A Standard Model of a Trading Economy
The standard trade model is built on four key relationships: (1) the relationship between
the production possibility frontier and the relative supply curve; (2) the relationship
between relative prices and relative demand; (3) the determination of world equilibrium by
world relative supply and world relative demand; and (4) the effect of the terms of
trade—the price of a country’s exports divided by the price of its imports—on a nation’s
welfare.
Production Possibilities and Relative Supply
For the purposes of our standard model, we assume that each country produces two goods,
food (F) and cloth (C), and that each country’s production possibility frontier is a smooth
curve like that illustrated by TT in Figure 6-1.1 The point on its production possibility
frontier at which an economy actually produces depends on the price of cloth relative to
food, PC/PF. At given market prices, a market economy will choose production levels that
1We have seen that when there is only one factor of production, as in Chapter 3, the production possibility frontier
is a straight line. For most models, however, it will be a smooth curve, and the Ricardian result can be viewed
as an extreme case.
CHAPTER 6 The Standard Trade Model 113
Food
production, QF
Cloth
production, QC
Q Isovalue lines
TT
Figure 6-1
Relative Prices Determine the
Economy’s Output
An economy whose production
possibility frontier is TT will produce
at Q, which is on the highest
possible isovalue line.
maximize the value of its output where QC is the quantity of cloth produced
and QF is the quantity of food produced.
We can indicate the market value of output by drawing a number of isovalue lines—that
is, lines along which the value of output is constant. Each of these lines is defined by an
equation of the form or, by rearranging,
where V is the value of output. The higher V is, the farther out an isovalue line lies; thus isovalue
lines farther from the origin correspond to higher values of output. The slope of an
isovalue line is In Figure 6-1, the highest value of output is achieved by producing
at point Q, where TT is just tangent to an isovalue line.
Now suppose that were to rise (cloth becomes more valuable relative to food).
Then the isovalue lines would be steeper than before. In Figure 6-2a the highest isovalue line
the economy could reach before the change in is shown as ; the highest line after
the price change is the point at which the economy produces shifts from to
Thus, as we might expect, a rise in the relative price of cloth leads the economy to produce
more cloth and less food. The relative supply of cloth will therefore rise when the relative
price of cloth rises. This relationship between relative prices and relative production is
reflected in the economy’s relative supply curve shown in Figure 6-2b.
Relative Prices and Demand
Figure 6-3 shows the relationship among production, consumption, and trade in the standard
model. As we pointed out in Chapter 5, the value of an economy’s consumption
equals the value of its production:
where and are the consumption of cloth and food, respectively. The equation above
says that production and consumption must lie on the same isovalue line.
The economy’s choice of a point on the isovalue line depends on the tastes of its
consumers. For our standard model, we assume that the economy’s consumption
DC DF
PCQC + PFQF = PCDC + PFDF = V,
VV2, Q1 Q2.
PC/PF VV1
PC/PF
-PC/PF.
QF = V/PF - 1PC /PFPCQC + PFQF = V, 2QC,
PCQC + PFQF,
114 PART ONE International Trade Theory
Food
production, QF
Cloth
production, QC
Q1
Q1
F
Q2
F
Q1
C Q2
C
TT
Q2
VV 2(PC /PF)2
VV 1(PC /PF)1
(a) (b)
Relative
quantity of
cloth, QC/QF
Relative price
of cloth, PC /PF
(PC /PF)2
(Q1
C/Q1
F) (Q2
C/Q2
F)
(PC /PF)1
2
1
RS
Figure 6-2
How an Increase in the Relative Price of Cloth Affects Relative Supply
In panel (a), the isovalue lines become steeper when the relative price of cloth rises from (PC /PF)1 to (PC/PF)2
(shown by the rotation from VV1 to VV2). As a result, the economy produces more cloth and less food and the
equilibrium output shifts from Q1 to Q2 Panel (b) shows the relative supply curve associated with the production
possibilities frontier TT. The rise from (PC/PF)1 to (PC/PF)2 leads to an increase in the relative production of
cloth from QC 1 /QF
1 to QC 2 /QF
2.
decisions may be represented as if they were based on the tastes of a single representative
individual.2
The tastes of an individual can be represented graphically by a series of indifference
curves. An indifference curve traces a set of combinations of cloth (C) and food (F) consumption
that leave the individual equally well off. As illustrated in Figure 6-3, indifference
curves have three properties:
1. They are downward sloping: If an individual is offered less food (F), then to be made
equally well off, she must be given more cloth (C).
2. The farther up and to the right an indifference curve lies, the higher the level of welfare
to which it corresponds: An individual will prefer having more of both goods to less.
3. Each indifference curve gets flatter as we move to the right (they are bowed-out to the
origin): The more C and the less F an individual consumes, the more valuable a unit of
F is at the margin compared with a unit of C, so more C will have to be provided to
compensate for any further reduction in F.
2There are several sets of circumstances that can justify this assumption. One is that all individuals have the same
tastes and the same share of all resources. Another is that the government redistributes income so as to maximize
its view of overall social welfare. Essentially, the assumption requires that effects of changing income distribution
on demand not be too important.
CHAPTER 6 The Standard Trade Model 115
Quantity
of food, QF
Quantity
of cloth, QC
Indifference curves
Q
TT
D
Cloth
exports
Food
imports
Isovalue line
Figure 6-3
Production, Consumption, and
Trade in the Standard Model
The economy produces at
point Q, where the production
possibility frontier is tangent
to the highest possible isovalue
line. It consumes at point D,
where that isovalue line is tangent
to the highest possible indifference
curve. The economy produces
more cloth than it consumes
and therefore exports cloth;
correspondingly, it consumes
more food than it produces
and therefore imports food.
As you can see in Figure 6-3, the economy will choose to consume at the point on the
isovalue line that yields the highest possible welfare. This point is where the isovalue line
is tangent to the highest reachable indifference curve, shown here as point D. Notice that
at this point, the economy exports cloth (the quantity of cloth produced exceeds the quantity
of cloth consumed) and imports food.
Now consider what happens when increases. Panel (a) in Figure 6-4 shows the
effects. First, the economy produces more C and less F, shifting production from to .
This shifts, from to the isovalue line on which consumption must lie. The economy’s
consumption choice therefore also shifts, from to
The move from to reflects two effects of the rise in First, the economy has
moved to a higher indifference curve, meaning that it is better off. The reason is that this
economy is an exporter of cloth. When the relative price of cloth rises, the economy can
trade a given amount of cloth for a larger amount of food imports. Thus the higher relative
price of its export good represents an advantage. Second, the change in relative prices
leads to a shift along the indifference curve, toward food and away from cloth (since cloth
is now relatively more expensive).
These two effects are familiar from basic economic theory. The rise in welfare is an
income effect; the shift in consumption at any given level of welfare is a substitution effect.
The income effect tends to increase consumption of both goods, while the substitution
effect acts to make the economy consume less C and more F.
