International Economics : Theory

and Policy

Paul R. Krugman
Princeton University
Chapter 6
Maurice Obstfeld The Standard Trade
University of California, Berkeley
Model
Marc J. Melitz
Harvard University

NINTH EDITION
 Chapter Organization
● Introduction
● Measuring the values of production
and consumption
● Welfare and terms of trade
● Effects of economic growth
● Effects of international transfers of income
● Effects of import tariffs and export subsidies
● Income distribution

Slid
e 5-2 .
 Introduction

Previous trade theories have emphasized

specific sources of comparative advantage
which give rise to international trade:
– Differences in labor productivity (Ricardian model)
– Differences in resources (Heckscher-Ohlin model)
● The standard trade model is a general model
of trade that combines ideas from the
Ricardian model and the Heckscher-Ohlin
model.
Slid
e 5-3 .
 Introduction
● The standard trade model combines ideas from the
Ricardian model and the Heckscher-Ohlin model.
1. Differences in labor, labor skills, physical capital, land and
technology between countries cause productive differences,
leading to gains from trade.
2. These productive differences are represented as differences
in production possibility frontiers, which represent the
productive capacities of nations.
3. A country’s PPF determines its relative supply curve.

4
 A Standard Model of a
Trading Economy
● The standard trade model is built on four key
relationships:
– Production possibility frontier and the relative supply
curve
– Relative prices and relative demand
– World relative supply and world relative demand
– Terms of trade and national welfare

Slid
e 5-5 .
 A Standard Model of a
Trading Economy

● Production Possibilities and Relative Supply

– Assumptions of the model:
● Each country produces two goods, food (F) and cloth(C)
● Each country’s production possibility frontier is a smooth
curve (TT)
– The point on its production possibility frontier at which
an economy actually produces depends on the price
of cloth relative to food, PC/PF.

Slid
e 5-6 .
 The Value of Production

● When the economy maximizes its production possibilities,

the value of output V lies on the PPF.
● V = PCQC + PF QF describes the value of output at market
prices, or, by rearranging,
● QF = V/PF – (PC /PF)QC,
– and when this value is constant the equation’s line is
called an isovalue line.
– Slope of the isovalue line equals – (PC /PF), and if
relative prices change the slope changes ∆(PC /PF)→
∆slope.
7 5-7
 Fig. 6-1: Relative Prices Determine Output

As we move farther from

the origin, the value of
output is increasing.
Optimally, the economy
produces the highest level
of output it can where the
PPF is tangent to the
isovalue line.

8
 Fig. 6-2: How an Increase in the Price of
Cloth Affects Output

If ↑(PC/PF) → the isovalue

line becomes steeper.
As ↑(PC/PF) → the economy
produces more cloth and less
food.

9
 Relative supply curve

10
 A Standard Model of a
Trading Economy
● Relative Prices and Demand
● The value of the economy’s consumption must equal
the value of its production.
– PC DC + PF DF = PC QC + PF QF = V
– where DC and DF are the consumption of cloth and
food, respectively.
● Production and consumption points must lie
on the same isovalue line.
● What determines consumption choices (demand)?
Slid
e
5-11 .
 Relative Prices and Demand

● Consumer tastes and prices determine

consumption choices.
● Consumer preferences are represented by
indifference curves: combinations of goods
that make consumers equally satisfied
(indifferent).
– Each consumer has her own preferences, but we
assume that we can represent the tastes of an
average consumer that represents all consumers.
This implies all tastes are identical, as are incomes.
12
 Three Properties of Indifference Curves

1. Indifference curves are downward sloping to

represent the fact that if an average consumer has
less cloth, she could have more food and still
be equally satisfied.
2. Indifference curves farther from the origin represent
larger quantities of food and cloth, which should
make consumers more satisfied.
3. Indifference curves are flatter when moving to the
right to represent the fact that as more cloth and
less food is consumed, an extra yard of cloth
becomes less valuable.
13 5-13
 Fig. 6-3: Production, Consumption, and
Trade in the Standard Model

Economy produces at pt Q
where isovalue line is tangent
to the PPF.
Economy consumes at pt D
where the same isovalue line
is tangent to the highest
possible indifference curve.
The economy produces more
cloth than it consumes and
therefore exports cloth;
correspondingly, it consumes
more food than it produces
and therefore imports food.

