ECON 3013/8015: International Economics - Honours and Graduate

Topic 2: Elasticities, Stability, and the Transfer Problem

Elasticity of the Offer Curve The elasticity of a countrys offer curve is equal to the absolute value of its elasticity of demand for imports, defined with respect to the relative price of the import good. That is, letting M denote the volume of imports, X the volume of exports, and PM/PX the price of the import good relative to the price of the export good, the elasticity of the offer curve is given by dM M = P PM d M PX PX Since, at each point on the offer curve, the price ratio PM/PX is just equal to the volume of exports offered divided by the volume of imports demanded, we can replace the above with dM M = X X d M M Then, noting that, for small changes, the proportionate change in a ratio is approximated by the proportionate change in the numerator minus the proportionate change in the denominator, we can write dM M = dX dM X M 1 = dX M . +1 dM X

or

Now consider a point such as Q on the offer curve shown in Figure 1. dX/dM is the reciprocal of the slope of the offer curve, BA/QA, while M/X is equal to QA/0A, so we have 1

BA + 0A BA QA 0B . +1 = = QA 0A 0A 0A

and therefore

0A 0B

Note that this elasticity value will be greater than 1 at points along the positively sloped (elastic) segment of the offer curve (such as point Q in Figure 1), will be equal to 1 at the point where the offer curve bends backwards (if it does), and will be less than one along any negatively sloped (inelastic) segment of the offer curve.

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Imports (M)

FIGURE 1
R

Exports (X)

Elasticities and Stability of Equilibrium: the Marshall-Lerner Condition When a good is in excess demand in world markets, its relative price will increase. Stability of the international trade equilibrium requires that this price change reduces the excess demand. An unstable equilibrium would be one where a rise in a goods relative price increased excess demand for it, causing a further price rise, leading to greater excess demand, etc. In the offer curve diagram of Figure 2, point Q is a stable equilibrium. At a relative price of wheat to cloth that is slightly less than the equilibrium terms of trade price ratio, such as is given by the slope of the line 0K, the foreign demand for wheat imports, 0A, exceeds the home supply of wheat exports, 0B, so there is world excess demand for wheat (and excess supply of cloth). This will cause the world price of wheat to rise relative to the price of cloth, rotating the terms of trade line back towards the equilibrium value, given by the slope of 0Q, and eliminating the excess demand. In order to get this stable outcome, each offer curve needs to cut the other from its concave side. We discuss the required condition more formally shortly. In the case shown in Figure 3, the equilibrium at point Q is unstable, with each offer curve cutting the other from its convex side. Here, excess demand for wheat occurs at a relative price of wheat to cloth that is greater than the equilibrium value (for example, with PW/PC as given by the slope of line 0J, the foreign demand for wheat imports exceeds the home supply of wheat exports by the amount FG). Since this excess demand will raise the world relative price of wheat, it will further increase PW/PC above the equilibrium value. Thus, starting from an unstable equilibrium, any small disturbance will result in a continuous movement away from that equilibrium point. Note, however, that although the equilibrium at point Q is unstable, the extent of movement away from this point in response to a shock is bounded by the existence of two equilibria, at S and T, that are stable. Thus, the potential instability problem is not that relative prices go on changing without limit but that there may be very large changes in world prices before a stable equilibrium is reached. In principle, it would be possible for there to be many intersections of two offer curves, alternating between stable and unstable equilibria. - 2 -

Cloth (Home Imports)

FIGURE 2
R

K Q R*

A Wheat (Home Exports)

Cloth (Home Imports)

FIGURE 3
J

S Q

T R* 0 F G Wheat (Home Exports)

The requirement for stability of the international trading equilibrium is the same Marshal-Lerner condition that should be familiar from the study of open economy macroeconomics. In that context, it is the condition required for a real exchange rate appreciation (defined as an increase in the relative price of home to foreign goods) to result in a reduction of net exports. The formal derivation is given below.

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Let p denote the terms of trade relative price cloth to wheat (PC/PW), M denote the volume of home imports of cloth, and M* denote the volume of foreign imports of wheat. The absolute home and foreign elasticities of import demand are then

=
For small changes,

dM M

dp p

and

* =
so

dM * M*

d (1 p ) (1 p )

d (1 p ) dp = , (1 p ) p

* =

dM * dp M* p

Foreign exports of cloth are equal to foreign imports of wheat multiplied by the relative price of wheat (1/p), so world excess demand for cloth is equal to M-M*/p and the stability condition that a rise in the relative price of cloth reduces excess demand for that good is dM d (M * p ) dp dp < 0 (1)

