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
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
U.S. Production Possibilities
1000
Corn
Blankets200
500
100
A
Mexico’s Production Possibilities
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!
U.S. Production Possibilities
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!
Mexico’s Production Possibilities
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)
Wage Rate Limits: An Example
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?
Wage Rate Limits: An Example
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?
Wage Rate Limits: An Example
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
More Than Two Countries: An Example
•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.
More Than Two Countries: An Example
•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).
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
ToT: 1C = 1.8W (or: 1W = .55C)
More Than Two Countries: An Example
•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.
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
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
Identical Supply Conditions
Y
X
(PX/PY)A
(CI1)A
(CI1)B
(PX/PY)B
E
e
Y1
Y4
X1 X46-101
Identical Supply Conditions
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
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, and▫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.
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
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