THE STANDARD TRADE MODEL

 1. Country’ choice of optimal solution

 2. The World’s Relative Supply-Demand
Equilibrium
 The economy’s choice of Optimal Output is the position (point) where
the Iso-Value Line just become the tangent line of the PPF curve.
 The Optimal Output State can be illustrated by three curves and lines:
◦ The PPF curve (which is Concave to the Origin O)
◦ The Iso-Value Line
◦ The Community Indifference Curve
 Three special positions of the economy:
◦ The Autarky point
◦ The point of production (before trade)
◦ The point of Consumption (or consumption bundle after trade)
◦ The consumption bundle is always outside its production possibility
frontier PPF
 The slope of the Iso-Value Line (Pc/Pf) becomes the Relative Price or the
Terms of Trade Line when Cloth is the Exported Good.
 This model is referred to as the Specific Factor Model in which there are
two factors of production stuck in an industry.
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 In Increase in the country’s Terms of Trade
(or the Relative Price of Cloth) – Pc/Pf will
enhance the country’s Welfare, while a decline
in the Terms of Trade reduces its welfare.
 This can be explained by the Substitution
Effect and The Income Effect.
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 When economic growth happens, the PPF
curve shifts out.
 If the PPF curve shifts out more on the
direction of producing more export goods, it
is said to “Export –Biased Growth”
 If the PPF curve shifts out more on the
direction of producing the good it imports, it
is said to have “Import- Biased Growth”.
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 Changes in the Equilibrium States happen by
the following cases:
◦ Shift of the Relative Supply Curve (RS)
◦ Shift of the Relative Demand Curve (RD)
◦ Shift of both Relative Supply (RS) and Relative
Demand Curves (RD).
 Assume that:
◦ The Home country exports Cloth (C)and imports
Food (F).
 Case a: If the Home country has “Export-
Biased Growth”
◦ Rybczynski Theorem Export –Biased Growth
causes the country to produce more of Cloth  Qc
increases and QF reduces  The World Relative
Supply Curve shifts to the right
◦  Export – Biased Growth tends to worsen the
country’s Terms of Trade (Pc/Pf reduces) to the
benefit of the rest of the world.
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 With the Export-Biased Growth, if the
deterioration of Terms of Trade is too large ,
we have the case of Immiserising Growth:
Economic Growth but welfare reduces.
 Case b: If the country has “Import- Biased
Growth”
◦  Import –Biased Growth causes the country to
produce more of Food  QF increases and Qc
reduces  The World Relative Supply Curve shifts
to the left
◦  Import – Biased Growth tends to improve the
country’s Terms of Trade (Pc/Pf increases) at the
the rest of the world’s expense.

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 Review: the Market Demand Curve (D) shifts
under the following effects:
◦ Changes in Consumer Income
◦ Changes in Consumer Tastes
◦ Changes in the Price of Related Goods
 If we consider the word “consumer” as the
whole country, the World Relative Demand
Curve RD will shift under the following
effects:
◦ Changes in a country’s Income
◦ Changes in a country’s Tastes
◦ Changes in the Price of Related Goods
 If there is a transfer of Income from the Home
country to the rest of the world  the Home
country’s Income reduces  the Home
country reduces demand for both goods Qc
and Qf. The Home country now is the Donor.
 And if the Home country’s Marginal
Propensity to spend is higher than that of
Foreign country  The Relative Demand
Curve RD shifts to the left, which worsen the
Donor’s Terms of Trade.
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 The Government Intervention into international trade may
appear in two forms: Import Tariff or Export Subsidy.
 Import Tariff refers to as tax levied on the imported
goods.
 If the imposing country is small, its tariff policy does not
affect the world market of the good. The tariff policy
creates Dead Weight Loss triangles to the society.
 However, the effect of tariff policy in terms of Dead
Weight Loss tends to understate the harm to society of
protectionism because DWL triangles do not consider the
harm tariff policy creates to those industries that use the
imported goods as their inputs.
 Now assume that the Home imposing country is a large
economy.
 When the country is large, its tariff policy will affect the world
market for the good, and hence, the World’s Relative Supply
and Demand Curve.
 When Home country imposes a tariff in its imported Food, the
following behaviors are expected to occur:
◦ Domestic Price of Food (Pf) increases
◦ Domestic producers will produce more Food (Qf) and less
Cloth (Qc)  the World Relative Supply curve of Cloth RS
shifts to the left
◦ Domestic consumers buy less Food and more Cloth  the
Relative Demand for Cloth (RD) shifts to the right
  The Home country’s Terms of Trade (Pc/Pf) increases to
the benefit of the Home country and the expense of the
Foreign country.
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 Assume that the Home country is large, which means that its
subsidy policy will affect the world market of the exported
good (Cloth).
 The Home country grants subsidy to its Export good (Cloth).
  Expected results:
◦ Domestic Price of Cloth increases relatively to the price of
Food
◦ Domestic producers produce more Cloth and less Food to
enjoy the subsidy  The World Relative Supply curve RS
shifts to the right.
◦ Domestic consumers demand more Food and less Cloth 
The World Relative Demand Curve RD shifts to the left.
  Total effect: the Home country’s Terms of Trade declines
to the benefit of the Foreign country and at the expense of
the Home country.
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