Offer Curves

How the Terms of Trade Are Established

Offer Curves are

all combinations of a countrys desired exports and imports at different terms of trade also known as reciprocal demand curves (J.S. Mills) measures of willingness to trade

Y Y1 Y2 C P (PX/PY)1

X1

X2

Y Y1 Y2 C P (PX/PY)1

X1

X2

(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 OCA X4 X (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 Bs Offer Curve

This will reflect Country Bs willingness to trade at different terms of trade Bs offer curve bows towards the axis with Bs import good on it

(PX/PY)1

Y7 Y8 Y

p c X7 X8 X

(PX/PY)1

Y7 Y8 Y

p c X7 X8 X

(PX/PY)1

Y9

X9

(PX/PY)1

Y10 (PX/PY)2 X10 (PX/PY)1 X11 X

Y11 Y

Y12 Y9 X9 X12

(PX/PY)2 OCB

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

Y OCA (PX/PY)E

OCB Y1

X1

Terms of Trade Equilibrium

Y OCA (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

Terms of Trade Equilibrium

Y OCA (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

How Do We Know Its 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
Y OCA (PX/PY)1

OCB

Disequilibrium
Y OCA (PX/PY)1

Y1 Y2

OCB

Disequilibrium
Y OCA (PX/PY)1

Y1 Y2

OCB At (PX/PY)1, country A wishes to import Y1 units, but country B is only interested in exporting Y2 units. That is, there is an excess demand for good Y. X

Disequilibrium
Y OCA (PX/PY)1

OCB

X2

X1

Disequilibrium
Y OCA (PX/PY)1

OCB At (PX/PY)1, country A wishes to export X1 units, but country B is only interested in importing X2 units. That is, there is an excess supply of good X. X2 X1 X

Disequilibrium
Excess demand for Y causes PY to rise Excess supply of X causes PX to fall Thus, (PX/PY) falls In other words, the terms of trade line gets flatter, moving the countries in the direction of equilibrium

Moving Towards Equilibrium

Y (PX/PY)1 OCA

OCB

Disequilibrium
Terms of trade lines that are flatter than (PX/PY)E, such as

Disequilibrium
Y OCA (PX/PY)2

OCB

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

Y OCA (PX/PY)2

OCB

A Note on the Terms of Trade

A countrys 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 As terms of trade, since A exports good X and imports Y (PY/PX) is country Bs terms of trade in this example

A Note on the Terms of Trade, continued

As As terms of trade (PX/PY) improve, Bs terms of trade (PY/PX) must be deteriorating and vice-versa

Shifts of Offer Curves

Anything that causes country As willingness to trade to change will shift As 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

Y OCA (PX/PY)E

OCB Y1

X1

Demand Changes in Country A

Y

(PX/PY)E

OCA

OCA'

OCB

Increased demand for imports by Country A causes a rightward shift of As offer curve
X

Demand Changes in Country A

Y

(PX/PY)E

OCA

OCA' (PX/PY)E' OCB

Y2

Volume of trade increases, but As terms of trade go down. Bs terms of trade improve. 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 As terms of trade

Demand Changes in Country B

Y OCA (PX/PY)E

OCB Y1

X1

Demand Changes in Country B

Y OCA (PX/PY)E OCB' OCB

Increased demand for imports by Country B shifts Bs OC upward

Demand Changes in Country B

Y OCA (PX/PY)E' (PX/PY)E OCB' Y2 OCB

Volume of trade increases, but Country Bs terms of trade decrease (and As terms of trade improve). X2 X

Other Demand Changes

Any decrease in a countrys 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 countrys terms of trade

Imposition of Tariff by Country A

Y OCA (PX/PY)E

OCB Y1

X1

Imposition of Tariff by Country A

Y OCA' OCA (PX/PY)E

OCB Y1

X1

Imposition of Tariff by Country A

Y OCA' OCA (PX/PY)E' (PX/PY)E OCB Y2

X2

Imposition of Tariff by Country A

Y OCA' OCA (PX/PY)E' (PX/PY)E OCB Y2

By imposing a tariff, Country A decreases trade volume, and improves its terms of trade (but Bs terms of trade deteriorate)
X2 X

Supply Changes
Changes in supply conditions will also shift a countrys offer curves around Examples include
productivity changes discovery of new resources

An Example: The Oil Shocks of the 1970s

Lets think of OPEC as one country Lets also think of the industrial countries as one country OPEC effectively decreased its willingness to trade Presumably this shifted OPECs offer curve to the left, increasing OPECs terms of trade and decreasing the industrial countries

Oil Shocks of the 1970s

OCOPEC

Other stuff

(PX/PY)pre-shock

OCIC Y1

X1

Oil

Oil Shocks of the 1970s

Other Stuff
OCOPEC' OCOPEC (PX/PY)E

OCIC Y1

X1

Oil

Oil Shocks of the 1970s

Other Stuff
OCOPEC' OCOPEC (PX/PY)post-shock (PX/PY)pre-shock OCIC Y1 Y2

X2 X1

Oil

Oil Shocks of the 1970s

Other Stuff
OCOPEC' OCOPEC (PX/PY)post-shock (PX/PY)pre-shock OCIC Y1 Y2 OPECs 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

1970 1973 1974 1979 1981 1985 1995 Oil-Exporting Countries 21 29 70 87 119 97 55 Industrial Countries 110 108 97 96 87 91 105

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 countrys perspective, the rest-of-worlds OC is a straight line

Small Countries and Offer Curves

Y
OCsmall

OCROW

Y1

X1

Small Countries and Offer Curves

Y
OCsmall

OCROW

Y1

Why is the ROW offer curve perceived to be a straight line?

X1

Small Countries and Offer Curves OC OC

' small small

OCROW

Y1

If the small country imposes a tariff on ROW products, it has no effect on the terms of trade

X1

Small Countries and Offer Curves OC OC

' small small

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 dont improve the terms of trade This is really the same point we made earlier: free trade is especially helpful to small developing countries