Chapter 4.

1 LESSON SUMMARY
1. Trade raises real incomes of trading countries.
Real income is simply inflation-adjusted income, measures the amount of disposable income available to
consumers.

2. The gross national income (GNI) is the sum of the value added by all the goods and services produced within a
particular country, including foreign investment, to which are added any product taxes (excluding subsidies),
and the value earned by the nation through overseas ventures.

3. There are at least two reasons why trade has an important influence upon the income distribution:
a) Resources (factors of production: land, labor, and capital) cannot be transferred immediately and without
costs from one industry to another,
b) Industries use different factors and a change in the production mix a country offers will reduce the
demand for some of the production factors and increase the demand for other production factors.

4. A factor of production is any resource that is used by firms to produce goods and services

5. The specific factor (SF) model was originally advanced by Jacob Viner, and it is a variant of the Ricardian
model.

The Ricardian model of trade was developed by English political economist David Ricardo in his magnum opus
On the Principles of Political Economy and Taxation (1817). It is the first formal model of international trade.

6. The modern version of the Ricardian model assumes that owners (countries) of factors of production for
products that are in demand would receive an increasing part of the world's global income.

7. The SF model is sometimes referred to as the Ricardo-Viner model.

8. Paul Samuelson and Ronald Jones, two American economists, elaborated the SF model based on specific
factors, which are, in fact, the factors of production-land, labor, and capital, Jones and Samuelson decided to
call these factors territory or terrain (T) (terra means land), labor (L), and capital (K)

9. Jones and Samuelson say that products like food (X) are made by using territory (T) and labor (L), while
manufactured products (Y) use capital (K) and labor (L).

Labor (L) is a mobile factor, one that can be used in both food and manufactured products.
Territory and capital are specific factors, territory (T) is used only for food and capital is used only for
manufactured products.

10. When labor moves from food to manufactured product, food production falls while output of the
manufactured product rises. The shape of the production function reflects the law of diminishing marginal
returns

11. The law of diminishing marginal returns is a theory in economics that predicts that after some optimal level of
capacity is reached, adding an additional factor of production will actually result in smaller increases in output.
12. Therefore, a country rich in capital and poor in land tends to produce more manufactured products than food
products, whatever the price. A country rich in land (territory), like most agricultural countries, tends to
produce more food.

13. Other factors held constant, an increase in capital will mean an increase in marginal productivity from the
manufactured sector, while an increase in territory will increase the production of food. It is, therefore,
important for those countries rich in capital and those countries rich in territory to trade with each other.

Chapter 4.2 LESSON SUMMARY

1. The standard model of trade (Paul Krugman-Maurice Obsfeld model) implies the existence of the relative
global demand curve resulting from the different preferences for a certain good and relative global supply
curve resulting from the different production possibilities
2. According to Paul Krugman and Maurice Obsfeld, the exchange rate, the rapport between the export prices
and the import prices, is determined by the intersection between the two curves, which is the equilibrium.
Relative prices determine the economy's output. Other factors being constant, the exchange rate improvement
for a country implies a substantial rise in the welfare of that country

3. Global demand or total demand refers to amount of money, which subjects (consumers) of an economy plan
to spend on goods and services at the different size of income or at given prices in a given period. Total
demand consists of personal consumption of households and individuals, gross private domestic investment
by businesses, gross government spending and net export.

4. Net exports are a measure of a nation's total trade. The formula for net exports is a simple one: The value of a
nation's total export goods and services minus the value of all the goods and services it imports equal its net
exports.

5. Market equilibrium is the intersection of the global demand curve and the global supply curve.
Market/economy equilibrium means that the national product and level of prices are shaped on the level on
which buyers are willing to buy what enterprises are ready to sell.

6. The aggregate demand curve shows how many goods and services consumers can and are willing to buy at
different total price levels, other conditions remaining the same. The size of purchases made by consumers
influences prices. The size of global demand changes the level of prices inversely. The crucial factor is the
elasticity of global demand in relation to interest rates or level of global wealth.

7. The supply curve represents the relationship between price and quantity supplied, with all other factors
affecting supply held constant. Quantity supplied (supply curve) is a function of price. A shift in the supply
curve happens when a nonprice determinant of supply changes and the overall relationship between price and
quantity supplied is affected.
8. The standard trade model is a general model that includes the Ricardian model, the Ronald Jones and Paul
Samuelson specific factors model and the Heckscher-Ohlin (H-O) model as special cases-two goods, food (F)
and cloth (C). Each country's production possibility frontier (PPF) is a smooth curve.

9. The standard trade model assumes the following

a) Each country produces two goods, food (F) and cloth (C)
b) Each country's production possibility frontier (PPF) is a smooth curve (TT).
c) The point on its PPF, at which an economy actually produces, depends on the price of cloth relative to
food, PC/PF.
d) Isovalue lines are lines along which the market value of output is constant.

10. A country's production possibility frontier (PPF) determines its relative supply function because it shows what
the country is capable of producing which should be maximized. National relative supply function determines
the world relative supply function, which along with world relative demand determines the equilibrium under
international trade

11. The slope of an isovalue line (relative price of cloth to food) equals PC/PF. The best point to produce is where
PPF is tangent to the isovalue line, a line of slope equal to the relative prices.

12. The value of an economy's consumption equals the value of its production: The economy's choice of a point
on the isovalue line depends on the tastes of its consumers, which can be represented graphically by a series
of indifference curves.

13. The standard trade model is built on four key relationships:

a) the relationship between the PPF and the world relative supply (RS) curve:
b) the relationship between relative prices (RP) and relative demand (RD);
c) the world equilibrium as determined by world RS and RD; and
d) how changes in the terms of trade affect a nation's welfare.

14. The world relative supply curve (RS) is upward sloping because an increase in the price of cloth/ price of food
(PC/PF) leads both countries to produce more cloth and less food.

15. The world relative demand curve (RD) is downward sloping because an Increase in price of cloth/ price of food
PC/PF leads both countries to shift their consumption mix away from cloth toward food

16. Terms of trade (TOT) means the price of a country's exports divided by a country's imports.

17. Generally, a rise in the TOT Increases a country's welfare, while a decline in the TOT reduces its welfare.
Intuitively, if TOT falls, price of what a country produces goes down relative to price of what the country
consumes. The relationship between TOT, total price of production, and a country's welfare is direct

Chapter 4.3 LESSON SUMMARY

1. According to the Heckscher-Ohlin theory (factor proportions theory), a country rich in a particular resource
should be exporting products that will use that resource and import products made from resources that the
country lacks

2. The first serious attempt to test the H-O theory was made by Russian-bom American economist Wassily W.
Leontief in 1953 when he studied the US economy closely The H-O theory predicts that the US would export
more capital-intensive goods and import labor-intensive goods. However, Leontiel was surprised to discover
that the US was actually exporting labor-intensive goods and importing capital-intensive goods. His analysis
became known as the Leontief paradox.

3. The Leontief paradox showed that in the international division of labor, the US specialized in labor intensive
rather than capital intensive goods.

4. A paradox is a seemingly absurd or self-contradictory statement or proposition that when investigated or

explained may prove to be well-founded or true

5. Wassily Leontief received a Nobel prize in 1973 for his contribution to the input-output analysis. Three of his
students, Paul Samuelson (specific factor model), Robert Solow, and Vernon Smith also received Nobel prizes