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Chapter 6
The Standard Trade Model
■ 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.
Case Study: Unequal Gains from Trade across the Income Distribution.
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 Economies 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.
30 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
Intertemporal Comparative Advantage.
Summary
APPENDIX TO CHAPTER 6: More on Intertemporal Trade
■ Chapter Overview
Previous chapters have highlighted specific sources of comparative advantage that give rise to
international trade. This chapter presents a general model that 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, 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 that 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 (ratio of export prices to import prices) 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 China 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 China’s particular growth biases.
For example, a case study in this chapter argues that the gains from trade with China are larger for U.S.
consumers at the bottom of the income distribution as they tend to consume relatively more tradable goods
(food, apparel, etc.) than richer consumers who spend relatively more on nontraded services. In teaching
Chapter 6 The Standard Trade Model 31
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. exports.
The example provided in the text considers the popular arguments in the media that growth in China 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 that emerges is that a country that experiences export-biased growth will have a deterioration in
its terms of trade, while a country that experiences import-biased growth has an improvement in its terms
of trade. A case study argues that this is really an empirical question, and the evidence suggests that the
rapid growth of countries like China has not led to a significant deterioration of the U.S. terms of trade nor
has it drastically improved China’s terms of trade. The countries most vulnerable to terms of trade shocks
are those that rely on exports of primary commodities with volatile prices. For example, the recent crash in
oil prices has incurred a loss of over 17% of GDP in Venezuela. For more diversified economies, the terms
of trade tends to be more stable.
The second area to which the standard trade model is applied is 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.
32 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
■ Answers to Textbook Problems
1.
2.
3. An increase in the terms of trade increases welfare when the PPF is right-angled. The production
Chapter 6 The Standard Trade Model 33
© 2018 Pearson Education, Inc.
highest indifference curve. An improvement in the terms of trade rotates the relative price line about
its intercept with the PPF rectangle (because there is no substitution of immobile factors, the
production point stays fixed). The economy can then reach a higher indifference curve. Intuitively,
although there is no supply response, the economy receives more for the exports it supplies and pays
less for the imports it purchases.
4. The difference from the standard diagram is that the indifference curves are right angles rather than
5. The terms of trade for Japan, a manufactures (M) exporter and a raw materials (R) importer, is the
world relative price of manufactures in terms of raw materials (pM/pR). The terms of trade change can
be determined by the shifts in the world relative supply and demand (manufactures relative to raw
34 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
© 2018 Pearson Education, Inc.
world RS and decreases the world RD (i.e., world RS shifts out and world RD shifts in). The
world relative price of manufactures declines, and Japan’s terms of trade deteriorate.
6. The declining price of services relative to manufactured goods shifts the isovalue line clockwise so
7. These results acknowledge the biased growth that occurs when there is an increase in one factor of
production. An increase in the capital stock of either country favors production of good X, while an
increase in the labor supply favors production of good Y. Also, recognize the Heckscher-Ohlin
8. Immiserizing growth occurs when the welfare deteriorating effects of a worsening in an economy’s
Chapter 6 The Standard Trade Model 35
© 2018 Pearson Education, Inc.
undergo very biased growth, and the economy must be a large enough actor in the world economy
such that its actions spill over to adversely alter the terms of trade to a large degree. This combination
of events is unlikely to occur in practice.
9. India opening its markets to world trade should be good for the United States if the change reduces
10. What matters for welfare are the external terms of trade. Suppose that country X exports good A and
11. International borrowing and lending implies a trade-off between the production of current and future
36 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
12. Comparative advantage in international borrowing and lending is driven by the relative price of future
consumption and, more specifically, the real interest rate. As the real interest rate rises, the relative
price of future consumption 1/(1 + r) falls. Effectively, a country with a high real interest rate is one
