offer curves how the terms of trade are established
TRANSCRIPT
Offer Curves
How the Terms of Trade Are Established
Offer Curves are
• all combinations of a country’s desired exports and imports at different terms of trade
• also known as reciprocal demand curves (J.S. Mills)
• measures of willingness to trade
Y
XY
X
(PX/PY)1
X2
Y2
X1
Y1
C P
Y
XY
X
(PX/PY)1
X2
Y2
X1
Y1
C P
X5
Y5
(PX/PY)1
Y
XY
X
(PX/PY)1
X5
Y5
(PX/PY)1
(PX/PY)2
X4X3
Y3
Y4
(PX/PY)2
X6
Y6
Y
XY
X
(PX/PY)1
X5
Y5
(PX/PY)1
(PX/PY)2
X4X3
Y3
Y4
(PX/PY)2
X6
Y6
OCA
Offer Curves
• Offer curves represent willingness to trade at every possible terms of trade
• As the relative price of good X rises, Country A becomes willing to export more and import more
• Offer curves “bow” towards the import good axis
Deriving Country B’s Offer Curve
• This will reflect Country B’s willingness to trade at different terms of trade
• B’s offer curve bows towards the axis with B’s import good on it
Y
XY
X
(PX/PY)1
p
X7
Y7
c
X8
Y8
Y
XY
X
(PX/PY)1
p
X7
Y7
c
X8
Y8
(PX/PY)1
X9
Y9
Y
XY
X
(PX/PY)1
(PX/PY)1
X9
Y9
(PX/PY)2
Y10
X10
Y11
X11
X12
Y12
(PX/PY)2
OCB
Terms of Trade Equilibrium
• The international terms of trade (that is, PX/PY) will be the slope of a line passing through the point where the offer curves cross.
• This equilibrium point takes into account demand and supply conditions in both countries
Terms of Trade Equilibrium
Y
X
(PX/PY)E
X1
Y1
OCA
OCB
Terms of Trade Equilibrium
Y
X
(PX/PY)E
X1
Y1
If these are the terms of trade,country A will desire to exportX1 units, and country B will want to import X1 units
OCA
OCB
Terms of Trade Equilibrium
Y
X
(PX/PY)E
X1
Y1
If these are the terms of trade,country A will desire to importY1 units, and country B will want to export Y1 units
OCA
OCB
How Do We Know It’s Equilibrium?
• Any terms of trade other than (PX/PY)E will result in– excess demand for one good– excess supply for the other
• Therefore relative prices will adjust until (PX/PY)E is reached
Disequilibrium
Y
X
(PX/PY)1OCA
OCB
Disequilibrium
Y
X
(PX/PY)1OCA
OCBY1
Y2
Disequilibrium
Y
X
(PX/PY)1OCA
OCBY1
Y2 At (PX/PY)1, country A wishesto import Y1 units, but country B is only interested in exporting Y2
units. That is, there is an excess demand for good Y.
Disequilibrium
Y
X
(PX/PY)1OCA
OCB
X1X2
Disequilibrium
Y
X
(PX/PY)1OCA
OCB
X1X2
At (PX/PY)1, country A wishesto export X1 units, but country B is only interested in importing X2
units. That is, there is an excess supply of good X.
Disequilibrium
• Excess demand for Y causes PY to rise
• Excess supply of X causes PX to fall
• Thus, (PX/PY) falls
• In other words, the terms of trade line gets flatter, moving the countries in the direction of equilibrium
Moving Towards Equilibrium
Y
X
(PX/PY)1 OCA
OCB
Disequilibrium
• Terms of trade lines that are flatter than (PX/PY)E, such as
Disequilibrium
Y
X
(PX/PY)2OCA
OCB
Disequilibrium
• Terms of trade lines that are flatter than (PX/PY)E will results in
– an excess demand for good X– an excess supply of good Y, and so
• (PX/PY) will rise
• That is, the terms of trade line will get steeper until (PX/PY)E is reached
Moving Towards Equilibrium
Y
X
(PX/PY)2OCA
OCB
A Note on the Terms of Trade• A country’s “terms of trade” are the price of its
exports divided by the price of its imports, so a rising terms of trade is good news
• In this example, (PX/PY) is country A’s terms of trade, since A exports good X and imports Y
• (PY/PX) is country B’s terms of trade in this example
A Note on the Terms of Trade, continued
• As A’s terms of trade (PX/PY) improve, B’s terms of trade (PY/PX) must be deteriorating and vice-versa
Shifts of Offer Curves
• Anything that causes country A’s willingness to trade to change will shift A’s offer curve– increased willingness to trade: OCA shifts right
– decreased willingness to trade: OCA shifts left
• These can be caused by– changes in demand conditions or– changes in supply conditions
Demand Changes in Country A
Y
X
(PX/PY)E
X1
Y1
OCA
OCB
Demand Changes in Country A
Y
X
(PX/PY)EOCA
OCB
Increased demand for importsby Country A causes a rightward shift of A’s offer curve
OCA'
Demand Changes in Country A
Y
X
(PX/PY)EOCA
OCB
Volume of trade increases, butA’s terms of trade go down. B’s terms of trade improve.
OCA'
(PX/PY)E'
X2
Y2
Demand Changes in A
• Any change that might make A demand more imports leads to a rightward OC shift, and thus– an increase in trade volume– a decrease in A’s terms of trade
Demand Changes in Country B
Y
X
(PX/PY)E
X1
Y1
OCA
OCB
Demand Changes in Country B
Y
X
(PX/PY)EOCA
OCB
OCB'
Increased demand for importsby Country B shifts B’s OCupward
Demand Changes in Country B
Y
X
(PX/PY)EOCA
OCB
OCB'
(PX/PY)E'
X2
Y2
Volume of trade increases,but Country B’s terms of tradedecrease (and A’s terms oftrade improve).
Other Demand Changes
• Any decrease in a country’s willingness to trade will shift its OC leftward or downward
• An example is when a country imposes an import tariff
• Tariffs therefore lead to decreased trade volume, but improve the imposing country’s terms of trade
Imposition of Tariff by Country A
Y
X
(PX/PY)E
X1
Y1
OCA
OCB
Imposition of Tariff by Country A
Y
X
(PX/PY)E
X1
Y1
OCA
OCB
OCA'
Imposition of Tariff by Country A
Y
X
(PX/PY)E
X2
Y2
OCA
OCB
OCA' (PX/PY)E'
Imposition of Tariff by Country A
Y
X
(PX/PY)E
X2
Y2
OCA
OCB
OCA' (PX/PY)E'
By imposing a tariff, Country Adecreases trade volume, andimproves its terms of trade (but B’s terms of trade deteriorate)
Supply Changes
• Changes in supply conditions will also shift a country’s offer curves around
• Examples include– productivity changes– discovery of new resources
An Example: The Oil Shocks of the 1970s
• Let’s think of OPEC as one country
• Let’s also think of the industrial countries as one country
• OPEC effectively decreased its willingness to trade
• Presumably this shifted OPEC’s offer curve to the left, increasing OPEC’s terms of trade and decreasing the industrial countries’
Oil Shocks of the 1970s
Otherstuff
Oil
(PX/PY)pre-shock
X1
Y1
OCOPEC
OCIC
Oil Shocks of the 1970s
OtherStuff
Oil
(PX/PY)E
X1
Y1
OCOPEC
OCIC
OCOPEC'
Oil Shocks of the 1970s
OtherStuff
Oil
(PX/PY)pre-shock
X1
Y1
OCOPEC
OCIC
OCOPEC' (PX/PY)post-shock
X2
Y2
Oil Shocks of the 1970s
OtherStuff
Oil
(PX/PY)pre-shock
X1
Y1
OCOPEC
OCIC
OCOPEC' (PX/PY)post-shock
X2
Y2OPEC’s terms of trade shouldhave improved, and the industrial countries’ should have worsened
Oil Shocks of the 1970s: Changes in the Terms of Trade
Oil-ExportingCountries
IndustrialCountries
1970 21 1101973 29 1081974 70 971979 87 961981 119 871985 97 911995 55 105
Offer Curves and “Small” Countries
• “Small” countries: those that are too small to affect world prices (and therefore the terms of trade) by their own actions
• From the “small” country’s perspective, the rest-of-world’s OC is a straight line
“Small” Countries and Offer Curves
Y
XX1
Y1
OC”small” OCROW
“Small” Countries and Offer Curves
Y
XX1
Y1
OC”small” OCROW
Why is the ROW offer curve perceived to be a straightline?
“Small” Countries and Offer Curves
Y
XX1
Y1
OCsmall
OCROW
OCsmall'
If the “small” country imposesa tariff on ROW products, ithas no effect on the terms of trade
“Small” Countries and Offer Curves
Y
XX1
Y1
OCsmall
OCROW
OCsmall'
If the “small” country imposesa tariff on ROW products, ithas no effect on the terms of tradeThis is the definition of a “small” country
“Small” Countries and Offer Curves
• Q: What is the optimal tariff for a “small” country?
• A: No tariff at all - tariffs reduce trade volume, but don’t improve the terms of trade
• This is really the same point we made earlier: free trade is especially helpful to small developing countries