Krugman_IM_ch05 - Chapter 5 The Standard Trade Model n...

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Chapter 5 The Standard Trade Model n Answers to Textbook Problems 1. Note how welfare in both countries increases as the two countries move from production patterns governed by domestic prices (dashed line) to production patterns governed by world prices (straight line). An increase in the terms of trade increases welfare when the PPF is right-angled. The production point is the corner of the PPF. The consumption point is the tangency of the relative price line and the highest indifference curve. An improvement in the terms of trade rotates the relative price line about its intercept with the PPF rectangle (since there is no substitution of immobile factors, the production point stays fixed). The economy can then reach a higher indifference curve. Intuitively, although there is no supply response, the economy receives more for the exports it supplies and pays less for the imports it purchases.
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17 Krugman/Obstfeld • International Economics: Theory and Policy, Eighth Edition 2. The difference from the standard diagram is that the indifference curves are right angles rather than smooth curves. Here, as terms of trade increase enables an economy to move to a higher indifference curve. The income expansion path for this economy is a ray from the origin. A terms of trade improvement moves the consumption point further out along the ray. 3. The terms of trade of Japan, a manufactures ( M ) exporter and a raw materials ( R ) importer, is the world relative price of manufactures in terms of raw materials ( p M / p R ). The terms of trade change can be
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Krugman_IM_ch05 - Chapter 5 The Standard Trade Model n...

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