The Importance of Offer Curves
In general, an offer curve shows the quantity of one good that an agent will export for each quantity of another good that it imports (Helman Krugman, 1989, p. 85). The Offer Curve is essentially derived from the country s PPF. Suppose that there is a country named A which enjoys both goods X and Y. The country is better at producing X, but wants to consume both goods. Now, at point C, the country is in autarky. The country can produce two units of Y for four units of X.
As trade begins with another country, A will start to specialize in the production of X. At point B, it can trade with another country and consume at point S. When full specialization occurs, country A produces at point A and consumes at point T (note that this is a higher indifference curve). In effect, the price has been reduced to one X for one Y. The economy is in the state of equilibrium.
There are important points to remember. If two large countries are trading, then the terms of trade are determined by each country s willingness to trade at a particular price ratio. If a country increases demand for imports, there is always an accompanied increase in willingness to supply exports to purchase those imports. Therefore, an increase in the demand for imports, or an increase in the supply of exports can be summarized as an increase in a country s willingness to trade. The effects of shifts in a country s willingness to trade depend on the import-demand elasticity of the partner country (Markusen et al, 1994). Greater demand for a country s exports can lead to a decrease in exports if the exporting country has inelastic demand for the partner country s imports. Growth that leads to a greater willingness to trade can generally lead to a deterioration or decrease in the country s terms of trade if the partner country has inelastic demand for imports from the growing country. Therefore one country s terms of trade is the inverse of the partner country s terms of trade.
Equilibrium is found at the relative price for the two goods where each is willing to purchase what the other country wants to sell. If a country s productive capacity (PPF) or its preference changes, it become more or less willing to trade at all price ratios. Now, the slope of the offer curve reflects the elasticity demand for imports (see the diagram).
Note that the slope of the offer curve is less than 1. The implication if a country faces inelastic demand for its exports, then the country can lose access to imports from growth. Suppose that a country exports wheat. Now, the demand for wheat is inelastic. The country s productive capacity increases that now, it produces more wheat. Instead of earning more revenue, the terms of trade deteriorate, and the country can buy fewer imports than before it can increase its output of wheat. Hence, an increase in the world price of, say, good X leads country A to buy more imports from country B, but uses fewer exports to purchase the imports. Country B faces inelastic demand for good Y. There is another possible scenario. Country B becomes more willing to trade through growth, but the effect is to lower its ability to import X, even though it is exporting more of good Y to A.
In general, the offer curve shows the demand-supply dynamics of economic participants, as it relates to international trade. As shown earlier, economic factors play an important role in determining world price ratios. Some of the economic factors are relative price ratios, expansioncontraction of production possibilities frontier, preference changes, and demand elasticity. The offer curve aggregates these factors into a single frame of analysis. Tariff rates and subsidies are generally determined by offer curves.
In general, tariffs and subsidies drive a wedge between the prices at which goods are traded internationally and the prices at which they are traded within a country. The terms of trade are intended to measure the ratio at which countries exchange goods. The terms of trade, as determined by the offer curve, correspond to external not internal prices. When analyzing the effects of a tariff or export subsidy supply and demand are deemed functions of external prices.
An analysis of offer curves is derived from the nation s production frontiers and indifference maps. In general equilibrium analysis, all market are considered, not just, say, for commodity X. This is very important because changes in the market for commodity X affect other markets and give rise to important influence on the market for commodity X itself. On the other hand, partial equilibrium analysis only uses demand and supply curves. It does not consider the influence and the relations which exist between the market for commodity X and the market for all other commodities in the economy.
Empirically, how do offer curves show the forces which determine world equilibrium price ratios In developing countries, price volatility is a common phenomenon. If general prices are plotted in a modified offer curve, then variable price wedges are common (Markusen et al, 1994). Now, if both importers and exporters agree on a target price and if the industrialized consuming countries are willing to provide initial financing, the stabilization fund purchases and restores the commodity whenever the market price falls below the target, thereby pushing it back. When market prices rise above the target, stocks are accumulated, pushing the price down. In a sense, analysis of offer curves provides concrete solutions for stabilizing world price ratios.
The offer curve indirectly shows the degree of export income volatility. The ability of countries to maintain their standard of living suffers when earning falls. Countries are likely to reduce their investment incomes and foreign earnings decline, which adversely affect their long-run growth (Bhagwati et al, 1998, p. 251). As economists argue, a long term answer to the problem of revenue volatility is product diversification. Countries that develop new or non-traditional export markets benefit from the fact that prices in these markets are not likely to change in the same direction all the time and the elasticity of demand for the individual goods is likely to be larger for a new entrant who accounts for a small share of the market.
In sum, the forces which determine world price ratios earnings volatility, aggregate supply and demand elasticity, price volatility, and investment level are determined by the use of offer curves.