14
 Prices and the Value of Consumption

● Prices also determine the value of

consumption.
– When ↑(PC/PF), the economy is better off when it
exports cloth: the isovalue line becomes steeper
and a higher indifference curve can be reached.
– A higher price for cloth exports means that more
food can be imported.
– ↑(PC/PF) makes consumers willing to buy less cloth
and more food.

15 5-15
 Substitution and Income Effects

● The part of the change in quantity demanded

that is caused by substitution of one good for
another is called the substitution effect.
● substitution effect The movement along a given
indifference curve that results from a change in
the relative prices of goods, holding real
income constant.

16
 income effect.

● The part of the change in quantity demanded

that is caused by a change in real income is
called the income effect.
● purchasing power and consumers will move to
a new indifference curve that is consistent with
this new purchasing power.
● income effect The movement from one
indifference curve to another that results from
the change in real income caused by a price
17 change.
 Effects of a Rise in the Relative Price of Cloth
and Gains from Trade

18
 The Welfare Effect 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 ↑PC/PF, the terms of trade
increase or “improve”.
● Because a higher price for exports ↑PX means that the
country can afford to buy more imports, an increase in
the terms of trade increases a country’s welfare.
● A decrease in the terms of trade decreases a country’s
welfare.

19
 A Standard Model of a
Trading Economy
● Determining Relative Prices
– Suppose that the world economy consists of two
countries:
● Home (which exports cloth)
– Its terms of trade are measured by PC/PF
– Its quantities of cloth and food produced are QC and QF
● Foreign (which exports food)
– Its terms of trade are measured by PF/PC
– Its quantities of cloth and food produced are Q* andQ*
C F

Slid
e
5-20 .
 A Standard Model of a
Trading Economy
– To determine PC/PF , one must find the intersection
of world relative supply of cloth and world relative
demand.
– PC/PF is determined by RS and RD
● The world relative supply curve (RS) is upward sloping
because an increase in PC/PF leads both countries to
produce more cloth and less food.
● The world relative demand curve (RD) is downward sloping
because an increase in PC/PF leads both countries to shift
their consumption mix away from cloth toward food.

Slid
e
5-21 .
 Fig. 6-5: World Relative Supply and Demand

RS has a positive slope

because ↑PC → both
countries to ↑QC and ↓QF.
RD has a negative slope
because ↑PC → both
countries to ↓DC and ↑DF.

22
23
 Economic Growth: A Shift of the RS
Curve

– Is economic growth in other countries good or bad for

our nation?
● It may be good for our nation because it means larger
markets for our exports and lower prices for ourimports.
● It may mean increased competition for our exporters.
– Is growth in a country more or less valuable when that
nation is part of a closely integrated world economy?
● It should be more valuable when a country can sell some of
its increased production to the world market.
● It is less valuable when the benefits of growth are passed on
to foreigners rather than retained at home.
Slid
e
5-24 .
 Growth and the Production
Possibility Frontier
Economic growth means an outward shift of a country’s
production possibility frontier. This growth can result
either from increases in a country’s resources or from
improvements in the efficiency with which these
resources are used
Growth is usually biased: it occurs in one sector more
than others, causing relative supply to shift.
– Rapid growth has occurred in US computer
industries but relatively little growth has occurred in
US textile industries.
Slid
e
5-25 .
 Growth and the Production
Possibility Frontier
– According to the Ricardian model, technological
progress in one sector causes biased growth.
– According to the Heckscher-Ohlin model, an
increase in one factor of production (e.g., an
increase in the labor force, arable land, or the
capital stock) causes biased growth.

