int economy kenen ch 2

8/2/2019 Int Economy Kenen Ch 2

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PARTTWO

INTERNATIONALRADETHEORYNDPOLICY


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2Comparativedvantageand he GainsromTrade

THE SSUESThis chapter ntroduces he nain methodsof trade heory and uses hem to study

. Why countries trade and how they gain liom rade.

. How tradeaffects he allocaiionof domcstic esourcesn each rudingcountry.

. How tariffs and other trade barriers aftect the gains tiom tade and modify thealhcatbn of resources.

The chapterbeginsby using demandand supplycurlcs to Nnalyzehe principal effectsofrrade. hen introduces more powerful techniques.

PRICESNDTRADE ATTERNSDifferences n prices rom country to couniry are the basic causeof lrade.They

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20 ComparalireAdvanlage nd theCaitrs rom Tradeother countrieswith much owerwage rates han Japan mpo( many Americanprcducts.Differencesn wage atesby rhemsetvesannotexplain rade atterns.Wemust ookfunherfor the bas;sof trade.An enddng two-way flow of goodsmust eflect systenatic ntemarionaldifferencesnrrru.tar"r of costsandprices.Some hingsmust be cheapero Foduce ar homeand withen be exportedo other countries.Otherrhings musrbe cheapero Foduce abroadandwill then be imponedfrom other countries.This generalizations krcwn as the lg! Efcompantfie.a.fiantape andcanbepurthisway:

I In a world of competitive markrs, tnde will occur and will be benffcialwhenever here are intemational dilfernces n relative costsof production.Japancanexport cars and camerasbecausers endowmenrof land, labor, capiiat. andtechnologyllow i ro ncreasersourput fthose oodswith hesmallesracrificein uFutof othergoods.The UnitedStares anexporraircraft andgrainbecauser can nffease tsoutput of thosegoodswith the smallest acritice n outputof othergoods_ hereat-resourcecosis of producingali four goods-aircrafi. cameras, ars,andgrain


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Pmduction, Consumption,and Trade in a SingleGood 2l

FIGURE-1Traden a SingleGoodihe domesti(demandcurve s Ds, thdomestic upptycurue s Sr, and the domeetic prics OPbefore rade isopened;he quantityOA sprodu(ed o meetdomesticdemand.Whn rade igperlrd-qLlhe orldpri.enp,,productionallstoOe,.onsump,lion risestoOC andQCismported o closethe ap.Beforerade,producer urptus asOfP,and(onsumer urplurwasPEr.After trade,producer urptus OF p, and con-tumersurplussP'El'f. Hence, roducer urplusattsby p,E,Ep,but consumerurptusrsesby P/E'EP,which s 'E,'E largerthan he fall in producersqrpluj-Th s_ilthwel_faregain rom rade.ThapioituEori effict or opening rade seA, which ontribursE Kf.This welfaregain resulB rom the substitution f tow-cost oreiqnoutout Jornigh-(ost omestic utput.Thconsumptionfte(t isAC which ontribuies E E. Thi,welfaregainsultsfromhe inoeasenconsumptionausd ythe reductionnprice.Theareaunder hedemand urve s meaningful,oo.Undersomewhatestrictiveassumpiionsthatneednot detainus, t neasures hecashequivatenr f the urilirt rhat consumersderive tom 6eir purchases fcameras.t f OAcameras reconsumecl,hatcashequivalenlr the areaOAEI But consumers ay O/EP for iheir caineras.Therefore. he areaof the

trianglePtT measureshe nethenehror consunersurplus.Equil ibriumfterTradesOpenedNow supposehat trade n carnerass pemitred and har he wortd'ssupplycurveis Sr. Theworldpdceof camerass OP', below heoid domesricrice,Op. and his sUe pricethat must come o plevail in ihe domesdcmarket f there are no transponcosrsor tariffs. How will this happen?As importedcanerasare ess expensivehan domesticcanreras,onsurners ill cease o buydomesric ameras t the old domesricprice,and heyFill raise heir total purchasesswell. Theywill movealong rheir demand urve rom t torThercm fiee slch asunptions: (l) Utiliq, cd bnessuEd h r,r;nal nunben, altowins us k)know le r{. d/rhe incEase n utility confenedby m incse jn coNunprion. notneEly lhe facttnlt tbeE is m in.Mse. (2) The udities or individualsm nelsured in conpmble units, .lloNinsns toglve hem comor .ashertuivaienh(3)ThenErginai utihy of income s onslm| alowing uslo used rnconeor cashnasDie rhaldo* notemw or strint whonFjce chnses alter ncones.


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, ! ,

Compamtive Advantagand the Gainsfrom TiadeE", increasingheirpuchases rom OA o OC As consumers tart o buy fbreign camems,howcvet domesticproducerswill reduce heir pdces n orderto remain n business'buttheycannotdo thal wiihour cuttingproduction.They will move aloog hen supplv curvefrom t to t', decreasingrcductbn from OA o O8. Thegapbetweendomesticdemandanil donesticsupply,OC,will befilled by impo sWhat arc the efiects on economicwelfarc?DomesticconsuneN will gain from theopeningof tradc,anddonesticproducenwill lose But thegain o consumers ill be argerthan he oss o producers, llowingconsumerjo compensateroducers ndstill comeoutahead.Accofdingly, hewill bea weltke gain from tradcfor the nationas a whole.ThetextatlachedoFigure - showshat onsumeruryIus ill risebv P't"EP, thatproducersurplus il fall by P/t/6P, and hat hedifferenceetweenhem s t'cl t. Thismeasuresthewelfaregain from trade.Notc 2-1proves hat the sizeof thega depends n the sizeof lhe changcn ihe domeslicpriceand of the resultingchange n inpori volume.(In thiscase, heprice change sPP', and hevolumechanges 0C, the wholcquantitvof importsrnadeavailablcby trade.)This simplediagrams deficientn manyways lt relieson ra*rer restrictiveassunptionsto measue consumersurplus. l does not dcscribe he economiccostsand benefitsof

Note 2'tMeasuring the wellarc Efleds of ftade and Tarifk

Thedrea fa trianglcs I x base height. ence,lhe rea f 6't"E in Figure -l is! x E' E" x KE.Bu.tE E' = OC. he nffeasen mport olume thewhole mpofyolumehere).andrt = PP'. the cbangen thedomesricprice caused v replacingthepretade doneslic price with the lower world price Therefore, he increasenwfare s

where A denotes achange, M is the quanlity ofimports, and p is thc initial domesticSirnilarly,he arcaof E'F'H' + FE"H 1n Figfie 2-2 s I tFr. \ FH).Btlr E'F' = QQt.FE' = C'C, and. 'H' = FH =lhedccreasen welfrre s

xQCxPP'=+'


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ProductionandConsumptionn GneralEquilibriumP\po'r ingorhe'go, 'J. lopa\r i { rmpof led\umerr\ l r ,Jy,n, ,rhrngab,,ur therer-,n, torrhepr i .edrf leren.e har ndu.r, UJde rhlhes,{ t ;pn(f i , icJrne,r,r, to$er rhunrheprehide domeslicprice. To investigale hcsema11crs. e must use gcneral_equilibriumnrodels.Before uming to them, howe\r lc t us ask how a tariffon importedcameraswiualtect the gains ftom trade.

