ECO2008 International Economics Week 8 PDF

ECO2008 International Economics The Standard Trade Model Week 8 Brian Varian Introduction (1 of 2) Standard trade model is a general model that includes Ricardian, specific factors, and Heckscher-Ohlin models as special cases. – Two goods, food (F) and cloth (C). – E...

ECO2008 International Economics The Standard Trade Model Week 8 Brian Varian Introduction (1 of 2) Standard trade model is a general model that includes Ricardian, specific factors, and Heckscher-Ohlin models as special cases. – Two goods, food (F) and cloth (C). – Each country’s PPF is a smooth curve. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Introduction (2 of 2) Differences in labor, human capital, physical capital, land, and technology between countries cause differences in production possibility frontiers. A country’s PPF determines its relative supply function. National relative supply functions determine a world relative supply function, which along with world relative demand determines the equilibrium under international trade. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Production Possibilities and Relative Supply (1 of 2) What a country produces depends on the relative price of PC cloth to food. PF An economy chooses its production of cloth QC and food QF to maximize the value of its output V  PCQC  PF QF , given the prices of cloth and food.  PC  – The slope of an isovalue line equals   .  PF  – Produce at point where PPF is tangent to isovalue line. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 6.1 Relative Prices Determine the Economy’s Output An economy whose production possibility frontier is TT will produce at Q, which is on the highest possible isovalue line. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Production Possibilities and Relative Supply (2 of 2) Relative prices and relative supply: – An increase in the price of cloth relative to food PC PF makes the isovalue line steeper. – Production shifts from point Q1 to point Q 2. – Supply of cloth relative to food QC rises. QF – Relative supply of cloth to food increases with the relative price of cloth to food. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 6.2 How an Increase in the Relative Price of Cloth Affects Relative Supply In panel (a), the isovalue lines become steeper when the relative price of cloth rises. As a result, the economy produces more cloth and less food. Panel (b) shows the relative supply curve associated with the production possibilities frontier TT. The rise in the relative price of cloth leads to an increase in the relative production of cloth. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Relative Prices and Demand (1 of 6) The value of the economy’s consumption must equal the value of the economy’s production. PC DC  PF DF  PCQC  PF QF V Assume that the economy’s consumption decisions may be represented as if they were based on the tastes of a single representative consumer. An indifference curve represents combinations of cloth and food that leave the consumer equally well off (indifferent). Copyright © 2018 Pearson Education, Ltd. All rights reserved. Relative Prices and Demand (2 of 6) Indifference curves – are downward sloping — if you have less cloth, then you must have more food to be equally satisfied. – that lie farther from the origin make consumers more satisfied — they prefer having more of both goods. – become flatter when they move to the right — with more cloth and less food, an extra yard of cloth becomes less valuable in terms of how many calories of food you are willing to give up for it. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Relative Prices and Demand (3 of 6) Consumption choice is based on preferences and relative price of goods: – Consume at point D where the isovalue line is tangent to the indifference curve. Economy exports cloth — the quantity of cloth produced exceeds the quantity of cloth consumed — and imports food. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 6.3 Production, Consumption, and Trade in the Standard Model The economy produces at point Q, where the production possibility frontier is tangent to the highest possible isovalue line. It consumes at point D, where that 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Relative Prices and Demand (4 of 6) Relative prices and relative demand – An increase in the relative price of cloth PC causes PF consumption choice to shift from point D1 to point D 2 DC – Demand for cloth relative to food falls. DF – Relative demand for cloth to food falls as the relative price of cloth to food rises. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 6.4 Effects of a Rise in the Relative Price of Cloth and Gains from Trade In panel (a), the slope of the isovalue lines is equal to minus the relative price of cloth. As a result, when that relative price rises, all isovalue lines become steeper. Production shifts from Q1 to Q2 and consumption shifts from D1 to D2. If the economy cannot trade, then it produces and consumes at point D3. Panel (b) shows the effects of the rise in the relative price of cloth on relative production (move from 1 to 2) and relative demand (move from 1 to 2). If the economy cannot trade, then it consumes and produces at point 3. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Relative Prices and Demand (5 of 6) An economy that exports cloth is better off when the price of cloth rises relative to the price of food: – the isovalue line becomes steeper and a higher indifference curve can be reached. A higher relative price of cloth means that more calories of food can be imported for every yard of cloth exported. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Relative Prices and Demand (6 of 6) If the economy cannot trade: – The relative price of cloth to food is determined by the intersection of relative demand and relative supply for that country. – Consume and produce at point D 3 where the indifference curve is tangent to the production possibilities frontier. Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Welfare Effects 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, the terms of trade rise. Because a higher relative 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 decline in the terms of trade decreases a country’s welfare. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Determining Relative Prices To determine the price of cloth relative to the price food, use relative supply and relative demand. – World supply of cloth relative to food at each relative price. – World demand for cloth relative to food at each relative price. – World quantities are the sum of quantities from the two countries in the world: QC  QC   and  DC  DC  . Q F  QF   D F  DF   Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 6.6a Equilibrium Relative Price with Trade and Associated Trade Flows Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Effects of Economic Growth (1 of 5) 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 is integrated in the world economy? The standard trade model gives us precise answers to these questions. Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Effects of Economic Growth (2 of 5) 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. – In the Ricardian model, technological progress in one sector causes biased growth. – In the Heckscher-Ohlin model, an increase in one factor of production causes biased growth. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 6.7 Biased Growth (1 of 2) Growth is biased when it shifts production possibilities out more toward one good than toward another. In case (a), growth is biased toward cloth, while in case (b), growth is biased toward food. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 6.7 Biased Growth (2 of 2) The associated shifts in the relative supply curve are shown in panel (c): shift to the right from RS1 to RS 2  when growth is biased toward cloth, and shift to the left from RS to RS  1 3 when growth is biased toward food. Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Effects of Economic Growth (3 of 5) 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 home 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 home 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 home country exports cloth and imports food. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 6.8 Growth and World Relative Supply Growth biased toward cloth shifts the RS curve for the world to the right (a), while growth biased toward food shifts it to the left (b). Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Effects of Economic Growth (4 of 5) Export-biased growth is growth that expands a country’s production possibilities dispro-portionately in that country’s export sector. – 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 production possibilities dispro-portionately in that country’s import sector. – Biased growth in cloth production in the foreign country is import-biased growth for the foreign country. Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Effects of Economic Growth (5 of 5) Export-biased growth reduces a country’s terms of trade, reducing its welfare and increasing the welfare of foreign countries. Import-biased growth increases a country’s terms of trade, increasing its welfare and decreasing the welfare of foreign countries. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Import 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 drive a wedge between prices in world markets and prices in domestic markets. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Relative Price and Supply Effects of a Tariff (1 of 2) If the home country imposes a tariff on food imports, the price of food relative to the price of cloth rises for domestic consumers. – Likewise, the price of cloth relative to the price of food falls for domestic consumers. – Domestic producers will receive a lower relative price of cloth, and therefore will be more willing to switch to food production: relative supply of cloth will decrease. – Domestic consumers will pay a lower relative price for cloth, and therefore will be more willing to switch to cloth consumption: relative demand for cloth will increase. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Relative Price and Supply Effects of a Tariff (2 of 2) When the home country imposes an import tariff, the terms of trade increase and the welfare of the country may increase. The magnitude of this effect depends on the size of the home country relative to the world economy. – If the country is a 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 may maximize national welfare at the expense of foreign countries. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 6.10 Effects of a Food Tariff on the Terms of Trade An import tariff on food imposed by Home both reduces the relative supply of cloth from RS to RS  and increases the relative demand 1 2 from RD1 to RD2  for the world as1 a whole. 2 As a result, the relative  PC   PC  price of cloth must rise from   to  .  PF   PF  Copyright © 2018 Pearson Education, Ltd. All rights reserved. Effects of an Export Subsidy (1 of 2) If the home country imposes a subsidy on cloth exports, the price of cloth relative to the price of food rises for domestic consumers. – Domestic producers will receive a higher relative price of cloth when they export, and therefore will be more willing to switch to cloth production: relative supply of cloth will increase. – Domestic consumers must pay a higher relative price of cloth to producers, and therefore will be more willing to switch to food consumption: relative demand for cloth will decrease. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Effects of an Export Subsidy (2 of 2) When the home country imposes an export subsidy, the terms of trade decrease and the welfare of the country decreases to the benefit of the foreign country. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 6.11 Effects of a Cloth Subsidy on the Terms of Trade An export subsidy on cloth has the opposite effects on relative supply and demand than the tariff on food. Relative supply of cloth for the world rises, while relative demand for the world falls. Home’s terms of trade decline as the relative price of cloth falls 1 2  PC   PC  from   to  .  PF   PF  Copyright © 2018 Pearson Education, Ltd. All rights reserved. Implications of Terms of Trade Effects: Who Gains and Who Loses? (1 of 4) The standard trade model predicts that – an import tariff by the home country can increase domestic welfare at the expense of the foreign country. – an export subsidy by the home country reduces domestic welfare to the benefit of the foreign country. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Implications of Terms of Trade Effects: Who Gains and Who Loses? (2 of 4) Additional effects of tariffs and subsidies that can occur in a world with many countries and many goods: – A foreign country may subsidize the export of a good that the U.S. 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Implications of Terms of Trade Effects: Who Gains and Who Loses? (3 of 4) 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Implications of Terms of Trade Effects: Who Gains and Who Loses? (4 of 4) 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Summary (1 of 2) 1. The terms of trade refers to the price of exports relative to the price of imports. 2. Export-biased growth reduces a country’s terms of trade, reducing its welfare and increasing the welfare of foreign countries. 3. Import-biased growth increases a country’s terms of trade, increasing its welfare and decreasing the welfare of foreign countries. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Summary (2 of 2) 4. When a country imposes an import tariff, its terms of trade increase and its welfare may increase. 5. When a country imposes an export subsidy, its terms of trade decrease and its welfare decreases. Copyright © 2018 Pearson Education, Ltd. All rights reserved.