Question

The counterpart to immobile factors on the supply side would be lack of substitution on the demand side. Imagine an economy where consumers always buy goods in rigid proportions (for example, one yard of cloth for every pound of food) regardless of the prices of the two goods. Show that an improvement in the terms of trade benefits this economy as well. Note: Show graph and label key points in the graph.

Answer 1

Sometimes both demand side and supply side will be unresponsive to relative price changes. In these economies Production Possibility Frontier (PPF) will be right angled whereas the indifference curve will L shaped. PPF shows the combinations of output that the economy can possibly produce.

[The economy can produce any combination on or inside the PPF curve. An indifference curve connects points on a graph representing different quantities of two goods, points between which a consumer is indifferent. Since there is lack of substitution between cloth and food the indifference curve will be L shaped]

If the PPF is right angled, an increase in terms of trade will increase the total welfare in the economy. The production point is at the corner of PPF, whereas the consumption point is at the tangency of the relative price line and highest indifference curve. Since there is no supply response, the economy receives more for the exports it supplies and pays less for the imports it purchases. So, when there is an improvement in the terms of trade relative price line relative price line rotates about its intercept with PPF rectangle (production point is fixed since there is no substitution of immobile factors).

Here in this case an increase in terms of trade will shift the economy to higher indifference curve, thereby achieving more welfare. A ray from the origin represents the income expansion path. A terms of trade improvement moves the consumption point further out along the income expansion path.