IBE303 International Economic Lecture 4

Lecture 4July 19th 2010Saksarun (Jay) Mativachranon

Announcement•No class next week (July 26th, 2010)!•Midterm exam is on August 2nd, 2010

▫8.45 – 10.15•No quiz today

•Lecture available at▫ http://www.slideshare.net/saark/ibe303-internationa-lect

ure-4

http://www.slideshare.net/saark/ibe303-internationa-lecture-4

http://www.slideshare.net/saark/ibe303-internationa-lecture-4

Response from regulations

Response from regulations•Creative Response

▫Firms subject to regulation may attempt to avoid the regulation or minimize the costs by conform to the letter, but not the intent

•Feedback Effect▫Consumers’ behavior change as a result of

regulations; undermining the original intent of the regulation

Terms of Trade

Assumptions of the Ricardian Model

•A 2-country, 2-commodity world•Perfect competition•No transportation costs•Factors mobile internally, immobile

internationally•Constant costs of production•Fixed technology for each country•All resources are fully employed•The “labor theory of value” holds

Notation•Let:•ax = labor time to produce 1 X in country

A•ay = labor time to produce 1 Y in country

A•bx = labor time to produce 1 X in country

B•by = labor time to produce 1 Y in country

B

Comparative Advantage Defined•Country A has a comparative advantage in

good X if:

• If country A has a comparative advantage in good X, country B must have a comparative advantage in good Y.

B

Y

X

A

Y

X

P

P

P

P

Y

X

Y

X

b

b

a

a

Y

Y

X

X

b

a

b

aor if or if

Comparative Advantage: An Example

Autarky Price Ratios (APRs)

1B = 5C, 1C = 1/5B

1B = 2C, 1C = 1/2B

Corn (X) Blankets (Y)

U.S. (A) 1 hour/bu 5 hrs/bl

Mexico (B) 3 hrs/bu 6 hrs/bl

Comparative Advantage•Since the U.S.’s APR for corn is lower

than Mexico’s (1/5 < 1/2), ▫the U.S. must have a comparative

advantage in corn.•Since Mexico’s APR for blankets is lower

than the U.S.’s (2 < 5), ▫Mexico must have a comparative advantage

in blankets.

Comparative Advantage and the Total Gains from Trade•Ricardo’s argument is that trade will be

mutually advantageous as long as the two countries’ autarky price ratios are different.

•How do we know that this is true?

Comparative Advantage and the Total Gains from Trade•The Production Possibilities Frontier

(PPF) is the set of all combinations of goods that a country is capable of producing, given available technology and resources.

•Suppose in our example ▫the U.S. has 1,000 hours of labor available

and Mexico has 1,800.

U.S. Production Possibilities

1000

Corn

Blankets200

500

100

A

Slope: rise/run = -1000/200 = -5

Slope of the PPF•for this example, -5•Notice: the slope (in absolute value) is the

APR of the good on the horizontal axis.•Therefore, the slope is the opportunity

cost of the good on the horizontal axis.•The slope is also the marginal rate of

transformation.

Mexico’s Production Possibilities

600

Corn

Blankets300

Slope = -2, or the opportunity cost of blankets

Classical Model: The Gains from Trade

•Suppose that in autarky▫the U.S. is at point A

Producing 500 corn Consuming 100 blankets

▫Mexico is at point B Producing 300 corn Consuming 150 blankets


1000

Corn

Blankets200

500

100

A


600

Corn

Blankets300

300

150

B

Classical Model: The Gains from Trade

•Suppose now that the U.S. and Mexico agree to trade at an “exchange rate” of ▫1B = 3.33C or 1C = .3B

•If the U.S. specializes in corn, how many units of corn could it produce? ▫1000

•If Mexico specializes in blanket manufacture, how many blankets could be made? ▫300

The Gains from Trade: U.S.•If the U.S. wants to continue to consume

500C▫They will now have 500C to trade for

blankets They produce 1,000C and 0B

•If the “exchange rate” is 1B = 3.33C (or, 1C = .3B), how many blankets can the U.S. get in exchange for 500C?▫150

•Therefore, the U.S. can consume outside its PPF (to point C) by trading!