Panel (b) in Figure 6-4 shows the relative supply and demand curves associated with the
production possibilities frontier and the indifference curves.3 The graph shows how the increase
in the relative price of cloth induces an increase in the relative production of cloth
(move from point 1 to 2) as well as a decrease in the relative consumption of cloth (move from
D1 D2 PC/PF.
D1 D2.
VV1, VV2,
Q1 Q2
PC/PF
3For general preferences, the relative demand curve will depend on the country’s total income. We assume
throughout this chapter that the relative demand curve is independent of income. This is the case for a widely
used type of preferences called homothetic preferences.
116 PART ONE International Trade Theory
Quantity
of food, QF
Quantity
of cloth, QC
TT
Q1
Q2
D1
D3
VV 1(PC /PF)1
D2
VV 2(PC /PF)2
(a) Production and Consumption (b) Relative Supply and Demand
Relative price
of cloth, PC /PF
3
1
2
1′
2′
RD
RS
Relative quantity
of cloth, QC/QF
Figure 6-4
Effects of a Rise in the Relative Price of Cloth and Gains from Trade
In panel (a), the slope of the isovalue lines is equal to minus the relative price of cloth, . As a result, when
that relative price rises, all isovalue lines become steeper. In particular, the maximum-value line rotates from
to Production shifts from to and consumption shifts from to If the economy cannot
trade, then it produces and consumes at point Panel (b) shows the effects of the rise in the relative price of
cloth on relative production (move from 1 to 2) and relative demand (move from to . If the economy
cannot trade, then it consumes and produces at point 3.
1¿ 2¿
D3.
VV1 VV2. Q1 Q2 D1 D2.
PC/PF
point to ). This change in relative consumption captures the substitution effect of the
price change. If the income effect of the price change were large enough, then consumption
levels of both goods could rise ( and both increase); but the substitution effect
of demand dictates that the relative consumption of cloth, decrease. If the economy
cannot trade, then it consumes and produces at point 3 (associated with the relative
price .
The Welfare Effect of Changes in the Terms of Trade
When increases, a country that initially exports cloth is made better off, as illustrated by
the movement from to in panel (a) of Figure 6-4. Conversely, if were to decline, the
country would be made worse off; for example, consumption might move back from to
If the country were initially an exporter of food instead of cloth, the direction of this
effect would be reversed. An increase in would mean a fall in and the country
would be worse off: The relative price of the good it exports (food) would drop. We cover
all these cases by defining the terms of trade as the price of the good a country initially
exports divided by the price of the good it initially imports. The general statement, then, is
that a rise in the terms of trade increases a country’s welfare, while a decline in the terms
of trade reduces its welfare.
PC/PF PC/PF,
D2 D1.
D1 D2 PC/PF
PC/PF
(PC/PF)32
DC/DF,
DC DF
1¿ 2¿
CHAPTER 6 The Standard Trade Model 117
Note, however, that changes in a country’s terms of trade can never decrease the country’s
welfare below its welfare level in the absence of trade (represented by consumption at ).
The gains from trade mentioned in Chapters 3, 4, and 5 still apply to this more general
approach. The same disclaimers previously discussed also apply: Aggregate gains are rarely
evenly distributed, leading to both gains and losses for individual consumers.
Determining Relative Prices
Let’s now suppose that the world economy consists of two countries once again named
Home (which exports cloth) and Foreign (which exports food). Home’s terms of trade are
measured by while Foreign’s are measured by We assume that these trade
patterns are induced by differences in Home’s and Foreign’s production capabilities, as
represented by the associated relative supply curves in panel (a) of Figure 6.5. We also
assume that the two countries share the same preferences and hence have the same relative
demand curve. At any given relative price Home will produce quantities of cloth
and food and while Foreign produces quantities and where
The relative supply for the world is then obtained by summing those
production levels for both cloth and food and taking the ratio: By
construction, this relative supply curve for the world must lie in between the relative supply
curves for both countries.4 Relative demand for the world also aggregates the demands
for cloth and food across the two countries: Since there are no differences
in preferences across the two countries, the relative demand curve for the world
overlaps with the same relative demand curve for each country.
The equilibrium relative price for the world (when Home and Foreign trade) is then
given by the intersection of world relative supply and demand at point 1. This relative
price determines how many units of Home’s cloth exports are exchanged for Foreign’s
food exports. At the equilibrium relative price, Home’s desired exports of cloth,
match up with Foreign’s desired imports of cloth, The food
market is also in equilibrium so that Home’s desired imports of food, match
up with Foreign’s desired food exports, The production possibility frontiers
for Home and Foreign, along with the budget constraints and associated production
and consumption choices at the equilibrium relative price are illustrated in
panel (b).
Now that we know how relative supply, relative demand, the terms of trade, and welfare
are determined in the standard model, we can use it to understand a number of important
issues in international economics.
Economic Growth: A Shift of the RS Curve
The effects of economic growth in a trading world economy are a perennial source of concern
and controversy. The debate revolves around two questions. First, is economic growth
in other countries good or bad for our nation? Second, is growth in a country more or less
valuable when that nation is part of a closely integrated world economy?
In assessing the effects of growth in other countries, commonsense arguments can be
made on either side. On one side, economic growth in the rest of the world may be good
for our economy because it means larger markets for our exports and lower prices for our
imports. On the other side, growth in other countries may mean increased competition for
our exporters and domestic producers, who need to compete with foreign exporters.
(PC/PF)1,
QF * - DF * .
DF - QF,
DC * - QC * QC - DC, .
(DC + DC * )/(DF + DF * ).
(QC + QC * )/(QF + QF * ).
QC/QF 7 QC * /QF * .
QF * , QC * QC QF,
PC/PF,
PC/PF, PF/PC.
D3
4For any positive numbers if X then X1 /Y1 6 (X1 + X2) / (Y1 + Y2) 6 X2 /Y2. X1, X2, Y1, Y2, 1 /Y1 6 X2 /Y2,
118 PART ONE International Trade Theory
1
RD
RS *
RS WORLD
RS
Relative price
of cloth, PC /PF
(PC /PF)1
Relative quantity
of cloth, (QC /QF )
(a) Relative Supply and Demand
Home Foreign
Q*
D*
D*
Q*
Q* D*
F
F
C C
VV 1(PC /PF )1
Q
D
DC QC
DF
QF
Home’s
food
imports
Home’s
cloth
exports
Quantity
of cloth, QC
Quantity
of food, QF
VV 1(PC /PF )1
Foreign’s
food
exports
Foreign’s
cloth
imports
Quantity
of cloth, QC
Quantity
of food, QF
(b) Production, Consumption, and Trade
Figure 6-5
Equilibrium Relative Price with Trade and Associated Trade Flows
Panel (a) shows the relative supply of cloth in Home (RS), in Foreign (RS*), and for the world. Home and
Foreign have the same relative demand, which is also the relative demand for the world. The equilibrium
relative price is determined by the intersection of the world relative supply and demand curves.
