C06 Krugman 11e PDF

International Economics: Theory and
Policy
Eleventh Edition
Chapter 6
The Standard
Trade Model
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Learning Objectives (1 of 2)
6.1 Understand how the components of the standard
trade model, production possibilities frontiers,
isovalue lines, and indifference curves fit together
to illustrate how trade patterns are established by
a combination of supply-side and demand-side
factors.
6.2 Recognize how changes in the terms of trade and
economic growth affect the welfare of nations
engaged in international trade.
Learning Objectives (2 of 2)
6.3 Understand the effects of tariffs and subsidies on
trade patterns and the welfare of trading nations
and on the distribution of income within countries.
6.4 Relate international borrowing and lending to the
standard trade model, where goods are exchanged
over time.
Preview
• Relative supply and relative demand
• The terms of trade and welfare
• Effects of economic growth, import tariffs, and export
subsidies
• International borrowing and lending
Introduction (1 of 2)
• Standard trade model is a general model that includes
Ricardian, specific factors, and Heckscher-Ohlin models as
special cases.
– Two goods, food (F) and cloth (C).
– Each country s PPF is a smooth curve.
Introduction (2 of 2)
• Differences in labor services, labor skills, physical
capital, land, and technology between countries cause
differences in production possibility frontiers.
• A country s PPF determines its relative supply function.
• National relative supply functions determine a world
relative supply function, which along with world relative
demand determines the equilibrium under international
trade.
Production Possibilities and Relative
Supply (1 of 2)
• What a country produces depends on the relative price of
PC
cloth to food .
PF
• An economy chooses its production of cloth QC and food
QF to maximize the value of its output V = PCQC + PF QF ,
given the prices of cloth and food.
æ PC ö
– The slope of an isovalue line equals - ç ÷.
è PF ø
– Produce at point where PPF is tangent to isovalue line.
Figure 6.1 Relative Prices Determine the
Economy’s Output
An economy whose production possibility frontier is TT will

produce at Q, which is on the highest possible isovalue line.
Production Possibilities and Relative
Supply (2 of 2)
• Relative prices and relative supply:
PC
– An increase in the price of cloth relative to food
PF
makes the isovalue line steeper.
– Production shifts from point Q1 to point Q 2 .
QC
– Supply of cloth relative to food rises.
QF
– Relative supply of cloth to food increases with the
relative price of cloth to food.
Figure 6.2 How an Increase in the Relative
Price of Cloth Affects Relative Supply
In panel (a), the isovalue lines become steeper when the relative price of
cloth rises. As a result, the economy produces more cloth and less food.
Panel (b) shows the relative supply curve associated with the production
possibilities frontier TT. The rise in the relative price of cloth leads to an
increase in the relative production of cloth.
Relative Prices and Demand (1 of 6)
• The value of the economy s consumption must equal the
value of the economy s production.
PC DC + PF DF = PCQC + PF QF = V
• Assume that the economy s consumption decisions may

be represented as if they were based on the tastes of a
single representative consumer.
• An indifference curve represents combinations of cloth
and food that leave the consumer equally well off
(indifferent).
• Indifference curves
– are downward sloping — if you have less cloth, then
you must have more food to be equally satisfied.
– that lie farther from the origin make consumers more
satisfied — they prefer having more of both goods.
– become flatter when they move to the right — with
more cloth and less food, an extra yard of cloth
becomes less valuable in terms of how many calories
of food you are willing to give up for it.
• Consumption choice is based on preferences and relative
price of goods:
– Consume at point D where the isovalue line is tangent
to the indifference curve.
• Economy exports cloth — the quantity of cloth produced
exceeds the quantity of cloth consumed — and imports
food.
• Relative prices and relative demand
PC
– An increase in the relative price of cloth causes
PF
consumption choice to shift from point D1 to point D 2
DC
– Demand for cloth relative to food falls.
DF
– Relative demand for cloth to food falls as the relative

price of cloth to food rises.
Figure 6.3 Production, Consumption,
and Trade in the Standard Model
The economy produces at point Q, where the production possibility frontier is

