The Standard Trade Model

The Standard Trade Model

• Addresses real-world trade problems by combining elements of the Ricardian and Heckscher-Ohlin models
• Can be used to Measure production and consumption values, assess effects on welfare of trade etc

Introduction

• Differences in labor, skills, capital, land, technology, and productivity between nations create production differences and trade gains
• Production possibility frontiers represent these productive capacities
• A country's PPF determines its relative supply curve
• National relative supply curves form the basis of the world relative supply
• Equilibrium in international trade is determined by the world relative demand

The Value of Production

• Two-good model with food (F) and cloth (C)
• Economy maximizes production possibilities by choosing the value of output V on the PPF
• V = PCQC + PFQF defines the value of output in a two-good model
• The isovalue line represents the eqation when the value is constant
• The slope of the isovalue line, with QF on the vertical axis, equals –(PC/PF), which represents the relative price of cloth
• Changes in relative prices cause the isovalue line's slope to change accordingly
• Concave PPFs require at least two input factors with a production technology allowing substitutability

The Value of Consumption

• The economy's consumption value equals its production value, assuming no international borrowing or lending
• PCDC + PFDF = PCQC + PFQF = V, D represents consumption
• Production choices derive from the economy's PPF and output prices
• Consumer preferences and prices drive consumption choices, illustrated by indifference curves
• It is assumed that representative consumer's choices show that income distribution changes, in particular regarding capital income, are negligible.

Prices and the Value of Consumption

• Prices determine both production (supply) and consumption (demand)
• When the price of cloth increases compared to food, there is an income and substitution effect
• Rise in cloth price relative to food means a better economy if it exports cloth
• A higher indifference curve results, meaning that more food can be imported
• Higher cloth prices will influence the demand curve for cloth vs food as demand dictates willingness to buy
• The welfare (income) change when the price of one good relative to the price of another changes indicates the income effect
• Graphically demonstrated by shifting the indifference curve
• The move from one good for another due to price change indicates the substitution effect
• Graphically demonstrated by moving along an indifference curve

Welfare and the Terms of Trade

• Terms of trade quantify the price of exports relative to imports
• If Home exports cloth and imports food, its terms of trade are Pc/PF
• Foreign terms of trade are PF/PC
• Increases in cloth price improves terms of trade
• Higher export prices allows the country to afford more imports

Determining Relative Prices

• Find the price of cloth relative to food through relative supply and relative demand
• Relative supply considers the world supply of cloth relative to the world supply of food at each relative price.
• Relative demand considers the world demand for cloth relative to the world demand for food at each relative price.
• World quantities are the aggregate amounts from domestic and foreign countries.

The Effects of Economic Growth

• Open economies should consider effects of economic growth
• If growth in China affects standard of living in the UK
• If growth in integrated world economy matters

The Effects of Economic Growth (cont.)

• Economic growth elsewhere is bad for the UK as they lose out on the market
• Economic growth elsewhere is good for the UK as it means larger markets exports
• The standard trade model clarifies this ambiguity
• Growth is usually biased toward specific sectors, causing relative supply to shift
• Ricardian model: technological progress in one sector causes biased growth
• Heckscher-Ohlin model: increases in production create the biased growth
• Biased cloth industry growth, home or foreign, lowers the relative price of cloth and the terms of trade for cloth exporters
• Biased food industry growth, home or foreign, raises the relative price of cloth and the terms of trade for cloth exporters
• Export-biased growth expands export production
• Import-biased growth expands import production
• Export-biased growth reduces the country's trade and reduces welfare and increases other economies' welfare
• Import-biased growth increases welfare

Has Growth in Asia/China Reduced the Welfare of High-Income Countries?

• The standard trade model predicts that import-biased growth in China reduces the UK terms of trade and the standard of UK living
• Data does not support this, particularly with regard to export sectors that compete with the UK
• High-income countries have positive trade changes from 1986-1995 while Asian countries show negative trade changes
• Asian countries have experienced export-biased growth, but are not necessarily import-biased
• Our model is too simplistic and assumes countries both compete and produce goods

Immiserising Growth

• Export-biased growth by poorer countries reduces the terms of trade so much such that they would have been better not growing
• Has strong effects on terms of trade

The Effects of International Transfers of Income

• Considers demand side effects
• Important to observe the effect of income transfers
• Transfers may influence trade and relative demand such as reparations and international loans

The Transfer Problem

• Debate between Bertil Ohlin and John Maynard Keynes around Germany following WWI
• How much of a burden were payments on Germany
• Nominal sums understate the sum as the terms of trade become less strong

The Effects of International Transfers of Income (cont.)

• The RD curve does not shift if the countries both spend the same value
• Propensities to spend will have trade effects
• Home has a higher marginal propensity, then transfer payments reduce relative demand.
• Donor country is better when foreign aid is higher due to terms of trade

The Effects of International Transfers of Income (cont.)

• Each country has a higher propensity for their domestic countries, creating left shifts after income from the domestic
• Countries mostly spend on their domestic products, which supports Keynes

Import Tariffs and Export Subsidies

• Import tariffs are taxes levied on imports, while export subsidies are payments given to domestic exporters.
• Used for income distribution but influence national welfare

Import Tariffs and Export Subsidies (cont.)

• Tariffs and subsidies determine wedge of price and internal and external markets
• Terms of trade indicates the product's exports relative to its impots
• Terms intend to measure at which countries exchange

Import Tariffs and Distribution of Income Across Countries

• A 20% tariff on food imports makes the internal price 20% higher.
• Consumer and product face a lower external market
• Producer receives a lower price and consumers consumes towards cloth
• The higher rise to the price improves trades at cost of outside parties

Import Tariffs and Distribution of Income Across Countries (cont.)

• Increased tariffs increase welfare, which improves the terms of trade and can benefit small countries
• The two-country model predicts an import tariff increases Home welfare.
• This requires small distortions within economy

Export Subsidies and Distribution of Income Across Countries

• If a subsidy on cloth exports exists, this will impact the food markets
• Producers and consumers will receive higher relative price of cloth
• As a reult, trade will be worse than other outside nations

Export Subsidies and Distribution of Income Across Countries (cont.)

• Creates clear effects
• Foreign leaves better
• Loss is caused by the countries terms

Import Tariffs and Export Subsidies with Multiple Countries and Goods

• Only considered one product
• Tariffs will influence global trades of multiple markets
• Foreign decreases the amount of trade by decreasing the terms of trade of exporting goods

Import Tariffs, Export Subsidies and Distribution of Income Within a Country

• Tariffs and trades have effects a country based on their economy
• Tariff increases good prices
• Shift trade balance

Summary

• Changes in prices causes effect and trade
• Exports are terms associated with higher prices for consumers
• Imports reduce the terms creating wealth and increase outside amount
• International trade relies on willingness to invest on the local side
• Tariffs can be strong