Study Unit 3

How to use these slides? While working through these slides: Keep your study guide and textbook open next to you. Ask questions if there is anything you do not understand. These slides do not cover the entire chapter, only some of the important points. Make sure you also study the other parts as stipulated by your study guide. Remember to make notes!

Follow us in your textbook… 11th ed. page 55 - 71 10th ed. page 61 - 80

The standard theory of international trade We will look at how comparative advantage and relative commodity prices are determined when costs are increasing We will also look at the basis and gains from trade under increasing costs

Production frontier with increasing costs It more realistic that a nation produces under increasing opportunity costs than under constant opportunity costs. Increasing opportunity costs implies that the country has to reduce the production of the one commodity so it can free up enough resources to produce 1 more unit of the other commodity.

The increasing opportunity costs yields a PPC that is concave to the origin See Figure 3.1, page 56: X

Marginal rate of transformation (MRT) OF X for Y: is the amount of good Y that the nation must give up in other to produce each extra unit of good X. The MRT is given by the slope of the PPC at the point of production. As one moves down the PPC, the MRT increases, reflecting an increase in the opportunity cost in the production of more of commodity X.

The reasons for increasing opportunity costs: Factors of production are not homogenous Factors of production are not used in the same degree of intensity in the production of all commodities. The difference in the PPF between countries is due to The different factor endowments between nations. Changes over time in availability of factors of production shifts the PPF

Community indifference curves Shows all combinations of two goods that give the same level of satisfaction to the community or nation Higher indifference curve reflects higher levels of satisfaction Indifference curves are negatively sloped and convex to the origin Indifference curves never intersect.

The marginal rate of substitution (MRS): is the rate at which a nation is willing to give up units of good Y to get one more unit of good X and still remain on the same indifference curve. MRTS is given by the slope of the indifference curve at the point of consumption. As the nation moves down the indifference curve the MRS declines

Do the following true or false questions… Increasing opportunity costs mean that the production possibilities frontier is convex from the origin. Increasing opportunity costs mean that the slope of the production possibilities frontier decreases as one moves down to the right. A nation experiences increasing costs for only one of the two products. The marginal rate of transformation refers to the amount of one good that a nation must give up to produce each additional unit of another good. Community indifference curves can cross each other. The marginal rate of substitution is the same along an indifference curve

Equilibrium in isolation To get the point of equilibrium if a nation does not trade, we use the PPF and the indifference curve. When there is no trade (autarky), the nation is in equilibrium if it reaches its highest attainable indifference curve given its PPF Equilibrium therefore occurs at the point of tangency between the highest attainable indifference curve and the PPF. At this point, the slope of the indifference curve=slope of the PPF. See figure 3.3, page 61.

Do the following true or false questions… In the absence of trade, a nation is in equilibrium when it reaches the highest indifference curve possible given its production frontier. The equilibrium-relative commodity price is isolation is given by the slope of the common tangent to the nation’s production frontier and the indifference curve.

Equilibrium relative commodity prices and comparative advantage The common slope of the two curves at the tangency point gives the equilibrium relative commodity prices and reflects the nation’s comparative advantage. The relative prices between nations differ due to: different shapes of the PPF different locations of the indifference curves See Figure 3.3 for explanation.

The nation with the lower relative price for a commodity has a comparative advantage in the production of the good and a comparative disadvantage in the other good. It must therefore specialise in the product of its comparative advantage. Read also gains from exchange and specialization. Figures 3.4 and Figure 3.5 are also important.

Do the following true or false questions… The difference in relative commodity prices between two nations is a reflection of their comparative advantage. Specialization will stop when relative commodity prices are equal in both nations and at that point trade is in equilibrium. With increasing costs, a nation is not able to consume beyond its production frontier. With increasing costs specialization is always complete in both nations. With trade each nation will produce more of the commodity of its comparative advantage

End of study unit 3