12Caves/Frankel/JonesWorldTradeandPayments:AnIntroduction,TenthEdition

Chapter3
ApplicationsoftheBasicModel
Chapter Organization
3.1

DisturbancesFromAbroadandtheTermsofTrade
AnincreaseinForeignDemand
SupplyShocks:EnergyPrices

3.2

ProtectingtheImportCompetingCommodity

3.3

GrowthandInternationalTrade

3.4

TheTransferProblem
TheTransferProblem:PurchasingPower
IsitBettertoGiveortoReceive?
TheTransferProblem:RealResources

3.5

WiderInterpretationsoftheBasicTradeModel
ManyTradedFinalCommodities
ManyCountries
TradeinIntermediateGoodsandInternationalFactorMobility
NonTradeableFinalCommodities
IntertemporalTrade
TradeinAssets

3.6

TradeandMarketStructure

3.7

Summary

13Caves/Frankel/JonesWorldTradeandPayments:AnIntroduction,TenthEdition

Appendix:TheStabilityIssue

Chapter Summary
Thischapterfocusesonsomesimpleapplicationsofthebasictrademodel.Theemphasisisonthefactthat
disturbancestoatradingworldhavebothdirectandindirecteffects.Theindirecteffectsoperatevia
adjustmentstoworldprices,andthepresenceoftheseeffectsoftenleadstointerestingandsurprisingresults.
Animportantpointtoemphasizeisthefactthattradelinkscountries,sothatdisturbancesinonecountrywill
haveworldwiderepercussions.Thefactthatworldmarketsforgoodsmustalwaysclearshouldalsobe
emphasized,asitisviathismarketclearingprocessthatthetermsoftradearedetermined.Inaddition,
disturbancesinacountrywillonlyimpactuponworldmarketsifthecountryislargeenoughsuchthatthey
affectworldsupplyanddemand.Thisisthedistinctionbetweensmallcountrieswhocannotaffectworld
pricesandlargecountrieswhocan.Thefinalimportantgeneralpointisthatthemagnitudeofthe
secondaryeffectsisgenerallyproportionaltoacountrysvolumeoftrade.Therefore,countriesthataremore
involvedinworldmarketsaremorelikelytofeeltheeffectsofchangesinthesemarkets.
Section3.1introducestheideathatchangesindomesticsupplyordemandforacommoditycanleadto
changesinworldsupplyanddemand.Thiswillleadtochangesinthetermsoftrade,whichwillhavean
impactuponalltradingcountries.Thediscussionoftheoilpriceshocksisimportantasitillustratesthe
mechanismthroughwhichadisturbanceinasmallnumberofcountriescanhaveasignificantimpactupon
theentireworld.
Section3.2discussestheeffectsofgovernmentactionuponworldprices.Theideathatgovernmentscan
advantageouslymanipulateworldpricesisthebasicmotivationfortradepolicy,whichisthesubjectof
PartIIIofthetext.
Section3.3discussestheparadoxofimmiserizinggrowth.Growthinacountrysexportsectorwillleadto
adeteriorationofthetermsoftradeforthatcountry.Thismayleadtothecountrybeingworseoffthan
theywerebeforegrowthoccurred.Thisisanexcellentillustrationofthecasewherethesecondaryeffects
ofthedisturbanceoutweightheprimaryeffects,leadingtoasomewhatparadoxicalresult.Notethe
necessityforthepresenceofinternationaltrade.Elasticityisalsoanimportantelementheresincethemore
inelasticisworlddemand,thelargerwillbethefallintheworldrelativepriceoftheexportgood.The
secondaryeffectsviaworldmarketswilldampenthegainsfromgrowth,andmaynotleadtolossesforthe
growingcountry.Therefore,immiserizinggrowthisnotanecessaryconsequenceofgrowthoftheexport
sector.Anotherimportantpointisthatgrowthmustbebiasedheavilytowardstheexportsectorinorder
fortheretobeasecondaryburden.Growthinacountrysimportsectorwillleadtoaloweringofimport
prices,andthusasecondaryblessingofgrowth.Afinalimportantpointisthattheworldasawholemust
gainasaresultofthegrowth.Thedeteriorationinthetermsoftradeforthegrowingcountryisalsoan
improvementinthetermsoftradeforcountriesthatimporttheirproducts.
Thenextsectionaddressesthetransferparadox.Adiscussionofthepoliciesadoptedtowardsthelosersof
W.W.IandW.W.IIprovidesinterestingbackgroundforthissection.Thetransfershiftsworlddemandfor
goods,withthedirectionoftheshiftreflectingtastedifferencesbetweencountries.Atransferofresources
acrosscountrieswillalsoaffectworldsuppliesifcountriesdifferintheirtechnologies.Thediscussionof
immiserizinggrowthcanbenestedintheframeworkofthetransferproblem,wherethegrowthrepresents
atransferofresourcestoacountryfromanagentuninvolvedinthetradingworld.Notethattransfersof
incomecannotleadtogainsforthetransferringcountryaslongasmarketsarestable.Theissueofmarket
stabilityisdiscussedindetailinboththeAppendixandSupplementtoChapter3.Thismaterialmaybe
usefulinsupplementingthediscussionofthetransferproblemandimmiserizinggrowth.

