Transcript Chapter 3

Chapter 3
Applications of
the Basic Model
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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.
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Figure 3.1 An Outward Shift in Foreign
Demand
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An Outward Shift in Foreign Demand
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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.
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Figure 3.1 An Outward Shift in Foreign
Demand
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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.
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Figure 2.C.1 Offer Curves
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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 importcompeting 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.
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Figure 3.2 Restriction on Exportables
Production
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Protection in the import-competing goods
• Is it possible that a government’s intervention (tariffs or nontariff-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.
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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.
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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.
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The Deterioration of Home’s TOT
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pc/pf
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Qc+Qc*/Qf+Qf*
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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).
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Figure 3.3 Immiserizing Growth
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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.
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Transfer Problem
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Historically, more direct forms of transfer is important.
Home is obligated to transfer money to foreign.
Franco-Prussian War in 1870-1871: 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?
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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
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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?
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Figure 3.4 Transfer and the Terms of Trade
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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!
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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
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Figure 3.5 Intertemporal Trade
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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
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Figure 3.A.1
Multiple Equilibria
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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.
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