Chapter 3 EXPANDED GAINS FROM TRADE WITH RESOURCE MOVEMENTS

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Alicia Reeves
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1 Chapter 3 EXPANDED GAINS FROM TRADE WITH RESOURCE MOVEMENTS Chapter 2 presented the simplest model of production and trade. Countries received endowments of final goods, which they either consumed or exchanged with other countries. This chapter complicates things a bit by assuming that countries receive an endowment of factors of production and a technology that can transform each type of good into another type of good. The switching of production from one good to the other is illustrated as a movement along a country's production possibilities frontier. We are not yet concerned with the details of how factors of production, such as labor, capital, and land, operate the technology in order to produce output; at this point, the technology can simply be thought of as a black box which converts the goods back and forth. Preferences and technology now combine to determine, in autarky, prices and the optimal production and consumption bundles. As in the last chapter, in autarky consumers choose the consumption bundle that yields the highest level of utility, subject to the country's resources. Profit-maximizing producers (or firms owned by consumers), when facing given prices, choose to produce at a point where a line whose slope reflects relative prices is tangent to the production possibilities frontier. If a country opens up for international trade and world prices differ from autarky prices, producers adjust by moving along the production possibilities curve. The direction of this change in production reflects the country's comparative advantage. While we usually think of comparative advantage as the result of differences in conditions of production, it could also reflect differences in tastes. Whatever the underlying reason, the gains from this change in production are in addition to the gains from trade discussed in Chapter 2. Further extending the analysis of production to varieties, international trade allows a country to produce fewer different varieties than it would produce in autarky. Together with the assumption that varieties are produced under increasing returns, which means that unit costs fall as more units are produced, trade induces producers to substitute towards producing more of the expensive (export) goods as well as to drop some varieties while producing more of others. The latter causes the production possibilities frontier to shift outwards, bestowing yet additional gains from trade. The elasticity of import demand is an important concept that, among other things, gauges how vulnerable a country is to changes in world markets. Import demand is, for example, relatively less elastic for goods that have few close substitutes. The concept of elasticity plays a central role in the transfer and growth analyses of Chapter 4 as well as in tariff analyses in Chapters 10 to 14.

2 SHORT-ANSWER QUESTIONS 1. What does a bowed-out production possibilities frontier reflect? 2. How would the production possibilities frontier look if opportunity costs were constant? 3. What is Robinson Crusoe's feasible set in autarky, when he can substitute between clothing and food in production? 4. Illustrate Robinson Crusoe's autarky equilibrium when production is flexible. 5. Define the concept of comparative advantage. Can one talk about comparative advantage in the exchange model? 6. In a two-good world of clothing and food, if the home country imports food, in which good does it have a comparative advantage? 7. Suppose the relative price of food falls. Do we need to know the trade pattern to predict: How producers respond? How consumers respond? 8. If a country's terms of trade improve, what happens to its real income? 9. Can an import demand curve be upward sloping? 10. Which of the following statements is false? Substitution and income effects reinforce each other for imports. Substitution and income effects reinforce each other for exports. 11. Suppose oil is imported and clothing is exported, and that import demand is inelastic. If the price of oil increases, will more or less clothing be exported?

3 PROBLEMS 1. Growth, Technological Progress, and the Production Possibilities Frontier: Illustrate in the diagram above what you think would happen to the production possibilities frontier if this country experienced improved technology in the production of: (c) clothing food clothing and food What would happen to the production possibilities frontier if the country got more of all factors of production instead? What would happen to the production possibilities frontier if the country, by opening to trade, could specialize in the production of a particular variety of food and thereby start to exploit previously unexploited economies of scale in the food sector?

4 2. Feasible Set with Production and with Trade: In the following diagram, point E indicates Robinson Crusoe's endowment of clothing and food, and TT the production possibilities frontier corresponding to a technology that will convert clothing into food and vice versa. What is Robinson Crusoe's feasible set in autarky? In which sense can Robinson gain by trading with Nature? (c) The locus labeled ii is an indifference curve. Assuming that Robinson Crusoe's preferences are homothetic, indicate in the diagram the solution to Robinson's problem as a consumer in autarky. (d) What is the interpretation of the tangent line at the best autarky consumption point? (e) What is Robinson's feasible set if he can trade internationally at the terms of trade indicated by the slope of the price line l-l? 3. Production Bias and Taste Bias: Draw diagrams of the autarky situation and the trade situation for the home and foreign countries for the following cases: The home country has a comparative advantage in food production and a taste bias for clothing, and the foreign country has a comparative advantage in clothing production and a taste bias for food. The home country has a comparative advantage in food production and a taste bias for food, and the foreign country has a comparative advantage in clothing and a taste bias for clothing.

