# Chapter 5

Topic 3 The Standard Trade Model Slides prepared by Thomas Bishop Copyright 2009 Pearson Addison-Wesley. All rights reserved. Preview 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

Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-2 Introduction Standard trade model combines ideas from the Ricardian and H-O models. 1. Differences in L services, L skills, K, T, and technology between countries cause productive differences, leading to gains from trade. 2. These productive differences are represented as differences in PPFs. 3. A countrys PPF determines its RS curve.

4. World equilibrium is determined by the intersection of RD and RS which occurs somewhere between national RS curves. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-3 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, and when this value is constant the equations line is called an isovalue line.

Slope of the isovalue line equals (PC /PF), and if (PC /PF) slope. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-4 Fig. 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.

0 Fig. 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. The Value of Consumption The value of the economys consumption must equal the value of its production. PC DC + PF DF = PC QC + PF QF = V

Production and consumption points must lie on the same isovalue line. What determines consumption choices (demand)? Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-7 The Value of Consumption (cont.) 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. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-8 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. Copyright 2009 Pearson Addison-Wesley. All rights reserved.

5-9 Fig. 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. 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. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-11 Prices and the Value of Consumption (cont.) The welfare when the P of one good changes relative to the P of another is called the income effect.

The income effect is represented by moving to another indifference curve. The substitution of one good for another when the P of the good changes relative to the other is called the substitution effect. The substitution effect is represented by moving along a given indifference curve. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-12 Fig. 4: Effects of a Rise in the Relative Price of Cloth Or shows proportionate DC and DF. Points to the left of

Or (like D2) represent proportionately greater DF relative to DC. r QF D2 D'1 D1 I2 I1 M1

M2 X1 When PC/PF QC and QF and welfare as PX so MF are cheaper. There is an D for both goods but relatively more for food for a given level of utility (I2) because PC/PF. Q1 X2 Q2

Income effect: D1 to D'1. P1 P2 0 QC Substitution effect: D'1 to D2. Welfare and the Terms of Trade The terms of trade refers to PX/PM. When a country exports cloth and PC/PF, the tot have improved.

Because PX means the country can afford to buy more imports, an tot a countrys welfare. A tot a countrys welfare. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-14 Determining Relative Prices PC/PF is determined by RS and RD. RS is world supply of cloth relative to that of food at each relative price. RD is world demand of cloth relative to that of food at each relative price. With 2 countries, world quantities are the sum of

quantities from the home and foreign countries. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-15 Fig. 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. The Effects of Economic Growth Is economic growth in China good for the

standard of living in the U.S.? Is growth in a country more or less valuable when it when it is closely integrated in the world economy? The standard trade model gives us precise answers to these questions. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-17 The Effects of Economic Growth (cont.) Common sense: Growth in NIE may be good for U.S. because this expands our potential export market. However, it may also mean that NIE will begin to compete with our exporters.

As K* and education* NIE may begin producing computers and software. Growth at home is also controversial: growth means we can produce more goods and sell them abroad. Yet, benefits of growth may be passed onto foreigners if supply of U.S. goods PX. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-18 The Effects of Economic Growth (cont.) Growth is usually biased: it occurs in one sector more than others, causing RS. E.g., Rapid growth has occurred in U.S. computer

industries but relatively little growth has occurred in U.S. textile industries. Ricardian model: technological progress in one sector causes biased growth. H-O model: S of 1 factor of production (e.g., K) causes biased growth in the sector that uses K intensively. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-19 Fig. 6: Biased Growth The Effects of Economic Growth (cont.) Biased growth and the resulting RS causes

a tot. Biased growth in the cloth industry (in either home or foreign) will PC/PF and tot for cloth exporters. Biased growth in the food industry (in either home or foreign) will PC/PF and tot for cloth exporters. Assume that home exports cloth and imports food. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-21 Fig. 7a: Growth and Relative Supply If either country experiences growth biased toward cloth RS shifts out on world markets tot and tot*.