At the international trade equilibrium, M*/p = M so, dividing the numerators of (1) by M (or M*/p) and the denominators by p, we have dM / M d (M * p ) / (M * p ) dp / p dp / p and hence < 0

(dM * M *) (dp p ) dM / M dp / p dp / p

<

or

dM M dM * M * < 1 dp p dp p

where the left-hand side is equal to - and the right-hand side is equal to *-1. Rearranging, we get the Marshall-Lerner condition for stability of equilibrium that

+ * > 1
i.e. that the sum of the absolute values of the home and foreign elasticities of demand for imports should be greater than unity. Note that the elasticity of demand for imports can be decomposed into a pure substitution elasticity (moving around a constant indifference curve) plus the marginal propensity to consume the import good, which is also the marginal propensity to import since variations in consumption can only come from variations in the volume of imports. Denoting the absolute value of the substitution elasticity as c and the marginal propensity to import as m, we can write the Marshall-Lerner condition as c + m + c* + m* > 1 or (c+c*) + m > 1-m* (2) where 1-m* is the foreign marginal propensity to consume that countrys export good (cloth). Note that c 0 and c* 0, since substitution (if any) can only be away from cloth and towards wheat when the relative price of cloth increases. m and 1-m* may be greater or less than zero, depending on whether cloth is a normal or inferior good in consumption in the country in question. The intuition for the result given by (2) is as follows. At equilibrium, home cloth imports are equal to foreign cloth exports. A small increase in the relative price of cloth (an improvement in the foreign terms of trade and a deterioration in the home terms of trade) will, to a first order approximation, raise foreign real income and
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reduce home real income by the same amounts. If m > 1-m*, the fall in home income will reduce home cloth consumption by a greater amount than the rise in foreign income increases foreign cloth consumption, so overall world demand for cloth will decrease even if the two substitution elasticities are both zero (if cloth and wheat are perfect complements in both countries). If, however, m < 1-m*, the income effects of the price change will tend to raise world cloth demand, by a greater amount the larger is the difference in the marginal propensities, and this effect will need to be offset by a sufficiently high value of the combined substitution elasticities in order for world excess demand to fall.
The Transfer Problem

Attention was first drawn to the transfer problem by J.M.Keynes in discussing the likely effects of the severe reparation payments that were imposed on Germany after World War I. He argued that Germany would not only bear the direct cost of these payments but would also suffer a terms of trade deterioration that would exacerbate the adverse consequences for its population. This stimulated a debate, in particular with Bertil Ohlin, over the question whether a country making a transfer, such as a reparation payment or the payment of foreign aid, would suffer an additional (or secondary) burden due to a terms of trade deterioration. In the end, it turns out that the analytical answer is relatively straightforward, but indeterminate, although many argue that the usual presumption should still be that Keynes was right. In our two country context, a transfer takes place when one country gives some of its income to the other. The effect on the donor countrys terms of trade depends on whether the transfer increases or reduces world demand for its export good. If world demand for that good is increased, then its relative price will rise and the donor country will get the secondary benefit of an improvement in its terms of trade that will partly offset the direct cost of the transfer. If world demand for the export good falls, then the terms of trade will deteriorate and the country will suffer the sort of secondary burden about which Keynes was concerned. The effect of the transfer on world demand for the export good depends on the marginal propensities of the two countries to consume that good. Suppose that the home country, which exports wheat, makes a transfer to the foreign country of an amount that would, at original relative prices, purchase T units of wheat. Foreign country income rises by this amount and its consumption of wheat increases by its marginal propensity to consume wheat (its marginal propensity to import, m*) times the increase in income. Home country income falls by the amount T and its consumption of wheat decreases by its marginal propensity to consume wheat (one minus its marginal propensity to consume cloth and, hence, 1-m) times the reduction in income. Thus, the change in world demand for wheat, at constant prices, is [m*-(1-m)]T. The world relative price of wheat will rise or fall according to whether this is positive or negative. Thus, the donor country will get the secondary benefit of a terms of trade improvement if m* > (1 m) m* < (1 m) so that so that m + m* > 1 m + m* < 1 and will suffer the secondary burden of a terms of trade deterioration if

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Note, by referring back to (2), that the condition required for the donor country to obtain a secondary benefit also guarantees stability of the international trade equilibrium, although this condition is by no means necessary for stability.
Can it be Better to Give than to Receive?

