International Economics Tenth Edition CHAPTER T H R E E 3 International Economics Tenth Edition The Standard Theory Of International Trade Dominick Salvatore John Wiley & Sons, Inc. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

In this chapter: Production Frontier with Increasing Costs Community Indifference Curves Equilibrium in Isolation Basis for and Gains from Trade with Increasing Costs Trade Based on Differences in Taste Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

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 (not a straight line). Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

FIGURE 3-1 Production Frontiers of Nation 1 and Nation 2 with Increasing Costs. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

The Production Frontier with Increasing Costs 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, 10th Edition © 2010 John Wiley & Sons, Inc.

Community Indifference Curves A community indifference curve shows combinations of two commodities that yield equal satisfaction to the community or nation. Represent measure of taste and preference. Characteristics of community indifference curves: The higher the curve, the greater the utility. Negative slope, convex to the origin. Different curves do not cross. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

FIGURE 3-2 Community Indifference Curves for Nation 1 and Nation 2. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

Community Indifference Curves The marginal rate of substitution (MRS) falls as more of good X is consumed. 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. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

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 its production constraint. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

FIGURE 3-3 Equilibrium in Isolation. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

Equilibrium in Isolation 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, 10th Edition © 2010 John Wiley & Sons, Inc.

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. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

FIGURE 3-4 The Gains from Trade with Increasing Costs. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

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 unbalanced. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

Basis for and Gains from Trade with Increasing Costs Under constant cost conditions, specialization is complete. Under increasing cost conditions, specialization is incomplete: As production moves along PPF toward comparative advantage good, relative costs change, thus changing basis and gains from trade. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

FIGURE 3-5 The Gains from Exchange and from Specialization. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

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, 10th Edition © 2009 John Wiley & Sons, Inc.

FIGURE 3-6 Trade Based on Differences in Tastes. Salvatore: International Economics, 10th Edition © 2009 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, 10th Edition © 2010 John Wiley & Sons, Inc.

FIGURE 3-7 Isoquants, Isocosts, and Equilibrium. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

FIGURE 3-8 Production with Two Nations, Two Commodities, and Two Factors. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

FIGURE 3-9 Derivation of the Edgeworth Box Diagram and Production Frontier for Nation 1. Salvatore: International Economics, 8th Edition © 2010 John Wiley & Sons, Inc.

FIGURE 3-10 Derivation of the Edgeworth Box Diagram and Production Frontier for Nation 2. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.