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Standard Trade Model Four Relationships

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					               International Economics


International Trade            International Finance
Open-economy Micro-Economics   Open-economy Macro-Economics


     Theory                         Theory
     -Inter-industry trade          -BoP
     -Intra-industry trade          -Short-run exchange rates
     Policy                         -Long-run exchange rates
     -Developing countries          Policy
     -Industrial countries          -Internal balance
     Issues                         -External balance
     -Trade groups                  Issues
     -Development                   -Global financial reform
                                    -Economic transition
In the world market, home exchanges
with foreign by specializing in the
production of a good/service in which
it has a comparative advantage and
trading (indirectly producing) for the
good/service in which it lacks a
comparative advantage to increase its
consumption possibilities.
Chapter 4
            Trade and Resources
• While trade is partly explained by differences
  in labor productivity, it also can be explained
  by differences in resources across countries.
• The Heckscher-Ohlin theory argues that
  differences in labor, labor skills, physical
  capital, land or other factors of production
  across countries create productive
  differences that explain why trade occurs.
   – Countries have a relative abundance of factors of
     production.
   – Production processes use factors of production
     with relative intensity.
    Heckscher-Ohlin Model
• Two countries - domestic and foreign
• Two inputs - labor and land
   – Labor services and land are the resources important for
     production.
   – The amount of labor services and land varies across
     countries, and this variation influences productivity.
   – The supply of labor services and land in each country is
     constant
   – Fixed coefficients or one method of production
• Two goods produced - cloth and food
   – both inputs used to produce both goods
   – Competition allows factors of production to be paid a
     “competitive” wage, a function of their productivities and the
     price of the good that they produce, and allows factors to be
     used in the industry that pays the most
              H-O Assumptions
• aTC
   – acres of land per one yard of cloth
• aLC
   – hours of labor per on yard of cloth
• aTF
   – acres of land per one calorie of food
• aLF
   – hour of labor per one calorie of food
• T - total supply of land
   – r=rent on one acre of land
• L - total supply of labor
   – w=wage per one hour of labor
       Production Possibilities

• Production possibilities are influenced by both
  land and labor (requirements):
                aTFQF + aTCQC ≤ T         Total amount of
                                          land resources


Land required for    Total units     Land required for    Total units
each unit of food    of food         each unit of cloth   of cloth
production           production      production           production

                              aLFQF + aLCQC ≤ L              Total amount of
                                                             labor resources

         Labor required for        Labor required for
         each unit of food         each unit of cloth
         production                production
The Production Possibility Frontier
   Without Factor Substitution
    Production Possibilities
• The opportunity cost of producing cloth in
  terms of food is not constant in this model:
   – it’s low when the economy produces a low amount
     of cloth and a high amount of food
   – it’s high when the economy produces a high
     amount of cloth and a low amount of food
      • Why? Because when the economy devotes all resources
        towards the production of a single good, the marginal
        productivity of those resources tends to be low so that the
        (opportunity) cost of production tends to be high
          – In this case, some of the resources could be used more
            effectively in the production of another good
       Production Possibilities
• The above PPF equations do not allow substitution of
  land for labor services in production or vice versa.
   – Unit factor requirements are constant along each line
     segment of the PPF.
• If producers can substitute one input for another in
  the production process, then the PPF becomes
  curved.
   – For example, many workers could work on a small plot of
     land or a few workers could work on a large plot of land to
     produce the same amount of output.
   – Unit factor requirements can very at every quantity of cloth
     and food that could be produced.
          Input Possibilities in Food Production




In the production of each
unit of food, unit factor
requirements of land
and labor are not
constant in the
Heckscher-Ohlin model
   The Production Possibility
Frontier with Factor Substitution
        Production and Prices

• The production possibility frontier describes what an
  economy can produce, but to determine what the
  economy does produce, we must determine the
  prices of goods.
• In general, the economy should produce at the point
  that maximizes the value of production, V:
                    V = PCQC + PFQF
   – where PC is the price of cloth and PF is the price of food.
    Production and Prices

• Define an isovalue line as a line representing
  a constant value of production, V.
  – V = PCQC + PFQF
  – PFQF = V – PCQC
  – QF = V/PF – (PC /PF)QC
  – The slope of an isovalue line is – (PC /PF)
Production and Prices
          Input Assumptions

• Look at factor intensities
  – Cloth is labor intensive
  – Food is land intensive


  – aLC/aTC >aLF/aTF
  – aLC/aLF >aTC/aTF
aTF
      Isoquant
aTC




                     FF




       Wage-rental
       ratio: w/r         CC

                               aLF
                               aLC
Wage-rental
ratio: w/r



              CC


                   FF


                        w/r




                        Land-labor
                        ratio: T/L
Figure 4.5
                 Predictions
           Comparative Advantage
• An economy with a high ratio of land to labor services
  is predicted to have a high output of food relative to
  cloth and a low price of food relative to cloth.
   – It will be relatively efficient at (have a comparative advantage
     in) producing food.
   – It will be relatively inefficient at producing cloth.

• An economy is predicted to be relatively efficient at
  producing goods that are intensive in the factors of
  production in which the country is relatively well
  endowed.
Comparative Advantage and Resources

• Suppose that the domestic country has an abundant
  amount of labor services relative to land.
   – The domestic country is abundant in labor services and the
     foreign country is abundant in land: L/T > L*/ T*
   – Likewise, the domestic country is scarce in land and the
     foreign country is scarce in labor services.
   – However, the countries are assumed to have the same
     technology and same consumer tastes.
• Because the domestic country is abundant in labor
  services, it will be relatively efficient at producing
  cloth because cloth is labor intensive.
      Heckscher-Ohlin vs Ricardo

• Unlike the Ricardian model, H-O predicts a
  country to be relatively efficient at (have a
  comparative advantage in) producing goods
  that are intensive in its abundant factors of
  production.
• An economy is predicted to export goods that
  are intensive in its abundant factors of
  production and import goods that are
  intensive in its scarce factors of production.
               Predictions
      Relative Price Equalization

• Heckscher-Ohlin model predicts that prices
  will be equalized across trading countries.
  – Home is the US
     • 9.399/.300 = 31.33 sq km/person


  – Foreign is China
     • 9.561/1.3 = 7.35 sq km/person
            Production Possibilities Frontier
Output QF         US 9.399/.300 = 31.33




                                          Output QC
            Production Possibilities Frontier
Output QF         China 9.561/1.3 = 7.35




                                           Output QC
Relative Price
PC/PF



                 RS
                 US


                      RSWorld
  (PC/PF)
                                RS*
                                China
  (PC/PF)W

  (PC/PF)*
                                RD
                                      World




                                 Relative Quantity
                                 QC/QF
 Figure 4.11
        Heckscher-Ohlin vs Ricardo

• Like the Ricardian model, the Heckscher-
  Ohlin model predicts a convergence of
  relative prices with trade.
  – With trade, the relative price of cloth is predicted to
    rise in the labor abundant (domestic) country and
    fall in the labor scarce (foreign) country.
     • In the domestic country, the rise in the relative price of
       cloth leads to a rise in the relative production of cloth and
       a fall in relative consumption of cloth; the domestic
       country becomes an exporter of cloth and an importer of
       food.
     • The decline in the relative price of cloth in the foreign
       country leads it to become an importer of cloth and an
       exporter
       of food.
            Predictions
    Increased Welfare from Trade

• A country can afford to consume more of both
  goods with trade and the country as a whole
  is made better off.
    Trade in the Heckscher-Ohlin Model


• Over time, the value of goods consumed is
  constrained to equal the value of goods produced for
  each country.
              PCDC + PFDF = PCQC + PFQF
     where DC represents domestic consumption demand of cloth
     and DF represents domestic consumption demand of food
              (DF – QF) = (PC /PF)(QC – DC)


            Quantity     Price of exports      Quantity
            of imports   relative to imports   of exports
     Trade in the Heckscher-Ohlin Model


