ECON7530

Lecture 6
The Standard Trade Model
Nhan Phan
UQ School of Economics
Country Trade Report
• Available under the Assessment tab on Blackboard
• Due: 4pm (Brisbane time) Thursday 05 October 2023.
Write a report of up to 1500 words:
1. Select a country and provide a brief overview of its recent
international trade with two of its trade partners, including data
and graphs.
2. Provide a theoretical grounding for the observed trade patterns
using the theories developed in the course (Gravity, Ricardian, H-O,
Standard Trade Model or New Trade Theory).
3. Evaluate how well your proposed model fit the data.
Country Trade Report – Some Tips
• Check for data availability, no points for going exotic.
• You are graded for what the quality of work, NOT for disclosing unknown facts
about North Korea or Afghanistan.
• Pick two of its trade partners – no need to be the top two.
• After describing the trade pattern (with graph/table support),
determine which theory fits this data relationship.
• Two different models should be explored (i.e. no Ricardian &
Ricardian)
• What if nothing fits? Then explain two that you thought should fit and then
explain that you found that none fits.
• Alternatively, find another partner that fits a model.
Country Trade Report – A Note
• You can get data from (remember to cite):
• Newspapers
• World Bank, OECD, OEC
• Trade patterns can change in 2020. So you can use:
• Pre-2020 data
• Not too early: data from 2010 onwards are acceptable, but need to cover a range to as
recent as possible.
• Data from 2020 – now
• Note the keyword: evaluate
• What are the good fit when applying this model, and the not-so-good?
• Overall, you still decided on this model. Why?
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Summary – The Heckscher-Ohlin Model
• An economy exports goods that are relatively intensive in its relatively
abundant factors of production and imports goods that are relatively
intensive in its relatively scarce factors of production.
• Owners of abundant factors gain, while owners of scarce factors lose with
trade.
• A country as a whole is predicted to be better off with trade, so winners could
in theory compensate the losers within each country.
• The Heckscher-Ohlin model predicts that relative output prices and
factor prices will equalize, neither of which occurs in the real world.
• Empirical support of the Heckscher-Ohlin model is weak except for
cases involving trade between high-income countries and
low/middle- income countries or when technology differences are
included.
Learning Objectives
• Understand how the components of the standard trade model fit
together to illustrate how trade patterns are established by a
combination of supply-side and demand-side factors.
• Production possibilities frontiers
• Isovalue lines
• Indifference curves
• Recognize how changes in the terms of trade and economic growth
affect the welfare of nations engaged in international trade.
• Understand the effects of tariffs and subsidies on trade patterns and
the welfare of trading nations and on the distribution of income
within countries.
 Part 1
Trade Patterns and Gains from Trade

Source: Flickr
Introduction
• Standard trade model is a general model that includes Ricardian and
Heckscher-Ohlin models as special cases.
• Differences in labour services, labour skills, physical capital, land,
and technology between countries cause differences in PPFs.
• A country’s PPF determines its relative supply function.
• National relative supply functions determine a world relative supply
function, which along with world relative demand determines the
equilibrium under international trade.
UQ Extend – The Standard Trade Model
Four key relationships:
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 supply
and world relative demand.
4. The effect of the terms of trade—the price of a country’s exports
divided by the price of its imports—on a nation’s welfare.
UQ Extend – PPFs and Relative Supply
• Suppose two goods (Food & Cloth)
• What a country produces depends on
𝑃𝐶
the relative price of its product - ൗ𝑃𝐹 .
• An economy chooses it production of
cloth 𝑄𝐶 and food 𝑄𝐹 to maximise the
value of its output 𝑉 = 𝑃𝐶 𝑄𝐶 + 𝑃𝐹 𝑄𝐹 ,
given the prices.
• Production at point Q: PPF is tangent
to the isovalue line.
UQ Extend – PPFs and Relative Supply
UQ Extend – Relative Prices and Demand
• Consumption side: The value of the economy’s consumption must
equal the value of the economy’s production.
• This holds both in autarky and with trade
𝑃𝐶 𝐷𝐶 + 𝑃𝐹 𝐷𝐹 = 𝑃𝐶 𝑄𝐶 + 𝑃𝐹 𝑄𝐹 = 𝑉
• Assume the economy’s consumption decisions is 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 curve – Properties
1. Downward sloping.
• Less cloth must be compensated by more food.
2. The further the curve is to the origin, the
consumer is more satisfied.
• Consumers prefer having more of both goods.
• Similar to the idea of the isovalue line.
3. Convex to the origin.
• Diminishing marginal utility
• The curve becomes flatter as it moves to the right.
• With more cloth and less food, an extra meter of
cloth becomes less valuable relative to the food
sacrificed.
UQ Extend – Relative Prices and Demand
• Consumption choice based on
preferences and the relative price:
• Consume where the isovalue line is
tangent to the indifference curve.
• Suppose Home exports cloth and
imports food.
• The quantity of cloth produced exceeds
the quantity of cloth consumed.
• The quantity of food consumed must
exceeds the quantity of food produced.
UQ Extend
World Equilibrium & Gains from Trade
The U.S. and Chinese Imports
• Increased trade between the United States and China has increased
the purchasing power of U.S. consumers.
• Easy access to cheaper imported goods.
• Jaravel and Sager (2019): increased trade with China between 2000
and 2007 induced large reductions in prices, generating substantial
increases in the purchasing power of U.S. households.
• On average those gains represented $1,500 per household per year.
• Over half of those gains were generated by price reductions of U.S.
produced goods in response to the increased competition from
Chinese imports.
UQ Extend – Terms of Trade
• Terms of trade: the price of exports relative to the price of imports.
𝑃𝐶
• For Home country: terms of trade is .
𝑃𝐹

