Offer Curves and the Terms of Trade

Partial and General Equilibrium analysis

The equilibrium international price ratio will be one such that the quantity supplied of
exports from each country will equal the quantity demanded for those exports by the
other country.
If the quantities supplied and demanded are not equal, then the international price
ratio will change until the quantity supplied equals the quantity demanded
The equilibrium international price ratio can be shown in two ways:
1. Partial equilibrium analysis: describes the equilibrium international price ratio by
looking at supply and demand in one industry, which assumes that any changes in
that industry are not large enough to affect other industries.
Partial equilibrium analysis uses the familiar tools of supply and demand to show
equilibrium
2. General equilibrium analysis: considers all industries simultaneously (which is
simply two industries in our simple model) in order to capture inter-industry effects
within each nation.
General equilibrium analysis uses offer curves to establish the relative price at
which quantity supplied equals quantity demanded for both exports and imports.

The offer curve of a nation (also called the reciprocal demand curve): shows at
each relative price the quantity supplied of exports and the quantity demanded for
imports.
 International equilibrium occurs when the quantity supplied of exports equals the
quantity demanded for imports by the other country, or where the offer curves
intersect.
 The international price ratio is known as the terms of trade.
 The terms of trade is defined as the ratio of the price of exports to the price of
imports.
 For two trading countries, because one country’s imports are another’s exports, the
terms of trade of one country is just the inverse of the terms of trade of the other.

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 The Equilibrium-Relative Commodity Price with Trade—
Partial Equilibrium Analysis

 At PX /PY larger than P1, Nation 1’s excess supply of commodity X in panel A gives
rise to Nation 1’s supply curve of exports of commodity X (S) in panel B.
 On the other hand, at PX /PY lower than P3, Nation 2’s excess demand for
commodity X in panel C gives rise to Nation 2’s demand for imports of commodity X
(D) in panel B.
 Panel B shows that only at P2 does the quantity of imports of commodity X
demanded by Nation 2 equal the quantity of exports supplied by Nation 1.
 Thus, P2 is the equilibrium PX /PY with trade.
 At PX /PY > P2, there will be an excess supply of exports of commodity X, and this
will drive PX /PY down to P2.
 At PX /PY < P2, there will be an excess demand for imports of X, and this will drive
PX /PY up to P2.

Offer Curves
 Comprise all combinations of a country’s desired exports and imports at different
terms of trade.
 Are also known as reciprocal demand curves (J.S. Mill).
 Measure a country’s willingness to trade.
 Can be derived from the PPF-indifference curve graph.

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Deriving Country A’s Offer Curve

 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 reflects 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.
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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.
 If these are the terms of trade, country A will desire to export 60 units of X, and
country B will want to import 60 units of X
 If these are the terms of trade, country A will desire to import 60 units of Y, and
country B will want to export 60 units of Y.

Any terms of trade other than (PX/PY)E (PB) (PB’) will result in
 Excess demand for one good
 Excess supply for the other

Therefore relative prices will adjust until (PX/PY)E is reached.

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 Disequilibrium

 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.
 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.
 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.

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Note that: 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.
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
 Changes in supply conditions.

Demand Changes in Country A

Increased demand for imports by Country A causes a rightward shift of A’s offer
curve.
Volume of trade increases, but A’s terms of trade go down. B’s terms of trade
improve.

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.

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 Chapter (3) Questions
Multiple Choice Questions (MCQs)
1. Which of the following statements is correct?
a. The demand for imports is given by the excess demand for the commodity
b. the supply of exports is given by the excess supply of the commodity
c. the supply curve of exports is flatter than the total supply curve of the commodity
d. all of the above
2. At a relative commodity price above equilibrium
a. the excess demand for a commodity exceeds the excess supply of the commodity
b. the quantity demanded of imports exceeds the quantity supplied of exports
c. the commodity price will fall
d. all of the above
3. The offer curve of a nation shows
a. the supply of a nation's imports
b. the demand for a nation's exports
c. the trade partner's demand for imports and supply of exports
d. the nation's demand for imports and supply of exports
4. The offer curve of a nation bulges toward the axis measuring the nations
a. import commodity
b. export commodity
c. export or import commodity
d. nontraded commodity
5. Export prices must rise for a nation to increase its exports because the nation:
a. incurs increasing opportunity costs in export production
b. faces decreasing opportunity costs in producing import substitutes
c. faces decreasing marginal rate of substitution in consumption
d. all of the above
6. Which of the following statements regarding partial equilibrium analysis is false?
a. It relies on traditional demand and supply curves
b. it isolates for study one market
c. it can be used to determine the equilibrium relative commodity price but not the
equilibrium quantity with trade
d. none of the above
7. Which of the following statements regarding partial equilibrium analysis is true?
a. The demand and supply curve are derived from the nation's production frontier and
indifference map
b. It shows the same basic information as offer curves
c. It shows the same equilibrium relative commodity prices as with offer curves
d. all of the above
8. In what way does partial equilibrium analysis differ from general equilibrium analysis?
a. The former but not the latter can be used to determine the equilibrium price with trade
b. the former but not the latter can be used to determine the equilibrium quantity with
trade
c. the former but not the latter takes into consideration the interaction among all markets
in the economy
d. the former gives only an approximation to the answer sought.
9. If the terms of trade of a nation are 1.5 in a two-nation world, those of the trade partner
are:
a. 3/4
b. 2/3
c. 3/2
d. 4/3