26
 Fig. 6-6: Biased Growth

27
28
 Relative Supply and the
Terms of Trade
● Biased growth and the resulting shift in relative supply
causes a change in the terms of trade.
– Biased growth in the cloth industry (in either the domestic 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 domestic or
foreign country) will raise the relative price of cloth and raise the
terms of trade for cloth exporters.
– Suppose that the domestic country exports cloth and
imports food.

Slid
e
5-29 .
 Growth and Relative Supply

If either country experiences

growth biased toward cloth
→ RS shifts out on world
markets → ↓tot and ↑tot*.

30
 Growth and Relative Supply

If either country experiences

growth biased toward food →
RS curve shifts in on world
markets → ↑tot and ↓tot*.

31
 Biased growth
● Export-biased growth is growth that expands a
country’s PPF disproportionally in production of that
country’s exports.
– Biased growth in the food industry in the foreign country is
export-biased growth for the foreign country.
● Import-biased growth is growth that expands a
country’s PPF disproportionally in production of that
country’s imports.
– Biased growth in cloth production in the foreign countryis
import-biased growth for the foreign country.

32
 Biased growth

● Export-biased growth reduces a country’s

terms of trade, generally reducing its
welfare and increasing the welfare of
foreign countries.
● Import-biased growth increases a country’s
terms of trade, generally increasing its
welfare and decreasing the welfare of
foreign countries.

33
34
 International Effects of Growth

– Export-biased growth in the rest of the world improves

our terms of trade, while import-biased growth abroad
worsens our terms of trade.
– Export-biased growth in our country worsens our
terms of trade, reducing the direct benefits of growth,
while import-biased growth leads to an improvement
of our terms of trade.

Slid
e
5-35 .
 A Standard Model of a
Trading Economy
– Immiserizing growth
● A situation where export-biased growth by poor nations can
worsen their terms of trade so much that they would be
worse off than if they had not grown atall
● It can occur under extreme conditions: Strongly
export-biased growth must be combined with very steep
RS and RD curves.
● It is regarded by most economists as more a theoretical
point than a real-world issue.

Slid
e
5-36 .
 Tariffs and Export Subsidies:
Simultaneous Shifts in RS and RD

● Import tariffs are taxes levied on imports

● Export subsidies are payments given to
domestic producers that export.
● Both policies influence the terms of trade and
therefore national welfare.
● Import tariffs and export subsidies affect both
relative supply and relative demand.
Slid
e
5-37 .
 Relative Demand and Supply Effects of a Tariff

– Tariffs drive a wedge between the prices at which

goods are traded internationally (external prices)
and the prices at which they are traded within a
country (internal prices).

● The terms of trade refers to the relative value

of a country’s exports and a country’s imports.
– Since exports and imports are traded in world
markets, the terms of trade measures external
prices. The terms of trade correspond to external,
not internal, prices.
38
 Relative Demand and Supply
Effects of a Tariff

● If home imposes a tariff on food imports, the

price of food relative to price cloth that domestic
citizens face is higher.
– Home producers will receive a lower relative price of
cloth, and therefore will be more willing to switch to
food production: the relative supply curve will shift.
– Home consumers will pay a lower relative price of
cloth, and therefore be more willing to switch to cloth
consumption: the relative demand curve will shift.
39
 Tariffs and Export Subsidies:
Simultaneous Shifts in RS and RD
● Effects of an Import Tariff
– Example: Suppose that Home imposes a 20% tariff on
its imports of food:
● This will raise Home’s internal PF/PC by 20% over the external
PF/PC
– Home’s internal PC/PF 20% < world PC/PF
– RS shifts left as Home’s QF increases and QC decreases.
– RD shifts right as Home’s DF decreases and DC increases.
● A Home import tariff improves Home’s terms of trade and
worsens Foreign’s.

Slid
e
5-40 .
 Fig. 5-10: Effects of a Tariff on the Terms of
Trade
Note: this graph reflects
the world market and
world prices. Tot refer to
external prices.

41
 Effects of an Import Tariff

When the domestic country imposes an import tariff, the terms

of trade increases and the welfare of the country may increase.
The magnitude of this effect depends on the size ofthe
domestic country relative to the world economy.
If the country is 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, a tariff rate that maximizes nationalwelfare at
the expense of foreign countries may exist.