Effects f an lmportTariffConsumers o not voluntnrily compensate roducerswhcn consumcrs ain andproducers bse. Hence, producers oftcn seek protecrion from impon comperilion. Manyrncrhods an be used o provideprotecrion. nd we will compare hem n Chaplcr9. Here,se cxamne the mosi commonmerhod.What wilt happen fdomesric producers ersuadelhcrrgovemment o imposea rariff on imporiedcameras?The principal effects of an impod 1ariff are shown in Figure 2-2, which reproiluces rhe

denand and supplycurvesused n Figure2-1 andrhe equitibriumal the world price Op,.Bcfore he hnffis imposcd.domeslicproducers upptyOO cameras, onestic consunendemdndOC and import\ are OC. An imporr tffiff will rajserhe domesticpriccsof im_po4edcamcras, ndconsumers ill slopbuying hem.As theyswitch odomestic ameras,however, hcy will bid up the pricesof lhosecameras ntil they are cqudl o ihc pricesol'mportedcameras. f rherariff is P,P| per camera, he domesricpnce will rise ro Op,,.Donesticconsumers i l reduce heirpurchaseso OC , donestic producersJi raile theirlales o O0'. and nports will lall from OCro 0'C,.To measurethe welfare effecrs of the taritl, we nusl know whal the gormment aloes\i ilh the tariff revenue. 11 ollects P'P, on each imported cameraand thuicotects t'' fHItlin total t]]riff revenue.Lct us assume hat ir curs someother rdx and thus rcturns thc revenueIhe re\r z ached ^ FjSU;2-2 ,hoqs rhJrprodu(er urptucwr ri .e b)P't'fl'P" and ihal co.sumer suryluswill lal by p,E,rpl/ Thcrefore. he consumers,losswill exceed he producen' gai'. even when consumers er bxck the iariff rcvenue.Thediilcrencebetwccn he consumers'oss and he producers, ain js E'F,r/, + Fo,fl,\hich mcasureshe wclfare oss rcsulting ftom the tariff_Note 2 I proves hal the sizeof the loss dependson the iarill rare and on the size of $e resulling change n impon

PRODUCTIONND CONSUMPTIONN GENERAL QUILIBRIUMMuch ofintemational ladc theorycan bedevetoped y consfuctinga very simpleS.neral-equilibriumnodel. r conrains wo countries hrt produce wo goodsusins twoIactorsof produciion.The model cannotyield tesrable ypothess boutrhe cornmoditycomposition f trade;a nore complicatedmodct.with mllnycounrricsNndgoods, sneedediitr thalpurpose.Ncvenheless,hc simplemodetcanbc used o ilustrate the aw of compar-rrNe advantage nd show he gains rom rradc. t alsoprovides eslabte yporhcses bouithe gencralcharaclcrof trade.Themodel s deveklpedn ituee steps. irsr,we will showhowproduction. onsumption.andpncesaredeterminedwhen rhcre s no iradc.Second,we wil show how rradeaffecrs

'ingle country.Third. we wilt iook ar two counrr ies ogcther o show how world nricesareJel(rm.Ied nd ho$ rhegarn. r, ,m mdeare hdred . jseen rheLaJin! cound(,


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2,4 Comparative Advantageand the Gainsfmm Trade

uQQCCQuant ' tyFIGURE-2ATariffon a SingleGoodThe demandandsupply urvs,Ds, s', and Sw,arereproducdrom Figure 1 Do-mstic roductions OO nitially,domesti( onsumptions OC and mportsareOC ArariffthataddsP'P'to the importpri(eraisesthe omestic ricetooP" Therefore,traise omestic roductiono oQ and tdu(erdomesticonsumptiono OC lmportsfal l toOC.ProducereurpluswasOEinit ial ly nd sOH P withthetat i f l Constrmer5urplus asP'E"I initiallyand s P"Hrwith the tarifi Hence, roducer urplusises vP'E'H'P", ndconsumerurplusal ls y P'E"HP", hich s E'f"HH' biggerhan herise n producer urplus. ut the government ollectsP'P" of tarifi revenue n eachimportedunit,or F'FHH' n totaltariff revenue, ndreturnt t to consumersy cuttingsome ther ax. lherefore,henetwel{areoss5E'E'HHI F'FHH'.orE'F'H'+FE .Theproduction ffect,QQ',alsocalled he protective ffct, ontributes 'F H', whichreflects hsubstilutiono{ high-(ostdomesticoutput for low-cort oreignoutputTheconsumption ffect,cc', contributes E"H.which eflectshe fall in consumptioncaused y he increasen Price-

Supply onditionsSupply onditionsn acountry roduc;ng wogoods anbedescribedv altm

duction runsfomvtionunGometimesatled productionossibil;tiesurve).t showsthe outputcombinationshat the countrycanproduce,given ts resources,echnologv.andeconomicorganization. he curvem/ in Figwe 2 3 is the ansformatbn curve or a coun-try producingcanelas andgrain. f the country devotedall its resourceso thegoductjonof cameras, utput would be Olcameras. lf it devotedall its resources l) heFoductionof grain, output would be Or' grain. If it divided its resowcesbetween he two actiYities, it would anive at a point suchas D, where cameraoutput s OXr andgrainoutput soXz.Theposilion and shapeof tbe tr:rnsfomationcurvedependon tbe quantitiesof land.labot andother resouneswith rvhich the country s endowedand on its technology f ithad more land, it could produce noregrain: thedistanceO?' would be longer, and thewholetransfonnationcurvewould be steeper.f it had a better way of making cameras.it couldproducemore cameras;he distanceOT would blonger, and he banslbmation


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Production and Consumption n Genral Equilibrium; :

B'

t rXtTBQuant i tyFIGURE.3]1reProdution ransformation urveTheposition ndshape fthcurvf' depend n the country's upplies fthe {actorsof production ndon itstechnology. hen he relative ri


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26 ComparativeAalvantageand the Gsins from Tradelet us choosea serof prices arbitrarily andshowhow it determinesbe output

ol eacn9oi1,.,.,,ri".p.i""r ."-"11t',t::':::::fi:|il l: j:*Tfiffi;::,T::H:grain hatmustbegivenupto purcbase camertlineBa'in Figure 3:

""'^U""n""'""".""."ffi:il.Tu:ff"fl',-:":i::illtr J i *:;[T'fJilill+;'ilTDrcducr An algehaic dmons$aion rs g\en#;i;'ruiirltl*:-'*:,nml'iTinil':::"?'i-:i$::

oa'andihus ma(imzes henational roduct'"hfu *"9**i:'t"l*'"1*::i:iil"''"I#:imeasuedat theirmarketPnces:valueof nationalProduci

= grainourputx priceof $a + cameraoutputx price of acamera

Dividing bothsidesbv thepticeof glain' wenave\alueofnaronalprodcr --grarnourpur camera urput

pl5ll]jryon*"r rr*pnceot gfarn

nationalproductmeasuredn grain= grainoutput+ cameraoutputx relativepriceot dcamera

:iljl:Tli#: ::'#"11"'H:1$1";l:::1".1ffi"?f"'Xi;outpuls OXrTherefore,national roducimeasurcdn grain= ox'z+ oxr " I4 = ox' * x'n' = ou' '

x':*"ffii:ir:x'l'liJ"?H"XT:1fl::'J':*XT:"4;i:tr-


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Production nd ConsumDtionn GeneralEouilibrium 27

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nrr ionalrodu(t ea\urcJn.amerr.