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10. If the terms of trade increase in a two-nation world, those of the trade partner
a. Deteriorate
b. Improve
c. remain unchanged
d. any of the above
11. If a nation does not affect world prices by its trading, its offer curve
a. is a straight line
b. bulges toward the axis measuring the import commodity
c. intersects the straight-line segment of the world's offer curve
d. intersects the positively-sloped portion of the world's offer curve
12. If the nation's tastes for its import commodity increases
a. the nation's offer curve rotates toward the axis measuring its import commodity
b. the partner's offer curve rotates toward the axis measuring its import commodity
c. the partner's offer curve rotates toward the axis measuring its export commodity
d. the nation's offer curve rotates toward the axis measuring its export commodity
13. If the nation's tastes for its import commodity increases:
a. the nation's terms of trade remain unchanged
b. the nation's terms of trade deteriorate
c. the partner's terms of trade deteriorate
d. any of the above
14. If the tastes for a nation import commodity increases, trade volume
a. Increases
b. Declines
c. remains unchanged
d. any of the above
15. A deterioration of a nation's terms of trade causes the nation's welfare to
a. Deteriorate
b. Improve
c. remain unchanged
d. any of the above
16. The equilibrium price and quantity for a commodity traded between two nations occurs
where
a. the slopes of the two offer curves are the same
b. the two offer curves intersect
c. the slopes of the two offer curves is equal to zero
d. the price ratio of good X for good Y is equals one
17. Suppose nation 1 is an importer of good X. In a general equilibrium framework, an increase
in the demand for good Y will
a. decreased the price of good X and increase the volume of imports of good X
b. decreased the price of good X and decrease the volume of imports of good X
c. increase the price of good X and increase the volume of imports of good X
d. increase the price of good X and decrease the volume of imports of good X
18. Suppose nation 1 is an importer of good X. In a general equilibrium framework, an increase
in the cost of producing good X in nation 2 will
a. decreased the price of good X and increase the volume of imports of good X
b. decreased the price of good X and decrease the volume of imports of good X
c. increase the price of good X and increase the volume of imports of good X
d. increase the price of good X and decrease the volume of imports of good X
19. It is possible to determine how much a nation will export over and above its domestic
consumption at various international prices, other things being equal, by finding a set of
equilibria. This schedule is:
a. the import demand curve for a nation
b. the export supply curve for a nation.
c. the production possibilities frontier for a nation
d. the “no-trade” equilibrium

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20. It is possible to determine how much a nation will import at various international prices,
other things being equal, by finding a set of equilibria. This schedule is the:
a. import demand curve for a nation
b. export supply curve for a nation
c. production possibilities frontier for a nation
d. “no-trade” equilibrium
21. International trade equilibrium occurs where:
a. there is no further way to increase production of any commodity
b. the home excess supply curve intersects with the home excess demand curve
c. the total world import demand curve intersects with the total world export supply
curve.
d. the amount produced in each nation is just equal to the amounts produced in every
other nation
22. The international relative price and total quantity of a traded good or service is
determined by:
a. labor shortages that occur worldwide
b. the World Trade Organization
c. the intersection of the total world import demand curve with the total world export
supply curve
d. natural resource availability compared with the industrial demand for those products.
23. If prices of a nation's exported products rise in comparison with prices paid for imports,
that nation experiences a:
a. rise in its international terms of trade
b. decline in its international terms of trade
c. reduction in its imports
d. reduction in its exports
24. Suppose that the U.S. price index for its imports rose from 100 to 120 from 2010 to 2011 and
the price index for its exports remained unchanged. Which of the following statements is
correct?
a. The U.S. terms of trade worsened between 2010 and 2011
b. The U.S. terms of trade improved between 2010 and 2011
c. The U.S. terms of trade improved in 2010 and worsened in 2011.
d. There was no change in the U.S. terms of trade between 2010 and 2011.
25. Suppose that there is an improvement in a country's terms of trade between 2010 and
2014. This improvement means that
a. the country can purchase more imports in 2014, with the same volume of exports as in
2010.
b. the country can purchase more exports in 2014, with the same volume of exports as in
2010.
c. the country needs to increase its exports in order to purchase the same volume of
imports as in 2010.
d. regarding its international trade, the country is worse off in 2014 than it was in 2010.

