Terms of Trade and Dynamic Effects

Abstract

In the analysis of Chapter 7 the assumption of perfect competition was extended to the world market and not merely to domestic markets. In particular it was assumed that the countries forming a customs union represented so small a share in the total world trade in a product, even collectively, that the world market price of that product was unaffected by changes in the union’s demand for imports of it. Hence the rest-of-the-world supply curves used in earlier diagrams were shown as horizontal lines, implying that the world price was fixed regardless of the union’s demand for the product. The customs union, in other words, was ‘small’ in relation to the total world market. The assumption is not always realistic. As noted in Chapter 3, in 1988 the European Community of twelve countries accounted for more than a third of total world imports; even excluding intra-community trade it accounted for around 22 per cent of world imports. This is not small by any standards; the consequences of removing the assumption of a ‘small’ customs union therefore need to be investigated.