Standard Model

Highlights

  • This is a “text book model,” which leads to important propositions.
  • For this model we make use of relative supply and demand functions, as described here:
    • In autarky, equilibrium price is determined at the intersection of relative national supply and demand.
    • Under free trade, TOT is determined at the intersection of relative world supply and demand.

TOT is defined rather broadly in standard models. For a given country, it is defined as the price of exports relative to price of imports. With an increase in TOT, a country affords to buy more of imported products. Conversely, a decline in TOT limits the ability of that country to import from the rest of the world. This is well in line with a 2×2 classical approach. It is more general, however.

  • Given TOT, countries’ production possibility frontiers, and their community indifference curves (which are the tools that we used in chapter one), countries identify their optimal output and consumption. The difference between their domestic output and consumption is then identified as exports (when output>consumption) or imports (when output<consumption).

  • Trade Policy:
    • Introducing a tariff on imports (e.g., food):
      • Leads to an increase in the price of imported product (food) relative to the price of exported product (clothing) in the domestic market.
      • Leads to a decline in the price of exported product (clothing) relative to the price of imported product (food) in the domestic market.
    • Production effects of tariffs at home:
      • Increase in relative price of imports (food) may provide an incentive for domestic producers to switch to the production of imported product (food).
      • Thus, the relative supply of exports (clothing) declines at home: relative supply shifts to the left.
    • Consumption effects of tariffs at home:
      • Increase in relative price of imports (food) may adversely affect the incentives for domestic consumers to purchase imported products (food).
      • Thus, the relative demand for exports (clothing) increases at home: relative demand shifts to the right.
    • Equilibrium effects of tariffs at home:
      • Domestic price of exports (clothing) relative to imports (food) increases.
      • The relative quantity may remain the same, increase, or decline. It depends on the magnitude of the above-mentioned shifts.
    • Equilibrium effects of tariffs abroad:
      • If home country is large enough, tariffs at home may lead to an increase in relative prices in the world. Thus, tariffs lead to an improvement in TOT.
      • If home country is small enough, tariffs at home may have no effect on relative prices in the world. Thus, tariffs only affect the domestic prices and not the TOT.

  • Trade Policy (cont’d):
    • Introducing a subsidy for exports (clothing):
      • Leads to an increase in the price of exported product (clothing) relative to the price of imported product (food) in the domestic market.
      • Leads to a decline in the price of imported product (food) relative to the price of exported product (clothing) in the domestic market.
    • Production effects of export subsidies at home:
      • Increase in relative price of exports (clothing) may provide an incentive for domestic producers to switch to the production of exported product (clothing).
      • Thus, the relative supply of exports (clothing) increases at home: relative supply shifts to the right.
    • Consumption effects of export subsidies at home:
      • Increase in relative price of exports (clothing) may adversely affect the incentives for domestic consumers to purchase exported products (clothing).
      • Thus, the relative demand for exports (clothing) declines at home: relative demand shifts to the left.
    • Equilibrium effects of export subsidies at home:
      • Domestic price of exports (clothing) relative to imports (food) declines.
      • The relative quantity may remain the same, increase, or decline. It depends on the magnitude of the above-mentioned shifts.
    • Equilibrium effects of export subsidies abroad:
      • If home country is large enough, export subsidies at home may lead to a decline in relative prices in the world. Thus, export subsidies lead to a decline in TOT.
      • If home country is small enough, export subsidies at home may have no effect on relative prices in the world. Thus, export subsidies only affect the domestic prices and not the TOT.

For a large country: import tariffs may increase TOT, improving the welfare of home country at the expense of the foreign country; export subsidies may lower TOT, adversely affecting the welfare of home country to the benefit of the foreign country. For a small country: import tariffs and export subsidies may have no significant effect on the TOT.

  • Economic growth is often biased — one sector may grow faster than other sectors. In this case, economic growth may affect relative supply, which in turn may affect the TOT.
    • Export-biased growth, which expands a country’s production possibilities disproportionately in that country’s exporting sector (i.e., the sector with comparative advantage), may shift the relative supply of exported product compared to imported product to the right. Given relative demand, this shift may lower TOT. Export-biased growth at home:
      • May adversely affect home’s welfare.
      • May improve foreign country’s welfare.
      • Example: ceteris paribus, growth in textile industry in China may improve welfare in the U.S.
    • Import-biased growth, which expands a country’s production possibilities disproportionately in that country’s importing sector (i.e., the sector with comparative disadvantage), may shift the relative supply of exported product compared to imported product to the left. Given relative demand, this shift may improve TOT. Import-biased growth at home:
      • May improve home’s welfare.
      • May adversely affect foreign country’s welfare.
      • Example: ceteris paribus, growth in textile industry in the U.S. may adversely affect welfare in China.