Panel (b) shows the associated equilibrium trade flows between Home and Foreign. At the equilibrium
relative price , Home’s exports of cloth equals Foreign’s imports of cloth; and Home’s imports of
food equals Foreign’s exports of food.
1PC>PF21
1PC>PF21
CHAPTER 6 The Standard Trade Model 119
We can find similar ambiguities when we look at the effects of growth at home. On one
hand, growth in an economy’s production capacity should be more valuable when that
country can sell some of its increased production to the world market. On the other hand,
the benefits of growth may be passed on to foreigners in the form of lower prices for the
country’s exports rather than retained at home.
The standard model of trade developed in the last section provides a framework that
can cut through these seeming contradictions and clarify the effects of economic growth in
a trading world.
Growth and the Production Possibility Frontier
Economic growth means an outward shift of a country’s production possibility frontier.
This growth can result either from increases in a country’s resources or from improvements
in the efficiency with which these resources are used.
The international trade effects of growth result from the fact that such growth typically
has a bias. Biased growth takes place when the production possibility frontier shifts out
more in one direction than in the other. Panel (a) of Figure 6-6 illustrates growth biased
toward cloth (shift from to ), while panel (b) shows growth biased toward food
(shift from to ).
Growth may be biased for two main reasons:
1. The Ricardian model of Chapter 3 shows that technological progress in one sector of
the economy will expand the economy’s production possibilities more in the direction
of that sector’s output than in the direction of the other sector’s output.
2. The Heckscher-Ohlin model of Chapter 5 showed that an increase in a country’s supply
of a factor of production—say, an increase in the capital stock resulting from saving
and investment—will produce biased expansion of production possibilities. The
bias will be in the direction of either the good to which the factor is specific or the
good whose production is intensive in the factor whose supply has increased. Thus
the same considerations that give rise to international trade will also lead to biased
growth in a trading economy.
The biases of growth in panels (a) and (b) are strong. In each case the economy is able
to produce more of both goods. However, at an unchanged relative price of cloth, the output
of food actually falls in panel (a), while the output of cloth actually falls in panel (b).
Although growth is not always as strongly biased as it is in these examples, even growth
that is more mildly biased toward cloth will lead, for any given relative price of cloth, to a
rise in the output of cloth relative to that of food. In other words, the country’s relative
supply curve shifts to the right. This change is represented in panel (c) as the transition
from to When growth is biased toward food, the relative supply curve shifts to
the left, as shown by the transition from to
World Relative Supply and the Terms of Trade
Suppose now that Home experiences growth strongly biased toward cloth, so that its output
of cloth rises at any given relative price of cloth, while its output of food declines (as
shown in panel (a) of Figure 6-6). Then the output of cloth relative to food will rise at any
given price for the world as a whole, and the world relative supply curve will shift to the
right, just like the relative supply curve for Home. This shift in the world relative supply is
shown in panel (a) of Figure 6-7 as a shift from to It results in a decrease in the
relative price of cloth from to , a worsening of Home’s terms of trade
and an improvement in Foreign’s terms of trade.
1PC /PF22 1PC /PF21
RS1 RS2.
RS1 RS3.
RS1 RS2.
T T1 T T3
TT1 TT2
120 PART ONE International Trade Theory
Food
production, QF
Cloth
production, QC
(a) Growth biased toward cloth
(c) Effects of biased growth on relative supply
TT 1 TT 2
Food
production, QF
Cloth
production, QC
(b) Growth biased toward food
TT 1 TT 3
Relative price
of cloth, PC /PF
Growth
biased
towards
food
Growth
biased
towards
cloth
RS2
RS1
RS3
Relative quantity
of cloth, QC / QF
Figure 6-6
Biased Growth
Growth is biased when it shifts production possibilities out more toward one good than toward
another. In case (a), growth is biased toward cloth (shift from to ), while in case (b),
growth is biased toward food (shift from to ). The associated shifts in the relative supply
curve are shown in panel (c): shift to the right (from to ) when growth is biased toward
cloth, and shift to the left (from RS1 to RS3) when growth is biased toward food.
RS1 RS2
TT1 TT3
TT1 TT2
CHAPTER 6 The Standard Trade Model 121
Notice that the important consideration here is not which economy grows but rather
the bias of that growth. If Foreign had experienced growth strongly biased toward
cloth, the effect on the world relative supply curve and thus on the terms of trade
would have been similar. On the other hand, either Home or Foreign growth strongly
biased toward food will lead to a leftward shift of the RS curve ( to ) for the
world and thus to a rise in the relative price of cloth from to (as
shown in panel (b)). This relative price increase is an improvement in Home’s terms of
trade, but a worsening of Foreign’s.
Growth that disproportionately expands a country’s production possibilities in the direction
of the good it exports (cloth in Home, food in Foreign) is export-biased growth.
Similarly, growth biased toward the good a country imports is import-biased growth. Our
analysis leads to the following general principle: Export-biased growth tends to worsen a
growing country’s terms of trade, to the benefit of the rest of the world; import-biased growth
tends to improve a growing country’s terms of trade at the rest of the world’s expense.
International Effects of Growth
Using this principle, we are now in a position to resolve our questions about the international
effects of growth. Is growth in the rest of the world good or bad for our country? Does the
fact that our country is part of a trading world economy increase or decrease the benefits of
growth? In each case the answer depends on the bias of the growth. Export-biased growth in
(PC/PF)1 (PC/PF)3
RS1 RS3
Relative price
of cloth, PC /PF
(PC / PF )1
(PC /PF)2
(a) Cloth-biased growth
1
RD
RS1
2
RS2
Relative price
of cloth, PC /PF
(PC / PF)1
(PC /PF)3
(b) Food-biased growth
1
RD
RS1
3
RS3
Relative quantity
of cloth,
QC + QC
QF + QF
*
*
Relative quantity
of cloth,
QC + QC
QF + QF
*
*
Figure 6-7
Growth and World Relative Supply
Growth biased toward cloth shifts the RS curve for the world to the right (a), while growth
biased toward food shifts it to the left (b).
122 PART ONE International Trade Theory
5“Immiserizing Growth: A Geometrical Note,” Review of Economic Studies 25 (June 1958), pp. 201–205.
the rest of the world is good for us, improving our terms of trade, while import-biased
growth abroad worsens our terms of trade. Export-biased growth in our own country worsens
our terms of trade, reducing the direct benefits of growth, while import-biased growth
leads to an improvement of our terms of trade, a secondary benefit.
During the 1950s, many economists from poorer countries believed that their nations,
which primarily exported raw materials, were likely to experience steadily declining terms
of trade over time. They believed that growth in the industrial world would be marked by
an increasing development of synthetic substitutes for raw materials, while growth in the
poorer nations would take the form of a further extension of their capacity to produce what
they were already exporting rather than a move toward industrialization. That is, the
growth in the industrial world would be import-biased, while that in the less-developed
world would be export-biased.