         (DF – QF) = (PC /PF)(QC – DC)
• This equation is the budget constraint for an
  economy, and it has a slope of – (PC /PF)
           (DF – QF) – (PC /PF)(QC – DC) = 0
   Budget Constraint
for a Trading Economy




         4-30
     Trade in the Heckscher-Ohlin Model

• The budget constraint touches the PPF so a
  country can always afford to consume what it
  produces.
• However, a country need not consume
  only the goods and services that it produces
  with trade.
  – Exports and imports can be greater than zero.
• Furthermore, a country can afford to
  consume more of both goods with trade and
  the country as a whole is made better off.
Trading Equilibrium
Trade Expands the Economy’s
  Consumption Possibilities




            4-33
              Predictions
        Factor Price Equalization

• Because Heckscher-Ohlin model predicts that
  prices will be equalized across trading
  countries, it therefore predicts that factors of
  production will produce and export a certain
  quantity goods until factor prices are
  equalized.
   – In other words, a predicted value of services from
     factors of production will be embodied in a
     predicted volume of trade between countries.
   Stolper-Samuelson Effect
• The ratio of relative output prices PC/PF
  relates to the ratio of relative input costs
  w/r.
• PC = aLCw + aTCr
• PF = aLFw + aTFr
            Heckscher-Ohlin vs Ricardo
• Unlike the Ricardian model, the Heckscher-Ohlin model predicts
  that input (factor) prices will be equalized among countries that
  trade.
• Relative output prices are equalized
    – because of the direct relationship between output prices and factor
      prices, factor prices are also equalized.
    – a rise in the price of cloth raises the purchasing power of domestic
      workers, but lowers the purchasing power of domestic land owners.
    – trade increases the demand of goods produced by abundant
      factors, indirectly increasing the demand of the abundant factors
      themselves, raising the prices of the abundant factors across
      countries.
• But factor prices are not really equal across countries: will
  converge across countries if:
    –   produce same goods
    –   possess same technology
    –   no barriers
    –   short run
                                  w/r




                SS

                                                            CC

                                    w/r2                                  FF

What happens if                                                      What happens if
                                        w/r1
PC/PF changes?                                                       T/L changes?


PC/PF
                PC/PF2   PC/PF1                TC/LC1   TF/LF1                 Land-labor
                                                                               ratio: T/L
   Figure 4.7                                      TC/LC2        TF/LF2
               Predictions
              Biased Growth
•   Rybczynski Effect
•   With constant relative prices, an increase in
    the relative supply of one factor causes a
    biased expansion of production possibilities
    of the good using that factor intensively.
    –   Increase in T --> increase QF
    –   Increase in L --> increase QC
•   A country will tend to be relatively effective
    at production of goods where it can exploit
    its abundant factors.
          Cloth Production

TC




                         C




     0C                      LC
          Food Production

TF

          F




     0F                     LF
             LF       LF1       0F
 TC




                            C
 TC1                                 TF1



                  F
                                     TF


      0C              LC1       LC

Figure 4.8
     Output QF      Production Possibilities Frontier




              QF'           Slope' = - MPLF /MPLC = -PC/PF


              QF
                          Slope = - MPLF /MPLC = -PC/PF




                       QC QC                              Output QC


Figure 4.10
           Predictions
          Income Distribution
• With constant relative factor supplies,
  an increase in relative price (RP)
  favors the intensive factor by more
  than the change in RP and decreases
  returns to the non-intensive factor.
         Income distribution
• A direct effect -
  – relative wage rate (w/r) increases as more labor is
    demanded in Cloth production.
• An indirect effect -
  – as land is substituted for the more expensive
    labor, the T/L ratio increases in both sectors.
    Marginal product of land and therefore
    landowners’ real rent decreases in terms of both
    goods. Marginal product of labor increases and
    therefore workers’ real wage increases in terms of
    both goods.
                           Marginal Product of Land
     Marginal product of
     land




     r1

r2
                                           MP T




                      Q1    Q2
                                                  Land Input T
                           Marginal Product of Labor
     Marginal product of
     labor




     w2

w1
                                           MPL




                      Q2    Q1
                                                  Labor Input L
                  Predictions
                 Income Inequality