tangent to the highest possible isovalue line. It consumes at point D, where that
isovalue line is tangent to the highest possible indifference curve. The economy
produces more cloth than it consumes and therefore exports cloth; correspondingly,
it consumes more food than it produces and therefore imports food.
• An economy that exports cloth is better off when the price
of cloth rises relative to the price of food:
– the isovalue line becomes steeper and a higher
indifference curve can be reached.
• A higher relative price of cloth means that more calories of
food can be imported for every yard of cloth exported.
• If the economy cannot trade:
– The relative price of cloth to food is determined by the
intersection of relative demand and relative supply for
that country.
– Consume and produce at point D 3 where the indifference
curve is tangent to the production possibilities frontier.
Figure 6.4 Effects of a Rise in the Relative
Price of Cloth and Gains from Trade
In panel (a), the slope of the isovalue lines is equal to minus the relative price of
cloth. As a result, when that relative price rises, all isovalue lines become
steeper. Production shifts from Q1 to Q2 and consumption shifts from D1 to D2. If
the economy cannot trade, then it produces and consumes at point D3. Panel (b)
shows the effects of the rise in the relative price of cloth on relative production
(move from 1 to 2) and relative demand (move from 1 to 2). If the economy
cannot trade, then it consumes and produces at point 3.
Unequal Gains from Trade across the
Income Distribution (1 of 2)
• Gains from trade due to imports becoming cheaper relative
to exports are unevenly distributed across consumers due
to differing consumption patterns.
• The distribution of income is one of the major sources of
divergence in consumption patterns (across broad good
categories).
• Consumers with lower income spend relatively more of
their income on food and some manufactured goods (such
as apparel), whereas consumers with higher income spend
relatively more on services.
Unequal Gains from Trade across the
Income Distribution (2 of 2)
• Because food and manufactured goods are traded much
more heavily than services, poorer consumers benefit
much more from lower import prices than richer
consumers.
• Estimated gains from trade are 35% higher for a consumer
at the 10th percentile of a country’s income distribution
relative to the 90th percentile.
• Poorer consumers gain relatively more than the median,
whereas richer consumers gain relatively less (though all
consumers enjoy net positive gains from trade).
Figure 6.5 Gains from Trade across the Income
Distribution (Relative to the Median Consumer)
The figure shows the relative gain and loss for a consumer at a given percentile of the
country’s income distribution relative to the median consumer in that country (at the 50th
percentile of the income distribution). The figure shows the average across 40 countries.
Although richer consumers gain relatively less than the median consumer (the relative
gain is negative), their overall gain from trade is still positive.
Source: Pablo D. Fajgelbaum and Amit K. Khandelwal, “Measuring the Unequal Gains
from Trade,” The Quarterly Journal of Economics (2016), pp. 1113–1180. See also
“Measuring the Distributional Effects of Trade through the Expenditure Channel,”
voxeu.org (November 2015).
The Welfare Effects of Changes in the
Terms of Trade
• The terms of trade refers to the price of exports relative
to the price of imports.
– When a country exports cloth and the relative
price of cloth increases, the terms of trade rise.
• Because a higher relative 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.
• A decline in the terms of trade decreases a country s
welfare.
Determining Relative Prices
• To determine the price of cloth relative to the price food,
use relative supply and relative demand.
– World supply of cloth relative to food at each relative
price.
– World demand for cloth relative to food at each relative
price.
– World quantities are the sum of quantities from the two
countries in the world:
(QC + QC * ) and
(
DC + DC * ).
(Q F + QF *
) (D
F + DF * )
Figure 6.6a Equilibrium Relative Price
with Trade and Associated Trade Flows
Figure 6.6b Equilibrium Relative Price
with Trade and Associated Trade Flows
The Effects of Economic Growth (1 of 5)
• Is economic growth in China good for the standard of living
in the U.S.?
• Is growth in a country more or less valuable when it is
integrated in the world economy?
• The standard trade model gives us precise answers to
these questions.
• Growth is usually biased: it occurs in one sector more than
others, causing relative supply to change.
– Rapid growth has occurred in U.S. computer industries
but relatively little growth has occurred in U.S. textile
industries.
– In the Ricardian model, technological progress in one
sector causes biased growth.
– In the Heckscher-Ohlin model, an increase in one
factor of production causes biased growth.
Figure 6.7 Biased Growth (1 of 2)
Growth is biased when it shifts production possibilities out more toward