1000

Corn

Blankets200

500

100

CA

150

The Gains from Trade: Mexico•If Mexico wants to continue to consume

150B▫They will now have 150B to trade for corn.

They produce 300B and 0C•If the “exchange rate” is 1B = 3.33C (or,

1C = .3B), how much corn can Mexico get in exchange for 150B?▫500

•Therefore, Mexico can also move outside its PPF (to point D) by trading!


600

Corn

Blankets300150

B300

500D

The Gains from Trade•Note: In general

▫The Ricardian model results in complete specialization.

•However, in trade between a small and a large country the small country may not be able to produce enough to satisfy the large country; the large country might then partially specialize.

The Consumption Possibilities Frontier (CPF)•The CPF is a collection of points that

represent combinations of corn and blankets that a country can consume if it trades.

U.S. Consumption Possibilities

1000

Corn

Blankets200

500

100

CA

150 300

CPF

The Consumption Possibilities Frontier (CPF)•The CPF’s slope is the same as the terms

of trade.•The CPF pivots around the production

point.•If trade is to the benefit of a country, the

CPF lies outside the PPF.

Mexico’s Consumption Possibilities

600

Corn

Blankets300150

B300

500D

1000CPF

The Limits to Mutually Advantageous Trade•“Exchange rate” must be at least as great

as Mexico’s APR.•“Exchange rate” must be no greater than

the U.S.’s APR.•Bottom line: we still don’t know how the

terms of trade will be determined, but they must be between the countries’ APRs if trade is to be mutually beneficial.

The CPF and “Small” Countries•The nearer are the terms of trade to a

country’s APR, the less that country will gain from trade.

•The farther away the terms of trade are from a country’s APR, the more that country will gain from trade.

•Moral: to Ricardo, small countries stand to gain a lot from trade, large countries gain less.

Adding Money to the Classical Model

•Suppose a money economy instead of a barter economy.▫A wage rate for each country, stated in that

country’s currency (e.g., in U.S. $2 per hr., in the U.K., £1 per hr.).

▫An exchange rate that relates the countries’ currencies (e.g., $1 = £1).

An Example

Wheat Cloth

Wage/hr

Labor/unit

Price/unit

Labor/unit

Price/unit

U.S. $2 2 3

U.K £1 6 4

An Example

Wheat Cloth

Wage/hr

Labor/unit

Price/unit

Labor/unit

Price/unit

U.S. $2 2 $4 3 $6

U.K £1 6 £6 4 £4

Adding Money to the Classical Model: An Example•The U.S. will export wheat, since it can

produce wheat for a lower price ▫$4, as compared with $6

•The U.K. will export cloth, since it can produce cloth for a lower price ▫$4, as compared with $6

The Export Condition•Country 1 should export good “j” when:

▫where a1j and a2j are the labor requirements/hr to

produce good “j” in countries 1 and 2▫W1 and W2 are the wage rates/hr in

countries 1 and 2▫e is country 1’s exchange rate (# of country

2’s currency units per 1 of country 1’s).

2211 WaeWa jj

The Export Condition•Country 1 should export good j when:

•That is▫when country 1’s good j price is lower than

2’s, stated in a common currency.•Therefore, the pattern of trade is

determined by▫Relative labor efficiency,▫Relative wage rates, and▫The exchange rate.

2211 WaeWa jj

The Export Condition•Country A should export good j when:

•Let’s re-write this as follows:

•Country A should export good j when:

2211 WaeWa jj

eW

W

a

a

j

j

1

2

2

1

Wage Rate Limits

•As Country 1’s wage rate goes up relative to Country 2’s, Country 1 finds it harder to sell its exports to Country 2.

