a Standard model of a Trading Economy If the relative price of cloth, PPF, increases, the economy's consumption choice shifts from Di to D2 The move from DI to D2 reflects two effects Income effect Substitution effect It is possible that the income effect will be so strong that when P(PF rises, consumption of both goods actually rises, while the ratio of cloth consumption to food consumption falls Copyright C 2003 Pearson Education, Inc Slide 5-11
Copyright © 2003 Pearson Education, Inc. Slide 5-11 • If the relative price of cloth, PC /PF , increases, the economy’s consumption choice shifts from D1 to D2 . – The move from D1 to D2 reflects two effects: – Income effect – Substitution effect – It is possible that the income effect will be so strong that when PC/PF rises, consumption of both goods actually rises, while the ratio of cloth consumption to food consumption falls. A Standard Model of a Trading Economy
A Standard model of a Trading Economy Figure 5-4: Effects of a Rise in the Relative Price of Cloth Food production, QF W(Pc/PE) W2(PCPF)2 Cloth production, Qc Copyright C 2003 Pearson Education, Inc Slide 5-12
Copyright © 2003 Pearson Education, Inc. Slide 5-12 TT Figure 5-4: Effects of a Rise in the Relative Price of Cloth Q1 VV1 (PC/PF ) 1 Q2 VV2 (PC/PF ) 2 D2 D1 A Standard Model of a Trading Economy Cloth production, QC Food production, QF
a Standard model of a Trading Economy The Welfare Effect of Changes in the Terms of Trade Terms of trade The price of the good a country initially exports divided by the price of the good it initially imports A rise in the terms of trade increases a country 's welfare while a decline in the terms of trade reduces its welfare Copyright C 2003 Pearson Education, Inc Slide 5-13
Copyright © 2003 Pearson Education, Inc. Slide 5-13 ▪ The Welfare Effect of Changes in the Terms of Trade • Terms of trade – The price of the good a country initially exports divided by the price of the good it initially imports. – A rise in the terms of trade increases a country’s welfare, while a decline in the terms of trade reduces its welfare. A Standard Model of a Trading Economy