one good than toward another. In case (a), growth is biased toward cloth,
while in case (b), growth is biased toward food.
Figure 6.7 Biased Growth (2 of 2)
The associated shifts in the relative supply curve are shown in

panel (c): shift to the right ( from RS1 to RS 2 ) when growth is
biased toward cloth, and shift to the left ( from RS to RS )
1 3
when growth is biased toward food.

• Biased growth and the resulting change in relative supply
causes a change in the terms of trade.
– Biased growth in the cloth industry (in either the home
or foreign country) will lower the price of cloth relative
to the price of food and lower the terms of trade for
cloth exporters.
– Biased growth in the food industry (in either the home
or foreign country) will raise the price of cloth relative
to the price of food and raise the terms of trade for
cloth exporters.
– Suppose that the home country exports cloth and
imports food.
Figure 6.8 Growth and World Relative
Supply
Growth biased toward cloth shifts the RS curve for the world to the
right (a), while growth biased toward food shifts it to the left (b).
• Export-biased growth is growth that expands a country’s
production possibilities dispro-portionately in that country’s
export sector.
– Biased growth in the food industry in the foreign
country is export-biased growth for the foreign country.
• Import-biased growth is growth that expands a country’s
production possibilities dispro-portionately in that country’s
import sector.
– Biased growth in cloth production in the foreign country
is import-biased growth for the foreign country.
• Export-biased growth reduces a country s terms of trade,
reducing its welfare and increasing the welfare of foreign
countries.
• Import-biased growth increases a country s terms of trade,
increasing its welfare and decreasing the welfare of foreign
countries.
Has the Growth of Newly Industrializing
Economies Hurt Advanced Nations? (1 of 3)
• Has the United States has suffered from a deterioration
in its terms of trade as some of its main trading partners
(such as China) experienced rapid growth?
– This would represent an aggregate income loss for
the United States.
• The standard trade model predicts that if the growth in
China mainly import-biased, the growth in sectors that
compete with U.S. exports would reduce the U.S. terms
of trade.
• But data indicates that changes in the U.S. terms of trade
have been small with no clear trend over last few decades.
– The U.S. terms of trade in 2014 was essentially at the
same level as it was in 1980.
• The terms of trade for China have deteriorated over the
past decade, suggesting their recent growth may have
been export-biased.
• Like the United States, most developed countries tend to
experience mild swings in their terms of trade, around 1
percent or less a year (on average).
• Some developing countries’ exports are heavily
concentrated in mineral and agricultural sectors.
– The prices of those goods on world markets are very
volatile, leading to large swings in the terms of trade.
– These swings in turn translate into substantial
changes in welfare.
Figure 6.9 Evolution of the Terms of
Trade for the United States and China
Source: World Development Indicators, World Bank.

Import Tariffs and Export Subsidies:
Simultaneous Shifts in RS and RD
• Import tariffs are taxes levied on imports.
• Export subsidies are payments given to domestic
producers that export.
• Both policies influence the terms of trade and therefore
national welfare.
• Import tariffs and export subsidies drive a wedge between
prices in world markets and prices in domestic markets.
Relative Price and Supply Effects of a
Tariff (1 of 2)
• If the home country imposes a tariff on food imports, the
price of food relative to the price of cloth rises for domestic
consumers.
– Likewise, the price of cloth relative to the price of food
falls for domestic consumers.
– Domestic producers will receive a lower relative price
of cloth, and therefore will be more willing to switch to
food production: relative supply of cloth will decrease.
– Domestic consumers will pay a lower relative price for
cloth, and therefore will be more willing to switch to
cloth consumption: relative demand for cloth will
increase.
Relative Price and Supply Effects of a
Tariff (2 of 2)
• When the home country imposes an import tariff, the
terms of trade increase and the welfare of the country
may increase.
• The magnitude of this effect depends on the size of the
home country relative to the world economy.
– If the country is a small part of the world economy, its
tariff (or subsidy) policies will not have much effect on
world relative supply and demand, and thus on the
terms of trade.
– But for large countries, a tariff may maximize national
welfare at the expense of foreign countries.
Figure 6.10 Effects of a Food Tariff on
the Terms of Trade
An import tariff on food imposed by Home both reduces the relative

supply of cloth ( from RS to RS ) and increases the relative demand
1 2
( from RD1 to RD2 ) for the world as1 a whole.