•As Country 1’s wage rate goes down relative to Country 2’s, Country 1 is less interested in importing from Country 2.

eW

W

a

a

j

j

1

2

2

1

Wage Rate Limits: An Example

Wheat Cloth

Wage/hr

Labor/unit

Price/unit

Labor/unit

Price/unit

U.S. $3 2 3

U.K £1 6 4

Suppose e = 0.5 (that is, $1 = £0.5)


Wheat Cloth

Wage/hr

Labor/unit

Price/unit

Labor/unit

Price/unit

U.S. $3 2 $6 3 $9

U.K £1 6 £6 4 £4

Suppose e = 0.5 (that is, $1 = £0.5)

Wage Rate Limits: An Example•Should the U.S. (Country 1) export wheat?

▫It should if

•Since ▫2/6 < 1/(3*0.5)▫The U.S. should export wheat

U.S. wheat price is $6 U.K. wheat price is £6 = $12 after exchange

rate• It’s easy to show that the U.K. should export

cloth.

eW

W

a

a

j

j

1

2

2

1

Wage Rate Limits: An Example•What if the U.S. wage rate rose to $6?


Wheat Cloth

Wage/hr

Labor/unit

Price/unit

Labor/unit

Price/unit

U.S. $6 2 $12 3 $18

U.K £1 6 £6 4 £4

Suppose e = 0.5 (that is, $1 = £0.5)

Wage Rate Limits: An Example•Now the U.S. wheat price is the same as

the U.K.’s, if we state them in a common currency.▫Exchange rate: £1 = $2

•Therefore, ▫If the wage rate in the U.S. should rise

above $6, the U.K. will no longer buy U.S. wheat (trade will cease).

Wage Rate Limits: An Example•What if instead the U.S. wage rate fell to

$2.67?


Wheat (X) Cloth (Y)

Wage/hr

Labor/unit

Price/unit

Labor/unit

Price/unit

U.S. (A) $2.67 2 $5.34 3 $8

U.K (B) £1 6 £6 4 £4

Suppose e = 0.5 (that is, $1 = £0.5)

Wage Rate Limits: An Example•What if the U.S. wage rate fell to $2.67?•Now the U.S. cloth price is the same as

the U.K.’s, if we state them in a common currency ($8).

•Therefore, if the wage rate in the U.S. should fall below $2.67, the U.S. will no longer buy U.K. cloth (trade will cease).

Calculating Wage Rate Limits Using the Export Condition•Solve the export condition for W1, for good X.•Solve the export condition for W1, for good Y.•These will give you Country A’s wage rate

limits.

•For wheat(X):▫2/6 = 1/(W1*0.5) → W1= 6

•For cloth(Y):▫3/4 = 1/(W1*0.5) → W1= 2.67

eW

W

a

a

j

j

1

2

2

1

Country 2’s Wage Rate Limits•Changes in Country 2’s wage rates also

can affect the pattern of trade.▫If 2’s wage rises too much, they will not be

able to export any more.▫If 2’s wage falls too much, 2 will no longer

wish to import.

Exchange Rate Limits•If Country 1’s currency appreciates

▫Imports will seem cheaper and exports more expensive.

•If 1’s currency appreciates enough▫A will no longer be able to export.

•If 1’s currency depreciates enough▫A will no longer wish to import.

More Than Two Goods•Having more than two goods has no effect

on the basic Classical model.•The export condition can still be used.

More Than Two Goods: An Example

Country Wage Rate

Computers Wheat Cloth Sheet Metal

Cheese

U.S. $3 2 2 3 4 5

U.K. £1 7 6 4 4 3

Suppose e = 0.5 (that is, $1 = £0.5)

More Than Two Goods: An Example•Suppose the exchange rate is still $1 =

£0.5 (that is, e = 0.5).•Then

•Use this as a “pointer”: ▫Country 1 should export everything to the

left of the pointer

67.05.03

1

1

2

eW

W

Country Wage Rate

Computers Wheat Cloth Sheet Metal

Cheese

U.S. $3 2

2 3 4 5

U.K. £1 7 6 4 4 3

Suppose e = 0.5 (that is, $1 = £0.5)

More Than Two Goods: An Example

W2/(W1*e) = 0.67

More Than Two Goods: An Example•If the U.S. wage rate were to fall

▫The pointer would move to the right▫U.S. would start exporting goods it

presently imports.•If the U.S. wage were to rise

▫The pointer would move left.•Changes in the U.K.’s wage, or the

exchange rate, would also move the pointer and thus affect the pattern of trade.