•   The Heckscher-Ohlin model predicts that
    owners of abundant factors will gain from
    trade and owners of scarce factors will lose
    from trade.
    –   wages of unskilled workers should increase in
        unskilled labor abundant countries relative to
        wages of skilled labor
    –   in some cases the reverse has occurred:
        •   compared to the U.S. and Canada, Mexico is abundant
            in unskilled workers.
        •   wages of skilled labor have increased more rapidly in
            Mexico than wages of unskilled labor.
Trade and Income Distribution
• Changes in income distribution occur with every
  economic change, not only international trade.
   – Changes in technology, changes in consumer preferences,
     exhaustion of resources and discovery of new ones all affect
     income distribution.
   – Economists put most of the blame on technological change
     and the resulting premium paid on education as the major
     cause of increasing income inequality in the US.

• It would be better to compensate the losers from
  trade (or any economic change) than prohibit trade.
   – The economy as a whole does benefit from trade.



  More later on this topic…
             Empirical Evidence of the
              Heckscher-Ohlin Model

• Tests on US data
   – Leontief found that U.S. exports were less capital-intensive
     than U.S. imports, even though the U.S. is the most capital-
     abundant country in the world: Leontief paradox.
   Factor Content of U.S.
Exports and Imports for 1962
             Empirical Evidence of the
              Heckscher-Ohlin Model

• Tests on US data
   – Leontief found that U.S. exports were less capital-intensive
     than U.S. imports, even though the U.S. is the most capital-
     abundant country in the world: Leontief paradox.
• Tests on global data
   – Bowen, Leamer, and Sveikauskas tested the Heckscher-
     Ohlin model on data from 27 countries and confirmed the
     Leontief paradox on an international level.
Testing the Heckscher-Ohlin Model
             Empirical Evidence of the
              Heckscher-Ohlin Model

• Tests on US data
   – Leontief found that U.S. exports were less capital-intensive
     than U.S. imports, even though the U.S. is the most capital-
     abundant country in the world: Leontief paradox.
• Tests on global data
   – Bowen, Leamer, and Sveikauskas tested the Heckscher-
     Ohlin model on data from 27 countries and confirmed the
     Leontief paradox on an international level.
• Tests on manufacturing data between low/middle
  income countries and high income countries.
   – This data lends more support to the theory.
  Skill Intensity and the Pattern of U.S.
       Imports from Two Countries




Source: John Romalis, “Factor Proportions and the Structure of Commodity Trade,” American Economic
Review, March 2004.
Changing Patterns of Comparative
          Advantage
Changing Patterns of Comparative
          Advantage
              Testing H-O
            Leontief Paradox
• US exports are less capital intensive
  than US imports
  – Human capital
  – R&D
  – Natural resources
  – Factor-intensity reversals
                      Summary

•   Substitution of factors used in the production
    process is represented by a curved PPF.
    –   When an economy produces a low quantity of a good, the
        opportunity cost of producing that good is low and the
        marginal productivity of resources used to produce that
        good is high.
    –   When an economy produces a high quantity of a good, the
        opportunity cost of producing that good is high and the
        marginal productivity of resources used to produce that
        good is low.
•   When an economy produces the most it can from its
    resources, the opportunity cost of producing a good
    equals the relative price of that good in markets.
                       Summary
•   If the relative price of a good increases, then the
    real wage or real lending/renting rate of the factor
    used intensively in the production of that good is
    predicted to increase,
    –   while the real wage and real lending/renting rates of other
        factors of production are predicted to decrease.
•   If output prices remain constant as the amount of a
    factor of production increases, then the supply of
    the good that uses this factor intensively is
    predicted to increase, and the supply of other goods
    is predicted to decrease.
•   An economy is predicted to export goods that are
    intensive in its abundant factors of production and
    import goods that are intensive in its scarce factors
    of production.
                    Summary
•   The Heckscher-Ohlin model predicts that relative
    output prices and factor prices will equalize, neither
    of which occurs in the real world.
•   The model predicts that owners of abundant factors
    gain, but owners of scarce factors lose with trade.
•   A country as a whole is predicted to be better off
    with trade, even though owners of scarce factors
    are predicted to be worse off without compensation.
•   Empirical support of the Heckscher-Ohlin model is
    weak except for cases involving trade between high
    income countries and low/middle income countries.
                    Review
                Pattern of Trade
• Trade is caused by:
  – Ricardo
    • differences in relative labor productivity
      (technology of labor)
  – H-O
    • endowments of factors
                    Review
               Income Distribution
• Effect of trade on welfare
  – Ricardo
     • general benefits?
  – H-O
     • favors the intensive factor by more than the
       change in RP and decreases returns to the non-
       intensive factor
    These are special cases