2
As a result, the relative
æ PC ö æ PC ö
price of cloth must rise from ç ÷ to ç ÷ .
è PF ø è PF ø
Effects of an Export Subsidy (1 of 2)
• If the home country imposes a subsidy on cloth exports,
the price of cloth relative to the price of food rises for
domestic consumers.
– Domestic producers will receive a higher relative price
of cloth when they export, and therefore will be more
willing to switch to cloth production: relative supply of
cloth will increase.
– Domestic consumers must pay a higher relative price
of cloth to producers, and therefore will be more willing
to switch to food consumption: relative demand for
cloth will decrease.
Effects of an Export Subsidy (2 of 2)
• When the home country imposes an export subsidy, the
terms of trade decrease and the welfare of the country
decreases to the benefit of the foreign country.
Figure 6.11 Effects of a Cloth Subsidy on
the Terms of Trade
An export subsidy on cloth has the opposite effects on relative

supply and demand than the tariff on food. Relative supply of
cloth for the world rises, while relative demand for the world falls.
Home’s terms of trade decline as the relative price of cloth falls
1 2
æ PC ö æ PC ö
from ç ÷ to ç ÷ .
è PF ø è PF ø
Implications of Terms of Trade Effects:
Who Gains and Who Loses? (1 of 4)
• The standard trade model predicts that
– an import tariff by the home country can increase
domestic welfare at the expense of the foreign country.
– an export subsidy by the home country reduces
domestic welfare to the benefit of the foreign country.
• Additional effects of tariffs and subsidies that can occur in a
world with many countries and many goods:
– A foreign country may subsidize the export of a good that
the U.S. also exports, which will reduce the price for the
U.S. in world markets and decrease its terms of trade.
§ The EU subsidizes agricultural exports, which reduce
the price that American farmers receive for their goods
in world markets.
– A foreign country may put a tariff on an imported good
that the U.S. also imports, which will reduce the price for
the U.S. in world markets and increase its terms of trade.
• Export subsidies by foreign countries on goods that
– the U.S. imports reduce the world price of U.S.
imports and increase the terms of trade for the U.S.
– the U.S. also exports reduce the world price of U.S.
exports and decrease the terms of trade for the U.S.
• Import tariffs by foreign countries on goods that
– the U.S. exports reduce the world price of U.S.
exports and decrease the terms of trade for the U.S.
– the U.S. also imports reduce the world price of U.S.
imports and increase the terms of trade for the U.S.
• Export subsidies on a good decrease the relative world
price of that good by increasing relative supply of that
good and decreasing relative demand of that good.
• Import tariffs on a good decrease the relative world price
of that good (and increase the relative world price of other
goods) by increasing the relative supply of that good and
decreasing the relative demand of that good.
International Borrowing and Lending (1 of 5)
• The standard trade model can be modified to analyze
international borrowing and lending.
– Two goods are current and future consumption (same
good at different times), rather than different goods at
the same time.
• Countries usually have different opportunities to invest to
become able to produce more in the future.
• A special kind of production possibility frontier, an
intertemporal production possibility frontier, depicts
different possible combinations of current output and future
output.
Figure 6.12 The Intertemporal Production
Possibility Frontier
A country can trade current consumption for future consumption in