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L, xi Xl IAB Quanl i lyFIGURE {Efficiency n Dolnertic ProductionWhen he re lat ive r iceofa (amera sgivenbythe elope l th l ineAA',product ion tD is efficienl and production at H is not. Both points lie on the same ransformationcurve but do nol yield the same levelso{ real national product. When the economyproducesat D, camera output is OXr, grain output is OXr, and real national producti, OB in terms o{ cameras.When the economy producesat H, .amera output is OXigrain output is OX:, and real national product is only OA in terms of Gmera5.or morc directly. Divide the national product measured in grain by the relarive pncc of a

nattunal roductmeasuedn grainrelative pdce of a carnera

OB.oB=oB x og=oB.

It is aclual camera outpul plus the camera equivalent of actual grain output.To show that production at D ma{mizes real national product. whether it is measured n

carturas or grain. let us perform an experiment using Figure 2,4. As before. the tansformation curve is n'. and the relative price of a camera s given by the slope of the LineBB'. Bulsupposehat productionstartsat 11,noi ,. and draw the line A,4' passing hrough l andparallcl o BF: This line marksoff the distancesOA and OAl,which measu.e eal nationalproduct in c4merasand grain. respectively, when fl is thc output point. Clearly, these aresmaller han OA and OB'. which measure ealnationalproductwhen il is the outputpoinl.

rThAeLtuaiunfv lo!s rom rhc i.rrharmtional pmduct nDasured in canerd i pnce of a cdem

Triom prcdr. r I fo\uren in. mi , t i . r , f " 'd i ,narional pnrdu.r ne$uEd in cmeras 0i .c ol c . i l- rJ ,vaJr ptuLru. ' ed. rredD antr


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28 ComparativeAdvantagand the Gainsfrom TradeCompetirile tums will nol stay at l/ Thev lvill prcduce more camerasand ressgrarl

moving the economyalongthe tansfomation curve n the direclionof D' They wjll dothis be;ause it will increasetheir profirs (The line A'4' is sieepcr than the aansformatiotrcuNc at t/ . Therefore, the Yaloeof an increase in canera output will exceed the value of,he.one' | ' 'nding,l .creJ'einerrrnoulpul 'Bymo\inginlhi tdirecl ion moreo\er 'i rm)raise eal;ational product,and hey maxinize il when hevget o D' The gaps'48 andA'Bdisappear.If firms weni beyond ,. rhey would reducercal national product lf thev movedto H'. tbr example. il would fall again to OA nnd OA' But profits would fall' too'

In briel a competirive economy will arrive md stav at D' where the relatile pnce oi acam.rd iequrl lorheslopeoflheLrun'formdrioncur\el 'oIno$nJ'rheDdryi 'd/r ' ' '

Demand onditionsDenand conditions n a countrvconsuming wo goods can

be describedbv aco/Nnunit! inaijfercncemaL It is consiructedrom individuals' ndifferencemaps'wltcbshowhow hosendividuals.ankarious ollcclions fgoodsa

An inditrcrence map is nra neup of inrlilleme c ner' Two of them areshown in Figurc2'5. Thepoint P defines collectionofgood!' OCr cameras ndOC2grain The ndifferenc'cu|ac Ur divides all such collections into thrce groups Thosc that lic below Ur are infbridto the colledion at Pi thev fumish lowcr levels of utility (satisfaction) Those that lic abo\tUr are superior to the collection at P; ihev fumish higher levels of utilitv And those thar[; righi on Ur are equivalenr to the collection at P; &ev fumish the same level of utilir\"whichis whv the consumerissaidto be ndifferentwhen asked o chooseamong hem-

Note that the indillerence curves get flatter as camera! replace gain in the colleclroDof goods. This property can be derived from a fundamental axiom in thc theorv ol con'sumerbehavior-the law of diminilhing marginal ulilitv It savs that each increasern lhelon.umprron l onegood)icld ' J 'mal lef 'Jdrrron'o uri l rr) The arPerhecon'umpriooof cameras. tne smutter the increale in utjlity obtnined bv adding one more camera Blimplication,a consumerwill requirc argerand argcr ncreasesn camera onsumptioncoh.cr ucce\\ ivee. easetngrJin on'umpl ion

To show how jndifference curves describe demmd condiiions, suppose hat consumeFhrvc OB of real income mensured n camerasand thai lhe relative price of a canera is grve'br- the slopot' the line Ba' Consumers can buv rnv combination of camerasand grar!li;mg on BB'. They can hale oci carneras nd OC: grain andwill thenwind uP at.R oDt'r," inaine'ence cuwe uo. They can also have ocr camerasand OC, srain and will thed$ inclup at P on the ndjfference urveUr. Consumenwill chooseP' of coursc'and he)..r a. r" bcrrer r l ;e ' ! 'n rhehighenanaindblendrl lercnceu^e $heo ci 'n 'umers reconslmincdby thc LineBa'

Because t the role thar he ine BB' plays n Figure 2-4 it is otten calleda 'd8r li'sh deoicls he wo constrainlshat controntconsumers:he ncomes heycan spendand he'T(, bu,ld a con.urity indi lercncenxp frcn individud rndifrsncc tnapsonenu$ tnak a nunEor asrnp(tuns. but de dc Lessst ictiverhan hoseone nd$ nake to n*su onsund surplurIt ij no1nccessaryo adopt a cddnrd neasuF ol nlilitv lo m4su the urilities or i'dividoals tr...p."br. -ir'. - o t "r ' rr" narginrlutiliq of inc'nc

constdl lt is sfhcjentlo dsme ddilt ,;dNidurl ha* lhe srne irdilTdcne naPs a'd rhal inconc elasriciliesor dcrund e utur-l(lh! a I perceDrrcENenreal ncone cluses I percentin'nmein hedenand or eah goodlAlrcmaiively.t issufhcicnlo *une ihxt ll ildividuals a!' idenh'xl ou'ces I rn'ome


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Pmduction and Consumption n GeneralEquilibrium

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FIGURE-5The ndifferenceMaoAll collections f goods hat tieon one indifferen(e urve ietdequat evets f utititykatidaction), ut any(ollection n U. esuperioro anyco ectionon Uo.Whenn(om;rt un me^asuredn cameras,nd rhe retative ri(eot a (amera sgivenby he stope frne Ine 6d . (onsumer{wi chooeehe (o ctiongivenat p, comprising C,camerasandOCl9rain. hat ol lect ionssuperiortonyothron , betow B,;(h dsthe nepncesat whichthey canspend hem_ herefore,heoutcomeshownar p canbe dcscribedby saying hatthe composinonof denand sSivenby the point onrhebudget inat whichits slope s equal o rheslopeof an ndifferencecurve, alsoknownas he ,,ar"iudt /rr? of

Equil ibriumn the Closed conomyWhenweexamined singtemarketand herewasnorrade,we ooked or rheDriceat which the domesric narkercle.red-where domesticaemana as eqJ to aomjstic

supply.t wasgiven y thepointE in Figure -1.When$e examinewo marketsosether.wemusrook ,tr hepoinrarwhichboh murkerc ear. r i, lhepoinrL rn rigure i, Letusseewhat happenshere.W}len roductionakes lace t E, rhesuppty f camerassOOr and hesuppty f grainn OOr. ln a compentiveeconomy,however productjonwi remainat t only when therelanvepriceof a camera s equrt to the stopeof thetransfonnarion urve at E and rhusequalo thestopf the ineBBl_When hjsconditions satislied, oreovethenarionalproductneasuredn camerass Or. and t must equal he narionat ncome n ihis sirnpleeconomywhercwe make oadjustmenrsordeFeciation,ndirecraxes. tc.). hevatuesof the goodsproducedat E musrequal he wages, enrs.andprofits paid to rhe i.actorsol producbon.heretorc. lheineAA mu{ behe budferine. rdconsumenr eoror. becau.e . i, rhehighe.r ndifierenceuNe he' can each henrtey arecon.U,in",tby that budget ine. Ihe demandor cameraswill be OCr andwin equalrhe supply.Thedemandor srainwill beO0, and wj equal he suppty.


