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ECON 4290 Study Guide - Midterm Guide: Contract Curve, Comparative Advantage, Edgeworth BoxExam

Course Code
ECON 4290
Xavier DeVassay
Study Guide

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Chapter 4
Applications and Interpretations
Chapter 4 combines the demand and production models studied thus far to derive some of
the most fundamental results in economics. The ultimate objective of economic analysis in
general is to assess how individuals fare as the economic environment changes. In
international trade, an important variable affecting the consumer's wellbeing is the
country's terms of trade. The terms of trade are affected by changes in worldwide demand
for and supply of tradable goods. Changing conditions in foreign countries may shift the
terms of trade, or, if the home country is large, the terms of trade may be altered by
changing conditions at home. By contrast, a small country is defined as a country unable
to affect the equilibrium prices in world markets.
Two issues that highlight the importance of the terms of trade, and therefore the
importance of world demand and supply elasticities, are the transfer problem and the
possibility of immiserizing growth. By increasing the supplies of some goods, growth
shifts a nation's production possibilities frontier outwards. We find that growth benefits a
small country; it may or may not benefit a large one. In general, secondary price effects
may dampen benefits from growth.
A transfer of real income always hurts the donor and helps the recipient if both countries
are small. However, world prices are likely to change as a result of the transfer if both
countries are large. From the perspective of the recipient, the terms of trade can improve
or worsen. If they were to worsen, can they ever worsen by so much that the offer of a
gift should be rejected?
The chapter closes with a discussion of some wider applications of the simple structure
presented up to this point.

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1. State at least two reasons why foreign demand for our exports might increase.
2. The price of oil went up fourfold between 1973 and 1974. Over the same period
the value of U.S. oil imports increased by a factor of three. Was American import
demand for oil elastic, unit elastic, or inelastic?
3. Is the elasticity of import demand for a given product likely to be larger in the
short run or in the long run?
4. What is the source of improved real income for a large country restricting
production of its export good?
5. Define growth.
6. If a large country is immiserized from growth, what must have happened to its
terms of trade?
7. True or False:
Growth is more likely to be immiserizing
(a) if growth is biased towards the imported good.
(b) the smaller is the growing country's elasticity of export supply.
(c) the larger is the trade partner's elasticity of import demand.
8. If the home country is immiserized from growth, is the foreign country necessarily
better off?
9. What is your advice to a government facing immiserizing growth?

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10. From 1982 to 1989 the annual trade deficit of the U.S. was rapidly increasing.
Suppose that countries have a taste bias for the goods in which they hold a
comparative advantage and thus export.
(a) How would the analysis of the transfer problem apply to the trade deficit?
(b) What would you expect would happen to the U.S. terms of trade from
1982 to 1989?
11. True or False:
When the home country, the exporter of clothing, makes a transfer to the foreign
country, which exports food, the terms of trade are likely to move against the
home country if both countries have high marginal propensities to consume
1. Preferred Elasticity of Trading Partner:
If foreign demand for our exports went up, would the foreigners prefer that our
export supply curve be of high or low elasticity?
2. Trade Restrictions and Terms of Trade:
The left panel of the following diagram illustrates the home country's export supply
curve of clothing and the foreign country's import demand curve for the same
product, while the right panel depicts the home country's import demand curve for
food and the foreign country's export supply curve of food.
(a) Illustrate the effect of imposing a ceiling on home exports in both panels.
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