PubPol/Econ 541. The Standard Model. Elaboration of diagrams in Krugman, Obstfeld & Melitz textbook. by Alan V. Deardorff University of Michigan 2016

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1 PubPol/Econ 541 The Standard Model Elaboration of diagrams in Krugman, Obstfeld & Melitz textbook by Alan V. Deardorff University of Michigan 2016

2 Trump on Tariffs From interview with WSJ Oct 23: WSJ: A lot of people say that tariffs are really the biggest threat to the economy long term. Mr. Trump: We don t have any tariffs. Mr. Trump: It s so much nonsense, OK. This is your story. We don t even have tariffs. I m using tariffs to negotiate. I mean, other than some tariffs on steel which is actually small, what do we have? I didn t put them on the USMCA. We have a trade deal. I didn t put them on in South Korea. We have a trade deal. That was the worst deal. That was a deal made by Hillary Clinton. It was a horrible deal. We made it into a sound deal. But I didn t put tariffs. Where do we have tariffs? We don t have tariffs anywhere. I read that today: We re worried about the tariffs. You know what happens? A business that s doing badly always likes to blame Trump and the tariffs because it s a good excuse for some incompetent guy that s making $25 million a year. Econ 340, Deardorff, Lecture 12: Trade Balance 2

3 Trump on Tariffs From WSJ follow-up Oct 24: Tariffs imposed on imports this year: Solar cells and panels: $7 billion imports Washing machines: $2 billion imports Steel: $29 billion imports Aluminum: $19 billion imports Chinese-made goods: $250 billion imports Industrial materials Components Consumer goods Econ 340, Deardorff, Lecture 12: Trade Balance 3

4 Trump on US-Canada Trade Balance Told by Canada's Justin Trudeau that Canada has a trade deficit with the US, Trump says "I said, 'Wrong, Justin, you do.' I didn t even know. I had no idea." In fact, by US data, the US has a surplus with Canada in goods and services, but a deficit if you count only goods. 2017, $billions: Goods: 17.5 Goods and services: +2.8 As economists explain, there is no reason why countries trade should balance, especially bilaterally, under either measure. Lecture 1: Overview 4

5 Quote from Trump: Lecture 1: Overview 5

6 Is he right about almost all countries? US Census reports goods trade balances of US with 234 countries for US has Surpluses with 130 Deficits with 104 But with our top-10 trading partners (ranked by exports plus imports) we have a surplus with only one: U.K. Of our top 50 partners, we have surpluses with only 36% Lecture 1: Overview 6

7 Outline Relative supply and demand International equilibrium Effects of growth Effects of trade barriers 7

8 The Standard Model* Assumes Two goods, cloth C and food F Outputs: Q F, Q C Prices: P F, P C Takes as given Production possibilities Represented by Production Possibility Frontier (PPF) Preferences for consumption Represented by community indifference curves Assumed to be homothetic (see below) *Name given to this model by Krugman and Obstfeld (1991) and subsequent editions. 8

9 The Standard Model Also assumes (as before) Homogeneous products Perfect competition No distortions (externalities, etc.) Zero costs of trade (transport, etc.) except when we add tariffs 9

10 The model Includes as special cases The Ricardian model (but linear PPF) Heckscher-Ohlin Model Specific factors model 10

11 Production Possibilities Q F Curvature Ricardian Model: Not curved Heckscher-Ohlin Model: due to industries different factor intensities Specific Factors Model: due to diminishing returns to nonspecific factor Q C 11

12 Prices Q F Price lines = iso-value lines: V = P C Q C +P F Q F or Q F = V/P F (P C /P F )Q C P C /P F V 1 V 2 V 3 Q C 12

13 Equilibrium Production Q F Tangency implies maximum value Supplies depend on price ratio: S C = S C (P C /P F ) S F = S F (P C /P F ) S F 0 P C 0 /P F 0 S C 0 Q C 13

14 Equilibrium Production Q F Thus Relative Supply, RS = S C /S F, also depends on price ratio, RP = P C /P F : S F 0 RS = RS(RP) RP 0 S C 0 Q C S F /S C =1/RS 14

15 How Supplies Depend on Prices Q F ΔRP = Δ(P C /P F ) > 0 RP 0 RP 1 => ΔS C > 0 ΔS F < 0 ΔRS > 0 S F 0 S F 1 S C 0 S C 1 Q C ΔRP = Δ(P C /P F ) > 0 15

16 Relative Supply RP = P C /P F It follows that RS(RP) is upward sloping RS RP 1 RP 0 RS 0 RS 1 RS= S C /S F 16

17 Preferences Q F Represented by a family of indifference curves for the whole country: Community indifference curves Q C 17

18 Preferences Q F If we knew the budget line, then we would use it to find demand, from Tangency between budget line and an indifference curve That s the most preferred bundle of the two goods that consumers can afford. Q C 18