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JO Comparative Advanfage and the Gaim from Tfade

B'

T'

a,

FIGURE.6Equilibriumn the Closed conomyUndr ompet i t iveond t iontequi l ibr iumi l lbeestabl ishedt E Camerautputwi l lbeOQtandwi l lequal the emandorcameras.rain utputwi l lbeOQ,andwi l lequalthe demand orgrain.The relat;vepriceof a camerawill equalthe slopeof the lineBE',and real nationalproductwill bOBmeasuredn .ameras

T'ro leaturesof this equilibrium deserlcspecialattentnrn:L we can locate E withoul Inowing the rclative price of a camera. when finnsmaxiinizeprolitsandconsumenmaximizeutilily, equilibrium n a closed .onomvis esrrblished at ihe /drget.l bclween the transfo.maiion curye and an nditrerencecuNe, iust as equilibrium in a single narket is established at the interseclonbets,ecn the supply and demNndcurves. The lnarginal Iate of transtbmation isequatcd to ihe marginal ratc of substitution, and each of then must equal therclativc price of a camera. We can, in fact. infcr that price from the slopes of thetwo ourves ai iheir tangency; we can draw a8' xfter linding E.2. When onc markel clears. he olhcr must clear. too. W}ten we havefound ihe rel-ative pdce that clears he camera market, we have found the one that clears the grainnarket. too- In oiher words. there is only one independent market '. a two-goodnodel. This importanipoint is provcd algebaically n Section of Appcndix A

what would happcn l, by chance, he relativepice of I camerawere different fromthe equilibdumpricc?Suppose hat the pricc iell below he one givenby the sloPes f thecurves at t. Firms would move to the no(hwesi along the transformation curvc. reducingthe supply of camcrasbelow O0r. Consumcn would nove ro the southeasthrough heindifference map, raising the demand for cxmelas above O0!. There would then be aneress denund fot cameras,which would r.tise ihe relative pnce of a camera, moving theeconomyback to E. Hence, is the only equilibrium point for the closedeconony.


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Trade in General EquilibriumTRADEN GENERAL QUILIBRIUMWhenanalyzingraden a single ood,usingFjgure2-1,we askedwharwoutdbappenf theworld priceof acanera was owerthan he donesric priceprevaitingbeforeFade Lus adfuess he samequestioDo the two-goodcconomy.How does rade aftect

xoducrron.., ,n.umpn. nJ conomicetfare henheetar i \pr ic;; t . .umeras o$c,n theworld market han n the domesricmarkerbefore rade s opened?Equilibriumn the OpenEconomyThc effects of irade are shown n Figure 2-7. Before rade. rhe economy s inatuilibrium at E, just as t was n Figue 2-6. Therelativepriceof a camera s g;venby theEopesof the ransfoffnarion urve rl and rhe ndifference urveUr. Ghe budgerine BBlLiomitted rcm dis and aterdiagmms. ecauset would clutter hediagrarnunne.essarily.)

Supposehat the relariveprice of a carneras lower jn rhe outsideworld. Represenr:i b! the slopeof the line FFl. Whentrade s opened and hereare no rransportcostsor

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xt arFGURE-7Eqrrilibriumn the OpenEconomyBclore rade,production nd consumptionakeptace t E/ and he rel4iye priceof(ahera h givnby he slopeof-!E rransfornEllon urveat E. When rade sopenedtt a lowerworld price,givenby the slopeof the tineFF, productionmoveso D and6nsumptionmoves o P. Camera utput Jallso OXr,consumptioniseso OCj, andXLC,of camera mports jllJhe gap.Grainproduction ises o OX),consumprionalhio Oa-,, ndc. & of grainexdoilTemove he surptus. onsumefeainbv movino iomon the indifieren(e urveUr to P on the higherindifterenceurve i,l. proOuctiondrd onsumption effectsare readily denti{ ied.Looking irsr at came.amports, heproductionffect s hedecreasen domestic upp y,er Xj, and he consumptioneffect6 the in(reasen domestic emand,OrCr.Together,hey deJine otat imports,XC,or MP.Looking extat grainexports,he production ffect sthe incrasendomesticsupply,Or&, and hconsumptionffect s he decreasen domestic emand,erCr.Together hey define otal exporrs, 2X2 t MD.


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32 ComparativeAdvantage and the Gainsfrom Tfadetarifft, ihe worldpnce cplacesheearlierdomestic rice Guidedbytheworldprice,profit'maxirnizing ims wil move he oulputpoint to D, $'hre he slopeof ihe transformanoncurve s equal o the slopeof fF'. The nadonalFoduct measuredn cameraswill be Ol''it will equal henational ncome,andFr' will be the budget ine Accordinglv'consumerswill maximizeutility by moving o thepoinl P. where he slopof the budget ine equalstheslopeof the ndifferencecurve Ur'If the economywere closed, herc would be an excessdemand or canems (equal oXrCr) andan excess upplyof grain equalo C?X2)- he newsituation ouldnot besustainable.Whenthe economycan tade with the outsideworld' however it cansatisfyits exccssdemand br camer.Nby imponing Xr Cr andselt off its excess upplv of grainb) c\ponrngC.Xr. Prodll{iion r D can bereconciled irh con'umprion r.P becau'ed, 'mesricurl 'c lsan e leded yu?ding rainorcame'asiader\beneDcrar.moreovebecauseorsumers anchoose nycollectionof goods ying on he budgetine fF' and husreach he nditrerence uNe Ur. They areDolconpelledto choose hepaaicularcollectiongiven ai t by the tangencybetwen he transfbrmation ulve andthe lower indifterence

The;rain erpot! sbojrynn Figure 2 7 3re ust ldrgeenough o pav for tbe cameraintpo.s. This isFoved algehaically in Section of AppendixA. and t canbe iUustatedgeometricallyby looking at two triangles,OFF' andMPD The egsof OFF' neasure herelativeprice of a cameran lhe world market:

relalive pfce of a camera = priceof acarnera OF'priceof grainBut OFF' is simil.r to MPD, identifiedhereafteras he tradetimgle.'fhercforc, OF' OFequalsMrlMP. Furthemore,MD equalsCzXr, the quantitv of grain exports,a'd MPequalsXlCr, tbequantityof carnerampots. Therefore,

pice of a camera MD quantityof grarnexPorts= q"-dty "f c.-"t" tt"pottt'

oF'

pdceof grainand

quantityof canera imponsx priceol a camera: quantityof grNinexportsx priceol grainThecountry's oreign trade s balanced.

