International Trade

The Standard Trade Model

Topic: use RS and RD to model international equilibrium and then discuss implications of elasticities of RS/RD curves and biases in growth

economy produces where indifference curve representing aggregated consumption preferences is tangent with PPF.
At that point, the slope of the PPF defines the relative prices.

production and consumption are determined separately.
define line of slope equal to the relative prices, called the isovalue line.
production determined by point of tangency between isovalue line and PPF.
isovalue line now determined by international equilibrium. For a small economy, it is taken as exogenous (given).
consumption determined by tangency between indifference curve and PPF.
difference between quantity consumed and produced represents quantity traded.

When relative prices are expressed as the price of exports divided by the price of imports, we call it the Terms of Trade.
Terms of trade represents the value of exports in terms of imports, or how much an economy has to give up in exports to receive a given value of imports.
All else being equal, the higher the terms of trade, the more valuable are a country's exports, and the more they can import, hence the higher will be the standard of living.
The relationship between terms of trade and standard of living are not quite as close, though, because as prices rise, quantity sold falls. The important changes are in export earnings, which is the product of price and quantity sold.

A relatively greater expansion of one factor results in biased growth.
Biased growth appears as a relatively greater shift of the PPF in the direction of the output which makes intensive use of the factor whose stock has expanded.
At constant prices, biased growth will result in an increase in the output of the sector that makes intensive use of the expanded factor, and a decrease in the output of the other sector.
Export-biased growth

relative growth in the abundant factor leading to an expansion of exports.
will cause a fall in the terms of trade and therefore a fall in welfare of the exporting country, a rise in welfare of the importing country.

relative growth in the scarce factor leading to a reduction of imports.
will cause a rise in the terms of trade and therefore a rise in welfare of the importing country, a fall in welfare of the exporting country.

substitution by DC's of synthetic products for natural commodities.
commodities are income inelastic so increasing wealth due to growth implies commodities are a smaller share of consumption.

Manufactured goods are income elastic and so make up a greater proportion of consumption as wealth increases due to growth
The process of development itself among the LDC's requires capital goods imported from the DC's.

Problem: Commodity exporters face cycles of boom and bust, and in the long run may experience a decline in their terms of trade.
Remedies:

Producer cartels - reduce output and increase price, hence increase terms of trade of commodities exporters. Tend to be unstable and breakdown.
Import substitution policies - protection for domestic manufacturing sector from foreign competition. Improve terms of trade but impart inefficiency due to high cost manufacturing.
Preferences - DC's give preference to manufactured goods from LDC's to support development. Beneficial as they are trade-expanding but tend to be politically sensitive when LDC's become competitive and therefore displace the manufacturing sector in the DC's.