• When a country exports cloth and the relative price of cloth

increases, the terms of trade rise.
• An increase in the terms of trade increases a country’ s welfare.
• Intuition: a higher relative price for exports means that the country can afford
to buy more imports.
• A decline in the terms of trade decreases a country’s welfare.
UQ Extend – Determining Relative Prices
• How is relative price determined as
a result of trade?
• In previous models: (world) relative
price must equalise after trade.
• Use world relative supply & world
relative demand
• World quantity:
𝑄𝐶 + 𝑄𝐶∗ 𝐷𝐶 + 𝐷𝐶∗
∗ 𝑎𝑛𝑑
𝑄𝐹 + 𝑄𝐹 𝐷𝐹 + 𝐷𝐹∗
UQ Extend – World Equilibrium with Trade
 Part 2
Economic Growth
and Gains from Trade

Source: Adobe Stock

UQ Extend
Big Questions: International Effects of Growth
1. Is economic growth in Foreign good for the standard of living in
Home country?
2. Is growth in Home more or less valuable when it is integrated in the
world economy?
• ➔ Another question: what kind of growth are we talking about?
• Growth is usually biased: it occurs in one sector more than others,
causing relative supply to change.
• Technological progress occurs predominately in one sector of production.
• The country experiences an increase in the endowment of one factor of
production.
Biased Growth
UQ Extend – International Effects of Growth
Biased growth and the resulting change in relative supply causes a
change in the terms of trade.
• Biased growth in the cloth industry (in either the home or foreign
country) will lower the relative price of cloth and lower the terms of
trade for cloth exporters.
• Biased growth in the food industry (in either the home or foreign
country) will raise the relative price of cloth and raise the terms of
trade for cloth exporters.
• Suppose that the home country exports cloth and imports food.
Biased Growth and World Relative Supply
UQ Extend – International Effects of Growth
Home’s perspective (exports cloth)
Export-biased growth: growth that expands a country’s production
possibilities disproportionately in that country’s export sector.
• Reduces a country’s terms of trade, reducing its welfare and increasing the
welfare of foreign countries.
𝑃𝐶
• Export-biased growth (cloth industry) ➔ ↓ ➔ Home’s 𝑇𝑜𝑇 ↓; Foreign’s
𝑃𝐹
𝑇𝑜𝑇 ∗ ↑ ➔ Decreasing Home’s welfare while increasing Foreign’s welfare.
Import-biased growth: growth that expands a country’s production
possibilities disproportionately in that country’s import sector.
• Increases a country’s terms of trade, increasing its welfare and decreasing
the welfare of foreign countries.
𝑃𝐶
• Import-biased growth (food industry) ➔ ↑➔ Home’s 𝑇𝑜𝑇 ↑; Foreign’s
𝑃𝐹
𝑇𝑜𝑇 ∗ ↓ ➔ Increasing Home’s welfare while decreasing Foreign’s welfare.
UQ Extend – Answering the Big Questions
1. Is economic growth in Foreign good for the standard of living in
Home country?
• Export-biased growth in Foreign benefits Home.
• Import-biased growth in Foreign harms Home.
2. Is growth in Home more or less valuable when it is integrated in the
world economy?
• Domestic import-biased growth benefits our welfare.
• Domestic export-biased growth reduces the welfare benefit of growth.
• But can it remove the benefit of growth completely?
Immiserizing growth
• Definition: export-biased growth in poor
nations would worsen their terms of
trade so much that they would be worse
off than if they had not grown at all.
• Bhagwati (1958): it can happen in a
rigorously specified model.
• Strongly export-biased growth.
• Very steep RS and RD curves.
• ➔ The change in terms of trade is large
enough to offset the favourable effects of an
increase in a country’s productive capacity.
Source: Langdana & Murphy (2013)
• More a theoretical point than a real-world
issue.
Case Study: The U.S. and China
• Changes in the U.S. terms of
trade have been small with no
clear trend over last few decades.
• The terms of trade for China have
deteriorated over the past
decade
• Their recent growth may have been
export-biased.

