International Trade and Welfare (Sec 7)

Question 1

Consider an economy with two sectors. Production factors are immobile between these sectors.
Hence, the same output quantities are produced regardless of the relative price of the two goods.
What does the transformation curve look like?

Answer 1

Transformation curve :
X axis - Y1 , Y axis - Y2
-P1 / P2 = downward sloping left to right curve
UA = curvy downward sloping curve with middle point touching middle point of 1st curve
-P1* / P2* = Right of first curve, steeper downward sloping curve
UT = Right to the UA curve

Question 2

What is terms of trade?

Answer 2

Terms of trade are defined as the price of a country’s exports divided by the price of it’s imports.
TOT = export price / import price = € export good / € import good = imported goods / exported goods

Question 3

Is an increase in terms of trade welfare enhancing in such an economy? (P1 increases)

Answer 3

• Under autarky the economy produces in the production point => (P1) does not change with trade
• Relative price becomes steeper, if TOT increases (goes through the production point)
• Under trade the economy can consume along the relative price curve and thus reaches a higher indifference curve

=> An increase in TOT is welfare enhancing !!

Question 4

Apply the standard trade model to illustrate whether a country benefits from commencing international trade using an appropriate graph.

Answer 4

Same as previous graph except extra convex curvy curve facing inwards (PPF) on left of -P1 / P2 curve with meeting at same middle point being A.
And UT curve hits PPF curve near bottom called point T (exports of goods)

Question 5

Describe the situation of previous graph

Answer 5

• We now have a steeper relative price line, increase in production good 1 and decrease in production good 2
• Iso - valueline :
  V = P1 . Y1 + P2 . Y2 <=> Y2 = V / P2 - P1 / P2 . Y1
• Under autarky consumption in the production point A

Trade:
- uniform relative world market price (P1 / P2 increase) => Y1 increase , Y2 decrease
- A country can swap goods along the relative world price
- Trade pattern : Export good 1, Import good 2

Question 6

Describe the consequences of international trade in respect of production, consumption and trade volume

Answer 6

1) Increase in welfare => higher indiff curve
2) Production effects => P1 / P2 increase due to trade so Y1 increase , Y2 decrease
3) Consumption effects => consumption of good 1 decreases, consumption of good 2 increases
- income effect : more income available to spend on both goods (higher IC)
- substitution effect : adjustment to the new relative price
Hence : substitution effect dominates the income effect

Question 7

What is the standard trade model?

Answer 7

Standard Trade Model :
-2 countries (Home and Foreign)
-2 goods (Food F and Cloth C)

Derivation of ISO - value lines :
Pc Qc + Pf Qf = V <=> Qf = V / Pf - Pc / Pf . Qc

• Pc Qc = value of cloth produced
• Pf Qf = value of food produced
• V = total value of goods produced
• Qf = quantity of food
• V / Pf = intersection with y axis
• -Pc / Pf . Qc = slope

Question 8

The standard trade model does not assume any dynamic effects such as economic growth in its
basic version. What are the effects of economic growth?

Answer 8

Effects of Economic growth :
- Economic growth in the rest of the world => larger market but more competition for home products
- Economic growth at home => you can sell more on the international market (more poss imports and exports

Economic growth => outward shift of a country’s production possibility frontier
- can produce more of both goods
- it is considered a good thing , economists aim for economic growth

Question 9

Is economic growth in other countries good or bad for the domestic country?

Answer 9

Obviously good => more to share ( aggregate , not distributional consideration)

Question 10

Is growth in a country more or less valuable when that nation is part of a closely integrated world economy?

Answer 10

Based on economic growth :
-PPF shifts outward more in one direction than the other.

Important consideration :
-Here it is not important which economy grows, but rather the bias of the growth is decisive

Assume : Home exports cloth , Foreign exports food
Food biased growth :
relative price of cloth in terms of food rises , (Pc / Pf increase = TOT)
- The relative price is the TOT
-Improvement of the home country’s TOT, deterioration in foreign TOT (Pf / Pc decreases = TOT)
-(V.s cloth biased-growth ) => just moves the other way

Role of TOT effects (home perspective) :
- Import biased growth (good additional secondary benefits from growth)
- V.s export biased growth (bad, reduce benefits from growth

-For distributional considerations , it does matter where economic growth happens and why !