Although there is a general presumption that countries will tend to have a higher marginal propensity to consume their export goods than do foreigners (see Krugman and Obstfeld, pp.101-102) so that a secondary burden is the more likely outcome, the possibility that the donor country might gain a secondary benefit raises the question whether, at least in principle, this could be sufficiently large that it outweighs the direct cost of the transfer and leaves the donor country better off than in the absence of the transfer. In fact, with two countries (but not necessarily in a multi-country setting) and if the two goods are not perfect complements, the donor must always be made worse off by making a transfer that is, the secondary benefit from a terms of trade improvement cannot be large enough to offset the direct cost. To see this, we ask whether a terms of trade change that would be large enough to leave the donor country exactly as well off as it was initially could be an equilibrium value for world prices. If the donor countrys welfare were unchanged, the welfare of the recipient country would also be unchanged (to a first order approximation for a small transfer). If neither countrys well-being changes, there will be no income effects resulting from the combination of transfer and terms of trade change, but the substitution effects due to the latter must cause both countries to consume less of the donor countrys export good. With a fixed world supply of that good, the lower demands must result in world excess supply and, therefore, the price ratio that would be required to leave the donor country with unchanged welfare cannot be an equilibrium value of world relative prices. The equilibrium must involve a lower relative price of the donors export good.

FIGURE 4
G S 0F

C1F

V Q

Cloth

C1H

0H

R - 6 -

T Wheat

The argument is illustrated in Figure 4, where the horizontal and vertical axes measure the total world endowment of wheat and cloth, respectively, with the home countrys endowment and consumption being measured from the origin 0H and the foreign countrys endowment and consumption being measured from the origin 0F. Suppose the initial endowment point is at E and that the two countries engage in trade, with Home exporting wheat and Foreign exporting cloth, to arrive at the post-trade equilibrium point Q, where Home is on its community indifference curve C1H and Foreign is on its community indifference curve C1F (these indifference curves have been pulled apart slightly from their point of tangency so as to make the diagram clearer). Note that, if we included the two countries offer curves in the diagram, they would have their origins at point E and intersect at point Q, with the equilibrium terms of trade price ratio of wheat to cloth being given by the slope of the line EQ. Now imagine that Home transfers the quantity of wheat EF to Foreign, so that the new endowment point from which the countries trade lies at F. In order for Home to be as well-off as at the original equilibrium, remaining on C1H, the relative price of wheat would need to rise so that it was equal to the slope of the line FG. At this terms of trade, Foreign would also remain on C1F (at least if the lump-sum transfer were sufficiently small we have made it relatively large in the diagram so that we can see what is happening). However, both countries will have substituted away from consumption of wheat, with Homes consumption point moving to V and Foreigns to W. Thus, Home will be demanding only 0HR wheat and Foreign will be demanding only 0FS wheat, leaving a total world excess supply of the amount RT. This excess supply will force the relative price of wheat below that given by the slope of FG, so the terms of trade can never improve sufficiently to make Home as well-off as before the transfer.
Immiserising Growth

Although a country cannot gain by giving away some of its endowment and cannot lose by being the recipient of a gift from another country, this is not to say that a country cannot gain by destroying some of its endowment or lose as a result of having some additional endowment bestowed upon it. The last case is referred to as immiserising growth, where a country is made worse off by an expansion in its production possibilities or, in our current case, by an exogenous increase in its endowment. The essential difference between the destruction of endowment and its transfer to another country is that the former changes world supply, whereas the latter does not. When the home country destroys some of its export good, this reduces total world supply of that good. So long as Homes marginal propensity to consume the export good is less than 1 (ie. the import good is strictly normal in consumption), home consumption of the exportable will not fall by as much as world supply has been reduced, so there will be excess world demand at unchanged prices and this will necessarily improve the home countrys terms of trade. This change in the terms of trade will reduce welfare in the foreign country. Consider again the possibility that the terms of trade improve sufficiently that the home country is exactly as well-off as initially. In Home, there will be a substitution effect that reduces consumption of the export good while, in Foreign, both the substitution and income effects will reduce consumption of that good. But world supply has also fallen and there is now no necessary presumption that these reductions

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in demand will exceed the reduction in supply. Thus, it is possible that, at the terms of trade that would leave the home country exactly as well-off as it was before it destroyed part of its export good endowment, there is still excess world demand for that good. In that case, the equilibrium terms of trade price ratio will be at a higher relative price of the export good and the home country will gain. J Cloth

