Big versus Small Countries and the Terms of Trade (15 minute read)
Learning Outcome:
At the end of this lesson, you will know how countries are defined as large or small in world markets, and how their market size affects terms of trade.Large vs. Small Countries
Large and small countries have different impacts on the world prices of commodities that they buy and sell in global markets. Size does not depend on the geographic or population size of the country. Size depends on a country's share in global trade in a commodity.
China provides a good example of a large country. Let's first consider its role in global electronics trade. 34% of world trade in electronics is sourced in China. When it experiences production shocks that cause its export supply to fall, such as the negative labor market effects of Covid, there is likely to be significant upward pressure on world electronics prices as buyers compete for the diminished supply. On the other hand, an increase in China's export supply of electronics could create a glut in the world market, pushing world prices down. China can also affect world prices when its imports account for a large share of world trade. China is the world's largest importer of soybeans and meat. A fall in its import demand, perhaps due to an imposition of import quotas, will shock world markets and likely lower the world prices of those commodities. Or, an increase in its import demand will tend to push world prices up.
But China - though a large economy - can also be a small country for some commodities. For example, it has limited exports of scientific instruments, so changes in its export supply will have limited effects on world prices of instruments. On the import side, China has limited imports of floor carpeting from foreign markets, so changes in its small quantity of carpet imports are unlikely to affect world prices.
Terms of Trade
The terms of trade describe the prices of a country's exports relative to its imports. It is calculated as the export price divided by the import price. Terms of trade is like bartering - how many imported bananas can I exchange for my exported apples? The quantities that can be exchanged will depend on the price of exported apples relative to the price of imported bananas.As an example, if apples are $10 per apple, and bananas are $2 per banana, then the terms of trade $10/$2 = five (Table 1). One apple can be exported in exchange for the import of five bananas.
| Initial terms of trade | World export price of apples (PWE) | World Import price of bananas (pwm) | Home country's terms of trade |
|---|---|---|---|
| Initial terms of trade | 10 | 2 | 5 |
| New terms of trade | 12 | 6 | 2 |
Terms of trade can improve or deteriorate. They improve if the export price increases relative to the price of the import, and deteriorate when the export price falls relative to the import price. Table 1 shows an example of a deterioration in the country's terms of trade. Prices of both apples and bananas increase, but the price of banana imports increases relative to the price of apple exports. With these price ratio changes from 5:1 to 2:1, the export of one apple is now exchanged for only 2 apples.
Large and Small Countries and the Terms of Trade
The size of a country in world markets determines whether a change in its export supply or import demand will affect its terms of trade. When a country has a large share in world markets, a change in its volume of trade with the world will affect its terms of trade if it causes world prices to change.
When a country is small in world markets, a change in the quantities of its export supply or import demand is unlikely to affect its terms of trade because its trade is too small to affect world prices.World Prices and the Terms of Trade in the UNI-CGE Model
In the UNI-CGE model, the world export price of commodity c, PWEc, is capitalized while the world import price of each commodity, pwmc, is in lower case. Recall the naming convention in our model, in which variable names are capitalized while the names of fixed parameters are in lower case. In the UNI-CGE model, PWE is an endogenous variable. Its value can change when export quantities change if the country is large in world markets. Its market size is determined by the export demand elasticity, edec. (You can learn more the about this elasticity in the lesson on Export Supply). Parameter pwm has a fixed value, which means that the country is implicitly defined as small in world markets because it cannot affect world prices for its imports.
Big in Export Markets, Small in Import Markets
Why does the UNI-CGE model allow the home country to be "big" in its export markets, but defines it as "small" in its import markets? This asymmetry is common in many single-country CGE models.
The treatment stems from the Armington assumption of product differentiation - that goods are differentiated by their source country. It follows that every country is the unique supplier of its export. Madagascar, for example, is the unique supplier of Madagascar vanilla beans. Madagascar, therefore, is a large country in world trade in Madagascar vanilla beans, so a change in its export supply is likely to affect its bean export price.
But, any single country is likely to be one of many who demand imports of a commodity in world markets. Many countries, for example, import Madagascar's vanilla beans. Any single importer, therefore, is unlikely to hold monopsony power in world markets. In the UNI-CGE model, the home country is always considered small in world markets for every commodity, and its world import price is fixed at its initial level.
Copyright: Cornerstone CGE 2024 CC 4.0 BY-NC-SA