© 2007 Pearson Addison-Wesley. All rights reserved Chapter 3 Applications of the Basic Model.

© 2007 Pearson Addison-Wesley.All rights reserved

Chapter 3

Applications of

the Basic Model

4-2Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Review

• Any country that moves from autarky to free trade can experience gains in real income.

• Suppose now we are already in the position of free trade equilibrium.

• Free trade could be measured as the matching-size trade triangle as before.

• But, assuming home is the clothing exporter, there exists a rising net export supply curve.


Figure 3.1 An Outward Shift in Foreign Demand


An Outward Shift in Foreign Demand

• Import demand increases due to taste changes.

• Import demand curve shifts right.

• It guarantees an increase in the relative price of exports.

• Terms of trade better-off

• Terms of trade=Price of Exports/Price of Imports

• It raises real income at home

• The increase of real income depends on (1) improvement of the TOT; (2) Increase of the export volume.


Figure 3.1 An Outward Shift in Foreign Demand


An Outward Shift in Foreign Demand

• An outward shift in foreign demand for home exports of clothing raises clothing’s price but may or may not increase home exports of clothing.

• The backward-bending supply curve.

• Home’s real income improves, but some of these gains spill over to greater home demand for clothing.

• If such an increase in home demand exceeds the greater quantity produced, a lower quantity is available for export.

• It corresponds to the segment BQR in the offer curve.


Figure 2.C.1 Offer Curves


Protection in the import-competing goods

• At free trade equilibrium, Is it possible that government step in and interfere with resource allocation to protect the import-competing food sector ?

• Possible.

• Special interest groups of agricultural industry could lobby for the government.

• SIG gains in expenditure of the national loss.

• E.g., the move from line 1 to line 2.


Figure 3.2 Restriction on Exportables Production



• Is it possible that a government’s intervention (tariffs or non-tariff-barriers) benefits for its whole country.

• No way when such a country is small.

• A small country cannot affect the world price (see line 2)

• But it is possible for a large country.

• When a large country restricts imports then it could cause the world price of food importables lowered (since less demand).

• Home’s terms of trade improves.

• Budget line rotates from line 1 to line 3.

• Representative consumers obtain higher utility.



• Some caveats though.

• The domestic adjustment from A to B distorts the domestic consumption as well.

• The food market needs to explore.

• Foreign retaliation is possible.


Immiserizing Growth

• Can an outward shift of the production-possibility schedule in a country with a constant population ever lead to a lowering of real income at home?

• Perhaps.• Balanced Growth• An expansion of both domestic exportable and importable

could affect the world market.• Dark side: it induces a deterioration on the terms of trade. • So, to some extent, it may erode the gains from trade.• Bright side: it causes real income to rise in trading partners

that are importers of the growing country’s exports.


The Deterioration of Home’s TOT

• pc/pf

• Qc+Qc*/Qf+Qf*


Immiserizing Growth

• Consider an extreme case.

• The growth could lower real incomes by being concentrated in domestic export sector and by significantly worsening the TOT.

• Figure 3.3

• Growth biased toward the nation’s export industry (clothing) can reduce real income by so worsening the TOT (from line 1 to line 2) that consumption (at D) ends up on a lower indifference curve than initially (at B).


Figure 3.3 Immiserizing Growth


Assumptions for Immiserizing Growth

(1) Grow primarily increases capacity and output in domestic export industries.

(2) World’s demand elasticity for the country’s export good is quite low.

This guarantees a worse-off of terms of trade.


Transfer Problem

• Historically, more direct forms of transfer is important.

• Home is obligated to transfer money to foreign.

• Franco-Prussian War in 1870-1871: France

• World War I: Germany

• Marshall Plan: US

• Gulf War in 1991: Japan, Germany, Kuwait, Saudi Arabia to US

• Southern-East Asian Crisis in 1997: IMF

• How does such a transfer affect the terms of trade?


Transfer Problem

• At any given price ratio, the home, or transferring, country can be expected to cut back its spending on all normal goods such as food.

• Foreign could increase all demand for all goods. The demand increase of food happens to some extent.

• The world demand curve for food could shift in or out.

• Marginal propensities to import (m or m*)

• T denotes transfer

• The world demand curve for food shifts to the right iff

(1-m*)T> mT


It is never better to give than to receive

• Secondary blessing is impossible in a 2-country setup.

• If the home makes a transfer, its real income is reduced.

• But if its terms of trade improve (price of food falls), then loss will not be so severe.

• The TOT moves in favor of home if the sum of import propensities satisfy: (1-m*)T < mT

• Let OB denote the full compensation for the home country for the transfer.

• Can the transfer shift world demand to the left sufficiently to reduce food’s price to 0B or lower?


Figure 3.4 Transfer and the Terms of Trade


It is never better to give than to receive

• No.• Since at point B, world demand must exceed world supply.• This is because no real income in both countries will be

changed if the price of food at point B. • Also, no income effect at B.• Only substitution effect exists. • Food’s lower relative price must call forth a substitution of

food for clothing in both countries.• Therefore, equilibrium must be at somewhere in between AB,

say, point G.• It is never better to give than to receive!


Some extensions of simple trade model

• Many final goods (intra-industry trade)

• Many countries

• Trade in intermediate goods and international factor mobility

• Non-tradable goods

• Trade in assets


Figure 3.5 Intertemporal Trade


Equilibrium Stability

• Before we assume a unique equilibrium.

• Two necessary assumptions:

• Price above equilibrium must have excess supply higher than excess demand, and vice versa.

• It is assumed that price is driven up iff the existence of excess world demand.

• Consider multiple free-trade equilibrium Panel a: three equilibria

• The middle equilibrium point C is unstable but is flanked by a pair of stable equilibria


Figure 3.A.1 Multiple Equilibria


Equilibrium Stability

• Say, the price of food is slightly higher, at 2, world demand is higher than world supply.

• It will jump up the food’s price, away from point C, but to D.• How about point 1?• Offer curve in panel B is also the case.• Consider price ratio curve 2, dis-equilibrium there. • TV is the excess of the home’s import demand of food over

foreign supplies• Remember the green line is home offer curve.• Therefore, food’s relative price will rise, going clockwise way

to the stable point I.

© 2007 Pearson Addison-Wesley. All rights reserved Chapter 3 Applications of the Basic Model.

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