International Economics Twelfth Edition CHAPTER T H R E E 3 International Economics Twelfth Edition The Standard Theory Of International Trade Dominick Salvatore John Wiley & Sons, Inc. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

Learning Goals: Understand how relative commodity prices and the comparative advantage of nations are determined under increasing costs. Show the basis and the gains from trade under increasing costs. Explain the relationship between international trade and deindustrialization in the U.S. and other advanced nations. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

Extending the simple trade model 3.1 Introduction Extending the simple trade model Increasing opportunity costs Tastes and preferences Incomplete specialization Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

3.2 The Production Frontier with Increasing Costs Increasing Opportunity Costs A nation must give up more and more of one commodity to release just enough resources to produce each additional unit of another commodity. Increasing cost production possibilities frontier is concave to the origin. The marginal rate of transformation (MRT) increases as more units of good X are produced. The marginal rate of transformation is another name for opportunity cost. The value of MRT is given by the slope of the PPF. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

FIGURE 3-1 Production Frontiers of Nation 1 and Nation 2 with Increasing Costs. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

3.2 The Production Frontier with Increasing Costs Reasons for Increasing Opportunity Cost and Differing PPFs Factors of production are not homogeneous, and thus producing increasing amounts of a good requires using inputs that are less productive. Different countries have different resource endowments, giving rise to different PPFs. May also use different technologies. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

3.3 Community Indifference Curves Combinations of two commodities that yield equal satisfaction to the community or nation. Negatively sloped and convex to the origin. Cannot cross. Slope = Marginal Rate of Substitution (MRS) The MRS of X for Y in consumption is the amount of Y that a nation could give up for one extra unit of X and still remain on the same indifference curve. The marginal rate of substitution (MRS) falls as more of good X is consumed. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

FIGURE 3-2 Community Indifference Curves for Nation 1 and Nation 2. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

3.3 Community Indifference Curves Problems The distribution of income is held constant when drawing community indifference curves, and a different income distribution could result in very different curves. Trade can change the distribution of income significantly, and thus expansion of trade may cause intersecting indifference curves and unclear effects on social welfare. Compensation principle: the nation benefits from trade if the winners would be better off even after compensating the losers. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

3.4 Equilibrium in Isolation Interaction of forces of demand (community indifference curves) and supply (production possibilities frontier) determine equilibrium for a nation in the absence of trade (autarky). Nations seek the highest possible indifference curve, given the production constraint. The equilibrium-relative commodity price in isolation = slope of tangency between PPF and indifference curve at autarky point of production and consumption. Relative prices are different in Nation 1 and Nation 2 because of different shape and location of PPF’s and indifference curves. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

FIGURE 3-3 Equilibrium in Isolation. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

3.5 The Basis for and Gains from Trade with Increasing Costs Relative commodity price differentials between two nations reflect comparative advantages, and form basis for mutually beneficial trade. Each nation should specialize in the commodity they can produce at the lowest relative price. Specialization will continue until relative prices equalize between nations. Specialization will usually be incomplete, since costs of production increase in each country with greater specialization. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

FIGURE 3-4 The Gains from Trade with Increasing Costs. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

3.5 The Basis for and Gains from Trade with Increasing Costs Equilibrium-relative commodity price with trade = common relative price at which trade is balanced. Balanced trade: quantity of X (Y) Nation 1(2) wants to export = quantity of X(Y) Nation 2(1) wants to import. Any other relative price could not persist because trade would be not be balanced. In general, the greater the change from a nation’s autarky price to the post-trade price, the greater the size of the gains from trade. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

3.5 The Basis for and Gains from Trade with Increasing Costs The Gains from Exchange and Specialization A nation’s gains from trade can be broken down into two components. Gains from exchange = increase in consumption from the change in the relative price (compared to the autarky price), holding production constant. (Point T in Figure 3-5) Gains from specialization = increase in consumption resulting from the reallocation of production towards the good in which the country has a comparative advantage, holding the world relative price constant. (Point E in Figure 3-5). Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

FIGURE 3-5 The Gains from Exchange and from Specialization. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

3.5 The Basis for and Gains from Trade with Increasing Costs The switch in production of goods from autarky to the trade equilibrium also causes changes in employment of factors of production in each sector. In industrialized countries, this implies loss of manufacturing jobs– deindustrialization. But empirical evidence shows that most manufacturing job loss has been due to change in labor productivity and other internal causes rather than trade. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

3.6 Trade Based on Differences in Taste Even if two nations have identical PPFs, basis for mutually beneficial trade will still exist if tastes, or demand preferences, differ. Nation with relatively smaller demand for X will have a lower autarky relative price for, and comparative advantage, in X. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

FIGURE 3-6 Trade Based on Differences in Tastes. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

Case Study 3-1 Comparative Advantage of the Largest Advanced and Emerging Economies Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

Case Study 3-2 Specialization and Export Concentration in Selected Countries Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

Case Study 3-3 Job Losses in High Import-Competing Industries Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

Case Study 3-4 International Trade and Deindustrialization in the United States, the European Union, and Japan Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

Case Study 3-4 International Trade and Deindustrialization in the United States, the European Union, and Japan Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

Appendix to Chapter 3 Production Functions, Isoquants, Isocosts and Equilibrium Production Theory with Two Nations, Two Commodities, and Two Factors The Edgeworth Box and Production Frontiers Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

FIGURE 3-7 Isoquants, Isocosts, and Equilibrium. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

FIGURE 3-8 Production with Two Nations, Two Commodities, and Two Factors. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

FIGURE 3-9 Derivation of the Edgeworth Box Diagram and Production Frontier for Nation 1. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

FIGURE 3-10 Derivation of the Edgeworth Box Diagram and Production Frontier for Nation 2. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

Copyright 2016 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in section 117 of the 1976 United States Copyright Act without express permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein. Need to add tables from the 4 cases studies. Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.