Chapter 7

Offer Curves
and the Terms
of Trade

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
 Learning Objectives
 Formulate a country’s offer curve and show
how it is obtained.
 Identify how the equilibrium international
terms of trade are attained.
 Explain how changes in supply and demand
conditions influence the international terms
and volume of trade.
 Demonstrate the usefulness of different
concepts of the terms of trade.

7-2
 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.

7-3
Y

C P
Y1
Y2 (PX/PY)1

Y X1 X2 X

(PX/PY)1

Y5
X5 X 7-4
Y
Y3

(PX/PY)1
Y4

(PX/PY)2

Y X3 X4 X
(PX/PY)2

(PX/PY)1
Y6

Y5
X5 X6 X 7-5
Y
Y3

(PX/PY)1
Y4

(PX/PY)2

Y X3 X4 X
OCA (PX/PY)2

(PX/PY)1
Y6

Y5
X5 X6 X 7-6
 Offer Curves

 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.

7-7
Deriving Country B’s Offer
Curve
 This will reflect 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.

7-8
Y
(PX/PY)1

p
Y7
c
Y8

Y X7 X8 X

(PX/PY)1

Y9

X9 X 7-9
Y
(PX/PY)1

Y10

(PX/PY)2
Y11

Y X10 X11 X

(PX/PY)1
(PX/PY)2
Y12 OCB
Y9

X9 X12 X 7-10
 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.

7-11
 Terms of Trade
Equilibrium
OCA
Y (PX/PY)E

OCB
Y1
If these are the terms of trade,
country A will desire to export
X1 units, and country B will
want to import X1 units.

X1 X 7-12
 Terms of Trade
Equilibrium
OCA
Y (PX/PY)E

OCB
Y1
If these are the terms of trade,
country A will desire to import
Y1 units, and country B will
want to export Y1 units.

X1 X 7-13
 How Do We Know It’s
Equilibrium?
 Any terms of trade other than
(PX/PY)E will result in
• excess demand for one good, and
• excess supply for the other.
 Therefore relative prices will adjust
until (PX/PY)E is reached.

7-14
 Disequilibrium
OCA
Y (PX/PY)1

OCB

X 7-15
 Disequilibrium
OCA
Y (PX/PY)1

Y1
OCB

Y2 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.

X 7-16
 Disequilibrium
OCA
Y (PX/PY)1

OCB

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.
X2 X1 X 7-17
 Disequilibrium

 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.

7-18
 Moving Towards
Equilibrium
OCA
Y (PX/PY)
1

OCB

X 7-19
 Disequilibrium

 Terms of trade lines that are flatter

than (PX/PY)E, such as

7-20
 Disequilibrium
OCA
Y (PX/PY)2

OCB

X 7-21
 Disequilibrium

 Terms of trade lines that are flatter

than (PX/PY)E will results in
• an excess demand for good X,
and
• an excess supply of good Y, and
so
 (PX/PY) will rise.
 That is, the terms of trade line will
get steeper until (PX/PY)E is reached.

7-22
 Moving Towards
Equilibrium
OCA
Y (PX/PY)2

OCB

X 7-23
 A Note on the Terms of
Trade
 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.

7-24
 A Note on the Terms of
Trade, continued
 As A’s terms of trade (PX/PY)
improve, B’s terms of trade (PY/PX)
must be deteriorating and vice-
versa.

7-25
 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 or
• changes in supply conditions.
7-26
 Demand Changes in
Country A
OCA
Y (PX/PY)E

OCB
Y1

X1 X 7-27
 Demand Changes in
Country A
OCA OCA'
Y (PX/PY)E

OCB

Increased demand for imports

by Country A causes a
rightward shift of A’s offer
curve.

X 7-28
 Demand Changes in
Country A
OCA OCA'
Y (PX/PY)E
(PX/PY)E'

OCB
Y2

Volume of trade increases, but

A’s terms of trade go down. B’s
terms of trade improve.

X2 X 7-29
 Demand Changes in A

 Any change that might make A

demand more imports leads to a
rightward OC shift, and thus
• an increase in trade volume, and
• a decrease in A’s terms of trade.

7-30
 Demand Changes in
Country B
OCA
Y (PX/PY)E

OCB
Y1

X1 X 7-31
 Demand Changes in
Country B
OCA
Y (PX/PY)E

OCB'

OCB

Increased demand for imports

by Country B shifts B’s OC
upward.

X 7-32
 Demand Changes in
Country B
OCA
Y (PX/PY)E
(PX/PY)E'
OCB'

Y2 OCB

Volume of trade increases,

but Country B’s terms of trade
decrease (and A’s terms of
trade improve).

X2 X 7-33
 Other Demand Changes

 Any decrease in a country’s

willingness to trade will shift its OC
leftward or downward.
 An example is when a country
imposes an import tariff.
 Tariffs therefore lead to decreased
trade volume, but improve the
imposing country’s terms of trade.

7-34
 Supply Changes

 Changes in supply conditions will

also shift a country’s offer curves
around.
 Examples include
• productivity changes, and
• discovery of new resources.

7-35
 Offer Curve Elasticity

 Until now, we’ve been dealing with

offer curves that are elastic.
 Offer curves can also be unit
elastic or even inelastic.
 The shape of the offer curves
depends on the elasticity of
demand for imports:
% Qd imports
%Pimports
7-36
 Offer Curve Elasticity
Y

From origin to point A, offer curve

B is elastic.
Y1 Between points A and B, offer curve
is inelastic.
At point A, offer curve is unit
A elastic.

X1 X
7-37
 Offer Curve Elasticity

 Over the elastic range, a 1%

change in the relative price of
imports will lead to a greater than
1% change in quantity of imports
purchased.
 Over the inelastic range, a 1%
change in the relative price of
imports will lead to a less than 1%
change in quantity of imports
purchased.
7-38
 Offer Curve Elasticity

 Recall that in general a country

gives up its export good in order to
purchase its import good.
 Over the elastic range, a relative
decline in the import price induces
a country to give up more of the
export good in order to buy more of
the import good.

7-39
 Offer Curve Elasticity

 Over the inelastic range, when

there is a relative decline in the
import price, a country is willing to
give up less of the export good in
order to buy more of the import
good.
 This would occur if the income
effect of a price change outweighs
the combined effects of
substitution and production.
7-40
 Other Concepts of the
Terms of Trade
 We’ve focused on the commodity
terms of trade so far, but there are
others:
• Income Terms of Trade
• Single Factoral Terms of Trade
• Double Factoral Terms of Trade

7-41