Some analysts even suggested that growth in the poorer nations would actually be selfdefeating.
They argued that export-biased growth by poor nations would worsen their
terms of trade so much that they would be worse off than if they had not grown at all. This
situation is known to economists as the case of immiserizing growth.
In a famous paper published in 1958, economist Jagdish Bhagwati of Columbia
University showed that such perverse effects of growth can in fact arise within a rigorously
specified economic model.5 However, the conditions under which immiserizing
growth can occur are extreme: Strongly export-biased growth must be combined with
very steep RS and RD curves, so that the change in the terms of trade is large enough to
offset the direct favorable effects of an increase in a country’s productive capacity. Most
economists now regard the concept of immiserizing growth as more a theoretical point
than a real-world issue.
While growth at home normally raises our own welfare even in a trading world, this is
by no means true of growth abroad. Import-biased growth is not an unlikely possibility,
and whenever the rest of the world experiences such growth, it worsens our terms of trade.
Indeed, as we point out below, it is possible that the United States has suffered some loss
of real income because of foreign growth over the postwar period.
Case Study
Has the Growth of Newly Industrializing Countries Hurt Advanced Nations?
In the early 1990s, many observers began warning that the growth of newly industrializing
economies would pose a threat to the prosperity of advanced nations. In the
Case Study in Chapter 5 on North-South trade, we addressed one way in which that
growth might prove to be a problem: It might aggravate the growing gap in incomes
between high-skilled and low-skilled workers in advanced nations. Some alarmists,
however, believed that the threat was still broader—that the overall real income of
advanced nations, as opposed to its distribution, had been or would be reduced by the
appearance of new competitors. For example, a 1993 report released by the European
Commission (the administrative arm of the European Union), in listing reasons for
Europe’s economic difficulties, emphasized the fact that “other countries are becoming
industrialized and competing with us—even in our own markets—at cost levels
which we simply cannot match.” Another report by an influential private organization
CHAPTER 6 The Standard Trade Model 123
6Commission of the European Communities, Growth, Competitiveness, Employment, Brussels 1993; World
Economic Forum, World Competitiveness Report 1994.
7Paul Samuelson, “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists
Supporting Globalization,” Journal of Economic Perspectives 18 (Summer 2004), pp. 135–146.
8“Shaking up Trade Theory,” Business Week, December 6, 2004.
went even further, arguing that the rising productivity of low-wage countries would
put immense pressure on high-wage nations, to such an extent that “the raison d’etre
of many countries is at stake.”6
These concerns appeared to gain some intellectual support from a 2004 paper by Paul
Samuelson, who created much of the modern theory of international trade. In that paper,
Samuelson, using a Ricardian model, offered an example of how technological progress in
developing countries can hurt advanced countries.7 His analysis was simply a special case
of the analysis we have just described: Growth in the rest of the world can hurt you if it
takes place in sectors that compete with your exports. Samuelson took this to its logical
conclusion: If China becomes sufficiently good at producing goods it currently imports,
comparative advantage disappears—and the United States loses the gains from trade.
The popular press seized on this result, treating it as if it were somehow revolutionary.
“The central question Samuelson and others raise is whether unfettered trade is always still
as good for the U.S. as they have long believed,” wrote Business Week, which went on to
suggest that such results might “completely derail comparative advantage theory.”8
But the proposition that growth abroad can hurt your economy isn’t a new idea, and
it says nothing about whether free trade is better than protection. Also, it’s an empirical
question whether the growth of newly industrializing countries such as China has actually
hurt advanced countries. And the facts don’t support the claim.
Bear in mind that the channel through which growth abroad can hurt a country is via
the terms of trade. So if the claim that competition from newly industrializing countries
hurts advanced economies were true, we should see large negative numbers for the
terms of trade of advanced countries and large positive numbers for the terms of trade
of the new competitors. In the Mathematical Postscript to this chapter, we show that the
percentage real income effect of a change in the terms of trade is approximately equal
to the percent change in the terms of trade, multiplied by the share of imports in
income. Since advanced countries on average spend about 25 percent of their income
on imports (the United States’ import share of GDP is lower than this average), a 1 percent
decline in the terms of trade would reduce real income by only about 0.25 percent.
So the terms of trade would have to decline by several percent a year to be a noticeable
drag on economic growth.
Table 6-1 shows how the terms of trade for both the United States and China have
changed over the last 30 years (average annual percentage change over the period).
The magnitude of the fluctuations in the terms of trade for the United States is
small, with no clear trend from decade to decade. The U.S. terms of trade in 2008
were essentially at the same level they were at in 1980. Thus, there is no evidence
that the United States has suffered any kind of sustained loss from a long-term deterioration
in its terms of trade. Additionally, there is no evidence that China’s terms
of trade have steadily appreciated as it has become increasingly integrated into the
world economy. If anything, its terms of trade over the last 30 years have deteriorated
somewhat.
One final point: In Samuelson’s example, Chinese technological progress makes the
United States worse off by eliminating trade between the two countries! Since what we
124 PART ONE International Trade Theory
TABLE 6-1 Average Annual Percent Changes in Terms of Trade
for the United States and China
Change by Decade Overall Change
1980–89 1990–99 2000–08 1980–2008
U.S. 1.6% 0.4% -1.0% 0.1%
China -1.4% 0.2% -3.3% -1.3%
actually see is rapidly growing China–U.S. trade, it’s hard to find much of a relationship
between the model and today’s reality.
9See M. Ayhan Kose, “Explaining Business Cycles in Small Open Economies: ‘How Much Do World Prices
Matter?’” Journal of International Economics 56 (March 2002), pp. 299–327.
10See Christian Broda and Cédric Tille, “Coping with Terms-of-Trade Shocks in Developing Countries,” Current
Issues in Economics and Finance 9 (November 2003), pp 1–7.
Most countries tend to experience mild swings in their terms of trade, around 1 percent or
less a year, as illustrated in Table 6-1. However, some developing countries’ exports are heavily
concentrated in mineral and agricultural sectors. The prices of those goods on world markets
are very volatile, leading to large swings in the terms of trade. These swings in turn translate
into substantial changes in welfare (because trade is concentrated in a small number of sectors,
and also represents a substantial percentage of GDP). In fact, some studies show that most of
the fluctuations in GDP in several developing countries (where GDP fluctuations are quite
large relative to the GDP fluctuations in developed countries) can be attributed to fluctuations
in their terms of trade.9 For example, Argentina suffered a 6 percent deterioration in its terms of
trade in 1999 (due to declining agricultural prices), which induced a 1.4 percent drop in GDP.
