Global Trade Lesson 4

Global Trade:4
Global Trade: Lessons
Lesson 1
The World Economy and Global Trade:
An Overview and Stylized Facts on Global Trade
Lesson 2
Lesson 3
Lesson 4
Lesson 5
Lesson 6
Theories of International Trade-I:
The Ricardian Model:
Labor Productivity and Comparative Advantage:
Theories of International Trade-II:
The Heckscher-Ohlin Model:
Factor Endowments and Comparative Advantage
Theories of International Trade-III:
The Standard Trade Model and Gains from Trade
Combination of Labor Productivity and Factor Endowments
Policy Instruments of International Trade:
Tariffs, Export Subsidies, Import Quotas, Export Restraints
Policy Issues of International Trade:
1) Free Trade vs. Protectionism
2) Liberalization in Developing Countries
3) The Role of the World Trade Organization
Main Text: Required:
1. International Economics: Theory & Policy, Krugman, P.R., and Obstfeld, M.,
8th Edition, Pearson-Addison-Wesley.
International Economics, Husted, S., and Melvin, M., 8th Edition, AddisonWesley.
International Economics, Gerber, J., 5th Edition, Addison-Wesley.
World Trade and Payments: An Introduction, Caves, R.E., Frankel, J.A., and
Jones, R.W., 10th Edition, Pearson-Addison-Wesley.
The World Economy: International Trade, Yarbrough, B.V., and Yarbrough,
R.M., 7th Edition, Thomson-South-Western.
Principles of Microeconomics, Only Chapter 3: Interdependence and the
Gains from Trade, Mankiw, N.G., 5th Ed., South-Western Cengage Learning.
Lesson 4
Lesson 4: Global trade theory-II: The Standard Trade Model
Procedure: The PowerPoint Presentation
Duration: 60 minutes
 This lesson combines the ideas of the Ricardian
trade model and the Heckscher-Ohlin model of
comparative advantage, and derives the Standard
trade model. This part describes the relevant
concepts and tools: relative supply and demand,
world price, and terms of trade.
Lesson 4 (cont.)
 List of Class needs: the text, a computer, and a notebook.
 Pre-class reading and preparation: Chapter 5 of the text.
 Activities and timing: Go over the entire presentation in 60
minutes and think about the main findings of the lesson.
Practice the diagrams in the lesson and find their uses.
 Identification of Learning Objectives: Objective #4 from
Section I
 Identification of the Global Workforce Skills for the lesson:
Skill point #3 in Section II
Lesson 4 (cont.)
Lesson notes and suggestions for Instructors: Read
the relevant chapters in the recommended texts
and look for online data for the latest figures of
global trade.
Acknowledgment: The Course Developer took help of
different sources as referred while preparing the study
materials. When a considerable number of diagrams have
been developed to enhance interest in the subject, many
diagrams come from the required text for the convenience
of the students.
The standard trade model
The standard trade model combines ideas from the
Ricardian model and the Heckscher-Ohlin model.
1. Differences in labor services, labor skills, physical capital,
land, and technology between countries cause
productive differences, leading to gains from trade.
2. A country’s production possibility frontier (PPF)
determines its relative supply function.
3. National relative supply functions determine world a
relative supply function, which along with world relative
demand determines an equilibrium under international
The standard trade model (cont.)
Recall that when the economy maximizes its
production possibilities, the value of output V lies
on the PPF.
describes the value of output in a two good
◦ and when this value is constant the equation’s
line is called and isovalue line.
◦ The slope of the isovalue line equals – (PC /PF),
and if relative prices change the slope changes.
Economy’s output
We saw in the
lesson how
the economy’s
output is
determined by
relative prices.
An economy
whose PPF is
TT will
produce at Q,
which is on
the highest
isovalue line.
Changes in prices & relative supply
The isovalue line
becomes 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.
Production & consumption
Production choices are determined by the
economy’s PPF and the prices of output.
This gives the supply side.
Question: What determines consumption
choices, which will give the demand side?
Answer: Consumer preferences and
prices determine consumption choices.
Production & consumption (cont.)
Consumer preferences are represented by
indifference curves.
An indifference curve (IC) shows different
combinations of goods that make consumers
equally satisfied (indifferent).
Each consumer has his or her own preferences,
but we pretend that we can represent the
preferences of an average consumer that
represents all consumers.
Note: Principles of Microeconomics, as recommended in
the Text page, has an elaborate discussion on the IC.
Production & Consumption in the
Standard Model
The economy
produces at point
Q, where PPF is
tangent to the
highest possible
isovalue line. It
consumes at point
D, where that
isovalue line is
tangent to the
highest possible
Trade in the Standard Model
In the previous slide we
saw that the economy
produces at point Q and
consumes at point D.
The economy produces
more cloth than it
consumes and
therefore exports cloth;
correspondingly, it
consumes more food
than it produces and
there imports food.
Welfare & the Terms of Trade (TOT)
The terms of trade (TOT) refers to the
price of exports relative to the price of
When a country exports cloth and the
relative price of cloth increases, the terms
of trade increase or improve.
Because a higher price for exports means
that the country can afford to buy more
imports, an increase in the terms of trade
increases a country’s welfare.
Determining Relative Prices
To determine the price of cloth relative to the
price food in our model, we again use relative
supply and relative demand.
Relative supply considers world supply of cloth
relative to that of food at each relative price.
Relative demand considers world demand of
cloth relative to that of food at each relative
In a two country model, world quantities are
the sum of quantities from the domestic and
foreign countries.
World Relative Supply & Demand
The higher PC/PF is,
the larger the world
supply of cloth
relative to food (RS)
and the lower the
world demand for
cloth relative to food
(RD). Equilibrium
relative price (here,
(PC/PF)1) is
determined by the
intersection of the
world relative supply
and demand curves.
Summary points
The Standard Trade Model: Combination
of the ideas in the Ricardian model and
the Heckscher-Ohlin model
Production and consumption
Determining exports and imports
Relative prices and changes in production
and consumption
Relative Supply and demand
Which model do you like the most to
explain global trade and why?
If relative demand for cloth goes up, what
happens to the relative price of cloth in
the world? Answer by using the diagram
of world relative demand and supply.
If both relative demand for and relative
supply of cloth go up, what happens to
the relative price of cloth in the world?
Answer by using the diagram of world
relative demand and supply.

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