• Ricardo good for pattern of trade
• H-O good for income distribution
   Chapter 5

Standard Trade Model
                     Introduction
•   The standard trade model combines ideas from the
    Ricardian model and the Heckscher-Ohlin model.
    1. Differences in labor services, 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 function.
    4. National relative supply functions determine world a
       relative supply function, which along with world relative
       demand determines an equilibrium under international
       trade.
       Standard Trade Model
              Four Relationships
1) Economy produces where PPF (summary of
   productive capacity) is tangent to isovalue or RP line
2) Indifference curves describe tastes and demand is
   where curve is tangent to isovalue or RP line
3) Improvement of terms of trade (an increase in RP of
   exports) increases welfare
4) Two country analysis determines world RP
     Food QF




               1   Isovalue line PC/PF




                               VV




                                         Cloth QC

Figure 5.1
       Increase in the Relative
Price of Cloth Affects Relative Supply




                 5-68
  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)?
  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).
  – Each consumer has his or her own preferences,
    but we pretend that we can represent the
    preferences of an average consumer that
    represents all consumers
 Food QF




               D1


Food Imports
                      Q1




                               V V Isovalue line PC/PF




               Cloth Exports             Cloth QC
                  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 by moving to
     another 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.
   – The substitution effect is represented by a moving
     along a given indifference curve.
     Food QF

                  Income effect
                                   D2
                                          Substitution effect
                          D1


   Food Imports
                                  Q1




                                                2     V V1 Isovalue line PC/PF



                                                      V V2

                          Cloth Exports                          Cloth QC

Figures 5.2-5.4
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.
  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.
Relative Price
PC/PF



                 RS



                      RSWorld
  (PC/PF)
                                RS*
  (PC/PF)W

  (PC/PF)*
                                RD
                                      World




                                 Relative Quantity
                                 QC/QF
      Standard Trade Model
            Three Applications
• 1) Economic growth and a shift of RS
  – only with a big country
  – export biased growth worsens terms of
    trade
  – import biased growth improves terms of
    trade
  – immiserizing growth - increase in welfare from
    growth < loss of lower terms of trade
  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 integrated in the world
  economy?
• The standard trade model gives us precise
  answers to these questions.
Effects of Economic 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.
  – 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 (ex., an
    increase in the labor force, arable land, or the
    capital stock) causes biased growth.
Biased Growth
Effects of Economic 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 domestic or
     foreign country) will lower the price of cloth relative to the
     price of food 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 price of cloth relative to the
     price of food and raise the terms of trade for cloth exporters.
   – Suppose that the domestic country exports cloth and
     imports food.
Relative Price
PC/PF



                 RS



                      RSWorld
  (PC/PF)
                                RS
  (PC/PF)W

  (PC/PF)
                                RD
                                     World




                                 Relative Quantity
                                 QC/QF
Growth and Relative Supply
Growth and Relative Supply
  Effects of Economic Growth
• Export-biased growth is growth that expands a
  country’s production possibilities disproportionally
  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,
     generally reducing its
     welfare and increasing the welfare of
     foreign countries.
  Effects of Economic Growth
• Import-biased growth is growth that expands a
  country’s production possibilities disproportionally 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,
     generally increasing its
     welfare and decreasing the welfare of
     foreign countries.
      Has Growth in Asia Reduced
 the Welfare of High Income Countries?

