Offer Curves

How the Terms of Trade Are Established

Offer Curves are

• all combinations of a country’s desired exports and imports at different terms of trade

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

• measures of willingness to trade

Y

XY

X

(PX/PY)1

X2

Y2

X1

Y1

C P

Y

XY

X

(PX/PY)1

X2

Y2

X1

Y1

C P

X5

Y5

(PX/PY)1

Y

XY

X

(PX/PY)1

X5

Y5

(PX/PY)1

(PX/PY)2

X4X3

Y3

Y4

(PX/PY)2

X6

Y6

Y

XY

X

(PX/PY)1

X5

Y5

(PX/PY)1

(PX/PY)2

X4X3

Y3

Y4

(PX/PY)2

X6

Y6

OCA

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

Y

XY

X

(PX/PY)1

p

X7

Y7

c

X8

Y8

(PX/PY)1

X9

Y9

Y

XY

X

(PX/PY)1

(PX/PY)1

X9

Y9

(PX/PY)2

Y10

X10

Y11

X11

X12

Y12

(PX/PY)2

OCB

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

Y1

OCA

OCB

Terms of Trade Equilibrium

Y

X

(PX/PY)E

X1

Y1

If 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

Y1

If 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– 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

Y2

Disequilibrium

Y

X

(PX/PY)1OCA

OCBY1

Y2 At (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

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)1 OCA

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– 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

Demand Changes in Country A

Y

X

(PX/PY)EOCA

OCB

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

OCA'

Demand Changes in Country A

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– a decrease in A’s terms of trade

Demand Changes in Country B

Y

X

(PX/PY)E

X1

Y1

OCA

OCB

Demand Changes in Country B

Y

X

(PX/PY)EOCA

OCB

OCB'

Increased demand for importsby Country B shifts B’s OCupward

Demand Changes in Country B

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

Imposition of Tariff by Country A

Y

X

(PX/PY)E

X1

Y1

OCA

OCB

Imposition of Tariff by Country A

Y

X

(PX/PY)E

X1

Y1

OCA

OCB

OCA'

Imposition of Tariff by Country A

Y

X

(PX/PY)E

X2

Y2

OCA

OCB

OCA' (PX/PY)E'

Imposition of Tariff by Country A

Y

X

(PX/PY)E

X2

Y2

OCA

OCB

OCA' (PX/PY)E'

By imposing a tariff, Country Adecreases trade volume, andimproves its terms of trade (but B’s terms of trade deteriorate)

Supply Changes

• Changes in supply conditions will also shift a country’s offer curves around

• Examples include– productivity changes– discovery of new resources

An Example: The Oil Shocks of the 1970s

• Let’s think of OPEC as one country

• Let’s also think of the industrial countries as one country

• OPEC effectively decreased its willingness to trade

• Presumably this shifted OPEC’s offer curve to the left, increasing OPEC’s terms of trade and decreasing the industrial countries’

Oil Shocks of the 1970s

Otherstuff

Oil

(PX/PY)pre-shock

X1

Y1

OCOPEC

OCIC

Oil Shocks of the 1970s

OtherStuff

Oil

(PX/PY)E

X1

Y1

OCOPEC

OCIC

OCOPEC'

Oil Shocks of the 1970s

OtherStuff

Oil

(PX/PY)pre-shock

X1

Y1

OCOPEC

OCIC

OCOPEC' (PX/PY)post-shock

X2

Y2

Oil Shocks of the 1970s

OtherStuff

Oil

(PX/PY)pre-shock

X1

Y1

OCOPEC

OCIC

OCOPEC' (PX/PY)post-shock

X2

Y2OPEC’s terms of trade shouldhave improved, and the industrial countries’ should have worsened

Oil Shocks of the 1970s: Changes in the Terms of Trade

Oil-ExportingCountries

IndustrialCountries

1970 21 1101973 29 1081974 70 971979 87 961981 119 871985 97 911995 55 105

Offer Curves and “Small” Countries

• “Small” countries: those that are too small to affect world prices (and therefore the terms of trade) by their own actions

• From the “small” country’s perspective, the rest-of-world’s OC is a straight line

“Small” Countries and Offer Curves

Y

XX1

Y1

OC”small” OCROW

“Small” Countries and Offer Curves

Y

XX1

Y1

OC”small” OCROW

Why is the ROW offer curve perceived to be a straightline?

“Small” Countries and Offer Curves

Y

XX1

Y1

OCsmall

OCROW

OCsmall'

If the “small” country imposesa tariff on ROW products, ithas no effect on the terms of trade

“Small” Countries and Offer Curves

Y

XX1

Y1

OCsmall

OCROW

OCsmall'

If the “small” country imposesa tariff on ROW products, ithas no effect on the terms of tradeThis is the definition of a “small” country

“Small” Countries and Offer Curves

• Q: What is the optimal tariff for a “small” country?

• A: No tariff at all - tariffs reduce trade volume, but don’t improve the terms of trade

• This is really the same point we made earlier: free trade is especially helpful to small developing countries