(The actual GDP loss was higher, but other factors contributed to this deterioration.) On the
other hand, Ecuador enjoyed an 18 percent increase in its terms of trade in 2000 (due to
increases in oil prices), which added 1.6 percent to the GDP growth rate for that year.10
The standard trade model is built on four key relationships: (1) the relationship between
the production possibility frontier and the relative supply curve; (2) the relationship
between relative prices and relative demand; (3) the determination of world equilibrium by
world relative supply and world relative demand; and (4) the effect of the terms of
trade—the price of a country’s exports divided by the price of its imports—on a nation’s
welfare.
Production Possibilities and Relative Supply
For the purposes of our standard model, we assume that each country produces two goods,
food (F) and cloth (C), and that each country’s production possibility frontier is a smooth
curve like that illustrated by TT in Figure 6-1.1 The point on its production possibility
frontier at which an economy actually produces depends on the price of cloth relative to
food, PC/PF. At given market prices, a market economy will choose production levels that
1We have seen that when there is only one factor of production, as in Chapter 3, the production possibility frontier
is a straight line. For most models, however, it will be a smooth curve, and the Ricardian result can be viewed
as an extreme case.
CHAPTER 6 The Standard Trade Model 113
Food
production, QF
Cloth
production, QC
Q Isovalue lines
TT
Figure 6-1
Relative Prices Determine the
Economy’s Output
An economy whose production
possibility frontier is TT will produce
at Q, which is on the highest
possible isovalue line.
maximize the value of its output where QC is the quantity of cloth produced
and QF is the quantity of food produced.
We can indicate the market value of output by drawing a number of isovalue lines—that
is, lines along which the value of output is constant. Each of these lines is defined by an
equation of the form or, by rearranging,
where V is the value of output. The higher V is, the farther out an isovalue line lies; thus isovalue
lines farther from the origin correspond to higher values of output. The slope of an
isovalue line is In Figure 6-1, the highest value of output is achieved by producing
at point Q, where TT is just tangent to an isovalue line.
Now suppose that were to rise (cloth becomes more valuable relative to food).
Then the isovalue lines would be steeper than before. In Figure 6-2a the highest isovalue line
the economy could reach before the change in is shown as ; the highest line after
the price change is the point at which the economy produces shifts from to
Thus, as we might expect, a rise in the relative price of cloth leads the economy to produce
more cloth and less food. The relative supply of cloth will therefore rise when the relative
price of cloth rises. This relationship between relative prices and relative production is
reflected in the economy’s relative supply curve shown in Figure 6-2b.
Relative Prices and Demand
Figure 6-3 shows the relationship among production, consumption, and trade in the standard
model. As we pointed out in Chapter 5, the value of an economy’s consumption
equals the value of its production:
where and are the consumption of cloth and food, respectively. The equation above
says that production and consumption must lie on the same isovalue line.
The economy’s choice of a point on the isovalue line depends on the tastes of its
consumers. For our standard model, we assume that the economy’s consumption
DC DF
PCQC + PFQF = PCDC + PFDF = V,
VV2, Q1 Q2.
PC/PF VV1
PC/PF
-PC/PF.
QF = V/PF - 1PC /PFPCQC + PFQF = V, 2QC,
PCQC + PFQF,
114 PART ONE International Trade Theory
Food
production, QF
Cloth
production, QC
Q1
Q1
F
Q2
F
Q1
C Q2
C
TT
Q2
VV 2(PC /PF)2
VV 1(PC /PF)1
(a) (b)
Relative
quantity of
cloth, QC/QF
Relative price
of cloth, PC /PF
(PC /PF)2
(Q1
C/Q1
F) (Q2
C/Q2
F)
(PC /PF)1
2
1
RS
Figure 6-2
How an Increase in the Relative Price of Cloth Affects Relative Supply
In panel (a), the isovalue lines become steeper when the relative price of cloth rises from (PC /PF)1 to (PC/PF)2
(shown by the rotation from VV1 to VV2). As a result, the economy produces more cloth and less food and the
equilibrium output shifts from Q1 to Q2 Panel (b) shows the relative supply curve associated with the production
possibilities frontier TT. The rise from (PC/PF)1 to (PC/PF)2 leads to an increase in the relative production of
cloth from QC 1 /QF
1 to QC 2 /QF
2.
decisions may be represented as if they were based on the tastes of a single representative
individual.2
The tastes of an individual can be represented graphically by a series of indifference
curves. An indifference curve traces a set of combinations of cloth (C) and food (F) consumption
that leave the individual equally well off. As illustrated in Figure 6-3, indifference
curves have three properties:
1. They are downward sloping: If an individual is offered less food (F), then to be made
equally well off, she must be given more cloth (C).
2. The farther up and to the right an indifference curve lies, the higher the level of welfare
to which it corresponds: An individual will prefer having more of both goods to less.
3. Each indifference curve gets flatter as we move to the right (they are bowed-out to the
origin): The more C and the less F an individual consumes, the more valuable a unit of
F is at the margin compared with a unit of C, so more C will have to be provided to
compensate for any further reduction in F.
2There are several sets of circumstances that can justify this assumption. One is that all individuals have the same
tastes and the same share of all resources. Another is that the government redistributes income so as to maximize
its view of overall social welfare. Essentially, the assumption requires that effects of changing income distribution
on demand not be too important.
CHAPTER 6 The Standard Trade Model 115
Quantity
of food, QF
Quantity
of cloth, QC
Indifference curves
Q
TT
D
Cloth
exports
Food
imports
Isovalue line
Figure 6-3
Production, Consumption, and
Trade in the Standard Model
The economy produces at
point Q, where the production
possibility frontier is tangent
to the highest possible isovalue
line. It consumes at point D,
where that isovalue line is tangent
to the highest possible indifference
curve. The economy produces
more cloth than it consumes
and therefore exports cloth;
correspondingly, it consumes
more food than it produces
and therefore imports food.
As you can see in Figure 6-3, the economy will choose to consume at the point on the
isovalue line that yields the highest possible welfare. This point is where the isovalue line
is tangent to the highest reachable indifference curve, shown here as point D. Notice that
at this point, the economy exports cloth (the quantity of cloth produced exceeds the quantity
of cloth consumed) and imports food.
Now consider what happens when increases. Panel (a) in Figure 6-4 shows the
effects. First, the economy produces more C and less F, shifting production from to .
This shifts, from to the isovalue line on which consumption must lie. The economy’s
consumption choice therefore also shifts, from to
The move from to reflects two effects of the rise in First, the economy has
moved to a higher indifference curve, meaning that it is better off. The reason is that this
economy is an exporter of cloth. When the relative price of cloth rises, the economy can
trade a given amount of cloth for a larger amount of food imports. Thus the higher relative
price of its export good represents an advantage. Second, the change in relative prices
leads to a shift along the indifference curve, toward food and away from cloth (since cloth
is now relatively more expensive).
These two effects are familiar from basic economic theory. The rise in welfare is an
income effect; the shift in consumption at any given level of welfare is a substitution effect.
The income effect tends to increase consumption of both goods, while the substitution
effect acts to make the economy consume less C and more F.
