BITS Pilani

Pilani Campus

Chapter 4
Demand and Supply, Offer Curves, and the
Terms of Trade
Instructor: Prof. Geetilaxmi Mohapatra1
 Introduction
 Previous Discussion
 Difference in relative commodity prices between two
nations in isolation is a reflection of their comparative
advantage and forms the basis for mutually beneficial trade.
 At equilibrium relative commodity price, trade is balanced
between both the nations.
• Here we will discuss
• 1) Partial equilibrium analysis

• 2) General equilibrium analysis using the

offer curves.
• 3) Concept of Terms of Trade

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 Partial Equilibrium
Analysis

The Equilibrium-Relative Commodity Price with Trade with Partial

Equilibrium Analysis.

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 Offer Curves

• Developed by Alfred Marshall and

Francis Ysidro Edgeworth
• Offer curve shows how much of its import
commodity the nation demand for it to be
willing to supply various amounts of its
export commodity.
• Offer curve incorporates both the elements
of demand and supply

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 Offer Curves

Offer curve shows nation’s willingness to

import and export at various relative
commodity prices.
Offer curve of a nation can be derived from
– 1) the nation’s PPF,
– 2) indifference map and

– 3) various hypothetical relative commodity

prices at which trade can take place.

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Derivation of the Offer
Curve of Nation 1

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Derivation and shape of the Offer
Curve of Nation 1
 Why is Nation 1’s offer curve bulging towards
the X axis and not towards Y axis?
 To induce N-1 to export more of X, the relative
price of commodity X must rise
 There are 2 reasons for it
1) N-1 incurs increasing opportunity cost in
producing more of commodity X (for export)
2) The more the commodity Y and less of
commodity X that N-1 consumes, with trade, the
more valuable to the nation is a unit of X at the
margin compared with a unit of Y.
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Formal Derivation of Nation
1’s Offer Curve

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 Derivation and shape of the Offer
Curve of Nation 2

 The offer curve for N-2 tells you how much imports of
commodity X, N-2 demands to be wiling to supply various
amount of commodity Y for exports.
 N-2 requires higher relative price of Y to be induced to
export more of Y.
 There are 2 reasons for it
 1) N-2 incurs increasing opportunity cost in producing
more of commodity Y (for export)
 2) The more the commodity X and less of commodity Y
that N-2 consumes, with trade, the more valuable to the
nation is a unit of Y at the margin compared with a unit of
X.

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Derivation of the Offer Curve of
Nation 2.

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The Equilibrium – Relative Commodity Price
with Trade – General Equilibrium Analysis
 The intersection of the two offer curves of the 2
nations defines the equilibrium relative commodity
price at which trade takes place between them.
 Only at this price, trade is balanced between the 2
nations.
 At any other relative commodity price, desired
quantity of imports and exports of the two
commodities would not be equal.
 It put pressure on the relative commodity price to
move towards its equilibrium level.

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Equilibrium-Relative Commodity Price with
Trade.

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 The Terms of Trade

The terms of trade of a nation are defined as the ratio of

the price of its export commodity to the price of its import
commodity.
This ratio is usually multiplied by 100 in order to express
the ToT in percentage.
Nation 1 exports commodity X and imports commodity Y,
the ToT of Nation 1 are given by PX/PY
 (When PX/PY=1 means 100 percentage)
 Nation 2 exports commodity Y and imports commodity
X, the ToT of Nation 2 are given by PY/PX
As for a two-nation world, the exports of a nation are the
imports of its trade partner, the ToT of the later are equal to
the inverse, or reciprocal , of the ToT of the former.
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Usefulness of the Model

 1. Trade improvement
 An improvement in a nation’s ToT is usually regarded as
beneficial to the nation in the sense that the prices that the
nation receives for its exports rise relative to the prices that
it pays for imports.
 2. Trade deterioration
 An deterioration in a nation’s ToT is usually regarded as
harmful to the nation in the sense that the prices that the
nation receives for its exports decrease relative to the
prices that it pays for imports.
 What happens when one nation’s ToT improves?
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 Usefulness of the Model

General Equilibrium Model

– It shows the conditions of production, supply in the two
nations,
– the tastes or demand preferences,
– the autarky point of production and consumption, the
equilibrium-relative commodity price in the absence of trade,
– and the comparative advantage of each nation;
It also shows the
– degree of specialization in production with trade,
– the volume of trade, the terms of trade, the gains from trade,
and the share of these gains going to each of the trading
nations.

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 Usefulness of the Model

The Further Extension of the Trade

Model
 To identify the basis for comparative
advantage;
 To examine the effect of international trade
on the returns, or earnings of resources or
factors of production in the two trading
nations.

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BITS Pilani, Pilani Campus
BITS Pilani, Pilani Campus
BITS Pilani, Pilani Campus
BITS Pilani, Pilani Campus
BITS Pilani, Pilani Campus
BITS Pilani, Pilani Campus
BITS Pilani, Pilani Campus
BITS Pilani, Pilani Campus
BITS Pilani, Pilani Campus
BITS Pilani, Pilani Campus