LESSON 5

• Relative prices and relative supply

  1. An increase in the price of cloth relative to food PC/PF makes the isovalue line steeper

  2. Supply of cloth relative to food QC/QF rises

  3. Relative supply of cloth to food increases with the relative price of cloth to food
• Economic growth


  • Is economic growth in other countries good or bad for our nation?
  • It may be good for our nation because it means larger markets for our exports. It may mean increased competition for our exporters
  • Is growth in a country more or less valuable when that nation is part of a closely integrated world economy?
  • It should be more valuable when a country can sell some of its increased production to the world market. It is less valuable when the benefits of growth are passed on to foreigners rather than retained at home
• Welfare effect of changes in the terms of trade

  1. The price of the good a country initially exports divided by the price of the good it initially imports

  2. A rise in the terms of trade increases a country's welfare, while a decline in the terms of trade reduces its welfare
• Key relationships in The Standard Trade Model


  • 1. Relationship between the production possibility frontier and the relative supply curve
  • 2. Relationship between relative prices and relative demand
  • 3. Determination of world equilibrium by world relative supply and world relative demand
  • 4. Effect of the terms of trade on a nation's welfare
• Indifference curves

  1. Are downward sloping - if you have less cloth, then you must have more food to be equally satisfied

  2. Lie farther from the origin make consumers more satisfied - they prefer having more of both goods

  3. Become flatter when they move to the right - with more cloth and less food, an extra yard of cloth becomes less valuable in terms of how many calories of food you are willing to give up for it
• Production possibilities and relative supply

  1. Assumptions of the model:

  2. Each country produces two goods, food (F) and cloth (C)

  3. Each country's production possibility frontier is a smooth curve

  4. The point on its production possibility frontier at which an economy produces depends on the price of cloth relative to food, PC/PF

  5. An economy whose production possibility frontier is TT will produce at Q, which is on the highest possible isovalue line

  6. Isovalue lines - Lines along which the market value of output is constant
• The Standard Trade Model


  • A general model of trade that admits specific models as special cases
• Relative prices and demand

  1. The value of an economy's consumption equals the value of its production

  2. The economy's choice of a point on the isovalue line depends on the tastes of its consumers, which can be represented graphically by a series of indifference curves
• Growth and the production possibility frontier

  Economic growth implies an outward shift of a country's production possibility frontier
• Implications of Terms of Trade Effects

  • A tariff (subsidy) has the direct effect of raising the internal relative price of the imported (exported) good, which might have perverse effects on internal prices (Metzler paradox)
• Biased Growth

  Takes place when production possibilities shift out more in one direction than in the other
• Standard Trade Model

  Export-biased growth in the rest of the world improves our terms of trade, while import-biased growth abroad worsens our terms of trade
• Import-biased growth

  Disproportionately expands a country’s production possibilities in the direction of the good it imports, improving the country's terms of trade at the rest of the world's expense
• Implications of Terms of Trade Effects

  • If Home imposes a tariff, its welfare increases as long as the tariff is not too large, while Foreign’s welfare decreases
  • If Home offers an export subsidy, its welfare deteriorates, while Foreign’s welfare increases
• Growth

  Implies an outward shift of a country’s production possibility frontier
• Presumptions about the terms of trade effects of transfers

  • A transfer will worsen the donor’s terms of trade if the donor has a higher marginal propensity to spend on its export good than the recipient
  • Most countries spend a much higher share of their income on domestically produced goods than foreigners do, possibly due to barriers to trade
• Increased production can be sold to the world market


  It is less valuable when the benefits of growth are passed on to foreigners rather than retained at home
• Export-biased growth

  Disproportionately expands a country’s production possibilities in the direction of the good it exports, worsening the country's terms of trade
• Have a great day ☺
• Reasons for biased growth

  • Technological progress in one sector of the economy
  • Increase in a country’s supply of a factor of production
• Effects of International Transfers

  International transfers of income may affect a country’s terms of trade by shifting the world relative demand curve due to changes in tastes, technology, and international transfers of income