Decomposinghe GainsromTradeThe text attached to Figure 2-7 divides the effecls of trade into production and

consumption effecis, but there is a better way io decompose he effects of trade in a general_5TheCainsrcm tade canbe nluslratedwithour cvendrawing .difrEne c!fles As the budget ineFF' lics nr 1henonhest of ti old equilibriumpoi E. n irchdes colldioN oI g@ds conlainingmoE cmeas a.d noE g.ain. Unlessonsune^' denmds cat be ra,i.rd bv nni [email protected] collections e necessdly superift to the collecriond6rcd b] E (co$men navDErer hc.olleclion delinedby P, ontaining noE cus$ bd lcsssFin, but.ould [email protected] more of ,,r, 8oods.)


16/27

Tlade in General Equilibrium

trURE 2.8O.@mposinghe Gain5rom Trade_t*9ain from ;nte.nationaexcha ge smeasuredyholding he outputpointat E andt-awingtheineHH'through .AsHH'is aral lel to F',tsstope easuresthelat ivet-(e of a camera n the world market,and the distanceOH measureseat national;toduct in cameras;t ispretrade arnera utput, OQ1, lus he camera quivatent J;tEtradegrainoutput, OOr.As OHako measureseat ncome,HH, s he budget ine..n E is he output point,and consumers ovo p,,which ieson an indifference1trYehigher han Ur but lower han Ur. Thega;n rom inrernational pecializations*5ned by allowing he outputpoint o shift{rom E to D. this permilstheadditionalr''t of


17/27

34 CompamtiveAdvantageand the Gainsfrom ,lladeDETERMINATIONF NTERNATIONALRICESWe haveconpteted lwo of the three sreps equired to pove rhe aw of compffanve

l."jll::',1: li* "*i ho$suppr)d Jemundundrrinn,elermjneome5r,;dc$:'].d.j-.* :...:11' "::ucing r\4o i,od\.ue ha\e.hounbo$rhfeconom)ecpoDdsFiiT::,"Ji;#fi;;'Hl;:#.,:*1']:;:;,,tillTt;.iilecanni,q tdre hehnat lepj ho$ hn$ wlrfldtflce, areAerenrunelna rou trey edecrintemaiionaldifferencesn costandpfiaestrucrures.The rade riangtcwasMpD in Figu2-7.Wl,ohelopefFF,,rain",.0.","*,;, #:ff#]ffififf:Tr.."ilHH'::11w:: batTcedgratnexports erc.iusrarge nousno pay or cameramporrswhenlheywereexchanged i wortd prices.Whenaneconomys vcry small, ts rradedoesnotaffectwortd pricc!. Ljke an ndividualprodurerrcon\umerna comperirr \(omesricarr., . , . "" **,*. _i Ur"""rr l irain or themnespondingquaftity ofcameraswithoutane"ting.aat;,e p,;cesntre worramffkel.WhenJneconom) . nor har"malt,ho0,,.""",."..*.,'i"1,.,,fi ;:, ;",::Jillll#:ilL:i:il.I:.:l:r(rco. cnrngrntsbe \uppt) oi fgraioe\pon, Jnd lhe demand br camerr mpon,.r ,o\^ an$e be5ureDar panrcutf f ude riangteepicr. tu f led8edquj t ,brrumthccundi t ions.nbr rdenriheda, ib b) tooUDg rd. jorp1. , " . -_a **ra. , *orfa,_i . , .(dmcomperrrrreevenwhenlherearcont l l$, ,counu_re\ . f tenumberoicounlnesdocrnot mdtier jf each counrry.s markets are compehuve ano govemment! do nor monopolizthr countries' foreign rrade.Trade unjres rhecounmes. competjrive markets,and the sumsof compelitive markets are likewise competirive_lEquilibrium ithTradeBetween woCountries

, , - j te]$o..ounrresaredesc,ibdblisure _q.hedome,r jc,dnsr,rmra,ioDunel\ , , . fne rorergnransrormddonu,\e \ r ,r A, Or i , tdrgertanOr; andOTsmalterhanozl, there s anobviousseise r) ;hiJh *" a","q"o" "*"._y t, 0"L "ul",o produce rarn han amera".omparedoLhebreign .;om1.ro empha,izehe nfluenre f co,rcondirionsn inremarionatrad..ne uo rountne.areassurnedbhavedenlicaldemand onditions. eprescnredy rhecommonndiffenncecurvesUo,Ur andU9:Look firsr at ihe inlernat e4uitibrja bcfore tr:producriornndonsumpri"";;';; ;;;, ;;fi f" ;::T,lj:,*; "'trj# f nT*:: dr: 'ndift.erenceulve /0. rn theforejsncconomy,hey akeplaceat E_.where'the:r:1to:natlon cuN:.1rl is tangenrothatsamendir*** *,,".' cr"*ty, ,r,"..r,,i,"pnce01acamerashighern thedomesncconomyhann he oreign conony,whichs' I ,a- ,k-o. ,um.dorrhr .eb. .drJnrhe.der t ,h. ren. . !wr t f , . .pa, t . . , t ' , . .h ."enLlnp,D tr r , l dg-m Jnd h! .onlu".n. oJtr0 In m , c q, ik senemt aur Int .onmor t?/ orTonn,r .ccrF, .hd. i .pe. ,dtpopn),har . , tutabr i rpond,r rbc,vtnrr r .qedonJintr \d

1e .T\e n !n nan. ,de. , I d. , ra dre ,rJ. cevn.h. Jt \ .po," , . . , . . * . . . .p" . , : ; ;r Jnu / he on r rrtughr hn e h,m rhcu.Ern..fhtr Drco.d.emdn-,of t t i "on.dd,etJ, \ep ""r ' ' vpr \er"ornrr j ' t ' i rom o8udcr "


18/27

Dtermination of International prices

FTGURE-sI Su8:iiiJ'"'

Equilibriumn a Two-CountryWortdfiiil ii:+Te1"!ffi1::ir:i"T3"T::Hfi';l*[f"r:.x.ri",^,ji,*t.rormatron utue rfi. Consumersn bothcoul,ii;N1r,r;::ht1;l:',ti1ii:l:#ii1;#:'#',,,,:::'.rif,Iljfonsumption oveso p, anddomestrconrul"';;:*{l*rru"x::,,;r.}.#'iilr:i+:i"f',:T"':"'".liiilf.l;:Hll';e:il:,:li:?i,TiijljJ";i,"ii.Tl;:y*ni*hl:i^',ru#"Dhatwe woutdexpect. ecausehdornestic(than ameras. ronomysbe ersuitedo producing rain

Lookoextartbe ffects f openingrade.When rade nifieshe wocounrries,arkets,::yi:r T:e, m:.lre!:ir.anJrhcruncrea'hen,ne,rd,ker,...,,"i*,;";:i.qarelhr.h,r condjr i^n:L Gt, ,halumeruurpur.en*a ,. , f , . rn, , , r . *o. ,"n,1., :outpurs, ustequalhegt()bal emando. camers,obo,'"-ai.s*inlu.;;;il;#:'tl'J"ii:::lT:H,i::ili,",ili:l:equ! lhcquJnrrr)t !merre\p,,nsuppt iedy he rher.nd he dme quct iry u\ lh,rrdior hrd