the same way that it can produce more of one good by producing
less of another.
• Suppose that Home has production possibilities biased
towards current output, while Foreign has production
possibilities biased towards future output.
– Foreign has better opportunities to invest now to
generate more output in the future.
• If you borrow 1 unit of output, you must repay principal +
interest = 1 + r in the future, where r is the real interest
rate.
• The price of future consumption relative to current
1
consumption is .
(1+ r )
– 1 unit of current consumption is worth 1 + r of future
consumption,
1
§ so 1 unit of future consumption is worth
(1+ r )
units of current consumption.
• Home exports current consumption and imports future
consumption.
• Home lends to Foreign by consuming less than it produces
now. Home able to consume more than produces in the
future when Foreign pays back the loan.
• Foreign borrows to be able to consume more than
produces now, and pays back the loan by consuming less
than produces in the future.
• When international borrowing and lending are allowed,
the world real interest rate is determined by the
intersection of world relative demand and world relative
supply.
– The world real interest rate will be between the real
interest rates that existed in the two country’s prior
to intertemporal trade.
– The real interest rate rises in the country that lends
(home) and falls in the country that borrows (foreign)
due to intertemporal trade.
Figure 6.13 Equilibrium Interest Rate
with Borrowing and Lending
Home, Foreign, and world supply of future consumption relative to current

consumption. Home and Foreign have the same relative demand for future
consumption, which is also the relative demand for the world. The equilibrium
interest rate is determined by the intersection of world relative supply and demand.
Summary (1 of 3)
1. The terms of trade refers to the price of exports relative
to the price of imports.
2. Export-biased growth reduces a country s terms of trade,
reducing its welfare and increasing the welfare of foreign
countries.
3. Import-biased growth increases a country s terms of
trade, increasing its welfare and decreasing the welfare
of foreign countries.
Summary (2 of 3)
4. When a country imposes an import tariff, its terms of
trade increase and its welfare may increase.
5. When a country imposes an export subsidy, its terms
of trade decrease and its welfare decreases.
Summary (3 of 3)
6. International borrowing and lending is intertemporal
trade, where countries with profitable investment
opportunities borrow funds today and repay lenders in
the future, benefiting both borrowers and lenders.
7. The price of future consumption relative to the price of
current consumption, 1/(1 + r), is determined like any
other relative price.
More On Intertemporal Trade
• Intertemporal budget constraint is similar to a regular
budget constraint in restricting expenditure to match
income, but in present discounted value terms so that
trade is balanced intertemporally.
– Every unit loaned now permits consuming 1+r more in
the future (C = current, F = future).
PC PC
DC + DF = QC + QF
PF PF
(1 + r )DC + DF = (1 + r )QC + QF
DF = QF + (1 + r )(QC - DC )
Figure 6A.1 Determining Home’s
Intertemporal Production Pattern
At a world real interest rate of r, Home’s investment level maximizes

the value of production over the two periods that the economy exists.
Figure 6A.2 Determining Home’s
Intertemporal Consumption Pattern
Home’s consumption places it on the highest indifference curve touching

its intertemporal budget constraint. The economy exports QC - DC
units of current consumption and imports DF - QF = (1+ r )(QC - DC )
units of future consumption.
Figure 6A.3 Determining Foreign’s Intertemporal
Production and Consumption Patterns
Foreign produces at point Q * and consumes at point D*

importing DC * - QC * units of current consumption and exporting
QF * - DF * = (1+ r ) ( DC * - QC * ) units of future consumption.
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International Economics: Theory and

An economy whose production possibility frontier is TT will

– Production shifts from point Q1 to point Q 2 .

• Assume that the economy s consumption decisions may

– Relative demand for cloth to food falls as the relative

The economy produces at point Q, where the production possibility frontier is

Growth is biased when it shifts production possibilities out more toward

The associated shifts in the relative supply curve are shown in

when growth is biased toward food.

Source: World Development Indicators, World Bank.

An import tariff on food imposed by Home both reduces the relative

( from RD1 to RD2 ) for the world as1 a whole.

An export subsidy on cloth has the opposite effects on relative

A country can trade current consumption for future consumption in

Home, Foreign, and world supply of future consumption relative to current

At a world real interest rate of r, Home’s investment level maximizes

Home’s consumption places it on the highest indifference curve touching

Foreign produces at point Q * and consumes at point D*

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