The theory of international trade has long been recognized as a rich field of application for general equilibrium models that are sufficiently simple to reveal the crucial role of demand and supply in affecting prices and outputs in a single market or in a few interrelated markets. Although the importance of both blades of the Marshallian scissors has frequently been noted, I think it is fair to say that the role of supply has been singled out for prime consideration, especially in the classical developments of comparative advantage theory associated with Ricardo and Graham, and in the voluminous literature on Heckscher-Ohlin models with its emphasis on relatice factor abundance and factor intensities. There are, however, some traditional questions in trade theory in which the specification of demand behavior assumes central importance. The possibility that growth may be immiserizing is one of these. The effect of transfer payments on the terms of trade is another. Perhaps even more basic is the concern with stability in equilibrium and the possibility of multiple free trade equilibria in commodity markets and markets for foreign exchange. It was this issue that Egon Sohmen addressed in his first publication, "Demand Elasticities and the Foreign-Exchange Market."
In this paper I intend to discuss the importance of demand for some propositions in trade theory by explicitly considering two "extreme" forms of demand behavior and one "intermediate" form. My focus is on the degree of substitutability between commodities that consumer express in their utility functions. In one extreme case indifference curves are right-angled (and homothetic), displaying no leeway for sudstituting a commodity that has become cheaper for a commodity that has not. At the opposite extreme is the case of parallel, linear indifference curves. The intermediate case is the assumption of Cobb-Douglas utility functions whereby smooth and continuous substitution in demand is always possible and indifference curves do not hit the axes. Figure 1 illustrates these three cases. Each is amenable to simple expressions and numerical illustration, thus making it feasible in what follows to suggest exercises whereby the trade theory propositions I wish to discuss can easily be illustrated.
Section I of the paper discusses the issue of stability and uniqueness of equilibrium which was of concern to Sohmen. Section II concentrates on the Cobb_Douglas form of the utility function to illustrate the crucial distinction in trade theory between demand elasticities and import demand elasticities. In Section III I illustrate how in a Ricardo-Graham model of world trade with many countries and commodities these simple forms of the demand functions delimit possible gains from free trade. Finally, in Section IV, I consider the question of technical progress in a Ricardian model in order to illustrate how the pattern of potential country gains or losses depends crucially in the nature demand, as illustrated by these three cases.
Stockholm: IIES , 1979. , 36 p.