19/27

36 ComparativeAdvantageand the Gainsfrom :lladffi ;:fr i'::.::i'":ffi: lfi::'jXl-t:"",.Li1gnrice)heommo,rices,heAs thc openjngot' radcreduceshe retal

*****#+t**+t;:H!:.i;:;::,""*-"*;l;*i,"Tix';ruli:5#*i$"j*f;"*L:,:,,;i,:*;T:s***$***,**qfiil.j,"r;ff*."r,:ff--*u$ffig*i+r;.i";3s*[-tl',,"rTheTerms f Trade ndGainsromTrade::::":.H,li:i:"":ii::;::'",::,:"il:#ff;fff ::ffii ,,*ffi:nrpons rom heother. reducrionn ihe clarxru;,;*'tx$**jj"lji,,::1:".1jft'r:il;,:';.;,,l;;;,m,*;":';*.;iiT:';i,;,"#thT#f*r$,ti: :,1:;.l;iil;#li'll'lll ;li:u;i::lllm'"',:'Y

Comparativedvantage nceAgain

": 'i.r :r{rilTlri;;:1ii-",l:;;'"il;::i::':i,n:.:l;r itxiiJ:Fru;lxr;::l*rrj*


20/27

Offer Curvesand Internationat Equilibrium'nusreacl the higher ndifferencecune Ur. Finally, it illusrrates he law of comoarative,JrJntdtse

If *le twocountriesshownn Figule2 9 had dentical ransfomationcurves.herecoutd:t no lradebetween hen. The poinrst and E' would coincide,and the rwo counrrieJxrceswouldbe denticalbefore adewasopened.Hence,heunifcarionofnaiionalmarketsrould bc withour onsequence,ecarset wouldnoraker elarjve rices. ach ountrv,sim. s ' f l rdsr,r) r. Jnd ach i'unrr) fon,umersouta.ra1here.o,, .nremrtuootie,ruLld.dristl inremal cmatrdsneJcb ounry cpararcly.rd rherewoutdbenoearnromrlemari , ,nalpecralTJ|ionr h,rm ntemudonat).LhanAe.u hen he ounrne\ 'ransorm, on unes e dRerenl.he nihcarionl nar;\rnalar(eG cturngeselative prices.affecting prodricrionand consumptionn eachcountry.Both.rountrie'dn fium.peciatr,/arionnder!hange.Nore n paniculrr te n,nfe ol rtrega;n::om ntemaaionalspecializarion_he donesriccconomys bettersuited o producesmin*Jn .dnera,. omparcdo he orejgn conomy. irh he prning t ,rude.r c\ptoirr t ,.imparativeadvantage. eaciing o the a[ in rhe etarivepriceofa carncra, omesticirms:.:-lducemore grainand fewercameras, nd he economy hus r,endso srreciatizen srain:nrdLcri,,n.}le orergn conom) r, a ci,mparatiredranragencajner!producrion_hcrror imageof the donesticeconomy'sdvantagen grainproducrion .nd alsoexploils::i .omparanveadvanlage.Reacting o the rise in the relative priceof lt camera,oreign:r-ms producemore cameras nd essgrain.andthe cconomy hus rends o specializen:5r(rd I'roduflion.Lookingal these ameesponsesom another tandpojnr.we cansay hat ade offsetshej.-direncen rclauvecrrciue,.Betore,lde sopened.amem:re retdri\etycarcen rhca-oesticeconomy.wbich s no1welt suited oproducehem.Tradediminisheshisrclariver:"rcity. Similariy. grajn is relativelyscarcen theforeigneconomy.burtradediminishesErr relat'vescarcity.B hendernandondirions rc denrical,as n Figure2 9, a diftbrerce n relativescarcitiesst.iffilyduetoaditrerencei,supplycondinons.Iicoutdbedue.however.toadjfferencex .rmrnd condirions. f rwo counrrieshave dcnricat ransformation uNesbut differentlnitrcnce nraps,heir relativepriceswill dilTerbelbre rade,buttradewjlt equatizheir=-:rii e pdces ndbe beneticiato consumels.Tr lale account fthis asrpossibiliiy.he awofcomparaiivedvanrageane esraied11Brmsof priceditfcrencesather hancost dif;.cnces:In a world of competitive merkets, trade *ill occur and will be benffcialwhenevercountries' relative priceswould bediffrnt without rrad.

I:E driierencen Fet.ade pricescan bedue ro a difierence n septy (cost)con{tirions,a:derence n demandondirions,r a combinationf rhe wo.

OFFERURVESND NTERNATIONALQUILTBRIUMHow do narker processes stabtishhe sortof tradingequilibriumdescribedby.!,-!re l'9? This questioncanbe answeredmosreasilyby rterivinganofer czrue o surniirue rherelevanlcoDdirjonsn eachcounrryandrhenputtjng rhe rwo countri;s, offer


21/27

38 ComparativeAdvantageand the Gains from TradeDeriving n OfferCurveAn oifcr curlc for the donestic econony is shown h the upperpan of Figurc

2 10. Thc horizonrrl axis shows ts tfade n cameras. he vertical axis shows ts rade iDgrain. The otl.r curlc ./(:). ,fscs nf(trmationabout elaiiveprices o comect rhe rwo tradello\rs. When he reladvcpriceofa c4mefa s equ3l o the slopeof the rre Fl.'. the donesticeconony denands Oyofcarncra inrpots and suppliesyW of grainexporis.

The oliercurve is dcnvcd ron theaansformarion urve and he ndifference ap. Lookback arFigure 2-9. When thc rclativepriceofacamen is equal o the slopeofU0 alt, ftedomestrc conomydocsnot makeany exportoflir. This point conesponds o the origin oitheotler cun e in Figurc 2 I 0. The slopeof the ofier cunat ts origin,givenby thedashcdlire tangent o it. correspondso the slopeof U0 at t. When rhe elaiivepdce ofa camerais lower than the price al E in Figure 2-9. the economy ofters grain exports in exchangefbf canera inports. When the price i! equal ro the slope of Pr. for illsiance. it ofters MDof grain expofs and demrndsMP of camerannpofis. Thesequantiries re reFoduced nFigure2-10.The ine FF'has the sane slopeasPD in Figxre2-9. The oiler ol grainexpodsis yW, the demand 1br canrcr! iml)olls is (]y. and the trade triangle Ol4{r is idenlicrl 1() hcrade triangle MPD in Figtrrc 2 L

Eachpoint on the otler curvcJOJ producesone such riangle.Those n the soxthweslquadrant regenelatedwhcn thc relativepriceofa camenis lo$er than heonegi!en by thcslopeofthe dashedine. The economyoffersgran expons n exchangebr canera rnports.Thoseh the no heaslquadrlDtaregenernred hen rhe elaiivepriceofa camera s highcrthan he one gilen by thc sklpc of lhe dashed ine. The economyoflers camcr.r rpons inexchangebr grain mporrs.'

Eachpoinl on r cotrntrl,s olTcrcune conesponcls niquely o a produclionpoint on thctanslbrllalion curve rnd a consumption oinl on an nditlerencecurve.Orcr curlcs, saidone economisl. csemblc hc hrndsofa clock. They conveymuch inlbrmrftm in N snnplefashionbut aredrilen by lt complexnechanismhiddenbehind hen.

