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Y X1 X2 X
X
Y
C P
Y1
Y2 (PX/PY)1
Y X1 X2 X
(PX/PY)1
Y5
X5 X
Y
Y3
(PX/PY)1
Y4
(PX/PY)2
Y X3 X4 X
(PX/PY)2
(PX/PY)1
Y6
Y5
X5 X6 X
Y
Y3
(PX/PY)1
Y4
(PX/PY)2
Y X3 X4 X
OCA (PX/PY)2
(PX/PY)1
Y6
Y5
X5 X6 X
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
(PX/PY)1
p
Y7
c
Y8
Y X7 X8 X
X
Y
(PX/PY)1
p
Y7
c
Y8
Y X7 X8 X
(PX/PY)1
Y9
X9 X
Y
(PX/PY)1
Y10
(PX/PY)2
Y11
Y X10 X11 X
(PX/PY)1
(PX/PY)2
Y12 OCB
Y9
X9 X12 X
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
OCA
Y (PX/PY)E
OCB
Y1
X1 X
Terms of Trade Equilibrium
OCA
Y (PX/PY)E
OCB
Y1
If these are the terms of trade,
country A will desire to export
X1 units, and country B will
want to import X1 units
X1 X
Terms of Trade Equilibrium
OCA
Y (PX/PY)E
OCB
Y1
If these are the terms of trade,
country A will desire to import
Y1 units, and country B will
want to export Y1 units
X1 X
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
OCA
Y (PX/PY)1
OCB
X
Disequilibrium
OCA
Y (PX/PY)1
Y1 OCB
Y2
X
Disequilibrium
OCA
Y (PX/PY)1
Y1 OCB
X
Disequilibrium
OCA
Y (PX/PY)1
OCB
X2 X1 X
Disequilibrium
OCA
Y (PX/PY)1
OCB
OCB
X
Disequilibrium
• Terms of trade lines that are flatter than
(PX/PY)E, such as
Disequilibrium
OCA
Y (PX/PY)2
OCB
X
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
OCA
Y (PX/PY)2
OCB
X
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
OCA
Y (PX/PY)E
OCB
Y1
X1 X
Demand Changes in Country A
OCA OCA'
Y (PX/PY)E
OCB
X
Demand Changes in Country A
OCA OCA'
Y (PX/PY)E
(PX/PY)E'
OCB
Y2
X2 X
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
OCA
Y (PX/PY)E
OCB
Y1
X1 X
Demand Changes in Country B
OCA
Y (PX/PY)E
OCB'
OCB
X
Demand Changes in Country B
OCA
Y (PX/PY)E
(PX/PY)E'
OCB'
Y2 OCB
X2 X
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
OCA
Y (PX/PY)E
OCB
Y1
X1 X
Imposition of Tariff by Country A
OCA' OCA
Y (PX/PY)E
OCB
Y1
X1 X
Imposition of Tariff by Country A
OCA' OCA (PX/PY)E'
Y
(PX/PY)E
OCB
Y2
X2 X
Imposition of Tariff by Country A
OCA' OCA (PX/PY)E'
Y
(PX/PY)E
OCB
Y2
By imposing a tariff, Country A
decreases trade volume, and
improves its terms of trade (but
B’s terms of trade deteriorate)
X2 X
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
OCOPEC
Other (PX/PY)pre-shock
stuff
OCIC
Y1
X1 Oil
Oil Shocks of the 1970s
OCOPEC' OCOPEC
Other (PX/PY)E
Stuff
OCIC
Y1
X1 Oil
Oil Shocks of the 1970s
OCOPEC ' OCOPEC (PX/PY)post-shock
Other
Stuff (PX/PY)pre-shock
OCIC
Y1
Y2
X2 X1 Oil
Oil Shocks of the 1970s
OCOPEC ' OCOPEC (PX/PY)post-shock
Other
Stuff (PX/PY)pre-shock
OCIC
Y1
Y2
OPEC’s terms of trade should
have improved, and the industrial
countries’ should have worsened
X2 X1 Oil
Oil Shocks of the 1970s:
Changes in the Terms of Trade
Oil-Exporting Industrial
Countries Countries
1970 21 110
1973 29 108
1974 70 97
1979 87 96
1981 119 87
1985 97 91
1995 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
OC”small”
Y OCROW
Y1
X1 X
“Small” Countries and Offer
Curves
OC”small”
Y OCROW
Y1
X1 X
“Small” Countries and Offer
OC
Curves
OC'
small
small
Y OCROW
Y1
If the “small” country imposes
a tariff on ROW products, it
has no effect on the terms of
trade
X1 X
“Small” Countries and Offer
OC
Curves
OC'
small
small
Y OCROW
Y1
If the “small” country imposes
a tariff on ROW products, it
has no effect on the terms of
trade
This is the definition of a
“small” country
X1 X
“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