Panel (b) in Figure 6-4 shows the relative supply and demand curves associated with the
production possibilities frontier and the indifference curves.3 The graph shows how the increase
in the relative price of cloth induces an increase in the relative production of cloth
(move from point 1 to 2) as well as a decrease in the relative consumption of cloth (move from
D1 D2 PC/PF.
D1 D2.
VV1, VV2,
Q1 Q2
PC/PF
3For general preferences, the relative demand curve will depend on the country’s total income. We assume
throughout this chapter that the relative demand curve is independent of income. This is the case for a widely
used type of preferences called homothetic preferences.
116 PART ONE International Trade Theory
Quantity
of food, QF
Quantity
of cloth, QC
TT
Q1
Q2
D1
D3
VV 1(PC /PF)1
D2
VV 2(PC /PF)2
(a) Production and Consumption (b) Relative Supply and Demand
Relative price
of cloth, PC /PF
3
1
2
1′
2′
RD
RS
Relative quantity
of cloth, QC/QF
Figure 6-4
Effects of a Rise in the Relative Price of Cloth and Gains from Trade
In panel (a), the slope of the isovalue lines is equal to minus the relative price of cloth, . As a result, when
that relative price rises, all isovalue lines become steeper. In particular, the maximum-value line rotates from
to Production shifts from to and consumption shifts from to If the economy cannot
trade, then it produces and consumes at point Panel (b) shows the effects of the rise in the relative price of
cloth on relative production (move from 1 to 2) and relative demand (move from to . If the economy
cannot trade, then it consumes and produces at point 3.
1¿ 2¿
D3.
VV1 VV2. Q1 Q2 D1 D2.
PC/PF
point to ). This change in relative consumption captures the substitution effect of the
price change. If the income effect of the price change were large enough, then consumption
levels of both goods could rise ( and both increase); but the substitution effect
of demand dictates that the relative consumption of cloth, decrease. If the economy
cannot trade, then it consumes and produces at point 3 (associated with the relative
price .
The Welfare Effect of Changes in the Terms of Trade
When increases, a country that initially exports cloth is made better off, as illustrated by
the movement from to in panel (a) of Figure 6-4. Conversely, if were to decline, the
country would be made worse off; for example, consumption might move back from to
If the country were initially an exporter of food instead of cloth, the direction of this
effect would be reversed. An increase in would mean a fall in and the country
would be worse off: The relative price of the good it exports (food) would drop. We cover
all these cases by defining the terms of trade as the price of the good a country initially
exports divided by the price of the good it initially imports. The general statement, then, is
that a rise in the terms of trade increases a country’s welfare, while a decline in the terms
of trade reduces its welfare.
PC/PF PC/PF,
D2 D1.
D1 D2 PC/PF
PC/PF
(PC/PF)32
DC/DF,
DC DF
1¿ 2¿
CHAPTER 6 The Standard Trade Model 117
Note, however, that changes in a country’s terms of trade can never decrease the country’s
welfare below its welfare level in the absence of trade (represented by consumption at ).
The gains from trade mentioned in Chapters 3, 4, and 5 still apply to this more general
approach. The same disclaimers previously discussed also apply: Aggregate gains are rarely
evenly distributed, leading to both gains and losses for individual consumers.
Determining Relative Prices
Let’s now suppose that the world economy consists of two countries once again named
Home (which exports cloth) and Foreign (which exports food). Home’s terms of trade are
measured by while Foreign’s are measured by We assume that these trade
patterns are induced by differences in Home’s and Foreign’s production capabilities, as
represented by the associated relative supply curves in panel (a) of Figure 6.5. We also
assume that the two countries share the same preferences and hence have the same relative
demand curve. At any given relative price Home will produce quantities of cloth
and food and while Foreign produces quantities and where
The relative supply for the world is then obtained by summing those
production levels for both cloth and food and taking the ratio: By
construction, this relative supply curve for the world must lie in between the relative supply
curves for both countries.4 Relative demand for the world also aggregates the demands
for cloth and food across the two countries: Since there are no differences
in preferences across the two countries, the relative demand curve for the world
overlaps with the same relative demand curve for each country.
The equilibrium relative price for the world (when Home and Foreign trade) is then
given by the intersection of world relative supply and demand at point 1. This relative
price determines how many units of Home’s cloth exports are exchanged for Foreign’s
food exports. At the equilibrium relative price, Home’s desired exports of cloth,
match up with Foreign’s desired imports of cloth, The food
market is also in equilibrium so that Home’s desired imports of food, match
up with Foreign’s desired food exports, The production possibility frontiers
for Home and Foreign, along with the budget constraints and associated production
and consumption choices at the equilibrium relative price are illustrated in
panel (b).
Now that we know how relative supply, relative demand, the terms of trade, and welfare
are determined in the standard model, we can use it to understand a number of important
issues in international economics.
Economic Growth: A Shift of the RS Curve
The effects of economic growth in a trading world economy are a perennial source of concern
and controversy. The debate revolves around two questions. First, is economic growth
in other countries good or bad for our nation? Second, is growth in a country more or less
valuable when that nation is part of a closely integrated world economy?
In assessing the effects of growth in other countries, commonsense arguments can be
made on either side. On one side, economic growth in the rest of the world may be good
for our economy because it means larger markets for our exports and lower prices for our
imports. On the other side, growth in other countries may mean increased competition for
our exporters and domestic producers, who need to compete with foreign exporters.
(PC/PF)1,
QF * - DF * .
DF - QF,
DC * - QC * QC - DC, .
(DC + DC * )/(DF + DF * ).
(QC + QC * )/(QF + QF * ).
QC/QF 7 QC * /QF * .
QF * , QC * QC QF,
PC/PF,
PC/PF, PF/PC.
D3
4For any positive numbers if X then X1 /Y1 6 (X1 + X2) / (Y1 + Y2) 6 X2 /Y2. X1, X2, Y1, Y2, 1 /Y1 6 X2 /Y2,
118 PART ONE International Trade Theory
1
RD
RS *
RS WORLD
RS
Relative price
of cloth, PC /PF
(PC /PF)1
Relative quantity
of cloth, (QC /QF )
(a) Relative Supply and Demand
Home Foreign
Q*
D*
D*
Q*
Q* D*
F
F
C C
VV 1(PC /PF )1
Q
D
DC QC
DF
QF
Home’s
food
imports
Home’s
cloth
exports
Quantity
of cloth, QC
Quantity
of food, QF
VV 1(PC /PF )1
Foreign’s
food
exports
Foreign’s
cloth
imports
Quantity
of cloth, QC
Quantity
of food, QF
(b) Production, Consumption, and Trade
Figure 6-5
Equilibrium Relative Price with Trade and Associated Trade Flows
Panel (a) shows the relative supply of cloth in Home (RS), in Foreign (RS*), and for the world. Home and
Foreign have the same relative demand, which is also the relative demand for the world. The equilibrium
relative price is determined by the intersection of the world relative supply and demand curves.