Chapter3ApplicationsoftheBasicModel14

Section3.5considerssomeotherissuesandextensionsofthebasictrademodel.Importantamongtheseis
intertemporaltrade.Thisbreaksthenecessityforequalitybetweenthevalueofimportsandthevalueof
exportsandallowsfortradedeficitsandsurpluses.
Section3.6introducestheideathatmarketstructureandtradearerelated,whichisthesubjectofseveral
discussionslaterinthetext.
TheAppendixandSupplementtoChapter3bothdiscusstheissueofstabilityofmarkets.Thismaterial,
althoughnotinthemainbodyofthechapter,hasbeenfoundtobeusefultocoverasithelpsin
understandingthetransferproblemandimmiserizinggrowth.
Keyconceptsintroducedinthischapterinclude
disturbancestoatradingworldhaveeffectsonworldmarketsandthusworldprices
thesesecondaryeffectscanoutweightheprimaryeffectsofthedisturbance,leadingtoparadoxical
resultssuchasimmiserizinggrowthandthetransferproblem
stabilityofmarketsmaylimittheextentofthemovementofworldpricestradeacrosstimecanleadto
tradedeficitsandsurpluses

15Caves/Frankel/JonesWorldTradeandPayments:AnIntroduction,TenthEdition

Suggested Answers to Textbook Questions

1.

Initially,productionwillbeatEandconsumptionatA.Growthproportionaltotheinitialvolumeof
productionwillleadtoadeclineintheworldrelativepriceofclothingiftheincomeelasticityoffoodis
greaterthanthatforclothing.Inthiscasetherelativedemandforclothingfalls.Ifthedeclineislarge
enough,consumptionmayshifttoapointlike,A,whichrepresentsalowerwelfarelevelthanatA.
2.

Ifimportsoffoodrepresent20percentofnationalincomeandthepriceoffoodrisesby10percent,
thenthecountrycanpurchase10percentlessfoodimports.Thiswillcorrespondtoa2percent
declineinnationalincome(asfoodimportsare20percentofincome).

3.

Beforethetransfer,thehomecountryimportsfood.ThehomecountrygivesTdollarstotheforeign
country.TheforeigncountryspendsT/2onfoodandT/2onclothing.Thehomecountryreduces
demandforfoodby2T/3unitsandclothingbyT/3units.Therefore,theworlddemandforfoodshifts
inward.Theworldrelativepriceoffoodthenfalls.Sincethehomecountryimportsfood,itstermsof
tradehaveimprovedasaresultoftheloan.Thereisthenasecondaryblessingtothehomecountry.

4.

Thisgrowthwillaffectacountystermsoftrade.Thetermsoftradewillshiftinfavorofthe
transferor.

Chapter3ApplicationsoftheBasicModel16

5.

Ifthehomecountrydiscoversanewprocessthatwillraiseproductivitytomorrowthenitwillhave
higheroutputinthefuture.Therefore,itwillwanttoincreaseconsumptiontoday.Itwilldothisby
runningatradedeficittodayandhavingatradesurplusinthenextperiod(afterproductionhas
expanded).Ifthiscausesthetermsoftradetoworseninthefuture(i.e.expandedproductioncauses
worldrelativesupplyforthecountrysexportgoodtoincrease,leadingtoafallintherelativeprice
oftheirexports),thenthiswillmakethegaininfutureincomeasresultoftechnologicalprogress
smaller.Thiswillreducethecountrysdesiretoborrowfromthefuture,makingthecurrenttrade
deficitandfuturesurplussmaller.However,thetermsoftradechangemaymaketheothercountrys
futureincomerisebymorethanthehomecountrys.Inthiscase,theforeigncountrywillwantto
increaseconsumptiontoday.Thehomecountrywillthenhaveatradesurplusnowandadeficitlater.