The ofter curve lbr tbc turcign economy s shown n rlre ower parr of Figurc 2 10. tis llatier it itsprigin thaD hc donesiic otler curvc bccauscU0 s nrtlcr at L' than at tiin Figure 2-9. Funhermorc, hc line fF' inte^ech thc forcign ollcr curlc in the nothe.$rquadrani.The lbreign cc(nuny suppliesOyr of canrcrr crpor6 and dcmrnds y'W+ ofgraur mports, and he tiidc triangleOy'W' is identicd lo |he tradc rianglc M'D* Pl inFigure 2-9.

Combining fferCurvesFigurc 2 l0 could be used to locrle equilibnun. We could rotaterhe line FF'

rhrough crch origin until we generaied hc natching pair of trade triangles Ol\y andOl'-ll'. \!t cln locatcequilibdum more easily,howclcr, by putring both ofier cuns

Thi\ i\ donc in Figurc 2 Ll. The fbreign of|cr curlc J'OJ' i! drawn as befbre.Thedone\tic o[.r.ur!eJOJ hasbeen lippedovcr The pnftappedringn thenortheasr uadranlno$ lhou s thedomesticdemand or carncra mpofs anddomestjcupply of gran expors.

"Th. onia cnn. .rnn.r pa$ rhroughhenonhw.$quadrantvh.n rxd s balrceJr theecoDmycrnnordenandcaDcrxxndeiaininpon!limultuneously.ll]ccuFccannorpasthroughrhe$Lrhqurdfunr treri rhee.onony.an ot ollercrnern xl gnin exporls innlraNonsly


22/27

Olfer Curvesand nternatioul F,quilibdum

gvLJ = r.4Pb CSs

,oJ isthedomestic f fer curve.t shows xportsupply nd mpon demand t!t ol prices.When he relative riceo{ a camerasequal o the slopeof the linedomestic conomy illsupplyyl/yof grainexports nddemandOyof camefaTfie rade riangleOyl4lcorrespondso the trade riangleMPD n Figure -9.of the curveat itsorigin,shownby he dashedine,correspondso the slope

39

hdifferen(curveUoat E in Figure -9; he economywill not offer or demandgoodwhn world and domestic ricesare the same.ThcurveJtO./' is the.offer curv.When he relativepriceof a camerat equal o the slopeof FF'.-e(onomywill supplyOy' of camra xports nd demandy'vl^ of grainThtradetriangleOV't ^ correspondstothetradetriangle 'D'P' in Figure


23/27

40 ComparativeAdyantageand the Gainsftom Tfade

FIGURE-11l"oGtingEquilibrium i th OffercurvesTh oreign offr curve, /'O./", is drawn as n Figure2-10.Ihe domestic fier curv,lOJ, s redrawnwith axe evrsd. he ntEection f thofier curvs t Wdfinesthe rad ing quil ibrium.he lat ive r i rcof a camran he worldmarktsgiv6-bythe elope f FF, drawn from the oriqin hrough the point \ry.Do_melti(rainexportsareeq;alto foreign_drainmpo.ts, -nd omeiic


24/27

Offer Curvesand International Equilibriumcameras ntheworld market.Thiswoulddrive down herelalivepriceof a canera, educingexpod supply. aisingimport demand,and thus reducing he excess upply.The Focesswould endwhen he rclativepriceofa camerawas equal o the slopeof FF'.

OfferCurves nd the Effects f an lmportTariffOffer curvesa.reused n subsequenthaplers o showhow demandconditions'economicgrowth,and otherphenomena ffect thc distribution of the gainsfton tradeThey arc alsoused o analyze beeffecisof tarjff

Whenwe used demandand suPplycurves o study the effects of an impod tadtr' wesimplificdihe problem by lixing the priceof a cameraon theworld narket. (lt wa-sOP'in Figure2-2.) We cando that hereby lixing the rcladvepice of a cameraon $e wortdm{ker. It is the slopeof the ine OJ" in Figure2 I 2 The nitial equilibriumoccursat W.whereOJ* intersectsOJ. the domesticoffer curvc,and he domesticpriceof a camcrasequal o the world pnce. A tariff on impoded cameraswill raise heir domesticprice l-erthatpnce begivenby the slopeof the ine OJr- Noic 2'2 proves hat the ariff rate canbe

4l

Note 2-2Measuringthe Level of a Tafiffl-et theworldpdceof acamera e2i and heworldpnceofgain bep: -ff the ariffraie on an imported camera is ,. the domestic price of a camera is

p,- t l - t t r ' .As there is no tariff on grain, its donestic price is equal to ils world price (i e..p, : pj). Dividing both sidesof the prcviousequationby pi, we have

p f ' = t l - t ta =t l t t7hr;wherep is therelativeprice of a cameran the domesticmarkelandp* is its relativeprice n the world ma.rket.In Figure2 12,domesticonsumersay W'v'grain for Ov' imponed ameras'sop is W'v'lOV'. Foreign upplierseceive 'v ' gain for Ov' cameras.or,* isZ' V' I Ov'. Accotdingty.

Y2-:6., ;z!-ov' ' ' ' ov"w'vz,v I

Btt W,Vt : WtZt + Zt V' \o W' V, Z, V' = | + WtZ, /Z ' V' , andw'z'' z tvt 'i5-


25/27

42 ComparativeAdvantageand the Gainsfmm Trade

FIGURE-12A Tarifi in a Two-Goodworldwhen aneconomys oo smalltoaffectworldprices,he foreignoffr curvebecomeethestraightineO./ ' , nd tsslope easurestheelat iverice fa cameran heworldmarket.quilibrium occurs t W initially,whre O-l' ntrsects ./, he domestic ffercurue. heconomymportsOvcameras ndexports vygrain,and hedomstic ricof a camerar equal o itsworld price.A tariff on camramports aiset he domesticpriceo{ a camera bove he world price Let hat new domestic ricebe givnby he;lope of OJr.Thdemand or camera mportswill fall to Ov', the supplvo{ grainexportswill fall to v'W, and he government ill collect ariff revenuquivalentoz' i l grain. hnewequi l ibr iumointmust ieon O-l ' , ut t5 ocar ion i l ldepnd

nthe w;y the government pendshe tariff revenue.{ it spendshe revenue n grain,thnewequi l ibr iumil l beat Z' ,where onsumersmport v'cameras ndpay orthemwith v'z'grain {theamounto{ grain emaining fterthegovernment asboughtz'r4l . lJ he government pendshe revenue n cameras,he newequilibriumwill beat Z', where consumeEmportov' cameras nd pay or themwith V Z gtair' atldthe oovernmentmportsy'v" cameras ndpaysor themwith z"W'grain As v'Z'andZ'd zdd up\o v'w', at\dv'w' equals '2", \otal grainexports re ust argeenoughto pay or totalcamera mports

meJ.ured] l , t , / 7 V. fte Jcm:rndor rmerd mP'r ls i l l ldl l romOt Io Ov l l 'esupply f grainexporrs il l fall from vw to v'w'. and hegovemment illcollect aritrrevenucquivalentn value o Z'W'ofgraiD-Thenew equilibriummust ie on OJ',1hc beign oftbr curveTo locatet preciselv,howevcr.we mustknow how the govemmcntspendshe tariff rcvenue lf il spends hcrevenucngrain. henewequilibrium ill occur t Z' Thesupplv f gain expor$wil1bereduced y Z'w' and hus all to v'Z', but his s ustcnoxgh o pry fbr Ov" of camefainpofts. i it spendshe revenuc n cameras,henewequilibrium ill occura1Z" Thesupply fgrainexporls il renainat v']v'. whichequals "V ", and his sjustenoughopar for Ov" of camerampots (Consumerswill buv Ov', asbefore,and hegovemmenrwill buy v'Z". thenumbert cltnbuvwith Z'tv' of grain' aisinghe otaldemando Ov " )when supply nddenand urveswereuscdn Figurc2-2 o illustaie be mpactof ar l f f . $c.uuld.eeh"' \ rbe uri l f i lecredun'Lrmpuonnd produLr ionhal' rnor be