Panel (b) shows the associated equilibrium trade flows between Home and Foreign. At the equilibrium
relative price , Home’s exports of cloth equals Foreign’s imports of cloth; and Home’s imports of
food equals Foreign’s exports of food.
1PC>PF21
1PC>PF21
CHAPTER 6 The Standard Trade Model 119
We can find similar ambiguities when we look at the effects of growth at home. On one
hand, growth in an economy’s production capacity should be more valuable when that
country can sell some of its increased production to the world market. On the other hand,
the benefits of growth may be passed on to foreigners in the form of lower prices for the
country’s exports rather than retained at home.
The standard model of trade developed in the last section provides a framework that
can cut through these seeming contradictions and clarify the effects of economic growth in
a trading world.
Growth and the Production Possibility Frontier
Economic growth means an outward shift of a country’s production possibility frontier.
This growth can result either from increases in a country’s resources or from improvements
in the efficiency with which these resources are used.
The international trade effects of growth result from the fact that such growth typically
has a bias. Biased growth takes place when the production possibility frontier shifts out
more in one direction than in the other. Panel (a) of Figure 6-6 illustrates growth biased
toward cloth (shift from to ), while panel (b) shows growth biased toward food
(shift from to ).
Growth may be biased for two main reasons:
1. The Ricardian model of Chapter 3 shows that technological progress in one sector of
the economy will expand the economy’s production possibilities more in the direction
of that sector’s output than in the direction of the other sector’s output.
2. The Heckscher-Ohlin model of Chapter 5 showed that an increase in a country’s supply
of a factor of production—say, an increase in the capital stock resulting from saving
and investment—will produce biased expansion of production possibilities. The
bias will be in the direction of either the good to which the factor is specific or the
good whose production is intensive in the factor whose supply has increased. Thus
the same considerations that give rise to international trade will also lead to biased
growth in a trading economy.
The biases of growth in panels (a) and (b) are strong. In each case the economy is able
to produce more of both goods. However, at an unchanged relative price of cloth, the output
of food actually falls in panel (a), while the output of cloth actually falls in panel (b).
Although growth is not always as strongly biased as it is in these examples, even growth
that is more mildly biased toward cloth will lead, for any given relative price of cloth, to a
rise in the output of cloth relative to that of food. In other words, the country’s relative
supply curve shifts to the right. This change is represented in panel (c) as the transition
from to When growth is biased toward food, the relative supply curve shifts to
the left, as shown by the transition from to
World Relative Supply and the Terms of Trade
Suppose now that Home experiences growth strongly biased toward cloth, so that its output
of cloth rises at any given relative price of cloth, while its output of food declines (as
shown in panel (a) of Figure 6-6). Then the output of cloth relative to food will rise at any
given price for the world as a whole, and the world relative supply curve will shift to the
right, just like the relative supply curve for Home. This shift in the world relative supply is
shown in panel (a) of Figure 6-7 as a shift from to It results in a decrease in the
relative price of cloth from to , a worsening of Home’s terms of trade
and an improvement in Foreign’s terms of trade.
1PC /PF22 1PC /PF21
RS1 RS2.
RS1 RS3.
RS1 RS2.
T T1 T T3
TT1 TT2
120 PART ONE International Trade Theory
Food
production, QF
Cloth
production, QC
(a) Growth biased toward cloth
(c) Effects of biased growth on relative supply
TT 1 TT 2
Food
production, QF
Cloth
production, QC
(b) Growth biased toward food
TT 1 TT 3
Relative price
of cloth, PC /PF
Growth
biased
towards
food
Growth
biased
towards
cloth
RS2
RS1
RS3
Relative quantity
of cloth, QC / QF
Figure 6-6
Biased Growth
Growth is biased when it shifts production possibilities out more toward one good than toward
another. In case (a), growth is biased toward cloth (shift from to ), while in case (b),
growth is biased toward food (shift from to ). The associated shifts in the relative supply
curve are shown in panel (c): shift to the right (from to ) when growth is biased toward
cloth, and shift to the left (from RS1 to RS3) when growth is biased toward food.
RS1 RS2
TT1 TT3
TT1 TT2
CHAPTER 6 The Standard Trade Model 121
Notice that the important consideration here is not which economy grows but rather
the bias of that growth. If Foreign had experienced growth strongly biased toward
cloth, the effect on the world relative supply curve and thus on the terms of trade
would have been similar. On the other hand, either Home or Foreign growth strongly
biased toward food will lead to a leftward shift of the RS curve ( to ) for the
world and thus to a rise in the relative price of cloth from to (as
shown in panel (b)). This relative price increase is an improvement in Home’s terms of
trade, but a worsening of Foreign’s.
Growth that disproportionately expands a country’s production possibilities in the direction
of the good it exports (cloth in Home, food in Foreign) is export-biased growth.
Similarly, growth biased toward the good a country imports is import-biased growth. Our
analysis leads to the following general principle: Export-biased growth tends to worsen a
growing country’s terms of trade, to the benefit of the rest of the world; import-biased growth
tends to improve a growing country’s terms of trade at the rest of the world’s expense.
International Effects of Growth
Using this principle, we are now in a position to resolve our questions about the international
effects of growth. Is growth in the rest of the world good or bad for our country? Does the
fact that our country is part of a trading world economy increase or decrease the benefits of
growth? In each case the answer depends on the bias of the growth. Export-biased growth in
(PC/PF)1 (PC/PF)3
RS1 RS3
Relative price
of cloth, PC /PF
(PC / PF )1
(PC /PF)2
(a) Cloth-biased growth
1
RD
RS1
2
RS2
Relative price
of cloth, PC /PF
(PC / PF)1
(PC /PF)3
(b) Food-biased growth
1
RD
RS1
3
RS3
Relative quantity
of cloth,
QC + QC
QF + QF
*
*
Relative quantity
of cloth,
QC + QC
QF + QF
*
*
Figure 6-7
Growth and World Relative Supply
Growth biased toward cloth shifts the RS curve for the world to the right (a), while growth
biased toward food shifts it to the left (b).
122 PART ONE International Trade Theory
5“Immiserizing Growth: A Geometrical Note,” Review of Economic Studies 25 (June 1958), pp. 201–205.
the rest of the world is good for us, improving our terms of trade, while import-biased
growth abroad worsens our terms of trade. Export-biased growth in our own country worsens
our terms of trade, reducing the direct benefits of growth, while import-biased growth
leads to an improvement of our terms of trade, a secondary benefit.
During the 1950s, many economists from poorer countries believed that their nations,
which primarily exported raw materials, were likely to experience steadily declining terms
of trade over time. They believed that growth in the industrial world would be marked by
an increasing development of synthetic substitutes for raw materials, while growth in the
poorer nations would take the form of a further extension of their capacity to produce what
they were already exporting rather than a move toward industrialization. That is, the
growth in the industrial world would be import-biased, while that in the less-developed
world would be export-biased.