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 Home has a comparative advantage in wheat, and Foreign has a comparative advantage in
cloth. Once trade occurs, Home produces 1,000 bushels of wheat, and Foreign produces
1,000 yards of cloth. The following table shows the amount of wheat that Home is willing
to supply and Foreign is willing to buy at various international prices.

26. According to previous table, What is the international price of wheat?

a. 1 yard/bushel
b. 3 yards/bushel
c. 5 yards/bushel
d. 7 yards/bushel
27. According to previous table, In equilibrium, how many bushels of wheat will Foreign
import?
a. 900 bushels
b. 700 bushels
c. 500 bushels
d. 300 bushels

Home has a comparative advantage in wheat, and Foreign has a comparative advantage in
cloth. Once trade occurs, Home produces 1,500 bushels of wheat, and Foreign produces
1,000 yards of cloth. The following table shows the amount of wheat that Home is willing
to trade to acquire more cloth.

28. According to previous table, If the international price of cloth is 1.5 bushels of wheat per
yard, how many bushels of wheat will Home export to Foreign?
a. 1,050 bushels
b. 800 bushels
c. 700 bushels
d. 550 bushels

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29. According to previous table, If the international price of cloth is 1.5 bushels of wheat per
yard, how many yards of cloth will Foreign export to Home?
a. 500 yards
b. 600 yards
c. 700 yards
d. 1,150 yards
30. According to previous table, Suppose that Home's trade price rose from 0.5 bushel of
wheat per yard of cloth in 2009 to a bushel of wheat per yard of cloth in 2010. What does
this movement represent in terms of Home's terms of trade?
a. It is an improvement in Home's terms of trade
b. It is a deterioration in Home's terms of trade
c. There is no change in Home's terms of trade
d. The answer cannot be determined based on the information provided
31. According to previous table, Suppose that Home's trade price rose from 0.5 bushel of
wheat per yard of cloth in 2009 to a bushel of wheat per yard of cloth in 2010. Which of
the following statements is true?
a. Home's situation had greatly improved in 2010.
b. Home's situation had deteriorated in 2010.
c. Home's situation was the same as it was in 2009.
d. Home's situation had slightly improved in 2010.
32. According to previous table, Suppose that Home's trade price rose from 0.5 bushel of
wheat per yard of cloth in 2009 to a bushel of wheat per yard of cloth in 2010. We
conclude that the change in Home's export price means that Home was worse off in 2010
than it was in 2009. Which of the following statements best explains this conclusion?
a. Home had to export twice as much wheat to obtain a yard of cloth in 2010 as it did in
2009
b. Home had to export half as much wheat to obtain a yard of cloth in 2010 as it did in
2009
c. Home had to export the same amount of wheat to obtain a yard of cloth in both 2009
and 2010
d. Home had to export three times the amount of wheat to obtain a yard of cloth in 2010
as it did in 2009.
33. With other things unchanged, a rise in the average price of imports or a fall in the average
price of exports will
a. improve the terms of trade
b. worsen the terms of trade
c. expand the production possibilities frontier
d. contract the production possibilities frontier
34. An increase in the price of imported goods will:
a. increase the volume of imports
b. decrease the volume of imports
c. shift the production possibility frontier inward
d. shift the production possibility frontier outward

# Ans. # Ans. # Ans. # Ans. # Ans.

1 D 8 D 15 D 22 C 29 C
2 C 9 B 16 B 23 A 30 B
3 D 10 A 17 A 24 A 31 B
4 B 11 C 18 D 25 A 32 A
5 D 12 D 19 B 26 C 33 B
6 C 13 B 20 A 27 C 34 B
7 D 14 A 21 C 28 A

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