5 4. Does Trade Create Similarity? Free trade allows consumers and producers in all countries to face the same market prices. As a consequence, we would expect consumption patterns between countries to be more similar with trade than in autarky. Also, we would expect production patterns to be more similar with trade. Comment on this assertion, using the following two extreme situations to illustrate your remarks: Countries have identical taste patterns, but different production possibilities frontiers. Countries have identical production possibilities frontiers, but different sets of indifference curves. 5. Sources of Gains from Trade when Varieties are Produced: A country is said to gain from trade if its real income is higher when trading than in autarky or, equivalently, if it can reach a higher indifference curve by trading. For a country where two homogeneous goods are consumed and produced, show that when the production possibilities frontier is bowed out, the gains from trade consist of two components: consumption gains and production gains. Suppose that both clothing and food consist of many varieties, and that each variety can be produced in a decreasing cost industry. Now show that the gains from trade consist of four components: gains from consuming more varieties, consumption gains (from trading at different prices than autarky prices), gains due to decreasing costs, and production gains (from switching between clothing varieties and food varieties).

6 6. Free Trade is Best, Some Trade is Better Than No Trade: A newly-formed Pacific island nation has just discovered a rich oil reserve. The only other industry in this nation is subsistence farming. The country's engineers agree that if all resources are put into oil production, the country can produce a great deal of oil, but if resources are concentrated in agriculture, then only a small amount of food can be produced. The nation's president has called upon you for advice. You notice immediately that the country's relative price of food is high relative to the world market relative price of food. The president believes that the country should not have to import its food supply. Draw a diagram and provide an explanation that might convince the president that the country's welfare is higher under trade than in autarky. The president agrees to open up for trade, but is not willing to reduce domestic production of food. Is the country better off than in autarky? Is it better off than in free trade? Can you think of reasons not included in your model that might support the president's position? 7. Responding to a Terms-of-Trade Change: Consider a country which produces the homogeneous products clothing and food, and which is already engaged in international trade. Explain in words and with a drawing how substitution effects in production and consumption and the income effect together determine a country's new welfare level after its terms of trade have improved. 8. The Geometry of a Terms of Trade Improvement: Consider the preceding diagram for a small country that exports clothing in order to import food. At the terms of trade p1 the production point is A and the

7 consumption point is B. Suppose now that the terms of trade improve. Draw a new budget line and label it p2. Assuming that preferences are homothetic, show how producers and consumers respond to the price change by indicating the substitution and income effects in production and consumption. In your diagram, has the volume of imports increased from the price change? Has the volume of exports increased from the price change? 9. The Terms of Trade Effect: The drawing below is a reproduction of Figure 3.8 in the textbook and shows the substitution and income effects from a reduction in the relative price of food. Suppose that the home country's endowment is at G instead of at E. Draw in the substitution and income effects of a change in price from that shown by line 1 to that illustrated by line 3. What happens to the magnitude of the substitution effect? Now suppose that the home country is endowed with H and is an exporter of food. Illustrate the substitution and income effects and explain how they differ from those in part. 10. Bilateral Trade Balances and Gains From Trade: The Gephardt Amendment to the Trade Bill of 1988 proposed that the United States levy tariffs against countries with which it has sustained trade deficits. Discuss the problems of a law that prevents a country from running sustained trade surpluses with some trading partners, and sustained trade deficits with others.

8 11. Trade Elasticities in General Equilibrium: Define p = pf/pc. From the balanced trade condition, pmf=xc, derive the algebraic relationship between the elasticity of import demand and the elasticity of export supply. 12. Elasticities and Stability: (c) (d) (e) What does this offer curve diagram tell you about the pattern of trade? What is the equilibrium point of trade, and what is the equilibrium price? An equilibrium is said to be stable if a price higher than the equilibrium price leads to excess supply, driving the price back down, and if a lower price than the equilibrium price leads to excess demand, thus forcing the price back up. Is the equilibrium that you identified in stable or unstable? (Hint: Show how a small change in the equilibrium price leads to excess supply or excess demand in the world market for food.) How must offer curves intersect for an equilibrium to be unstable? In the range from O to G we say that the home offer curve is elastic and from G on we say that it is inelastic. Explain the economic intuition corresponding to these definitions in terms of substitution and income effects.

Chapter 6 TRADE AND LOCAL INCOME DISTRIBUTION: THE SPECIFIC FACTORS MODEL

Chapter 6 TRADE AND LOCAL INCOME DISTRIBUTION: THE SPECIFIC FACTORS MODEL One of the main implications of the Ricardian model is that everyone is better off with free trade. Workers can earn higher wages