• A recent study asks whether the flood in Thailand in 2011 impacted Swedish importing firms

 The two countries are both rather small

 And they are far away from each other

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Recent research: Climate change risks and trade

• We have a look at the study by Forslid and Sanctuary (2022): Climate Risks and Global Value Chains:
The impact of the 2011 Thailand flood on Swedish firms

• The flood in Thailand in 2011 had large repercussions: 46.5 billion USD damage, large parts of the
country affected by the flood

• The manufacturing sector in Thailand was severely affected, e.g. with Toyota needing 42 days to
resume production, Honda 174 days

• Thailand produced a large share of the world’s hard disk drives in 2011

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Recent research: Climate change risks and trade

Swedish firms imported
mostly products from Thailand
in the sectors machinery &
equipment and electronic
products (Source, million SEK,
2010)

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Recent research: Climate change risks and trade

The authors compare how imports

evolved around the flood in Thailand
for Swedish firms importing from
Thailand before the event and other
Swedish firms (Source, parallel
trends graph after removing a linear
time trend)

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Recent research: Climate change risks and trade

• Their results suggest that not all Swedish firms could substitute products from Thailand by imports
from other countries:

“Thai imports by Swedish businesses fell by around 90%: Swedish imports from Thailand were around
€100 million lower in 2012, the year following the flood. Moreover, sales by exposed Swedish firms dropped
8% in 2012.”

• Swedish firms have been differently affected:

 Larger Swedish firms have been less affected

 Firms with more diverse trade linkages could buffer the shock
 Switching to other (Asian or EU) suppliers took some time ( fixed costs to change supply
chains)

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Self-check
• Explain the standard trade model and how it relates to the Ricardo and Heckscher-Ohlin model.

• Provide the definition of indifference curves and terms of trade.

• Explain how a change in the terms of trade can affect a country’s welfare.

• During the pandemic, the price of oil declined severely. Use the concept of “Terms of Trade” to
assess welfare effects for oil exporting countries.

• How does “biased growth” affect the terms of trade? Explain!

• Choose a recent example of tariffs and discuss how these tariffs would affect the terms of trade in
the standard trade model.

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