Offer Curves How the Terms of Trade Are Established

Offer Curves are all combinations of a country’s desired exports and imports at different terms of trade also known as reciprocal demand curves (J.S. Mills) measures of willingness to trade

Y XY X (P X /P Y ) 1 X2X2 Y2Y2 X1X1 Y1Y1 CP

Y XY X X2X2 Y2Y2 X1X1 Y1Y1 CP X5X5 Y5Y5

Y XY X X5X5 Y5Y5 (P X /P Y ) 2 X4X4 X3X3 Y3Y3 Y4Y4 X6X6 Y6Y6

Y XY X (P X /P Y ) 1 X5X5 Y5Y5 (P X /P Y ) 2 X4X4 X3X3 Y3Y3 Y4Y4 X6X6 Y6Y6 OC A

Offer Curves Offer curves represent willingness to trade at every possible terms of trade As the relative price of good X rises, Country A becomes willing to export more and import more Offer curves “bow” towards the import good axis

Deriving Country B’s Offer Curve This will reflect Country B’s willingness to trade at different terms of trade B’s offer curve bows towards the axis with B’s import good on it

Y XY X (P X /P Y ) 1 p X7X7 Y7Y7 c X8X8 Y8Y8

Y XY X p X7X7 Y7Y7 c X8X8 Y8Y8 X9X9 Y9Y9

Y XY X X9X9 Y9Y9 (P X /P Y ) 2 Y 10 X 10 Y 11 X 11 X 12 Y 12 (P X /P Y ) 2 OC B

Terms of Trade Equilibrium The international terms of trade (that is, P X /P Y ) will be the slope of a line passing through the point where the offer curves cross. This equilibrium point takes into account demand and supply conditions in both countries

Terms of Trade Equilibrium Y X (P X /P Y ) E X1X1 Y1Y1 OC A OC B

Terms of Trade Equilibrium Y X (P X /P Y ) E X1X1 Y1Y1 If these are the terms of trade, country A will desire to export X 1 units, and country B will want to import X 1 units OC A OC B

Terms of Trade Equilibrium Y X (P X /P Y ) E X1X1 Y1Y1 If these are the terms of trade, country A will desire to import Y 1 units, and country B will want to export Y 1 units OC A OC B

How Do We Know It’s Equilibrium? Any terms of trade other than (P X /P Y ) E will result in –excess demand for one good –excess supply for the other Therefore relative prices will adjust until (P X /P Y ) E is reached

Disequilibrium Y X (P X /P Y ) 1 OC A OC B

Disequilibrium Y X (P X /P Y ) 1 OC A OC B Y1Y1 Y2Y2

Disequilibrium Y X (P X /P Y ) 1 OC A OC B Y1Y1 Y2Y2 At (P X /P Y ) 1, country A wishes to import Y 1 units, but country B is only interested in exporting Y 2 units. That is, there is an excess demand for good Y.

Disequilibrium Y X (P X /P Y ) 1 OC A OC B X1X1 X2X2

Disequilibrium Y X (P X /P Y ) 1 OC A OC B X1X1 X2X2 At (P X /P Y ) 1, country A wishes to export X 1 units, but country B is only interested in importing X 2 units. That is, there is an excess supply of good X.

Disequilibrium Excess demand for Y causes P Y to rise Excess supply of X causes P X to fall Thus, (P X /P Y ) falls In other words, the terms of trade line gets flatter, moving the countries in the direction of equilibrium

Moving Towards Equilibrium Y X (P X /P Y ) 1 OC A OC B

Disequilibrium Terms of trade lines that are flatter than (P X /P Y ) E, such as

Disequilibrium Y X (P X /P Y ) 2 OC A OC B

Disequilibrium Terms of trade lines that are flatter than (P X /P Y ) E will results in –an excess demand for good X –an excess supply of good Y, and so (P X /P Y ) will rise That is, the terms of trade line will get steeper until (P X /P Y ) E is reached

Moving Towards Equilibrium Y X (P X /P Y ) 2 OC A OC B

A Note on the Terms of Trade A country’s “terms of trade” are the price of its exports divided by the price of its imports, so a rising terms of trade is good news In this example, (P X /P Y ) is country A’s terms of trade, since A exports good X and imports Y (P Y /P X ) is country B’s terms of trade in this example

A Note on the Terms of Trade, continued As A’s terms of trade (P X /P Y ) improve, B’s terms of trade (P Y /P X ) must be deteriorating and vice-versa