• The standard trade model predicts that import biased
  growth in China reduces the U.S. terms of trade and
  the standard of living in the U.S.
   – Import biased growth for China would occur in sectors that
     compete with U.S. exports.

• But this prediction is not supported by data: there
  should be negative changes in the terms of trade for
  the U.S. and other high income countries.
   – In fact, changes in the terms of trade for high income
     countries have been positive and negative for developing
     Asian countries.
 Average Annual Percent
Changes in Terms of Trade
      Standard Trade Model
            Three Applications
• 2) Income transfers and a shift of RD
   – war reparations
   – foreign aid
   – capital flight
• How do transfers of income across countries
  affect relative demand and the terms of
  trade?
  – Differences in marginal propensity to consume
Effects of International Transfers of Income



• After the transfer of income from the domestic
  country,
  – demand of foreign goods could fall in the domestic
    country and demand of domestic goods could rise
    in the foreign country,
  – so the relative demand might not decrease and
    the terms of trade might not fall.
Effects of International Transfers of Income



• How much does demand of 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 spend on its own goods than on
    imports, demand of its own goods will rise
    more than demand of imports from the
    domestic country.
Effects of International Transfers of Income


 • How much does demand of 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 of its own goods will fall more
      than demand of imports from the foreign country.
 • If each country has a higher marginal
   propensity to spend on its own products,
   relative demand would decrease after a
   transfer of income from the domestic country.
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, other barriers,
  and preferences cause domestic residents to
  favor domestic goods.
• We predict that the relative demand will
  decrease with a transfer of income,
  decreasing the terms of trade for the donor
  nation.
Effects of International Transfers of Income


• In addition, production of non-traded goods
  and services may change, affecting the
  relative supply of traded goods and
  reinforcing the change in the terms of trade.
  – 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 and production of non-traded
    goods in the donor country, so that these
    resources can be used in its export sector.
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 the foreign country, 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.
Relative Price
PC/PF




                 RS

   (PC/PF)

  (PC/PF)W
                                    RD
  (PC/PF)
                           RD
                                World
                      RD


                           Relative Quantity
                           QC/QF
     Standard Trade Model
           Three Applications
• 3) Tariffs and subsidies
  – separates internal from external RP
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 the terms of trade and
    therefore national welfare.
Import Tariffs and Export Subsidies

  • Import tariffs and export subsidies drive a
    wedge between prices in world markets (or
    external prices) and prices in domestic
    markets (or internal prices).
    – Since exports and imports are traded in world
      markets, the terms of trade measures relative
      external prices.
 Import Tariffs and Distribution of Income
             Across Countries

• If the domestic country imposes a tariff on food
  imports, the price of food relative to price cloth that
  domestic individuals and institutions face rises.
   – Likewise, the price of cloth relative to the price of food that
     domestic individuals and institutions face falls.
   – Domestic producers will receive a lower relative price of
     cloth, and therefore will be more willing to switch to food
     production: relative supply will decrease.
   – Domestic consumers will pay a lower relative price of cloth,
     and therefore be more willing to switch to cloth consumption:
     relative demand will increase.
Relative Price
PC/PF            Tariff on Food
                         Improves Home’s Terms of Trade

                              RS’

  (PC/PF)’’
                                    RS

   (PC/PF)’

  (PC/PF)W
                                                 RD’
                                         RD
                                              World




                                          Relative Quantity
                                          QC/QF
 Import Tariffs and Distribution of Income
             Across Countries

• 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 of
  the 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 national
     welfare at the expense of foreign countries may exist.
  Export Subsidies and Distribution of
      Income Across Countries

• If the domestic country imposes a subsidy
  on cloth exports, the price of cloth relative to
  price food that domestic individuals and
  institutions face rises.
   – Domestic producers will receive a higher relative
     price of cloth when they export, and therefore will
     be more willing to switch to cloth production for
     export: relative supply will increase.
   – Domestic consumers must pay a higher relative
     price of cloth to producers who have the option of
     exporting, and therefore will be more willing to
     switch to food consumption: relative demand will
     decrease.
Relative Price
PC/PF            Subsidy on Cloth
                        Worsens Home’s Terms of Trade




                                 RS
                                        RS’

  (PC/PF)W

   (PC/PF)’
   (PC/PF)’’                             RD
                                              World
                                  RD’



                                          Relative Quantity
                                          QC/QF
    Export Subsidies and Distribution of
        Income Across Countries


• When the domestic country imposes an
  export subsidy, the terms of trade decreases
  and the welfare of the country decreases to
  the benefit of the foreign country.
   Import Tariffs, Export Subsidies and
 Distribution of Income Across Countries


• The two country, two good model predicts
  that
  – an import tariff by the domestic country can
    increase domestic welfare at the expense of the
    foreign country.
  – an export subsidy by the domestic country
    reduces domestic welfare to the benefit of the
    foreign country.
     Import Tariffs and Export Subsidies
             in Other Countries

• But we have ignored the effects of tariffs and
  subsidies that occur in a world with many countries
  and many goods:
   – A foreign country may subsidize the export of a good that the
     US also exports, which will reduce the price for the U.S. in
     world markets and decrease its terms of trade.
       • The EU subsidizes agricultural exports, which reduce the price
         that American farmers receive for their goods in world markets.
   – A foreign country may put a tariff on an imported good that
     the U.S. also imports, which will reduce the price for the U.S.
     in world markets and increase its terms of trade.
     Import Tariffs and Export Subsidies
             in Other Countries


• Export subsidies by foreign countries on goods that
   – the U.S. imports reduce the world price of U.S. imports and
     increase the terms of trade for the U.S.
   – the U.S. also exports reduce the world price of U.S. exports
     and decrease the terms of trade for the U.S.

• Import tariffs by foreign countries on goods that
   – the U.S. exports reduce the world price of U.S. exports and
     decrease the terms of trade for the U.S.
   – the U.S. also imports reduce the world price of U.S. imports
     and increase the terms of trade for the U.S.
Import Tariffs and Export Subsidies

• Export subsidies on a good decrease the
  relative world price of that good by increasing
  relative supply of that good and decreasing
  relative demand of that good.
• Import tariffs on a good decrease the relative
  world price of that good (and increase the
  relative world price of other goods) by
  increasing the relative supply of that good
  and decreasing the relative demand of that
  good.
      Import Tariffs, Export Subsidies, and
     Distribution of Income Within a Country

• Because of changes in relative prices,
  import tariffs and export subsidies have effects on
  income distribution among producers within a
  country.
• Generally, a domestic import tariff increases income
  for domestic import-competing producers by allowing
  the price of their goods to rise to match increased
  import prices, and it shifts resources away from the
  export sector.
• Generally, a domestic export subsidy increases
  income for domestic exporters, and it shifts resources
  away from the import-competing sector.
                   Summary
•   A change in relative prices, say due to trade, causes
    an income effect and a substitution effect.
•   The terms of trade refers to the price of exports
    relative to the price of imports in world markets.
•   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.
                     Summary
•   The effect of international transfers of income depend on
    the marginal propensity to spend on domestic goods, but
    generally the relative demand of a donor will decrease
    with such transfers, causing a decrease in its terms of
    trade.
•   When the domestic country imposes an import tariff, its
    terms of trade increases and its welfare may increase.
•   When the domestic country imposes an export subsidy,
    its terms of trade decreases and its welfare decreases.
•   Generally, a domestic import tariff increases income for
    domestic import-competing producers and shifts
    resources away from the export sector.
•   Generally, a domestic export subsidy increases income
    for domestic exporters
    and shifts resources away from the
    import-competing sector.