Book Title
International Economics: Theory and Policy 9th Edition

978-0132146654 Chapter 6 Lecture Notes

December 18, 2019
24  Krugman/Obstfeld/Melitz •   International Economics: Theory & Policy, Ninth Edition
Chapter 6
The Standard Trade Model
.1 Chapter Organization
A Standard Model of a Trading Economy
  Production Possibilities and Relative Supply
  Relative Prices and Demand
  The Welfare Effect of Changes in the Terms of Trade
  Determining Relative Prices
  Economic Growth: A Shift of the RS Curve
  Growth and the Production Possibility Frontier
  World Relative Supply and the Terms of Trade
  International Effects of Growth
  Case Study: Has the Growth of Newly Industrializing Countries Hurt Advanced Nations?
Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD
  Relative Demand and Supply Effects of a Tariff
  Effects of an Export Subsidy
  Implications of Terms of Trade Effects: Who Gains and Who Loses?
International Borrowing and Lending
Intertemporal Production Possibilities and Trade
The Real Interest Rate
Intertemporal Comparative Advantage
APPENDIX TO CHAPTER 6: More on Intertemporal Trade
.2 Chapter Overview
Previous chapters have highlighted specific sources of comparative advantage which give rise to
international trade. This chapter presents a general model which admits previous models as special cases.
This “standard trade model” is the workhorse of international trade theory and can be used to address a wide
range of issues. Some of these issues, such as the welfare and distributional effects of economic growth,
transfers between nations, and tariffs and subsidies on traded goods, are considered in this chapter. The
standard trade model is based upon four relationships. First, an economy will produce at the point where the
production possibilities curve is tangent to the relative price line (called the isovalue line). Second,
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
25  Krugman/Obstfeld/Melitz •   International Economics: Theory & Policy, Ninth Edition
indifference curves describe the tastes of an economy, and the consumption point for that economy is
found at the tangency of the budget line and the highest indifference curve. These two relationships yield
the familiar general equilibrium trade diagram for a small economy (one which takes as given the terms of
trade), where the consumption point and production point are the tangencies of the isovalue line with the
highest indifference curve and the production possibilities frontier, respectively.
You may want to work with this standard diagram to demonstrate a number of basic points. First, an autarkic
economy must produce what it consumes, which determines the equilibrium price ratio; and second, opening
an economy to trade shifts the price ratio line and unambiguously increases welfare. Third, an improvement
in the terms of trade increases welfare in the economy. Fourth, it is straightforward to move from a small
country analysis to a two-country analysis by introducing a structure of world relative demand and supply
curves which determine relative prices.
These relationships can be used in conjunction with the Rybczynski and the Stolper-Samuelson theorems
from the previous chapter to address a range of issues. For example, you can consider whether the dramatic
economic growth of countries like Japan and Korea has helped or hurt the United States as a whole, and
also identify the classes of individuals within the United States who have been hurt by the particular growth
biases of these countries. In teaching these points, it might be interesting and useful to relate them to current
events. For example, you can lead a class discussion on the implications for the United States of the
provision of forms of technical and economic assistance to the emerging economies around the world or
the ways in which a world recession can lead to a fall in demand for U.S. export goods.
The example provided in the text considers the popular arguments in the media that growth in Japan or
Korea hurts the United States. The analysis presented in this chapter demonstrates that the bias of growth
is important in determining welfare effects rather than the country in which growth occurs. The existence
of biased growth and the possibility of immiserizing growth are discussed. The Relative Supply (RS) and
Relative Demand (RD) curves illustrate the effect of biased growth on the terms of trade. The new terms
of trade line can be used with the general equilibrium analysis to find the welfare effects of growth. A general
principle which emerges is that a country which experiences export-biased growth will have a deterioration
in its terms of trade, while a country which experiences import-biased growth has an improvement in its
terms of trade. A case study points out that growth in the rest of the world has made other countries more
like the United States. This import-biased growth has worsened the terms of trade for the United States.
The second area to which the standard trade model is applied are the effects of tariffs and export subsidies
on welfare and terms of trade. The analysis proceeds by recognizing that tariffs or subsidies shift both the
relative supply and relative demand curves. A tariff on imports improves the terms of trade, expressed in
external prices, while a subsidy on exports worsens terms of trade. The size of the effect depends upon the
size of the country in the world. Tariffs and subsidies also impose distortionary costs upon the economy.
Thus, if a country is large enough, there may be an optimum, nonzero tariff. Export subsidies, however,
only impose costs upon an economy. Internationally, tariffs aid import-competing sectors and hurt export
sectors while subsidies have the opposite effect.
The chapter then closes with a discussion of international borrowing and lending. The standard trade model is
adapted to trade in consumption across time. The relative price of future consumption is defined as 1/(1 r),
where r is the real interest rate. Countries with relatively high real interest rates (newly industrializing
countries with high investment returns for example) will be biased toward future consumption, and will
effectively “export” future consumption by borrowing from established developed countries with relatively
lower real interest rates.
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley