16Krugman/ObstfeldInternationalEconomics:TheoryandPolicy,EighthEdition

Chapter5
TheStandardTradeModel

.1

nAnswers to Textbook Problems

1.

Notehowwelfareinbothcountriesincreasesasthetwocountriesmovefromproduction
patternsgovernedbydomesticprices(dashedline)toproductionpatternsgovernedbyworld
prices(straightline).

17Krugman/ObstfeldInternationalEconomics:TheoryandPolicy,EighthEdition

AnincreaseinthetermsoftradeincreaseswelfarewhenthePPFisrightangled.Theproductionpointisthe
cornerofthePPF.Theconsumptionpointisthetangencyoftherelativepricelineandthehighest
indifferencecurve.Animprovementinthetermsoftraderotatestherelativepricelineaboutitsintercept
withthePPFrectangle(sincethereisnosubstitutionofimmobilefactors,theproductionpointstays
fixed).Theeconomycanthenreachahigherindifferencecurve.Intuitively,althoughthereisnosupply
response,theeconomyreceivesmorefortheexportsitsuppliesandpayslessfortheimportsitpurchases.
2. Thedifferencefromthestandarddiagramisthattheindifferencecurvesarerightanglesratherthan
smoothcurves.Here,astermsoftradeincreaseenablesaneconomytomovetoahigherindifference
curve.Theincomeexpansionpathforthiseconomyisarayfromtheorigin.Atermsoftrade
improvementmovestheconsumptionpointfurtheroutalongtheray.
3. ThetermsoftradeofJapan,amanufactures(M)exporterandarawmaterials(R)importer,istheworld
relativepriceofmanufacturesintermsofrawmaterials(pM /pR).Thetermsoftradechangecanbe
determinedbytheshiftsintheworldrelativesupplyanddemand(manufacturesrelativetorawmaterials)
curves.Notethatinthefollowinganswers,worldrelativesupply(RS)andrelativedemand(RD)are
alwaysMrelativetoR.Weconsiderallcountriestobelarge,suchthatchangesaffecttheworldrelative
price.
a. OilsupplydisruptionfromtheMiddleEastdecreasesthesupplyofrawmaterials,whichincreasesthe
worldrelativesupply.Theworldrelativesupplycurveshiftsout,decreasingtheworldrelativepriceof
manufacturedgoodsanddeterioratingJapanstermsoftrade.
b. Koreasincreasedautomobileproductionincreasesthesupplyofmanufactures,whichincreasesthe
worldRS.Theworldrelativesupplycurveshiftsout,decreasingtheworldrelativepriceof
manufacturedgoodsanddeterioratingJapanstermsoftrade.
c. U.S.developmentofasubstituteforfossilfueldecreasesthedemandforrawmaterials.Thisincreases
worldRD,andtheworldrelativedemandcurveshiftsout,increasingtheworldrelativepriceof
manufacturedgoodsandimprovingJapanstermsoftrade.Thisoccursevenifnofusionreactorsare
installedinJapansinceworlddemandforrawmaterialsfalls.
d. AharvestfailureinRussiadecreasesthesupplyofrawmaterials,whichincreasestheworldRS.The
worldrelativesupplycurveshiftsout.Also,Russiasdemandformanufacturesdecreases,which
reducesworlddemandsothattheworldrelativedemandcurveshiftsin.Theseforcesdecreasethe
worldrelativepriceofmanufacturedgoodsanddeteriorateJapanstermsoftrade.
e. AreductioninJapanstariffonrawmaterialswillraiseitsinternalrelativepriceofmanufactures.This
pricechangewillincreaseJapansRSanddecreaseJapansRD,whichincreasestheworldRSand
decreasestheworldRD(i.e.,worldRSshiftsoutandworldRDshiftsin).Theworldrelativepriceof
manufacturesdeclinesandJapanstermsoftradedeteriorate.
4. Theseresultsacknowledgethebiasedgrowthwhichoccurswhenthereisanincreaseinonefactorof
production.AnincreaseinthecapitalstockofeithercountryfavorsproductionofGoodX,whilean
increaseinthelaborsupplyfavorsproductionofGoodY.Also,recognizetheHeckscherOhlinresultthat
aneconomywillexportthatgoodwhichusesintensivelythefactorwhichthateconomyhasinrelative
abundance.CountryAexportsGoodXtoCountryBandimportsGoodYfromCountryB.
Thepossibilityofimmiserizinggrowthmakesthewelfareeffectsofatermsoftradeimprovementdueto
exportbiasedgrowthambiguous.Importbiasedgrowthunambiguouslyimproveswelfareforthe
growingcountry.
a. Astermsoftradeworsen,Aswelfaremayincreaseor,lesslikely,decrease,andBswelfare
increases.
b. Astermsoftradeimprove,AswelfareincreasesandBswelfaredecreases.
c. Bstermsoftradeimprove,BswelfareincreasesandAswelfaredecreases.

Chapter5TheStandardTradeModel18

d. Bstermsoftradeworsen,Bswelfaremayincreaseor,lesslikely,decrease,andAswelfare
increases.
5. Immiserizinggrowthoccurswhenthewelfaredeterioratingeffectsofaworseninginaneconomysterms
oftradeswampthewelfareimprovingeffectsofgrowth.Forthistooccur,aneconomymustundergo
verybiasedgrowth,andtheeconomymustbealargeenoughactorintheworldeconomysuchthatits
actionsspillovertoadverselyalterthetermsoftradetoalargedegree.Thiscombinationofeventsis
unlikelytooccurinpractice.
ConsiderSaudiArabia.Iftheycoulddramaticallyincreasetheiroutputofoil,thentheworldpriceofoil
andtheirtermsoftradewoulddecline.Ifthedemandforoilisinelastic,whichislikelyespeciallyinthe
shortrun,SaudiArabiasoilexportrevenuewouldactuallydecline.However,ifasinglecountryhasthat
muchcontroloverworldprice,thentheycanusethispowertotheiradvantagebyrestrictingexports.An
exporttariffwouldreducetheRSofoiland(slightly)increasetheRDforoil,improvingtheSaudis
termsoftrade.

6. Aidwhichmustbespentonexportsincreasesthedemandforthoseexportgoodsandraisestheirprice
relativetoothergoods.Therewillbeatermsoftradedeteriorationfortherecipientcountry.Thiscanbe
viewedasapolarcaseoftheeffectofatransferonthetermsoftrade.Here,themarginalpropensityto
consumetheexportgoodbytherecipientcountryis1.Thedonorbenefitsfromatermsoftrade
improvement.Aswithimmiserizinggrowth,itistheoreticallypossiblethatatransferactuallyworsens
thewelfareoftherecipient.