Fig. 7b: Growth and Relative Supply If either country experiences growth biased toward food RS curve shifts in on world markets tot and tot*. The Effects of Economic Growth (cont.) Export-biased growth is growth that expands a countrys PPF disproportionately toward that countrys export sector. Biased growth in the food industry in foreign is export-biased growth for foreign. Import-biased growth is growth that expands

a countrys PPF disproportionately toward that countrys import sector. Biased growth in the cloth industry in foreign is import-biased growth for foreign. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-24 The Effects of Economic Growth (cont.) Export-biased growth tends to worsen a growing countrys tot to the benefit of foreign countries. Import-biased growth tends to improve a growing countrys tot at the expense of foreign countries.

Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-25 Fig. 8a: Export-biased Growth r QY Overall, welfare is depressed by tot (I2 < I1). However, the tot has not cancelled out all of the benefits of growth (i.e., prod capacity) as I2 > I0.

D1 D2 I1 I2 See handout on Growth and Welfare for further explanation. D0 I0 Q2 Q0

Q1 P0 0 P0,1 QX P2 r Fig. 8b: Import-biased Growth

D2 QY Overall, welfare increased because of the prod capacity (I1 > I0) and the tot (I2 > I1). I2 D1 I1 D0 See handout on Growth and Welfare for further

explanation. Q1 I0 Q2 Q0 P0,1 P2 0 P0 QX

Has Growth in Asia Reduced the Welfare of High Income Countries? Standard trade model predicts that import biased growth in China tot in U.S. and our standard of living. Import biased growth for China would occur in sectors that compete with U.S. exports. But this prediction is not supported by data: should see tot for U.S. and other high income countries. In fact, tot for high income countries and tot* for developing Asian countries. Copyright 2009 Pearson Addison-Wesley. All rights reserved.

5-28 Table 1: Average Annual Percent Changes in Terms of Trade NIE have experienced export-biased growth which has tot*. E.g., Chinas export volume grew by 14% per year from 1992 to 2002. Thus, Chinas tot by 13% which shaved 3% off of Chinas growth in real income. Chinas exports of L-intensive manufactured goods tot in U.S., but tot in Mexico (because they export similar products). Between 1998 and 2003, Chinese-manufactured X to U.S. grew by 15.2% per year which was 2.5X as fast as Mexicos exports. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-29

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 of traded goods and therefore RD. International loans may also influence RD in SR, before the loan is paid back. How do transfers of income across countries affect RD and tot? Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-30

The Effects of International Transfers of Income (cont.) Income (Y) transferred from home to foreign Y and Y*, which may shift RD curve. Note: RS does not shift as long as only money is transferred. If Y* proportionate D*C and D*F is matched by Y DC and DF RD does not shift and tot are unaffected! However, if spending patterns differ between the 2 countries RD shifts and tot. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-31

The Effects of International Transfers of Income (cont.) If home has a higher marginal propensity to spend on cloth than foreign does at fixed PC/PF, Y RD for cloth. In this case (Fig. 9), an income transfer from home causes tot and tot*. Alternatively, if home has a lower marginal propensity to spend on cloth than foreign does transfer of income to foreign RD for cloth tot and tot*. In this case, RD curve would shift outward. Copyright 2009 Pearson Addison-Wesley. All rights reserved.

5-32 Fig. 9: One Possible Effect of a Transfer on the Terms of Trade The RD curve will only shift inward when home transfers income to foreign, if home has a higher marginal propensity to spend on cloth than foreign does. The Effects of International Transfers of Income (cont.) Rule: a transfer worsens the donors tot if the donor

has a higher marginal propensity to spend on its export good than the recipient. In reality: when examining countries spending patterns, each has a preference for its own goods. E.g., In U.S., imports are only 15% of national income. So we spend 85% of our income on domestically produced goods. ROW spends 9% of its income on U.S. goods. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-34 The Effects of International Transfers of Income (cont.) Data suggests that if U.S. transferred income to ROW RD for U.S. goods tot.

We spend income at home because of natural and artificial barriers to trade. Non-traded goods ensure that the majority of our income is spent on domestic goods (e.g., housing, education, and medical services). Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-35 The Effects of International Transfers of Income (cont.) Non-traded and export sectors compete for resources. If U.S. transfers income abroad D for nontraded goods releases factors to work in export sector X tot.