26/27

Recommended Readingsdone n Figure2 12, which doesnor show what happenso productionor consumplion.But offer curvesarc helptul in anotherway. By showingwhat happenso relativeprices,rhey ell us how the ffifl affects rade n gain, aswell as rade n cameras. alne|a mpo[sfall to OV'or Ov" (dependingn thc way n whicb herevenues spent).Grainexportsfal:tto V'Z' or v" 2". We wil retumto thesematters n Chapter9, where we k)ok moreIhoroushlvat the effecisof tariffs.

SUMMARYTrade arises and is mutualy beneficial whenever there are ntemational difierences

in relative costs ofproduction. This is dre du .y'.,-Pdldtire ddrd'?rdaeand the tundamentalproposition of tade theory. Trade restrictio's, such as tarifts. tend to reduce ihe gains fron

Ordinary supply and demand cufles can be used to illustate the main effects of tradeWhen the world pdce of a good is lower than its donestic price, tradc raises the quantitydenanded by dornestic consumersand reduces he quantity supplied by domestic producers-Tte resulting innease in consumer surplus excceds ihe desease in producer surplus. andthe difference measues tte welfare gain frorn lrade. Supply and demand curves can alsobe used to illustrate the majn effects of a taritr, which reduces the quantity demaDded bydomestic consumersand raisesthe quantity supplicd by domestic pmducers The resultingdecrease n consumer surplus cxceeds the inci:ase in producer surplus, and the differencemeasures he welfare cost of the tariff:

But trade involves a two way flow of goods and can be analyzed cornpletelv onlv bv usinggeneral-equilibnum models. The simplest model of this son contains two goods. Supplyconditions are represented by a aansformadon curve Demand conditions are represeniedby an indifference map.

In a closed economy. the markets lbr the two goods cannot clef unlessproductbn andconsumptbn take place at a coirnnon point ln an open economy, ihey can clear whenproduction and consumptioD tate place at ditrerent points deGning a lrade triangle- Thegains frorn trade are representedby the movement to a higher inditerence curve Thevcan be decomposed into gains from intemational exchange and gains ftom intemational

A two country model is requhed to show how the terms of trade are established Thequantity of expons offered by one country must equal ihe quanlity of impofts demandedby the other (The r,'o countries tade triangles must be identical ) The terms of tradedetemine how the gains ftom trade aredisiribuGd Offers curves can be used1o llustratethe determination of thc terms of trade in a two-good model and show how tiriffs aftbct the

RECOMMENDEDEADINGSOn transfomationcu.ves,differcnce curves,dd tradePdlems.*e Wassilvw Leontiel-ThcUseoflnditrerencc urves tbeAnalysis fForeiSn tude:QMx.rU JoUML.t E onDhics.24(May I 933)r eprinlcd n Americu EcononicAssociano! Reddinssn the heor!- t Inlenationatrrade (Philadelphia:Bli*iston, 1949).ch. I 0. For dolhcr derivalionof the offer curle andextensve

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44 Comparative Advantage and the Gains from Tradeap![catiors. seeJamesE. Meade.A Geontetn oI Ihterutonal Zfade(London:Alle! & Unw]n,1952). hs. v.Fd d way ro illusraLe rhegains rom tmde wnhoul using contuunily indilTerenceurles.seePeter B. Kenen. 'Or the G@netry of Wefm ftononLs:' Qwn. r Jotmnl oJ Econonns,7l (Aueu( 1957)i rcpdnted n P B. Kenen, rrals n lrterutiobal Economicstuircero\ N.J.:Pnncelon niversiry ns. 1980).The moslgeneralestalenemof theeains iom tr2de,goingbeyondLhewo-goodmodel. sSivenby Paul A. Smuelson. 'TheGains rom IntemarionalTmde OnceAgrin," Ec,,,ni. ./odlel,72(December962).

QUESTIONSND PROBLEMSIO(l) Adapt FigDre2-l io showfia! a oounq/ rill export a good{hen the world price ishigher han thc prctradedomesdcprice. Identify lhe quanrily ol expons. he changcs n domesticptuducLion ndconsumption.he cha.ges n prcducerdd consums surplus,and thenetchoge in(2) Adapt Figw 2 1 10showhow a lall jn thewoddpriccof a cameraaffectsd economtimponing canens. ldentily thc effects or the qumtities prod&ed, .onsumed.dd imported, onF)duce. and consmer surplus,md on &onomic wettbrc.(3) Useyour answer o (2) to show trr an mpoft trif| can be uwd ro prevertdomesricproductionroD chdging in responk b a bll in the worldpriceofa camera.denrily the rifrate ddttuiff revenue. heeffectson qlanntiesconsunedand nported, and he cffect on economicwelfsrc,conpared o condinonsrevaiiing belbreod aier rhe au in price.would you favor o! oppose hispolicy?Explain-(4) Adapt FigDre2'7 to show how d incmse in therctllive priceof a cmera atT6rsdeconotDy xlorting cameras.dentif tbeelt@tson thequa.iitiesof caDe6 andgrainlrodued andconsuned,on thcqudlities erporredald impofled, dd on economicwelfde.(5) Adapt Figurc2 910prcvethe statemert n rhe reir that countdeswirh idenlicaltru$fomtion cun cs cangain roh rrade f rheyhavediftbrcnr lditrerence maps. dentify rhequanlitiesproduced ndconsunedbeforeandafter he openingof trade. hequaDritiesraded,and hc effecr oneconomicwelfm in eachcounrf. Explainhowyourdiagrm illustrateshe restarenenr f lhe aw ofcompardtivcadvant2ge,hich says hat benelicial radewill ecur whencverwo counfied rclativep.iceswouldbe differenr withoul trade.(6) Fig!.e 212 was said o represenrheeff@ls of a tdiff on importodceeras, andNole2 2 shoved hat the rilf cte is equal o W,Z'/Z,V,. ShowrharFigure2 12 cd besaidb represenlLneeflecr.oraLlr i troneiponrdgruequdtr,v Ot rndLhdrhrs \pon tui f irr r . equJ oIne mpon rr i l ,are.(7) When descnbin8he ellects of a. increalein the relativepriceof a camera, he rextsaid hatfifN will producenore cmeras ed lessgrain.But lims rbatgrowgGin do nol nomallymate camel?l.Hetrce.t wouldbe mde accumreo say har RrmsgrowinSBnin will contEct as heirpront fall dd lirms mabrg caheEs will expandas heirprofrs nse.To complele hisstory explainhowthe behavlorof investos couldforce nms produciregrainro .ont at ad allow nnnsmakina

lusec AFFndlx C for oullines

int economy kenen ch 2

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