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Chapter 33: Terms of Trade

The Terms of Trade

The division of the gains from trade depends on the terms of trade. The terms of trade are measured by the ratio of the price of exports to the price of imports.

Terms of Trade

Index of Export Prices Index of Import Prices

x 100

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A rise in the index: country gets more imports per unit of exports a favourable change for the country

A fall in the index: country gets fewer imports per unit of exports an unfavourable change for the country

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Index Numbers

Index Numbers
Used to compare changes in some variable relative to some base period.

Important when the variables are measured in different units.

Value of index in given period

absolute value in given period absolute value in base period

X 100

Expresses the value of some series in any given year as % of its value in the base year

Index Numbers: An Example

Index Numbers: An Example

For each index number the value in the base year is 100. Index Steel in 2011=122.5 that means that in 2011 the steel output was 22.5% greater than in 2001.

How much steel output changed from 2005 to 2007? Index steel output in 2005=125.0 Index steel output in 2007=132.5 Percentage increase: (132.5-125.0)/125.0=0.06, or 6%

Changes in quantity demanded and shifts of the demand curve

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Demand Schedules and Demand Curves

Demand Schedule
140 120

Demand curve

Price of Carrots

Price per Tonne

Quantity Demanded

100 80 60 40 20 0

U V W X Y

20 40 60 80 100

110 85 65 50 40

Y X W
V U

20 40 60 80 100 120 140

Quantity of Carrots
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A change in variables other than price will shift the demand curve to a new position.

average household income prices of other products distribution of income or population expectations about the future
Price of Carrots

140 120 100 80 60 40 20 0

D0

D1 Y X W V U

20 40 60 80 100 120 140

Quantity of Carrots

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Do I need to know the algebra of market equilibrium? YES!

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Price Elasticity of Demand

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The Measurement of Price Elasticity

Elasticity (Greek letter eta:) is defined as:

percentage change in quantity demanded percentage change in price

Demand elasticity is negative, but economists usually emphasize the absolute value. It is also unit free.
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The Measurement of Price Elasticity

We are interested in the arc elasticity.

=
Price A

QD/QD p/p

Elasticity usually measures the change in p and Q relative to some base values of p and Q.
B

Which ones to use? We will use the average price and quantity

Quantity
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Demand elasticity between point A and point B on some demand curve is:

QD/QD p/p

where p and QD are the average price and average quantity, respectively. It can also be written as:

(QB - QA)/[(QB + QA)/2] (pB - pA)/[(pB + pA)/2]

(QB - QA)/Q (pB - pA)/p

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Elasticity falls as you move down a linear demand curve. Elastic

10
Price

>1

Unit Elastic

=1
5

<1 Inelastic

10 Quantity Demanded
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Other elasticities
Price elasticity of supply: Similar to price elasticity of demand. Income elasticity of demand: Normal (elasticity>0) Inferior goods (elasticity<0) Cross elasticity of demand: Complement (elasticity<0) Substitute (elasticity>0)
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Price floor, price ceiling and quotas

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Price floor and price ceiling

Price

Excess supply

S Price floor

p1 p0 p2 Excess demand Q1 Q0 Q2 E

Price ceiling

D Quantity

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Substitution and Income Effects

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Substitution and Income Effects

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Marginal and Total Utility

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Utility Schedules and Graphs

Total Utility
0 30 50 65 75 83 89 93 96 98 99

Marginal Utility
30 20 15 10 8 6 4 3 2 1

Utility

Movies Attended per Month

0 1 2 3 4 5 6 7 8 9 10

100 80 60 40 20 0 2 4

total utility

10

Marginal Utility

Quantity of Movies
30 20 10 0 2

marginal utility

10

Quantity of Movies
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Utility Maximizing Condition

A utility-maximizing consumer allocates expenditures so that the utility obtained from the last dollar spent on each product is equal.

For two products X and Y, the utility-maximizing condition is: MUX pX = MUY pY or MUX MUY = pX pY

In the second equation, we see the consumer adjusting her consumption (and thus the ratios of MUs) in response to changes in relative prices.
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Producers in the short run

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TP Total product Quantity of Labour MC Cost Cost TC TVC ATC AVC TFC AFC Output Output
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AP MP Quantity of Labour

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Remember! Make sure you understand the relationship between: MP and AP MC and AVC and ATC

Make sure you understand table 7-2.

Assume that all firms have the same structure of costs (remember that natural monopolies are special!)

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Study Guide. Ex. 11 page 183

If the level of production is 50 units, TFC is a) $350 c) $500 b) $7 d) $10

e) Indeterminable with data provided

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Producers in the long run

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The relationship between long-run and shortrun costs

Cost per Unit

SRATC curves

LRAC

Output per Period

A short-run ATC curve cannot fall below the LRAC curve. Each SRATC curve is tangent to the LRAC curve at the level of output for which the quantity of the fixed factor is optimal.
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Long Run Average Cost Curve

For two factors K and L, the cost-minimizing condition is:

MPK pK

MPL pL

or

MPK MPL

pK pL

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Diminishing marginal returns and diseconomies of scale

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Diminishing Marginal Product vs. Diseconomies of Scale

Say Q = f(K,L) Diseconomies of scale: multiply K and L by a>1, then f(a*K,a*L) < a*f(K,L) Diminishing marginal product: At some point, for fixed K, f(K,L+1)-f(K,L) < f(K,L)-f(K,L-1)

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Different market structures

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Idea: consider both costs and demand!

MC p

ATC AVC AFC Q

New concepts: TR, AR and MR

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Idea: consider both costs and demand!

MC

ATC AVC AFC Q

New concepts: TR, AR and MR

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Should the Firm Produce at All? The rule: firm does not shut down if p>AVC How Much Should the Firm Produce? The rule: choose output where MR = MC.

Profits = (p - ATC) x q

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Summary
Perfect Competition Many small firms. All firms are price takers. Free entry and exit. Zero profits in the long run equilibrium. AR = MR = price Price = MC Monopolistic Competition Many small firms. Some market power. Free entry and exit. Zero profits in the long run equilibrium. Excess capacity Price > MC Price > MC Price > MC Oligopoly Few large firms. Considerable market power. Often significant entry barriers. Profit depend on the nature of the rivalry and on entry barriers. Monopoly Single firm faces the entire market demand. Total market power. Entry barriers Profits can persist if sufficient entry barriers.

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Perfect competition vs other market structures

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Perfect Competition: Short Run

Perfect Competition: Long Run

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Monopolistic Competition: Short Run

Monopolistic Competition: Long Run

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Monopoly
Cartels Effects of cartels, problems that cartels face Price discrimination Types of price discrimination Consequences of perfect price discrimination

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Oligopoly: Nash Equilibrium

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As output One-half monopoly output One-half monopoly output Cooperative Two-thirds monopoly output

Bs output

20

20

15

22

Outcome Nash

Two-thirds monopoly output

22

15

17

17

equilibrium

But notice that the Nash equilibrium does not maximize joint profits this is the classic example of the prisoners dilemma!
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Demand curves for firms in different market structures