Recipients income D for non-traded goods factors move from export to the non-traded goods sector X* and tot*. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-36 The Effects of International Transfers of Income (cont.) In 1998, several Asian countries were in crisis as investor confidence collapsed in 1997. Countries like South Korea and Thailand saw a sudden reversal of international K flows. Foreign banks that had been lending heavily to these countries, now stopped lending and demanded that

the existing loans be repaid. These countries quickly went from receiving large transfers to making large transfers! As predicted, these countries experienced tot which exacerbated the financial crisis. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-37 Import Tariffs and Export Subsidies Import tariffs are taxes levied on imports. Export subsidies are payments given to domestic producers that export. Both policies influence tot and therefore national welfare.

Import Tariffs If home imposes a tariff on food imports PC/PF internally. Home producers: face a lower PC/PF, so they will produce more food and less cloth: RS of cloth shifts in. Home consumers: face a lower PC/PF, so they will consume more cloth and less food: RD of cloth shifts out. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-40 Fig. 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. Import Tariffs (cont.) When home imposes an import tariff, tot and homes welfare may increase. The magnitude of this effect depends on the size of the home country relative to the world economy. If the country is small, its tariff (or subsidy) policies will not have much effect on world RS and RD, and thus on tot. But for large countries, a tariff rate that maximizes national welfare at the expense of foreign countries may exist.

Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-42 Export Subsidies If home imposes a subsidy on cloth exports, PC/PF internally. Domestic producers: face a higher PC/PF when they export, so they produce more cloth and less food: RS of cloth shifts out. Domestic consumers: face a higher PC/PF, so they consume more food and less cloth: RD of cloth shifts in. Copyright 2009 Pearson Addison-Wesley. All rights reserved.

5-43 Fig. 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. Income Distribution Two dimensions: 1. Distribution of income between countries (i.e.,

international distribution of income) 2. Distribution of income within countries Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-45 Import Tariffs and International Distribution of Income Home imposes a tariff tot and tot* but impact on homes welfare is not so clear cut. tot benefits home, but PM distorts production decisions: encourages homes producers to use scarce resources to produce a good that home does not have a comparative advantage in. PM distorts consumer decisions and hurts

consumers through a reduction in their purchasing power. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-46 Import Tariffs and International Distribution of Income (cont.) Welfare rises with tot as long as the tariff is not too large and does not substantially distort production and consumption decisions. Later, we will study an optimum tariff for large countries. For a small country, optimum tariff is zero: cannot impact its tot and only distorts

5-48 International Distribution of Income with Multiple Countries and Goods Are foreign export subsidies good for U.S.? Yes in a simple 2 country and 2 good model. But in reality, subsidies to exports of goods the U.S. exports is harmful. E.g., EU subsidies of agricultural exports hurt U.S. farmers by reducing prices they receive on world markets (i.e., tot). Alternatively, subsidies to exports of goods the U.S. imports is beneficial! Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-49

International Distribution of Income with Multiple Countries and Goods (cont.) Are foreign import tariffs bad for U.S.? Yes in a simple 2 country and 2 good model. But in reality, foreign tariffs on goods U.S. imports are beneficial. Why? Foreign tariff lowers world demand for goods we import which raises our tot. Thus, in reality: subsidies to exports of goods U.S. imports is beneficial, while tariffs against U.S. exports is harmful. Copyright 2009 Pearson Addison-Wesley. All rights reserved. 5-50

Distribution of Income Within Countries View that subsidies of foreign exports of goods that the U.S. imports is beneficial, is not held by G officials. E.g., When a Commerce Dept. study found EU was subsidizing steel exports to U.S., our G ordered EU to raise its P of steel. Why? Subsidies of EU exports of steel to the U.S. have an impact on our income distribution. U.S. consumers gain from cheaper steel; as do U.S. exporters who use steel as a factor of production (e.g., Caterpillar and Ford). But, U.S. steel workers and company owners lose! Copyright 2009 Pearson Addison-Wesley. All rights reserved.

5-51 Distribution of Income Within Countries (cont.) Foreign tariffs and subsidies relative goods prices factor rewards because of factor immobility and differences in the factor intensity of different industries. In general, a tariff helps the import-competing sector at home while hurting the export sector. 1. Pulls resources out of the export sector. 2. P of resources (like steel) that the export sector uses as an input. This costs and PX making our producers less competitive on world markets.