19 Equilibrium Demand Q F D F 0 S F 0 D 0 S 0 Given prices, income is the value of production. So the budget line is the price line tangent to the PPF. And demand is given by its tangency with an indifference curve. D C 0 S C 0 Q C 19

20 Trade Q F For arbitrary prices, demand will not equal supply D F 0 S F 0 M F 0 D 0 S 0 X C 0 Trade Triangle Their difference will be trade: Exports: S C D C =X C Imports: D C 0 S C 0 Q C D F S F =M F 20

21 Relative Demand Q F D F 0 D 0 We will use this first, however, to find Relative Demand: RD = D C /D F S F 0 S 0 D C 0 S C 0 RP 0 Q C D F /D C =1/RD 21

22 How Demands Depend on Prices Q F RP 1 D 1 RP 0 D D 0 0 F D C 0 RP 0 Q C ΔRP = Δ(P C /P F ) > 0 =>? With no assumption on preferences (indifference curves) we can say little about how prices affect demand (Recall income and substitution effects ) 22

23 Homothetic Preferences Q F Q C We assume: each indifference curve is a radial expansion or contraction of all others Thus: Ratio of demands depends only on ratio of prices Change in income (with prices fixed) does not change relative demand RD = D C /D F 23

24 How Demands Depend on Prices Q F D 1 F RP 1 D 1 RP 0 D D 0 0 F D 1 D 0 C C RP 0 Q C With homotheticity: ΔRP = Δ(P C /P F ) > 0 => ΔD F > 0 ΔRD < 0 But we still don t know ΔD C >,=,< 0 That s why we now work with relative supply and demand. 24

25 Relative Demand RP = P C /P F RP 1 It follows that RD(RP) is downward sloping (Drawn as a straight line, but it could curve, and in either direction.) RP 0 RD RD 1 RD 0 RD= D C /D F 25

26 Autarky Equilibrium RP = P C /P F RS Combine RS and RD RP aut RD RQ aut RQ= Q C /Q F 26

27 World Relative Supply & Demand For international equilibrium, we need world relative supply and demand (of 2 countries) These cannot be gotten by just adding up those for the individual countries Instead, they are weighted averages of the separate countries Q C W = Q C + Q C * Q F W = Q F + Q F * => RQ W = = Q F Q F + Q F * Q C + Q C * Q F + Q F * Q Q C F * + Q + Q * F F Q F Q C * Q F * RQ W = β QF RQ + (1 β QF )RQ* where Q F β QF = QF + Q F * 27

28 Thus: World Relative Supply & RS W = β SF RS + (1 β SF )RS* where β SF = S F S F + S F * Demand RD W = β DF RD + (1 β DF )RD* where D β DF = F DF + D F * 28

29 World Relative Supply RP = P C /P F RS* World relative supply is RS W a weighted average; RS W RS thus lies between the domestic and foreign relative supplies β SF (Strictly speaking, these should not be parallel) RQ= Q C /Q F The larger is the home share of supply, β SF = S F S F + S F * the closer this will be to RS 29

30 World Relative Demand RP = P C /P F Because of homotheticity, RD is the same in both countries. RD W =RD=RD* So world relative demand is the same as well. RQ= Q C /Q F

31 International Market Equilibrium RP = P C /P F RS* Int l market equilibrium is RS W the relative price that RS equates world relative supply to world relative demand. RP 0 RQ 0 RD W RQ= Q C /Q F As drawn, the home country is assumed to be the larger relative supplier of good C, so home exports C. 31

32 International Market Equilibrium RP = P C /P F RP 0 RS* RS W RS The next slide shows production, consumption, and trade in this equilibrium RD W RQ 0 RQ= Q C /Q F 32

33 International Market Equilibrium Q F Q F * S F * D F D F * S F D C S C S C * D C * Q C Q C * 33

34 International Trade Q F Trade Triangles (Identical) Q F * S F * X F * D F D F * M F S F X C M C * D C S C S C * D C * Q C Q C * 34

35 Effects of Growth: Small Country Q F D 1 If prices are given from world market and do not change, then growth of PPF benefits the country. D 0 S 0 S 1 This is true whether the growth is Neutral Biased toward export (cloth) Q C Biased toward import (food) 35

36 Effects of Growth: Small Country Q F D 0 D 1 S 0 S 1 Q C If prices are given from world market and do not change, then growth of PPF benefits the country. This is true whether the growth is Neutral Biased toward export (cloth) Biased toward import (food) 36

37 Effects of Growth: Small Country Q F D 1 D 0 S 1 S 0 Q C If prices are given from world market and do not change, then growth of PPF benefits the country. This is true whether the growth is Neutral Biased toward export (cloth) Biased toward import (food) 37

38 Effects of Growth: Large Country Growth of a large country will usually change world prices So the previous 3 slides no longer show the final effects of growth They do, however, show what happens for given prices, and thus tell us how world relative supply may shift (world relative demand will not shift, if the countries have the same homothetic preferences) 38