Multiple Choice Questions

1.

Inaworldwithmanycountries,
(a)
(b)
(c)
(d)
(e)

thevalueofexportsandimportsbetweeneachpairofcountriesmustbeequal.
theremustbezeronettradeacrossvarietiesofanygood.
immiserizinggrowthcannotoccur.
thereisnosecondaryeffectofatransferofresourcesfromonecountrytoanother.
thevalueofexportsandimportsbetweenpairsofcountriesmaynotbeequal.

Answer:(e)
2.

Anincreaseinforeigndemandforhomesexportsmust
(a)
(b)
(c)
(d)
(e)

becausedbyadropinthepriceofhomesexportgood.
causeariseinthepriceofhomesexport.
increasehomesexports.
decreasehomesexports.
noneoftheabove.

Answer:(b)
3.

AnincreaseindemandforUSexportsmayleadto
(a)
(b)
(c)
(d)
(e)

adeclineinUSexportvolume.
adeteriorationofUStermsoftrade.
ashiftintheworldsupplyforthisgood.
adecreaseinworlddemand.
adecreaseinUSrealincome.

Answer:(a)
4.

AdecreaseinthesupplyofUSimportswill
(a)
(b)
(c)
(d)
(e)

shiftworlddemandfortheimports.
increaseworldsupplyfortheimports.
notaffectworldprices.
leadtoincreasedvolumeofUSimports.
leadtoadeteriorationinUStermsoftrade.

Answer:(e)

17Caves/Frankel/JonesWorldTradeandPayments:AnIntroduction,TenthEdition

5.

Taxingimportsleadsto
(a)
(b)
(c)
(d)
(e)

increaseddomesticproductionoftheimportedgood.
increaseddomesticconsumptionoftheimportedgood.
anincreaseintheworldsupplyoftheimportedgood.
anincreaseintheworldpriceoftheimportedgood.
anincreaseintheworlddemandfortheimportedgood.

Answer:(a)
6.

Asmallcountrythatcannotaffectworldprices
(a) mayexperienceimmiserizinggrowth.
(b)
(c)
(d)
(e)

maygainfrommakingatransferabroad.
willexperiencewelfarelossesfromapolicyofimportprotection.
willhavenochangeinwelfarefromapolicyofimportprotection.
canonlyaffectworlddemandandnotworldsupplyforgoods.

Answer:(c)
7.

Acountrycangainbyrestrictingproductionofitsexportcommodity
(a)
(b)
(c)
(d)
(e)

onlyifitissmall,sothenegativeeffectsarenotlarge.
ifitislargeanddemandforitsexportissufficientlyinelastic.
always.
never.
ifitissmallanddemandforitsexportissufficientlyelastic.

Answer:(b)
8.

Immiserizinggrowthismostlikelytooccurif
(a)
(b)
(c)
(d)
(e)

worlddemandelasticityforthegrowingcountrysexportsislow.
worlddemandelasticityforthegrowingcountrysexportsishigh.
worldsupplyelasticityforthegrowingcountrysexportsislow.
worldsupplyelasticityforthegrowingcountrysexportsishigh.
elasticitydoesnotmatter.

Answer:(a)
9.

Immiserizinggrowthismostlikelytooccurif
(a)
(b)
(c)
(d)
(e)

growthisconcentratedinacountrysimportsector.
growthisbalancedacrossexportsandimports.
growthisconcentratedingoodswithhighworlddemandelasticity.
thecountryexperiencinggrowthissmall.
growthisconcentratedinacountrysexportsector.

Answer:(e)
10. Growthconcentratedinalargecountrysimportsectorwillleadto
(a)
(b)
(c)
(d)

anincreaseinworldsupplyofitsimports,andthusanimprovementinitstermsoftrade.
anincreaseinworldsupplyofitsimports,andthusadeteriorationinitstermsoftrade.
anincreaseinworlddemandforitsimports,andthusanimprovementinitstermsoftrade.
anincreaseinworlddemandforitsimports,andthusadeteriorationinitstermsoftrade.

Chapter3ApplicationsoftheBasicModel18

(e) nochangeinthecountrystermsoftrade.
Answer:(a)
11. Whichofthefollowingstatementsisincorrect?
(a)
(b)
(c)
(d)
(e)

Immiserizinggrowthismostlikelytoresultfromgrowthbiasedtowardsexports.
Immiserizinggrowthismostlikelytoresultifdemandelasticityforacountrysexportsislow.
Balancedgrowthcannotbeimmiserizing.
Asmallcountrycannotexperienceimmiserizinggrowth.
Immiserizinggrowthismostlikelytoresultiftradevolumesarelarge.

Answer:(c)
12. Ifcountry1transfersincometocountry2,thetermsoftradewillworsenforcountry1if
(a)
(b)
(c)
(d)
(e)

1smarginalpropensitytoimportis0.5and2smarginalpropensitytoimportis0.5.
1smarginalpropensitytoimportis0.5and2smarginalpropensitytoimportis0.7.
1smarginalpropensitytoimportis0.7and2smarginalpropensitytoimportis0.5.
1smarginalpropensitytoimportis0.3and2smarginalpropensitytoimportis0.5.
1smarginalpropensitytoimportis0.3and2smarginalpropensitytoimportis0.8.

Answer:(d)
13. Ifthereareonlytwocountriesandbothhavemarginalpropensitytoimportof0.3,then
(a)
(b)
(c)
(d)
(e)

givingawayincomemayleadtowelfaregains.
givingawayincomewillalwaysleadtowelfarelosses.
receivingmoneymayresultinwelfarelosses.
thetermsoftrademoveinfavorofthegivingcountry.
receivingmoneywillalwaysresultinwelfarelosses.

Answer:(b)
14. Atransferofpurchasingpower
(a)
(b)
(c)
(d)
(e)

doesnotaffectworldprices.
mayshiftworlddemand.
mayshiftworldsupply.
mayshiftbothworldsupplyanddemand.
alwayscausesthetermsoftradetomoveinfavorofthegiver.

Answer:(b)
15. Atransferofrealresources
(a)
(b)
(c)
(d)
(e)

doesnotaffectworldprices.
mayshiftworlddemand.
mayshiftworldsupply.
mayshiftbothworldsupplyanddemand.
alwayscausesthetermsoftradetomoveinfavorofthegiver.

Answer:(d)

19Caves/Frankel/JonesWorldTradeandPayments:AnIntroduction,TenthEdition

16. Thereareonly2countries.Country1canproduceonlyfoodand2onlyclothing.Country2transfers
resourcesto1.Then
(a)
(b)
(c)
(d)
(e)

worldfoodoutputfalls.
worlddemandforfoodrises.
thetermsoftradewillnotchange.
theworldrelativepriceoffoodwillfall.
theworldrelativepriceoffoodwillrise.

Answer:(d)
17. Therearetwocountriesintheworld.CountryAexportsfoodwhilecountryBexportsclothing.
Demandforbothishighlyinelasticandverylittleofeachgoodisconsumedinthecountryitis
produced.OneyearcountryAhasanunusuallylargecropoffood.AstheAseconomicadviser,
whatdoyourecommend?CountryBwilltakenoretaliatoryactionagainstyou.
(a)
(b)
(c)
(d)
(e)

Donothing.Sellallthefoodcrop.
Burnsomeof,allormorethantheexcessfood.
Givetheexcessfoodawayandtakeadvantageofasecondarybenefitofthegift.
Trytoproduceevenmorefood.
Youcantmakeanyrecommendationfromtheinformationgiven.

Answer:(b)
18. Supposeasmallnationwithbalancedtraderealizesthatitoverestimateditsnaturalresources.Itis
evidentthatitsincomewillfallinthefuture.Howwillitstradingpatternchange?
(a)
(b)
(c)
(d)
(e)

Itwillnotchange.Tradewillremainbalanced.
Thecountrywillbegintoimportmorenowwhileincomeishigh.
Thecountrywillruntradesurplusestosaveforlowerfutureincome.
Thecountrywillexportlessnowsothatexportswillnotfallinthefuture.
Itwillnotchangenow,butimportswillfallinthefutureasincomeandexportsfall.Tradewill
alwaysremainbalanced.

Answer:(c)
19. Thetermsoftradeforacountrywillchangeasaresultof
(a)
(b)
(c)
(d)
(e)

changesintastes.
changesinforeigntechnology.
changesinforeignresourceendowments.
(a)and(c).
alloftheabove.

Answer:(e)
20. Whichofthefollowingstatementsisincorrect?
(a)
(b)
(c)
(d)
(e)

Withgrowth,theworldasawholealwaysgains.
Growthinacountrysexportsectorwillalwaysbeimmiserizing.
Atransferofrealresourcesshiftsworlddemands.
Atransferofpurchasingpowershiftsworlddemands.
Expectedfutureproductivityincreasesmaybeanexplanationfortradedeficits.

Answer:(b)