Quiz 6: The Standard Trade Model


Under standard trade model, production possibilities frontiers are, isovalue lines, and indifference curves are combined together to illustrate the trade patterns between countries and the resultant gains from the trade. In the given case, Norway and Sweden will have two different production possibility curves which are represented as PPF N and PPF S in the following diagrams. Figure (a)for Norway Figure (b)for Sweden img PPF of Norway Sweden PPF N and PPF S indicate the different combinations of fish and automobiles that can be produced within the given resources of each country. It is to be noticed that PPF N will be a steeper one implying that the country is relatively more productive in fishing and PPF S will be a flatter one implying the country is relatively more productive in automobiles. In the absence of trade, the economy of the Norway and Sweden will produce at a point on the respective PPF s where it is tangent to the respective highest possible isovalue line (a line along which the value of output is constant and whose slope is equal to minus the ratio of relative price of the two goods). As, we know that the value of an economy's consumption equals the value of its production, so the production point and the consumption point must lie on the same isovalue line. Therefore, in a pre-trade situation, at the point of tangency between PPF S and isovalue lines, the respective highest indifference curve will also be tangent which is shown by point E in figure (a)for Norway and in figure (b)for Sweden. When trade is opened between the two countries, the isovalue lines in Norway and Sweden will shift as shown in the respective figures in red color. The movement of production and trade will move production from point E to point A in both the countries. At the new production point, both countries will be able to trade to a final consumption point (point B )on a higher indifference curve IC 1 than the original indifference curve IC. At point B , consumers of both the countries are better off. At point B , Norway's exports fish are matched by Sweden's imports of fish. In the same way, the amount of exports of automobiles of Sweden is matched by that of Norway's imports. Thus, both Norway and Sweden gain from trade.

Gains from trade refer to net benefits due to allowing free trade with each other and increasing the volume of trade with lower tariffs. Thus, gains from trade increase the consumer surplus, and producer surplus and welfare of the countries. Assumptions: 1. There are two countries (country N, and country S)2. There are two goods (fish, and Volvos)3. Tastes and preferences are same in both countries. In the problem, it is given that country N specializes in the production of fish due to having a long coast that borders on the north Atlantic. Thus, the country N is exporting fish to country S. Country S specializes in the production of Volvos due to having a greater endowment of capital. Thus, the country S is exporting Volvos to country N. Thus, both the countries are gaining from the trade. Welfare in both countries increases as the two countries move from production patterns governed by domestic prices to production governed by world prices. a)The overfishing problem can result in a decline in welfare for country N. img Due to over fishing, there is reduction of country N production possibilities away from fish. This is happened due to fall in the production of fish relative to automobiles. Thus, country N moves down to IC 2 which represent fall in welfare. The reduction of country N 's production possibilities away from fish cause the production of fish relative to automobiles to fall. Thus, despite the higher relative price of fish exports, country ' N ' moves down to a lower indifference curve representing a drop in welfare. b)The overfishing problem could result in an increase in welfare for Norway. img The increase in the relative price of fish shifts causes country N 's relative production of fish to rise (despite the reduction in fish productivity). Thus, the increase in the relative price of fish exports allows country ' N ' to move to a higher indifference curve and higher welfare. Thus, from the above diagrams, it is clear that both countries are gaining from trade. In the above graphs, indifference curves shift to rightward from IC1 to IC2. This means, the welfare of both countries increase due to the free trade.

________________________________________________________________________Changes in relative price generally affects the relative supply of goods. But sometimes countries are unresponsive to a change in relative price. If there is no substitution of factors of production between various sectors, the relative supply cannot be altered. In such cases, the production possibility frontier ( PPF )will be right-angled indicating that the country will produce the two goods in rigid ratio and the output of the two goods is free from the relative prices. The shape of the PPF will be rectangle-shaped which is shown in the diagram below: img Right-angled PPF The production point on the rectangle-shaped PPF is the corner point A at which the original relative price line (red color)is tangent. The consumption point is also at the point A where the red relative price line is tangent to the highest indifference curve IC. Now, when terms of trade improve, there will be no change in the production point because of immobility of factors of production. But the relative price line will rotate clockwise so that the new relative price line (green color)still touches the original production point A. The new relative price line will be tangent to a higher indifference curve IC 1 at point B. This indicates that a rise in terms of trade increases the welfare. Even though the country does not produce more, its export earnings are more than its import payments which enables them to improve their welfare.