39 Effects of Growth: Large Country Recall that RS W = β SF RS + (1 β SF )RS* where S F β SF = SF + S F * This will increase if either RS or β SF goes up (since we ve assumed RS > RS*) From the slides for neutral, export-biased, and import-biased growth, one or both of these must happen unless growth is strongly biased toward the import (food) 39

40 Effects of Neutral Growth on World RP = P C /P F RP 0 RP 1 Price: Large Country RS* RS W0 RS 0 =RS 1 RD W RS W1 Large country growth, if neutral RS does not change β SF rises since S F rises RS W shifts right World relative price of cloth goes down. RQ 0 RQ= Q C /Q F Neutral Growth of Large Home Country 40

41 Effects of Export-Biased Growth on RP = P C /P F RP 0 RP 1 World Price: Large Country RS* RS W0 RD W RS W1 RS 0 RS 1 RQ= Q C /Q F Export-biased Growth of Large Home Country Large country growth, if export-biased Both RS and RS W shift right because RS rises β SF rises World relative price of cloth goes down by more than in the neutral case. 41

42 Effects of Growth: Large Country Since the country that has grown (Home) was exporting cloth, RP = P C /P F is a worsening of its Terms of Trade The growing country is therefore worse off than if the price had not changed Can it be worse off than if it had not grown? Yes: The Case of Immizerizing Growth 42

43 Effects of Export-biased Growth and Small Decline of T of T Q F D 1 D 2 Fall in Terms of Trade prevents Home from reaching D 1, but it still benefits from growth by reaching D 2, since that is on a higher indifference curve than D 0. D 0 S 0 S 2 S 1 Q C 1. Export-biased growth at unchanged prices 2. Resulting fall in Terms of Trade 43

44 Immizerizing Growth Q F D 0 D 1 D 2 Larger fall in Terms of Trade prevents Home from reaching D 0, leaving it on lower indifference curve than if it had not grown at all. S 0 S 2 S 1 Q C 1. Export-biased growth at unchanged prices 2. Resulting fall in Terms of Trade 44

45 Effects of Import-Biased Growth on RP = P C /P F RP 1? RP 0 RP 1? World Price: Large Country RS* RS W1? RS W0 RD W RS W1? RS RS 1 0 RQ= Q C /Q F Import-biased Growth of Large Home Country Large country growth, if import-biased RS shifts left RS W may shift right or left because RS falls β SF rises World relative price of cloth may rise or fall. 45

46 Effects of trade barriers A trade barrier might include Import tariff Import quota or other non-tariff barrier Export tax Quantitative export restriction 46

47 Effects of trade barriers All of these have the effect of raising the domestic relative price of the imported good above the world price In the model here, the home country exports cloth, so a trade barrier causes: P C /P F < P CW /P F W ; i.e., RP < RP W or in a 2-country world: P C /P F < P C */P F * ; i.e., RP < RP* 47

48 Trade Barriers in a Small Country Q F Home Supply Q F Home Demand (if on same curve) RP W =RP 0 RP W =RP 0 RP 1 RP 1 1/RS 1 1/RS 0 1/RD 0 1/RD 1 Q C Q C 48

49 Trade Barriers in a Small Country Thus RS shifts left RD shifts right As Home is small, RP W does not change We ll look in an addendum below at what happens inside the small country 49

50 Trade Barriers in a Large Country Still true that RS shifts left RD shifts right Now, since RS W and RD W are weighted averages that include RS and RD, we must also have RS W shifts left RD W shifts right 50

51 Trade Barriers in a Large Country RP = P C /P F RP 1 RS W1 RS W0 Trade barrier by home country causes RP to rise The Terms of Trade of Home to improve. RP 0 RD W0 RD W1 RQ= Q C /Q F 51

52 Addendum on Tariff in General Equilibrium Slides above, for small country, showed Production (supply) in levels Consumption (demand) only as a ratio Reason is that levels of consumption depend on income, which includes both Income from production Revenue from tariffs and/or rents from NTBs Assume now that tariff revenue is redistributed to consumers to be spent like any other income. The following (not included in Krugman-Obstfeld) shows determination of production and consumption 52

53 Effects of Tariff in Small Country Q F 1/RD 1 D 0 D 1 S 1 RP W1 =RP W0 RP 1 RP 0 =RP W0 S 0 Q C Tariff on F raises price of F above world and thus lowers the relative price of C in the country. This appears as one of the parallel flatter lines RP 1. One determines supply, at S 1. Another determines relative demand, RD 1. D 1 then has ratio RD 1 but same value at world price RP W0 as S 1 (thus balanced trade). 53

54 Effects of Tariff in Large Country Q F D 0 D 1 S 1 RP W1 >RP W0 RP 0 =RP W0 S 0 Now the reduced trade that the tariff would have caused if prices did not change causes the world price of cloth to rise. This makes it possible (but not certain) that the country will move to a higher indifference curve, as shown. Q C 54