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
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
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.
28 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
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. 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. 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 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.
Chapter 6 The Standard Trade Model 29
◼ Answers to Textbook Problems
1. If the relative price of palm oil increases in relation to the price of lubricants, this would increase the
production of palm oil, because Indonesia exports palm oil. Similarly, an increase in relative price of
lubricants leads to a shift along the indifference curve, towards lubricants and away from palm oil for
Indonesia. This is because Palm oil is relatively expensive, hence reducing palm oil consumption in
Indonesia.
2.
In panel a, the reduction of Norway’s production possibilities away from fish cause the production of
fish relative to automobiles to fall. Thus, despite the higher relative price of fish exports, Norway moves
down to a lower indifference curve representing a drop in welfare.
3. The terms of trade of the home country would worsen. This is because a strong biased production
towards cloth would increase the home country’s supply of cloth and shifts the supply curve to the
right. At the same time, the production of wheat would decline relative to the production of cloth. An
increased supply of cloth would reduce the price at the domestic and at the international market. The
30 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
4. The difference from the standard diagram is that the indifference curves are right angles rather than
smooth curves. Here, a terms of trade increase enables an economy to move to a higher indifference
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 materials)
curves. Note that in the following answers, world relative supply (RS) and relative demand (RD) are
always M relative to R. We consider all countries to be large, such that changes affect the world
relative price.
a. An oil supply disruption from the Middle East decreases the supply of raw materials, which
increases the world relative supply of manufactures to raw materials. The world relative supply
b. Korea’s increased automobile production increases the supply of manufactures, which increases
the world RS. The world relative supply curve shifts out, decreasing the world relative price of
manufactured goods and deteriorating Japan’s terms of trade.
c. U.S. development of a substitute for fossil fuel decreases the demand for raw materials. This
d. A harvest failure in Russia decreases the supply of raw materials, which increases the world RS.
The world relative supply curve shifts out. Also, Russia’s demand for manufactures decreases,
which reduces world demand so that the world relative demand curve shifts in. These forces
decrease the world relative price of manufactured goods and deteriorate Japan’s terms of trade.
e. A reduction in Japan’s tariff on raw materials will raise its internal relative price of manufactures
6. The declining price of services relative to manufactured goods shifts the isovalue line clockwise so
that relatively fewer services and more manufactured goods are produced in the United States, thus
reducing U.S. welfare.
Chapter 6 The Standard Trade Model 31
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 result
that an economy will export that good that uses intensively the factor which that economy has in
relative abundance. Country A exports good X to country B and imports good Y from country B. The
possibility of immiserizing growth makes the welfare effects of the terms of trade improvement due
to export-biased growth ambiguous. Import-biased growth unambiguously improves welfare for the
growing country.
a. The relative price of good X falls, causing country A’s terms of trade to worsen. A’s welfare may
increase or, less likely, decrease, and B’s welfare increases.
8. Immiserizing growth occurs when the welfare deteriorating effects of a worsening in an economy’s
terms of trade swamp the welfare improving effects of growth. For this to occur, an economy must
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
the relative price of goods that China sends to the United States and hence increases the relative price
of goods that the United States exports. Obviously, any sector in the United States hurt by trade with
China would be hurt again by India, but on net, the United States wins. Note that here we are making
10. An import tariff makes the imported goods more expensive in the domestic market as compared to
the world market. In a two commodity system e.g. food and cloth, an imposition of import tariff on
cloth makes the cloth more expensive for people in the domestic market. Eventually, the internal
price of food is cheaper than the relative price in the external market. This pushes the domestic
producers to produce cloth as the relative price is higher. The home consumers shift their
32 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
The parties emphasize on the reduction of tariff to increase its trade with the partner country under
the free trade agreements. When a tariff is reduced by both the partner countries, it increases the trade
volume between the two countries. The reduction of tariff and free flow of commodities between the
11. When a country borrows for the present consumption, it is liable to make the payment in future by
sacrificing its future consumption. This means, in future the country has to return the principal
borrowing amount with some interest rate. If a country borrows 1 unit at present, it has to return (1+
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 that has
high returns on investment. Such a country will prefer to borrow today and take advantage of the high
return on investment and enjoy the fruits of current investment with high returns in the future.
a. Countries like Argentina and Canada should have high real interest rates as there are large
investment opportunities that have yet to be exploited. These countries will have a low price of
future consumption and will be biased toward exporting future consumption, preferring to
borrow today.
c. The discovery of large oil reserves that do not require a significant investment to extract will cause
real interest rates in Saudi Arabia to fall (large increase in wealth). This will cause the relative
price of future consumption to rise, making it more likely that Saudi Arabia will have a PPF
biased toward exporting present consumption. Saudi Arabia will increase their current lending as a
result of these oil discoveries.