Adding Transportation Costs•Assume:

▫All transportation costs are paid by the importer.

▫Transportation costs are measured in terms of their labor content.

•Country 1’s export condition:

•Suppose in previous example t-costs are 1 labor hour.

eW

W

a

ta

j

rjj

1

2

2

1 )(

Transportation Costs: An Example

Coun-try

Wage Rate

Computers

Wheat Cloth Sheet Metal

Cheese

U.S. $3 2+1 2+1 3 4 5

U.K. £1 7 6 4+1 4+1 3+1

W2/(W1*e) = 0.67

Transportation Costs: An Example•Notice that although the U.K. has a

comparative advantage in cloth, it will no longer export this product, since

•In the real world, some products with high t-costs (e.g., bulky ones) are not traded.

67.06.0)(

1

2

2

1

eW

W

a

ta

j

rjj

More Than Two Countries•Having more than two countries also has

no effect on the basic Classical model.

More Than Two Countries: An Example

Country Wheat Cloth

U.K 2 3

France 3 5

U.S. 3 6

AutarkyPrice Ratios

1C = 1.5W1W = 0.67C

1C = 1.67W1W = 0.6C

1C = 2W1W = 0.5C


•U.K. has the CA in cloth, since its autarky cloth price is the lowest.

•U.S. has the CA in wheat, since its autarky wheat price is the lowest.


•If the Terms of Trade (ToT) are 1C = 1.8W (or: 1W = .55C)▫Then the U.S. will export wheat (because

the international wheat price is greater than the U.S. domestic price).

•France and the U.K. will export cloth (because the international cloth price is greater than their domestic prices).


Country Wheat Cloth

U.K 2 3

France 3 5

U.S. 3 6

AutarkyPrice Ratios

1C = 1.5W1W = 0.67C

1C = 1.67W1W = 0.6C

1C = 2W1W = 0.5C

ToT: 1C = 1.8W (or: 1W = .55C)


•If the terms of trade are 1C = 1.6W (or: 1W = .625C), then ▫The U.S. and France will export wheat

(because the international wheat price is greater than their domestic prices).

▫The U.K. will export cloth.


Country Wheat Cloth

U.K 2 3

France 3 5

U.S. 3 6

AutarkyPrice Ratios

1C = 1.5W1W = 0.67C

1C = 1.67W1W = 0.6C

1C = 2W1W = 0.5C

ToT: 1C = 1.6W (or: 1W = .625C)

Evaluating the Classical Model•Empirical studies generally show that the

classical model is consistent with observed trading patterns.

•However, the complexity of today’s world means the Classical model cannot supply a complete understanding of international trade.

Consumer Behavior Theory•How do consumers decide how much of

each good to consume?

Consumer Indifference (CI) Curves

Y

X

A

B

Consumers are indifferent between pt. A and pt. B, and all other pts. on the CI.

There are many, many CIs each representing higher or lower levels of consumer satisfaction.

Consumer Indifference Curves

Y

XS1

S2

S3

Utility on S3 > Utility on S2 > Utility on S1

Consumer Indifference Curves•Are downward sloping because the goods

are substitutes.•Slope is Marginal Rate of Substitution

(MRS):

•Are convex because of the principle of diminishing MRS.

•Represent the welfare of an entire country, NOT an individual.

y

x

MU

MUMRS

Consumer Budget Constraint

Y

X

Budget constraint shows combinations of X and Y that can be purchased with a given level of income at fixed prices.

The slope of the budget constraint is –Px/Py

Consumer Equilibrium•Given relative prices (PX/PY) and income,

consumers will choose a combination of X and Y that puts them on the highest possible community indifference curve.

•Consumer equilibrium occurs where

x

x

y

x

P

P

MU

MUE

Consumer Equilibrium

Y

XS1

S2

S3

Budget constraint

E

Production Possibilities Frontier•Most PPFs are bowed out, not straight

lines.•This is because resources are not equally

suited to all kinds of production.•Slope of a tangent line at any point along

the PPF is:▫the marginal rate of transformation, or▫the opportunity cost of the horizontal axis

good, or MCX/MCY.