42
 Effects of an Export Subsidy
● If the home country imposes a subsidy
on cloth exports, the price of cloth relative to price
food that domestic citizens face
is higher.
– Domestic producers will receive a higher relative price
of cloth, and therefore will be more willing to switch to
cloth production: the relative supply curve will shift.
– Domestic consumers will pay a higher relative price of
cloth, and therefore be more willing to switch to food
consumption: the relative demand curve will shift.
Slid
e
5-43 .
 Example:
● Example: Suppose that Home offers 20% subsidy onthe
value of cloth exported:
– This will make Home’s internal PC/PF 20% > world PC/PF.
– RS shifts right as Home’s QC increases and QF decreases.
– RD shifts left as Home’s DC decreases and DF increases.
● A Home export subsidy worsens Home’s terms of trade
and improves Foreign’s.

44
 Fig. 5-11: Effects of an Export Subsidy on the
Terms of Trade

This graph refers to

world markets and
world prices. Tot will fall
if the country is large
enough to impact world
markets.

45
 Implications of Terms of Trade
Effects: Who Gains and Who Loses?

– The International Distribution of Income

● If Home (a large country) imposes a tariff, its welfare
increases as long as the tariff is not too large, while Foreign’s
welfare decreases.
● If Home offers an export subsidy, its welfare deteriorates,
while Foreign’s welfare increases.
– The Distribution of Income Within Countries
● Atariff (subsidy) has the direct effect of raising the internal
relative price of the imported (exported) good.
● Tariffs and export subsidies might have perverse effects on
internal prices (Metzler paradox).

Slid
e
5-46 .
 Tariffs and Export Subsidies:
Simultaneous Shifts in RS and RD

● Metzler Paradox:
– The International Distribution of Income
● Terms of trade (ToT) effect so large that a tariff might lower
the internal price of the imported good. (Tariff improves ToT.)
● An export subsidy might lower the ToT so much thatthe
internal price of the export good falls.

Slid
e
5-47 .
 Summary

● The standard trade model provides a

framework that can be used to address a wide
range of international issues and admits
previous trade models as special cases.
● A country’s terms of trade are determined by
the intersection of the world relative supply and
demand curves.
● Economic growth is usually biased. Growth that
is export-biased (import-biased) worsens
Slid (improves) the terms of trade.
e
5-48 .
 Summary

● International transfers of income may affect a

country’s terms of trade, depending if they shift
the world relative demand curve.
● Import tariffs and export subsidies affect both
relative supply and demand.
● The terms of trade effects of an export subsidy
hurt the exporting country and benefit the rest of
the world, while those of a tariff do the reverse.
Slid – Both trade instruments have strong income
e
5-49 distribution effects within countries. .
Appendix: Representing International
Equilibrium with Offer Curves
Figure 5A-1: Home’s Desired Trade at a Given Relative Price
Home’s
imports, DF -
QF

Desired
T
imports
of food

PC/P
F
O Desired Home’s
exports exports, QC -
Slid of cloth
e
DC
5-50 .
Appendix: Representing International
Equilibrium with Offer Curves
Figure 5A-2: Home’s Offer Curve
Home’s
imports, DF -
C
QF
T2

T1

O
Home’s
exports, QC -
Slid
e
DC
5-51 .
Appendix: Representing International
Equilibrium with Offer Curves
Figure 5A-3: Foreign’s Offer Curve
Foreign’s
exports, Q*F –
D*F

O
Foreign’s
imports, D*C –
Slid
e
Q *C
5-52 .
Appendix: Representing International
Equilibrium with Offer Curves
Figure 5A-4: Offer Curve Equilibrium
Home’s imports of food, DF– QF
Foreign’s exports of cloth, Q*F –
D*F C

F
E
Y

O X
Home’s exports of cloth, QC – DC
Slid Foreign’s imports of cloth, D*C –
e
5-53 Q *C .