1. Offer Curves and the Terms of Trade
Chapter 7
Offer Curves and the Terms of Trade
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Learning Objectives
Formulate a country’s offer curve and show how it is obtained.
Identify how the equilibrium international terms of trade are attained.
Explain how changes in supply and demand conditions influence the international terms and volume of trade.
Demonstrate the usefulness of different concepts of the terms of trade.

3. Offer Curves
comprise all combinations of a country’s desired exports and imports at different terms of trade.
are also known as reciprocal demand curves (J.S. Mill).
measure a country’s willingness to trade.
can be derived from the PPF-indifference curve graph.

4. Y C P Y1 Y2
(PX/PY)1 Y X1 X2 X
(PX/PY)1 Y5 X5 X
7-4

5. Y Y3 (PX/PY)1 Y4 (PX/PY)2 X3 X4 Y X (PX/PY)2 (PX/PY)1 Y6 Y5 X5 X6 X
7-5

6. Y Y3 (PX/PY)1 Y4 (PX/PY)2 X3 X4 Y X OCA (PX/PY)2 (PX/PY)1 Y6 Y5 X5 X6
7-6

7. 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.

8. 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.

9. Y
(PX/PY)1 p Y7 c Y8 Y X7 X8 X
(PX/PY)1 Y9 X9 X
7-9

10. Y (PX/PY)1 Y10 (PX/PY)2 Y11 Y X10 X11 X (PX/PY)1 (PX/PY)2 OCB Y12 Y9
7-10

11. Terms of Trade Equilibrium
The international terms of trade (that is, PX/PY) 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.

12. Terms of Trade Equilibrium
OCA
(PX/PY)E Y
OCB Y1
If these are the terms of trade,
country A will desire to export
X1 units, and country B will
want to import X1 units. X1 X

13. Terms of Trade Equilibrium
OCA
(PX/PY)E Y
OCB Y1
If these are the terms of trade,
country A will desire to import
Y1 units, and country B will
want to export Y1 units. X1 X

14. How Do We Know It’s Equilibrium?
Any terms of trade other than (PX/PY)E will result in
excess demand for one good, and
excess supply for the other.
Therefore relative prices will adjust until (PX/PY)E is reached.

15. Disequilibrium
OCA
(PX/PY)1 Y
OCB X

16. Disequilibrium OCA (PX/PY)1 Y Y1 OCB Y2 At (PX/PY)1, country A wishes
to import Y1 units, but country B
is only interested in exporting Y2
units. That is, there is an excess
demand for good Y. X

17. Disequilibrium OCA (PX/PY)1 Y OCB At (PX/PY)1, country A wishes
to export X1 units, but country B
is only interested in importing X2
units. That is, there is an excess
supply of good X. X2 X1 X

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

19. Moving Towards Equilibrium
OCA
(PX/PY)1 Y
OCB X

20. Disequilibrium
Terms of trade lines that are flatter than (PX/PY)E, such as

21. Disequilibrium
OCA
(PX/PY)2 Y
OCB X

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

23. Moving Towards Equilibrium
OCA
(PX/PY)2 Y
OCB X

24. 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, (PX/PY) is country A’s terms of trade, since A exports good X and imports Y.
(PY/PX) is country B’s terms of trade in this example.

25. A Note on the Terms of Trade, continued
As A’s terms of trade (PX/PY) improve, B’s terms of trade (PY/PX) must be deteriorating and vice-versa.

26. 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: OCA shifts right
decreased willingness to trade: OCA shifts left
These can be caused by
changes in demand conditions or
changes in supply conditions.

27. Demand Changes in Country A
OCA
(PX/PY)E Y
OCB Y1 X1 X

28. Demand Changes in Country A
OCA
OCA' Y
(PX/PY)E
OCB
Increased demand for imports
by Country A causes a
rightward shift of A’s offer
curve. X

29. Demand Changes in Country A
OCA'
OCA Y
(PX/PY)E
(PX/PY)E'
OCB Y2
Volume of trade increases, but
A’s terms of trade go down. B’s
terms of trade improve. X2 X

30. 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, and
a decrease in A’s terms of trade.

31. Demand Changes in Country B
OCA
(PX/PY)E Y
OCB Y1 X1 X

32. Demand Changes in Country B
OCA
(PX/PY)E Y
OCB'
OCB
Increased demand for imports
by Country B shifts B’s OC
upward. X

33. Demand Changes in Country B
OCA
(PX/PY)E Y
(PX/PY)E'
OCB' Y2
OCB
Volume of trade increases,
but Country B’s terms of trade
decrease (and A’s terms of
trade improve). X2 X

34. 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.

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

36. Offer Curve Elasticity
Until now, we’ve been dealing with offer curves that are elastic.
Offer curves can also be unit elastic or even inelastic.
The shape of the offer curves depends on the elasticity of demand for imports:

37. Offer Curve Elasticity
From origin to point A, offer curve is elastic.
Between points A and B, offer curve is inelastic.
At point A, offer curve is unit elastic. B Y1 A X1 X

38. Offer Curve Elasticity
Over the elastic range, a 1% change in the relative price of imports will lead to a greater than 1% change in quantity of imports purchased.
Over the inelastic range, a 1% change in the relative price of imports will lead to a less than 1% change in quantity of imports purchased.

39. Offer Curve Elasticity
Recall that in general a country gives up its export good in order to purchase its import good.
Over the elastic range, a relative decline in the import price induces a country to give up more of the export good in order to buy more of the import good.

40. Offer Curve Elasticity
Over the inelastic range, when there is a relative decline in the import price, a country is willing to give up less of the export good in order to buy more of the import good.
This would occur if the income effect of a price change outweighs the combined effects of substitution and production.

41. Other Concepts of the Terms of Trade
We’ve focused on the commodity terms of trade so far, but there are others:
Income Terms of Trade
Single Factoral Terms of Trade
Double Factoral Terms of Trade