The PPF with Increasing Opportunity Costs

Y

X

PPF

Problems With Classical Theory•Labor theory of value is unrealistic.•Assumption of constant opportunity costs

is too restrictive.•Demand is largely ignored.

Autarky Equilibrium•In the absence of trade

▫producers will seek to maximize profits.▫consumers will seek to maximize utility.

Production Equilibrium In Autarky•Producers will choose to produce where

the relative cost of producing one more unit of X is just equal to the relative price at which the producer can sell a unit of X.

•That is, equilibrium occurs where

x

x

y

xp P

P

MC

MCE

Producer Equilibrium in Autarky

Y

X

E

Autarky Price Line

PPF

At point E, MCX/MCY = PX/PY.

Consumer Equilibrium in Autarky•Given relative prices (PX/PY) and income,

consumers will choose a combination of X and Y that puts them on the highest possible community indifference curve.

•Consumer equilibrium occurs where

x

x

y

xc P

P

MU

MUE

Consumer Equilibrium

Y

XCI1

CI2

CI3

CI4

Budget constraint

E

Autarky Equilibrium•In equilibrium, supply and demand jointly

determine PX/PY, and therefore how much X and Y is produced (and consumed).

Autarky Equilibrium

Y

X

E

X1

Y1

Community indifferencecurve

PPF

Price line

The Introduction of International Trade•Trade will cause relative prices to change.•Producers will respond to this by altering

relative production of goods X and Y.•Consumers will respond to this by altering

relative consumption of goods X and Y.

Production in Trade•Let’s suppose that Country A has a

comparative advantage in good X.•What will happen to the relative price of

good X as Country A moves to trade?▫It will rise (otherwise, Country A would not

wish to produce more of good X in order to export it).

Production in Trade

Y

X

E

X1

Y1

E'

X2

Y2

Int’l Price Line

Autarky Price Line

Steeper int’l price linemeans PX/PY has increased.

Trade Equilibrium

Y

X

E'

X2

Y2

C'

X3

Y3

F

Country A Exports X3X2 (the distance FE’)Imports Y3Y2 (the distance FC’)

exports

imports

Movement From Autarky to Trade

•Movement to trade causes relative price of good X to rise.

•Higher relative price means more X will be produced, less Y .

•Higher relative price of X lowers consumption of X, raises consumption of Y.

•Extra X is exported, shortfall in Y is met by imports.

Production and Consumption Gains from Trade•There are two distinct sources of trade

gains▫Consumption gain:

Even if producers don’t change production levels, welfare is enhanced.

▫Production gain: Specialization in the comparative advantage

product leads to higher welfare.

Consumption Gains

Y

X

Even if producers don’t change production levels in response to a change to (Px/Py)2, the new consumer equilibrium at C is on a higher indifference curve.E

(Px/Py)2

C

Production Gains

Y

X

E'

C'

Eventually producers adjust production levels to E’. This permits additional gains to C’.

E

(Px/Py)2

C

Countries A and B Together•Let’s continue to suppose that A has a

comparative advantage in good X.•Therefore, B must have a comparative

advantage in good Y.•It must also be true that

By

x

Ay

x

P

P

P

P

Exports, Imports in A and B

Country A Country BY Y

X XX1

Y1

X4

Y4E e

X2

Y2

X5

Y5e'

E'

C'

c'

X3

Y3

Imp.

Exp.

X6

Y6

Exp.

Imp.

Minimum Conditions for Trade•Trade will be mutually advantageous as

long as the two countries’ APRs differ.•This can occur because of:

▫differences on the supply side, or▫differences on demand side, or▫Both.

Identical Demand Conditions•Suppose that the citizens of Country A

have the exact same tastes and preferences as the citizens of Country B.

•Then their community indifference curves would be identical.

•Autarky prices will still differ between the countries as long as the countries differ on their supply sides.

Identical Demand Conditions

Y

X

CI1

Y2

(PX/PY)T

(PX/PY)T

f

F

X3

Y3

X5

Y5

CI2

C’, c’

X2

Identical Demand Conditions•Even if demand conditions are the same,

differences in supply conditions would cause differences in APRs across countries, and so:▫Trade could still be mutually advantageous.▫Implicitly, this is what is going on in the

Classical model.

Identical Supply Conditions•What if two countries have identical

technologies and resource endowments?•Then their PPFs would be identical.•The Classical model would predict no

trade, but what does the Neoclassical model show?

Identical Supply Conditions

Y

X

PPF for both countries

6-100


Y

X

(PX/PY)A

(CI1)A

(CI1)B

(PX/PY)B

E

e

Y1

Y4

X1 X46-101


Y

X

E

e

Y1

Y4

X1 X4

E’, e'

(PX/PY)T

X3

Y3

6-102

Identical Supply ConditionsY

X

E

e

Y1

Y4

X1 X4

E’, e'

X3

Y3

C'

c'

X5

Y5

X2

Y2

6-103

Identical Supply Conditions•Even if supply conditions are the same,

differences in demand conditions would cause differences in APRs across countries, and so:▫Trade could still be mutually advantageous.▫This was not a possibility in the Classical

model, because it assumed away demand.

Offer Curves•comprise all combinations of a country’s

desired exports and imports at different terms of trade.

•are also known as reciprocal demand curves (J.S. Mill).

•measure a country’s willingness to trade.•can be derived from the PPF-indifference

curve graph.

Offer Curves•Offer curves represent willingness to

trade at every possible terms of trade.•As the relative price of good X rises,

Country A becomes willing to export more and import more.

•Offer curves “bow” towards the import good axis.

Deriving Country B’s Offer Curve•This will reflect Country B’s willingness to

trade at different terms of trade.•B’s offer curve bows towards the axis with

B’s import good on it.

Y

XY

X

(PX/PY)1

p

X7

Y7

c

X8

Y8

(PX/PY)1

X9

Y9

7-111

Y

XY

X

(PX/PY)1

(PX/PY)1

X9

Y9

(PX/PY)2

Y10

X10

Y11

X11

X12

Y12

(PX/PY)2

OCB

7-112

Terms of Trade Equilibrium•The international terms of trade (that is,

PX/PY) will be the slope of a line passing through the point where the offer curves cross.

•This equilibrium point takes into account demand and supply conditions in both countries.

Terms of Trade Equilibrium

Y

X

(PX/PY)E

X1

Y1If these are the terms of trade,country A will desire to exportX1 units, and country B will want to import X1 units.

OCA

OCB

Terms of Trade Equilibrium

Y

X

(PX/PY)E

X1

Y1If these are the terms of trade,country A will desire to importY1 units, and country B will want to export Y1 units.

OCA

OCB

How Do We Know It’s Equilibrium?•Any terms of trade other than (PX/PY)E

will result in▫excess demand for one good, and▫excess supply for the other.

•Therefore relative prices will adjust until (PX/PY)E is reached.

Disequilibrium

Y

X

(PX/PY)1OCA

OCB

Disequilibrium

Y

X

(PX/PY)1OCA

OCBY1

Y2At (PX/PY)1, country A wishesto import Y1 units, but country B is only interested in exporting Y2

units. That is, there is an excess demand for good Y.

Disequilibrium

Y

X

(PX/PY)1OCA

OCB

X1X2

At (PX/PY)1, country A wishesto export X1 units, but country B is only interested in importing X2

units. That is, there is an excess supply of good X.

Disequilibrium•Excess demand for Y causes PY to rise.•Excess supply of X causes PX to fall.•Thus, (PX/PY) falls.•In other words, the terms of trade line

gets flatter, moving the countries in the direction of equilibrium.

Moving Towards Equilibrium

Y

X

(PX/PY)1OCA

OCB

Disequilibrium•Terms of trade lines that are flatter than

(PX/PY)E, such as

Disequilibrium

Y

X

(PX/PY)2OCA

OCB

Disequilibrium•Terms of trade lines that are flatter than

(PX/PY)E will results in▫an excess demand for good X, and▫an excess supply of good Y, and so

•(PX/PY) will rise.•That is, the terms of trade line will get

steeper until (PX/PY)E is reached.

