INTERNATIONAL TRADE

Chapter 5: The Standard Trade Model

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• A standard model of a trading economy
o Measuring the values of production and consumption

o Welfare and terms of trade

o Determining relative prices

o Effects of economic growth

• Effects of international transfers of income

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A standard model in a trading economy
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 (PPF),
which represent the productive capacities of nations.
3. A country’s PPF determines its relative supply curve.
4. National relative supply curves determine world relative
supply, which along with world relative demand
determines an equilibrium under international trade.

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The Value of Production

• Recall that 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
in a two good model, and when this value is
constant the equation’s line is called and
isovalue line.
¨ The slope of any equation’s line equals – (PC /PF),
and if relative prices change the slope changes.

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The Value of Production

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The Value of Production

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The Value of Consumption

• The value of the economy’s consumption is

constrained to equal the value of the
economy’s production.
PC DC + PF DF = PC QC + PF QF = V

• Production choices are determined by the

economy’s PPF and the prices of output.
• What determines consumption choices
(demand)?

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The Value of Consumption

• Consumer preferences and prices determine

consumption choices.
• Consumer preferences are represented by
indifference curves: combinations of goods that
make consumers equally satisfied (indifferent).
• Consumer feels equally satisfied with any points
of good combinations on the indifference curves

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Consumer preferences and The Value of Consumption

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Consumer preferences and The Value of Consumption

• Indifference curves are downward sloping to represent

the fact that if a consumer has more cloth, he could have
less food and still be equally satisfied.
• Indifference curves farther from the origin represent larger
quantities of food and cloth, which should make
consumers more satisfied and better off.
• Indifference curves are flatter when moving to the right:
the more cloth and the less food that is consumed, the
more valuable food becomes relative to cloth.

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Prices and the Value of Consumption

• Prices also determine the value of consumption.

o When the price of cloth rises relative to the price of food,
the economy is better off when it exports cloth: a higher
indifference curve results.
o A higher price for cloth exports means that more food can
be imported.
o A higher relative price of cloth will also influence
consumption decisions about cloth versus food
=> a higher relative price of cloth makes consumers willing
to buy less cloth and more food.

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Prices and the Value of Consumption

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 Prices and the Value of Consumption

• The change in welfare (income) when the price of one

good changes relative to the price of another is called the
income effect.
¨ The income effect is represented graphically by
shifting the indifference curve.
• The substitution of one good for another when the price of
the good changes relative to the other is called the
substitution effect.
¨ This substitution effect is represented graphically by
a moving along a given indifference curve.

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Welfare and 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 increase or
“improve”.
• Because a higher 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 decrease in the terms of trade decreases a
country’s welfare.

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Determining Relative Prices

• To determine the price of cloth relative to the

price food in our model, we again use relative
supply and relative demand.
¨ Relative supply considers world supply of cloth
relative to that of food at each relative price
¨ Relative demand considers world demand of cloth
relative to that of food at each relative price
¨ In a two country model, world quantities are
the sum of quantities from the domestic and
foreign countries.

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Determining Relative Prices

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The Effects of Economic Growth

• Is economic growth in China good for the

standard of living in the US?
• Is growth in a country more or less valuable
when it when it is integrated in the world
economy?
• The standard trade model gives us precise
answers to these questions.

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The Effects of Economic Growth

• 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.
¨ 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.
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The
Effects of
Economic
Growth

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The Effects of Economic Growth

• 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.

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The Effects
of Economic
Growth

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The Effects
of Economic
Growth

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The Effects of Economic 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 country is
import-biased growth for the foreign country.

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The Effects of Economic 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.

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Case study: Has Growth in Asia Reduced
the Welfare of High Income Countries?
• The standard trade model predicts that import biased
growth in China reduces the US terms of trade and
the standard of living in the US.
¨ Import biased growth for China would occur in sectors that
compete with US exports.

• But this prediction is not supported by data: there

should be negative changes in the terms of
trade for the US and other high income countries.
¨ In fact, the terms of trade for high income countries have
been positive and negative for developing Asian countries.

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Case study: Has Growth in Asia Reduced the
Welfare of High Income Countries?

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The Effects of International Transfers of Income

• Transfers of income sometimes occur from one

country to another.
¨ War reparations or foreign aid may influence
demand for traded goods and therefore relative
demand.
¨ International loans may also influence relative
demand in the short run, before the loan is paid
back.
• How do transfers of income across countries affect
relative demand and the terms of trade?

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The Effects of
International Transfers of Income
• If the domestic country generates national
income for transfers by:
¨ increasing the price of imports (PF) to reduce their
purchases of imports and by decreasing the price
of exports (PC) to increase their sales,
¨ the relative demand curve should shift left and
the terms of trade would fall.

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The Effects of
International Transfers of Income

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The Effects of
International Transfers of Income
• But after the transfer of income from the
domestic country,
¨ demand for foreign goods could fall in the domestic
country and demand for domestic goods could rise in
the foreign country,
¨ so the relative demand curve might not shift left
and the terms of trade might not fall.

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The Effects of
International Transfers of Income
• How much does demand for domestic goods
increase in the foreign country when it receives a
transfer of income from the domestic country?
¨ If the foreign country has a higher marginal
propensity to consume (MPC) on its own goods
than on imports, demand for its own goods will
rise more than demand for imports from the
domestic country.

• Recall: the marginal propensity to consume (MPC) is the concept that

the increase in personal consumer spending (consumption) occurs with
an increase in disposable income (income after taxes and transfers)
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The Effects of
International Transfers of Income
• How much does demand for foreign goods decrease in
the domestic country when it reduces its income
through a transfer?
¨ If the domestic country has a higher marginal
propensity to spend on its own goods than on imports,
demand for its own goods will fall more than demand
for imports from the foreign country.
• If each country has a higher marginal propensity to
spend on its own products, the relative demand curve
would shift left after a transfer of income from the
domestic country.

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The Effects of
International Transfers of Income
• In fact, countries spend most of their (marginal)
income on their own products.
¨ Americans spend only 11% of national income on
imports and 89% on domestically produced goods.
• Transportation costs, tariffs, and other barriers
cause domestic residents to favor domestic goods.
• We predict that the relative demand curve will shift
left with a transfer of income, decreasing the terms of
trade for the donor nation.

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The Effects of
International Transfers of Income
• In addition, the existence of non-traded goods and
services may cause relative supply shifts that
reinforce the decrease in the terms of trade for a
donor country.
¨ Industries that produce non-traded goods and services
compete for resources with industries that produce
traded goods.
¨ A transfer of income from a donor country will
reduce demand for and production of non-traded
goods in the donor country, so that these resources
can be used in its export sector.

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The Effects of
International Transfers of Income
¨ The supply of exports relative to imports in the
donor country increases, reducing the terms of
trade for the donor country.
¨ A transfer of income from a donor country will
increase demand for and production of non-traded
goods in foreign countries, so that fewer resources can
be used in its export sector.
¨ The supply of exports relative to imports in the
foreign country decreases, reducing the terms of
trade for the donor country.

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Summary

1. A change in relative prices, say due to trade, causes an

income effect and a substitution effect.
2. The terms of trade refers to the price of exports
relative to the price of imports in world markets.
3. Export-biased growth reduces a country’s terms of
trade, generally reducing its welfare and increasing the
welfare of foreign countries.
4. Import-biased growth increases a country’s terms of
trade, generally increasing its welfare and decreasing the
welfare of foreign countries.

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Summary

5. The effect of international transfers of income

depend on the marginal propensity to spend on
domestic goods, but generally the relative
demand curve of donor country will shift
left leading to a decrease in the terms of
trade.

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