INTERNATIONAL ECONOMICS Chp 3. Salvatore, D. Standard Theory of International Trade

Standard Trade Model The standard trade model is built on four key relationships: Production possibility frontier and the relative supply curve Relative prices and relative demand World relative supply and world relative demand Terms of trade and national welfare PPF is a curve showing the various alternative combinations of 2 commodities that a nation can produce by fully utlizing all of its resources wirh the best technology available to it.

Assumptions of the model: Each country produces two goods, X and Y PPF is concave curve (Due to Increasing Opportunity Cost)‏ Slope at any point along PPF curve is measured as Marginal Rate of Transformation (MRT) showing the rate of change between the production of X and Y MRTx,y = ΔY/ ΔX Increasing opp costs: means that the nation must give up more and more of one commodity to release just enough resources to produce each additional unit of another commodity MRT in other words means MRT of X for Y means the amount of Y that a nation must give up to produce each additional unit of X

Increasing Opportunity Cost Increasing Opportunity Cost arises because, factors of production (resources) a. Are not homogeneous (they are not identical of the same quality)‏ b. are not used in the same fixed proportion or intensity in the production process Non homogeneous: factor are not identical or of the same quality for example land used for agriculture Intensity: This means as a nation produces more of X, it must utilize resources that are less efficient or less suitable for the production of X. As a result the nation must give up more and more of Y to release just enough resources to produce each additional unit of X.

Production Frontiers of Nation 1 and Nation 2 with Increasing Costs. Concave PPF refelect increasing opp costs in each nation in the production of both commodities. Nation1: Nation 1 wants to produce more of X, startinf from A on its PPF Sine at A the nation is already utlizing all of its resources with the best technology available , the nation can only produce more of X by reducing the o/p of Y. Nation 1 must give up more and more of Y for each additional batch of 20X that it produces Nation 2 incurs increasing opp costs in temns of forgone X for each additional batch of 20Y it produces. MRT(the slope of PPF) for nation 1 at A is 1/4: nation 1 must give up ¼ unit of Y to produce each additional unit of X. At B nation 1 must give up 1 Y to produce aech additional unit of X therefore movt from A to B involves and increase in the slope (MRT) from ¼ to 1 refelecting the increasing opp cost in producing more X

Community Indifference Curves Community indifference curves represents the choices and preferences of the society graphically by a series of curves. Each curve traces a set of combinations of X and Y consumption that leave the community equally well off Movement along the indifference curve measures the Marginal Rate of Substitution (MRS) between x and y They have three properties: Downward sloping The farther up and to the right each lies, the higher the level of welfare to which it corresponds Each gets flatter as we move to the right CIC shows the various combinations of two commodities that yield equal satisfaction to the community or nation. Higher curves refer to greater satisfaction, lower curves to less satisfaction

FIGURE 3-2 Community Indifference Curves for Nation 1 and Nation 2. Assion: Tastes/DD perefernces different in the two nations Pts N and A give equal satisfaction to Nation 1 since they are both on the same IC. Pts T and H refers to a higher level of satisfaction since they are on a higher IC For nation 2: A'=R'<H'<E' CIC is negatively sloped because as a nation consumes more of X it must consume less of Y if the nation is to have the same level of sstisfaction MRS of X for Y in consumption refers to the amount of Y that a nation could give up for one extra unit of X and still remain on the same IC. For example the MRS of IC1 is greater at N than at A.

Equilibrium in Isolation The value of an economy's consumption equals the value of its production (in autarky): Production Consumption PyQy + PxQx = Px Cx + PyCy Where Cx and Cy are consumption amount of X and Y The point on production possibility frontier at which an economy actually produces depends on the price of x relative to y, Px/Py In the absence of trade, a nation is in EQM when it reaches the highest IC possible given its PPF This occurs at the point where a CIC is tangent to the nation's PPF The common slope of the two curves the the tangency point gives the internal EQM relative commodity pricein the nation and reflects the nation's comparative advantage.

FIGURE 3-3 Equilibrium in Isolation. The force of SS as given by the nation's PPF and the forces of demand as given by the CIC together determines the EQM relative commmodity price in autarky. Nation 1 is in EQM or maximizes its welfare in isolation by producing and consuming at point A where its PPF is tangent to the IC The EQM relative price of X in nation 1 is given by the common slope of its PPF and IC at A thus PA= 1/4 Nation 2 is in EQM at point A' where its PPF is tangent to IC'. For nation 2 PA'=4 Since the realtive price of X is lower in nation1 than in nation 2, nation 1 has a comparative advantge in X and nation 2 in Y. A difference in relative commodity prices between 2 nations is a reflection of their comparative advantage and forms the basis for mutually beneficial trade.

Movement along the PPF Curve If the relative price of X, (Px/Py), increases, the economy’s production point moves from A to B and due to trade consumption choice shifts from A to E for US and in UK production from A` to B` and consumption from A’ to E’. The move from A to B reflects two effects: Income effect Substitution effect

Case of Trade If the world economy consists of two countries: US (which exports X)‏ Its terms of trade are measured by PB Px/Py Its quantities of X and Y produced are X=130 and Y= 20 After trade 60 units of X exported for 60 units of Y import UK (which exports Y) Its quantities produced of X = 40 and Y =120 After trade 60 units of Y exported in return for 60 units of X imported

FIGURE 3-4 The Gains from Trade with Increasing Costs. W/o trade: Relative price of X PA= ¼ in US and PA'=4 in UK, US has comp advantge in X and UK in Y W trade US now specialize in the production and export of X and UK specializes in the production and export of Y With trade, AS US specializes in the productn of X it incurs increasing opp costs in the productn of X the same as Y. This process of sepcialization continues until the realtive commodity prices become equal in the two nations. US (nation 1) moves from A to B in production. By then exchanging 60X for 60Y for nation 2 (see traingle BCE), nation 1 ends up consuming at E (on IC3, 70X and 80Y). Thus US gains 20X and 20Y from trade compare to autarky. UK (nation2) moves from A' to B' in production. By exchanging 60Y for 60X with nation 1 (triangle B'C'E') nations 2 ends up consuming at pt E'(100X and 60Y) and also gains 20X and 20Y PB=PB' id the EQM relative price -the price at which trade is balanced. Any other relative price could not persist bcoz trade would be unblanced e.g US would want to export more X than the amount of X UK is willing to import

Gains from Trade Both countries gains from trade because they reach to an indifference curve higher than autarky levels. After trade each countries’ producers increases the production of comparatively advantageous products (good X for US and good Y for UK). They face better international relative prices for their advantageous products (for US good X prices from ¼ to 4/4, and for UK good Y prices from 4/1 to 4/4)

Trade Based on Differences in Tastes. Identical PPF due to similar technology in both countries but different choices, shown by different indifference curves

EK 4307 Homework 2 Collect the latest trade data (exports and imports) for Any TWO of the following countries - Brunei - Two more countries that you like Identify the most popular two export and import items of the countries you selected. Calculate the total share of these two items out of their total exports and imports.

Below table shows the output per labor in Japan and Australia for producing Corn and MP 3 Players Japan Australia Corn 2 8 MP3 12 2 Which country has the absolute advantage in producing Corn and MP3 production? Will there be any trade according to Adam Smith’s theory of absolute advantage? (if yes who is exporting which product) Which country has comparative advantage in corn and in MP3 production? Show your calculation. If both countries have 100 Labor, draw and show the production possibilities frontier for both countries. If each country specializes on the product with comparative advantage show the amount of gains from trade. What will be the range of possible level of terms of trade for each good?