Shifts of Offer Curves Anything that causes country A’s willingness to trade to change will shift A’s offer curve –increased willingness to trade: OC A shifts right –decreased willingness to trade: OC A shifts left These can be caused by –changes in demand conditions or –changes in supply conditions

Demand Changes in Country A Y X (P X /P Y ) E X1X1 Y1Y1 OC A OC B

Demand Changes in Country A Y X (P X /P Y ) E OC A OC B Increased demand for imports by Country A causes a rightward shift of A’s offer curve OC A '

Demand Changes in Country A Y X (P X /P Y ) E OC A OC B Volume of trade increases, but A’s terms of trade go down. B’s terms of trade improve. OC A ' (P X /P Y ) E ' X2X2 Y2Y2

Demand Changes in A Any change that might make A demand more imports leads to a rightward OC shift, and thus –an increase in trade volume –a decrease in A’s terms of trade

Demand Changes in Country B Y X (P X /P Y ) E X1X1 Y1Y1 OC A OC B

Demand Changes in Country B Y X (P X /P Y ) E OC A OC B OC B ' Increased demand for imports by Country B shifts B’s OC upward

Demand Changes in Country B Y X (P X /P Y ) E OC A OC B OC B ' (P X /P Y ) E ' X2X2 Y2Y2 Volume of trade increases, but Country B’s terms of trade decrease (and A’s terms of trade improve).

Other Demand Changes Any decrease in a country’s willingness to trade will shift its OC leftward or downward An example is when a country imposes an import tariff Tariffs therefore lead to decreased trade volume, but improve the imposing country’s terms of trade

Imposition of Tariff by Country A Y X (P X /P Y ) E X1X1 Y1Y1 OC A OC B

Imposition of Tariff by Country A Y X (P X /P Y ) E X1X1 Y1Y1 OC A OC B OC A '

Imposition of Tariff by Country A Y X (P X /P Y ) E X2X2 Y2Y2 OC A OC B OC A ' (P X /P Y ) E '

Imposition of Tariff by Country A Y X (P X /P Y ) E X2X2 Y2Y2 OC A OC B OC A ' (P X /P Y ) E ' By imposing a tariff, Country A decreases trade volume, and improves its terms of trade (but B’s terms of trade deteriorate)

Supply Changes Changes in supply conditions will also shift a country’s offer curves around Examples include –productivity changes –discovery of new resources

An Example: The Oil Shocks of the 1970s Let’s think of OPEC as one country Let’s also think of the industrial countries as one country OPEC effectively decreased its willingness to trade Presumably this shifted OPEC’s offer curve to the left, increasing OPEC’s terms of trade and decreasing the industrial countries’

Oil Shocks of the 1970s Other stuff Oil (P X /P Y ) pre-shock X1X1 Y1Y1 OC OPEC OC IC

Oil Shocks of the 1970s Other Stuff Oil (P X /P Y ) E X1X1 Y1Y1 OC OPEC OC IC OC OPEC '

Oil Shocks of the 1970s Other Stuff Oil (P X /P Y ) pre-shock X1X1 Y1Y1 OC OPEC OC IC OC OPEC ' (P X /P Y ) post-shock X2X2 Y2Y2

Oil Shocks of the 1970s Other Stuff Oil (P X /P Y ) pre-shock X1X1 Y1Y1 OC OPEC OC IC OC OPEC ' (P X /P Y ) post-shock X2X2 Y2Y2 OPEC’s terms of trade should have improved, and the industrial countries’ should have worsened

Oil Shocks of the 1970s: Changes in the Terms of Trade

Offer Curves and “Small” Countries “Small” countries: those that are too small to affect world prices (and therefore the terms of trade) by their own actions From the “small” country’s perspective, the rest-of-world’s OC is a straight line

“Small” Countries and Offer Curves Y X X1X1 Y1Y1 OC ”small” OC ROW

“Small” Countries and Offer Curves Y X X1X1 Y1Y1 OC ”small” OC ROW Why is the ROW offer curve perceived to be a straight line?

“Small” Countries and Offer Curves Y X X1X1 Y1Y1 OC small OC ROW OC small ' If the “small” country imposes a tariff on ROW products, it has no effect on the terms of trade

“Small” Countries and Offer Curves Y X X1X1 Y1Y1 OC small OC ROW OC small ' If the “small” country imposes a tariff on ROW products, it has no effect on the terms of trade This is the definition of a “small” country

“Small” Countries and Offer Curves Q: What is the optimal tariff for a “small” country? A: No tariff at all - tariffs reduce trade volume, but don’t improve the terms of trade This is really the same point we made earlier: free trade is especially helpful to small developing countries