FIGURE 5

M U S T R* W Q

C1

CB D

Wheat

In Figure 5, Homes initial endowment is at point E and, with the equilibrium terms of trade price ratio PW/PC = 0M/0N, it exports wheat and imports cloth to consume at point Q on C1. Now suppose that Home destroys the amount FE of wheat, shifting its endowment point to F. In order for Home to have the same level of welfare as initially, the terms of trade would need to improve to PW/PC = 0J/0K, which would allow Home to trade away from F to reach point S on C1. At this terms of trade Home would want to export the quantity AB of wheat. If this happens to coincide with the amount of wheat that Foreign wants to import at that terms of trade, then PW/PC = 0J/0K will be the equilibrium terms of trade and Home will be as well-off as before the destruction of wheat endowment. However, if Foreign wants to import more or less wheat than AB at this terms of trade, the equilibrium price ratio will be a value of PW/PC that is higher or lower than 0J/0K and Home will gain or lose, respectively, from the destruction of wheat endowment. In order for point Q to have been the initial equilibrium, the foreign offer curve drawn with its origin at E must have passed through Q. Since nothing has changed in the foreign country, its offer curve will have unaltered shape. Thus, if it is now drawn with its origin at F, it must pass through point T (which lies to the left of Q by the

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same distance as F lies to the left of E). One possibility is that the foreign offer curve has the shape shown by the solid line labelled R*, intersecting with the relative price line JK exactly at point S. In that case, PW/PC = 0J/0K will be the new equilibrium terms of trade and Home will neither gain nor lose from destroying part of its wheat endowment. However, if the foreign offer curve were more inelastic at the initial equilibrium so that it had the shape shown by the dashed segment TU, Foreigns desired imports of wheat at PW/PC = 0J/0K would exceed Homes desired exports by the amount CB, so the new equilibrium price ratio would be PW/PC > 0J/0K and Home would gain from destroying wheat endowment. On the other hand, if the foreign offer curve were less inelastic at the initial equilibrium, so that it had the shape shown by the dashed segment TW, Foreigns desired wheat imports would be less than Homes desired wheat exports by the amount BD at the terms of trade PW/PC = 0J/0K so the new equilibrium terms of trade value would need to be lower than this and Home would lose from destroying wheat endowment. It can be seen, then, that whether the home country can gain from destroying part of its export good endowment depends on whether the foreign offer curve is sufficiently inelastic at the initial equilibrium. Clearly, if that equilibrium were to lie on the elastic portion of the foreign offer curve, Home could never gain from destroying endowment. The immiserising growth case is simply the reverse of the above. If Home could gain from destroying wheat endowment, it must be made worse off if it receives an exogenous increase in its endowment of that good. Students should check their understanding by confirming this result in a diagram similar to Figure 5, but with the Home endowment of wheat being increased rather than reduced. Finally, it may be noted that, in contrast to the transfer case where it doesnt matter whether the endowment transferred consists of donor country export good or donor country import good (or some combination of the two), a country can only (possibly) gain from destroying part of its export good endowment. Destruction of import good endowment must always make it worse off because the reduced world supply of that good will raise its relative price and thus generate an adverse terms of trade change that reinforces the cost of the lost income.
PROBLEMS

1.

Imagine the case where the international trade equilibrium lies on the inelastic section of both the home and foreign countries offer curves such that both have the same (negative) slope at the point of intersection (ie if a line is drawn tangent to the home offer curve at this point, it will also be tangent to the foreign offer curve). Using the geometric representation of the elasticity of an offer curve, show that the sum of the (absolute values of) the home and foreign elasticities of demand for imports must be + * = 1. Now draw an offer curve diagram for the case in which the sum of these elasticities is + * < 1 at the intersection point. What can you say about the stability of the equilibrium at this point? Repeat the exercise for the case where + * > 1 at the intersection of the offer curves.

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2.

The economics of the transfer problem draws attention to the fact that an international transfer of purchasing power (such as a reparations payment or the payment of foreign aid) may impose a "secondary" burden or benefit on the transferor. (a) Explain what is meant by a "secondary" benefit and state and explain the conditions necessary for the transfer to produce such a benefit. If both the home and the foreign country have identical, homothetic preferences, what will be the effect of a transfer from the home country to the foreign country on the terms of trade? In the two country model we have been examining, is it possible for the secondary benefit to be so large that the transferor is actually made better off by the transfer (and the transferee made worse off)?

(b)

3.

Countries A and B are each endowed with quantities of cloth and wheat. At the free trade equilibrium, A exports wheat and B exports cloth. Now consider each of the following changes to the initial setting. (i) (ii) (iii) an exogenous increase in Bs endowment of wheat by Z units; an exogenous reduction in As endowment of wheat by Z units; and a transfer of purchasing power from A to B of an amount sufficient to purchase Z units of wheat at initial prices.

Without any further information, to what extent is it possible to rank these changes in terms of their effects on economic welfare in country A and B? If you knew that country A would benefit from (ii) would that allow a more definitive ranking?

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