Some analysts even suggested that growth in the poorer nations would actually be selfdefeating.
They argued that export-biased growth by poor nations would worsen their
terms of trade so much that they would be worse off than if they had not grown at all. This
situation is known to economists as the case of immiserizing growth.
In a famous paper published in 1958, economist Jagdish Bhagwati of Columbia
University showed that such perverse effects of growth can in fact arise within a rigorously
specified economic model.5 However, the conditions under which immiserizing
growth can occur are extreme: Strongly export-biased growth must be combined with
very steep RS and RD curves, so that the change in the terms of trade is large enough to
offset the direct favorable effects of an increase in a country’s productive capacity. Most
economists now regard the concept of immiserizing growth as more a theoretical point
than a real-world issue.
While growth at home normally raises our own welfare even in a trading world, this is
by no means true of growth abroad. Import-biased growth is not an unlikely possibility,
and whenever the rest of the world experiences such growth, it worsens our terms of trade.
Indeed, as we point out below, it is possible that the United States has suffered some loss
of real income because of foreign growth over the postwar period.
Case Study
Has the Growth of Newly Industrializing Countries Hurt Advanced Nations?
In the early 1990s, many observers began warning that the growth of newly industrializing
economies would pose a threat to the prosperity of advanced nations. In the
Case Study in Chapter 5 on North-South trade, we addressed one way in which that
growth might prove to be a problem: It might aggravate the growing gap in incomes
between high-skilled and low-skilled workers in advanced nations. Some alarmists,
however, believed that the threat was still broader—that the overall real income of
advanced nations, as opposed to its distribution, had been or would be reduced by the
appearance of new competitors. For example, a 1993 report released by the European
Commission (the administrative arm of the European Union), in listing reasons for
Europe’s economic difficulties, emphasized the fact that “other countries are becoming
industrialized and competing with us—even in our own markets—at cost levels
which we simply cannot match.” Another report by an influential private organization
CHAPTER 6 The Standard Trade Model 123
6Commission of the European Communities, Growth, Competitiveness, Employment, Brussels 1993; World
Economic Forum, World Competitiveness Report 1994.
7Paul Samuelson, “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists
Supporting Globalization,” Journal of Economic Perspectives 18 (Summer 2004), pp. 135–146.
8“Shaking up Trade Theory,” Business Week, December 6, 2004.
went even further, arguing that the rising productivity of low-wage countries would
put immense pressure on high-wage nations, to such an extent that “the raison d’etre
of many countries is at stake.”6
These concerns appeared to gain some intellectual support from a 2004 paper by Paul
Samuelson, who created much of the modern theory of international trade. In that paper,
Samuelson, using a Ricardian model, offered an example of how technological progress in
developing countries can hurt advanced countries.7 His analysis was simply a special case
of the analysis we have just described: Growth in the rest of the world can hurt you if it
takes place in sectors that compete with your exports. Samuelson took this to its logical
conclusion: If China becomes sufficiently good at producing goods it currently imports,
comparative advantage disappears—and the United States loses the gains from trade.
The popular press seized on this result, treating it as if it were somehow revolutionary.
“The central question Samuelson and others raise is whether unfettered trade is always still
as good for the U.S. as they have long believed,” wrote Business Week, which went on to
suggest that such results might “completely derail comparative advantage theory.”8
But the proposition that growth abroad can hurt your economy isn’t a new idea, and
it says nothing about whether free trade is better than protection. Also, it’s an empirical
question whether the growth of newly industrializing countries such as China has actually
hurt advanced countries. And the facts don’t support the claim.
Bear in mind that the channel through which growth abroad can hurt a country is via
the terms of trade. So if the claim that competition from newly industrializing countries
hurts advanced economies were true, we should see large negative numbers for the
terms of trade of advanced countries and large positive numbers for the terms of trade
of the new competitors. In the Mathematical Postscript to this chapter, we show that the
percentage real income effect of a change in the terms of trade is approximately equal
to the percent change in the terms of trade, multiplied by the share of imports in
income. Since advanced countries on average spend about 25 percent of their income
on imports (the United States’ import share of GDP is lower than this average), a 1 percent
decline in the terms of trade would reduce real income by only about 0.25 percent.
So the terms of trade would have to decline by several percent a year to be a noticeable
drag on economic growth.
Table 6-1 shows how the terms of trade for both the United States and China have
changed over the last 30 years (average annual percentage change over the period).
The magnitude of the fluctuations in the terms of trade for the United States is
small, with no clear trend from decade to decade. The U.S. terms of trade in 2008
were essentially at the same level they were at in 1980. Thus, there is no evidence
that the United States has suffered any kind of sustained loss from a long-term deterioration
in its terms of trade. Additionally, there is no evidence that China’s terms
of trade have steadily appreciated as it has become increasingly integrated into the
world economy. If anything, its terms of trade over the last 30 years have deteriorated
somewhat.
One final point: In Samuelson’s example, Chinese technological progress makes the
United States worse off by eliminating trade between the two countries! Since what we
124 PART ONE International Trade Theory
TABLE 6-1 Average Annual Percent Changes in Terms of Trade
for the United States and China
Change by Decade Overall Change
1980–89 1990–99 2000–08 1980–2008
U.S. 1.6% 0.4% -1.0% 0.1%
China -1.4% 0.2% -3.3% -1.3%
actually see is rapidly growing China–U.S. trade, it’s hard to find much of a relationship
between the model and today’s reality.
9See M. Ayhan Kose, “Explaining Business Cycles in Small Open Economies: ‘How Much Do World Prices
Matter?’” Journal of International Economics 56 (March 2002), pp. 299–327.
10See Christian Broda and Cédric Tille, “Coping with Terms-of-Trade Shocks in Developing Countries,” Current
Issues in Economics and Finance 9 (November 2003), pp 1–7.
Most countries tend to experience mild swings in their terms of trade, around 1 percent or
less a year, as illustrated in Table 6-1. However, some developing countries’ exports are heavily
concentrated in mineral and agricultural sectors. The prices of those goods on world markets
are very volatile, leading to large swings in the terms of trade. These swings in turn translate
into substantial changes in welfare (because trade is concentrated in a small number of sectors,
and also represents a substantial percentage of GDP). In fact, some studies show that most of
the fluctuations in GDP in several developing countries (where GDP fluctuations are quite
large relative to the GDP fluctuations in developed countries) can be attributed to fluctuations
in their terms of trade.9 For example, Argentina suffered a 6 percent deterioration in its terms of
trade in 1999 (due to declining agricultural prices), which induced a 1.4 percent drop in GDP.
(The actual GDP loss was higher, but other factors contributed to this deterioration.) On the
other hand, Ecuador enjoyed an 18 percent increase in its terms of trade in 2000 (due to
increases in oil prices), which added 1.6 percent to the GDP growth rate for that year.10
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