Moving Towards Equilibrium

Y

X

(PX/PY)2OCA

OCB

A Note on the Terms of Trade•A country’s “terms of trade” are the price

of its exports divided by the price of its imports, so a rising terms of trade is good news.

•In this example, (PX/PY) is country A’s terms of trade, since A exports good X and imports Y.

•(PY/PX) is country B’s terms of trade in this example.

A Note on the Terms of Trade, continued•As A’s terms of trade (PX/PY) improve, B’s

terms of trade (PY/PX) must be deteriorating and vice-versa.

Shifts of Offer Curves•Anything that causes country A’s

willingness to trade to change will shift A’s offer curve.▫increased willingness to trade: OCA shifts

right▫decreased willingness to trade: OCA shifts

left•These can be caused by

▫changes in demand conditions or▫changes in supply conditions.

Demand Changes in Country A

Y

X

(PX/PY)E

X1

Y1

OCA

OCB


Y

X

(PX/PY)EOCA

OCB

Increased demand for importsby Country A causes a rightward shift of A’s offer curve.

OCA'


Y

X

(PX/PY)EOCA

OCB

Volume of trade increases, butA’s terms of trade go down. B’s terms of trade improve.

OCA'

(PX/PY)E'

X2

Y2

Demand Changes in A•Any change that might make A demand

more imports leads to a rightward OC shift, and thus▫an increase in trade volume, and▫a decrease in A’s terms of trade.

Demand Changes in Country B

Y

X

(PX/PY)E

X1

Y1

OCA

OCB


Y

X

(PX/PY)EOCA

OCB

OCB'

Increased demand for importsby Country B shifts B’s OCupward.


Y

X

(PX/PY)EOCA

OCB

OCB'

(PX/PY)E'

X2

Y2

Volume of trade increases,but Country B’s terms of tradedecrease (and A’s terms oftrade improve).

Other Demand Changes•Any decrease in a country’s willingness to

trade will shift its OC leftward or downward.

•An example is when a country imposes an import tariff.

•Tariffs therefore lead to decreased trade volume, but improve the imposing country’s terms of trade.

Supply Changes•Changes in supply conditions will also

shift a country’s offer curves around.•Examples include

▫productivity changes, and▫discovery of new resources.

Offer Curve Elasticity•Until now, we’ve been dealing with offer

curves that are elastic.•Offer curves can also be unit elastic or

even inelastic.•The shape of the offer curves depends on

the elasticity of demand for imports:

imports

imports

P

%

Qd %

Offer Curve Elasticity

Y

XX1

Y1

A

From origin to point A, offer curve is elastic.Between points A and B, offer curve is inelastic.At point A, offer curve is unit elastic.

B

Offer Curve Elasticity•Over the elastic range, a 1% change in

the relative price of imports will lead to a greater than 1% change in quantity of imports purchased.

•Over the inelastic range, a 1% change in the relative price of imports will lead to a less than 1% change in quantity of imports purchased.

Offer Curve Elasticity•Recall that in general a country gives up

its export good in order to purchase its import good.

•Over the elastic range, a relative decline in the import price induces a country to give up more of the export good in order to buy more of the import good.

Offer Curve Elasticity•Over the inelastic range, when there is a

relative decline in the import price, a country is willing to give up less of the export good in order to buy more of the import good.

•This would occur if the income effect of a price change outweighs the combined effects of substitution and production.

Other Concepts of the Terms of Trade

•We’ve focused on the commodity terms of trade so far, but there are others:▫Income Terms of Trade▫Single Factoral Terms of Trade▫Double Factoral Terms of Trade

Midterm Topics

Midterm Topics•Economic growth•Regulation and Antitrust Policy•Incentives and costs of Regulation•International Trade

IBE303 International Economic Lecture 4

Education

Transcript of IBE303 International Economic Lecture 4