Figure: Evolution of the Terms of Trade for

the U.S. and China
Source: World Development Indicators, World Bank.
 Part 3
Protectionism and Relative Prices

Source: Wikimedia
Commons
Import Tariffs and Export Subsidies
• Import tariffs: taxes levied on imports.
• Export subsidies: payments given to domestic producers that export.
• Both policies influence the terms of trade ➔ national welfare.
• Import tariffs and export subsidies drive a wedge between prices in
world markets and prices in domestic markets.
• We will study about this in more details in Lecture 9
• Now: understand the interaction of protectionism on relative supply and
relative demand ➔ Relative price ➔ Terms of trade (thereby welfare).
• Lecture 9: also will examine deadweight loss and overall welfare change.
Effects of a Tariff
• If Home imposes a tariff on food imports: the relative price of food
rises for domestic consumers.
• Likewise, the relative price of cloth falls for domestic consumers.
• Relative supply of cloth will decrease.
• Domestic producers will receive a lower relative price of cloth, and therefore
will be more willing to switch to food production.
• Relative demand for cloth will increase.
• Domestic consumers will pay a lower relative price for cloth, and therefore
will be more willing to switch to cloth consumption.
• ➔ Home’s terms of trade may increase, and its welfare may increase.
Effects of a Tariff

Figure: Effects of a
Food Tariff on the
Terms of Trade
Effects of a Tariff
Why “may”? The magnitude depends on the size of Home 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.
• ➔ No effects on the terms of trade.
• For large countries, a tariff may maximize national welfare at the
expense of foreign countries.
• E.g. the Chinese import tariffs on imports of U.S. Soybeans (imposed in April
2018) resulted in an approx. 20% fall in the price of Soybeans.
• In the previous graph, we assume the country is large.
Effects of an Export Subsidy
• If Home imposes a subsidy on cloth exports, the relative price of cloth
rises for domestic consumers.
• Relative supply of cloth will increase.
• Domestic producers will receive a higher relative price of cloth when they
export, and therefore will be more willing to switch to cloth production.
• Relative demand for cloth will decrease.
• Domestic consumers must pay a higher relative price of cloth to producers,
and therefore will be more willing to switch to food consumption.
• ➔ Home’s terms of trade may decrease, and its welfare decreases.
• Again, this depends on Home’s size relative to the world economy.
Effects of an Export Subsidy

Figure: Effects of a
Cloth Subsidy on the
Terms of Trade
So, Who Gains and Who Loses?
• Export subsidies on a good decrease the relative world price of that good.
• Import tariffs on a good decrease the relative world price of that good.
Suppose Home is large, the standard trade model predicts that
• an import tariff by Home country can increase domestic welfare at the
expense of Foreign country.
• an export subsidy by Home country reduces domestic welfare to the
benefit of Foreign country.
But the real world does not simply consist of only two countries now, does
it?
So, Who Gains and Who Loses?
A Multi-national Case
Additional effects of tariffs and subsidies that can occur in a world with
many countries and many goods:
• Another country may subsidise the export of a good that Home also
exports, which will reduce the price for Home in world markets and
decrease its terms of trade.
• The EU subsidises agricultural exports (CAP), which reduce the price that
American farmers receive for their goods in world markets.
• Another country may put a tariff on an imported good that Home also
imports, which will reduce the price for Home in world markets and
increase its terms of trade.
So, Who Gains and Who Loses?
A Multi-national Case
• Export subsidies by foreign countries on goods that
• Home imports reduce the world price of Home imports and increase its
terms of trade.
• Home also exports reduce the world price of Home exports and decrease its
terms of trade.
• Import tariffs by foreign countries on goods that
• Home exports reduce the world price of Home exports and decrease the
terms of trade for Home country.
• Home also imports reduce the world price of Home imports and increase the
terms of trade for Home country.
• There is also a deadweight loss effect – more on Lecture 9!
Summary
• The terms of trade refers to the price of exports relative to the price
of imports.
• Export-biased growth reduces a country’s terms of trade, reducing its
welfare and increasing the welfare of foreign countries.
• Import-biased growth increases a country’s terms of trade, increasing
its welfare and decreasing the welfare of foreign countries.
• When a country imposes an import tariff, its terms of trade increase
and its welfare may increase.
• When a country imposes an export subsidy, its terms of trade
decrease and its welfare decreases.