© 2007 Pearson Addison-Wesley. All rights reserved Chapter 3 Applications of the Basic Model

4-2 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Review Any country that moves from autarky to free trade can experience gains in real income. Suppose now we are already in the position of free trade equilibrium. Free trade could be measured as the matching-size trade triangle as before. But, assuming home is the clothing exporter, there exists a rising net export supply curve.

4-3 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 3.1 An Outward Shift in Foreign Demand

4-4 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. An Outward Shift in Foreign Demand Import demand increases due to taste changes. Import demand curve shifts right. It guarantees an increase in the relative price of exports. Terms of trade better-off Terms of trade=Price of Exports/Price of Imports It raises real income at home The increase of real income depends on (1) improvement of the TOT; (2) Increase of the export volume.

4-5 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 3.1 An Outward Shift in Foreign Demand

4-6 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. An Outward Shift in Foreign Demand An outward shift in foreign demand for home exports of clothing raises clothing’s price but may or may not increase home exports of clothing. The backward-bending supply curve. Home’s real income improves, but some of these gains spill over to greater home demand for clothing. If such an increase in home demand exceeds the greater quantity produced, a lower quantity is available for export. It corresponds to the segment BQR in the offer curve.

4-7 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 2.C.1 Offer Curves

4-8 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Protection in the import-competing goods At free trade equilibrium, Is it possible that government step in and interfere with resource allocation to protect the import- competing food sector ? Possible. Special interest groups of agricultural industry could lobby for the government. SIG gains in expenditure of the national loss. E.g., the move from line 1 to line 2.

4-9 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 3.2 Restriction on Exportables Production

4-10 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Protection in the import-competing goods Is it possible that a government’s intervention (tariffs or non- tariff-barriers) benefits for its whole country. No way when such a country is small. A small country cannot affect the world price (see line 2) But it is possible for a large country. When a large country restricts imports then it could cause the world price of food importables lowered (since less demand). Home’s terms of trade improves. Budget line rotates from line 1 to line 3. Representative consumers obtain higher utility.

4-11 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Protection in the import-competing goods Some caveats though. The domestic adjustment from A to B distorts the domestic consumption as well. The food market needs to explore. Foreign retaliation is possible.

4-12 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Immiserizing Growth Can an outward shift of the production-possibility schedule in a country with a constant population ever lead to a lowering of real income at home? Perhaps. Balanced Growth An expansion of both domestic exportable and importable could affect the world market. Dark side: it induces a deterioration on the terms of trade. So, to some extent, it may erode the gains from trade. Bright side: it causes real income to rise in trading partners that are importers of the growing country’s exports.

4-13 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Deterioration of Home’s TOT pc/pf Qc+Qc*/Qf+Qf*

4-14 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Immiserizing Growth Consider an extreme case. The growth could lower real incomes by being concentrated in domestic export sector and by significantly worsening the TOT. Figure 3.3 Growth biased toward the nation’s export industry (clothing) can reduce real income by so worsening the TOT (from line 1 to line 2) that consumption (at D) ends up on a lower indifference curve than initially (at B).

4-15 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 3.3 Immiserizing Growth

4-16 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Assumptions for Immiserizing Growth (1)Grow primarily increases capacity and output in domestic export industries. (2)World’s demand elasticity for the country’s export good is quite low. This guarantees a worse-off of terms of trade.

4-17 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Transfer Problem Historically, more direct forms of transfer is important. Home is obligated to transfer money to foreign. Franco-Prussian War in : France World War I: Germany Marshall Plan: US Gulf War in 1991: Japan, Germany, Kuwait, Saudi Arabia to US Southern-East Asian Crisis in 1997: IMF How does such a transfer affect the terms of trade?

4-18 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Transfer Problem At any given price ratio, the home, or transferring, country can be expected to cut back its spending on all normal goods such as food. Foreign could increase all demand for all goods. The demand increase of food happens to some extent. The world demand curve for food could shift in or out. Marginal propensities to import (m or m*) T denotes transfer The world demand curve for food shifts to the right iff (1-m*)T> mT

4-19 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. It is never better to give than to receive Secondary blessing is impossible in a 2-country setup. If the home makes a transfer, its real income is reduced. But if its terms of trade improve (price of food falls), then loss will not be so severe. The TOT moves in favor of home if the sum of import propensities satisfy: (1-m*)T < mT Let OB denote the full compensation for the home country for the transfer. Can the transfer shift world demand to the left sufficiently to reduce food’s price to 0B or lower?

4-20 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 3.4 Transfer and the Terms of Trade

4-21 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. It is never better to give than to receive No. Since at point B, world demand must exceed world supply. This is because no real income in both countries will be changed if the price of food at point B. Also, no income effect at B. Only substitution effect exists. Food’s lower relative price must call forth a substitution of food for clothing in both countries. Therefore, equilibrium must be at somewhere in between AB, say, point G. It is never better to give than to receive!

4-22 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Some extensions of simple trade model Many final goods (intra-industry trade) Many countries Trade in intermediate goods and international factor mobility Non-tradable goods Trade in assets

4-23 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 3.5 Intertemporal Trade

4-24 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Equilibrium Stability Before we assume a unique equilibrium. Two necessary assumptions: Price above equilibrium must have excess supply higher than excess demand, and vice versa. It is assumed that price is driven up iff the existence of excess world demand. Consider multiple free-trade equilibrium Panel a: three equilibria The middle equilibrium point C is unstable but is flanked by a pair of stable equilibria

4-25 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 3.A.1 Multiple Equilibria

4-26 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Equilibrium Stability Say, the price of food is slightly higher, at 2, world demand is higher than world supply. It will jump up the food’s price, away from point C, but to D. How about point 1? Offer curve in panel B is also the case. Consider price ratio curve 2, dis-equilibrium there. TV is the excess of the home’s import demand of food over foreign supplies Remember the green line is home offer curve. Therefore, food’s relative price will rise, going clockwise way to the stable point I.