The Standard Theory of International Trade Chapter 3 Chapter 3 The Standard Theory of International Trade The Standard Theory of International Trade Chapter 3

1 Introduction Extend our simple model to increasing opportunity costs. Introduce tastes or demand preferences with community indifference curves. See how these forces of supply and demand determine the equilibrium relative commodity price in each nation in the absence of trade under increasing opportunity costs.

1 Introduction Key Terms Marginal rate of transformation Community indifference curve Marginal rate of substitution Autarky Equilibrium relative commodity price in isolation/with trade Incomplete specialization Deindustialization

2 Increasing Opportunity Costs The increasing amounts of one commodity that a nation must give up to release just enough resources to produce each additional unit of another commodity. This is reflected in a production frontier that is concave from the origin (rather than a straight line).

2.1 Illustration of Increasing Opportunity Costs

2.2 Determinants of of PPF What determine the shape? Production possibility frontiers are different because the two nations have different factor endowments or resources at their disposal or they use different technologies in production.

2.3 Marginal Rate of Transformation (MRT) MRT is the amount of one commodity that a nation must give up to produce each additional unit of another commodity. It is another name for the opportunity cost of a commodity and is given by the slope of the production frontier at the point of production. If the slope of the production frontier of Nation 1 at point A is 1/4, it means that Nation 1 must give up 1/4 of a unit of Y to release enough resources to produce one additional unit of X at this point.

3 Community Indifference Curve

3.1 Marginal Rate of Substitution The 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 indifference curve. This is given by the absolute slope of the community indifference curve at the point of consumption and declines as the nation moves down the curve. The declining MRS shows that the more of X and less of Y a nation consumes, the more valuable to the nation is a unit of Y at the margin compared with a unit of X. Therefore, the nation can give up less and less Y for each additional unit of X it wants.

3.2 Difficulties with CIC A set of community indifference curves reflect a particular income distribution in the nation. A different income distribution would result in a completely new set of indifference curves. The new curve may intersect the previous indifference curve. This happens as a nation opens trade or increases its volume of trade. Exporters benefit but domestic producers competing with imports will suffer.There is also different impact on consumers. Trade will change the distribution of real income in the nation and may cause indifference curves to intersect. How to solve it?

4 Equilibrium In Isolation In isolation, a nation is in equilibrium when it reaches the highest indifference curve with given production frontier. It is at the point where a CIC is tangent to the nation’s PPF. The common slope of the two curves at the tangency point gives the internal equilibrium relative commodity price and reflects the nation’s comparative advantage. The tangency point can be on lower indifference curves, but it would not maximize the nation’s welfare; on higher curves, the nation would not achieve the level of welfare with the existing resources and technologies.

4.1 Equilibrium In Isolation

4.2 Equilibrium-Relative Commodity Price in Isolation The equilibrium relative commodity prices in each nation in autarky are determined by the forces of supply (as given by the nation’s production possibility frontiers) and the forces of demand (given by the nation’s indifference map) in each nation. Under increasing costs: If indifference curve is of a different shape, it would be tangent to the production frontier at a different point and determine a different relative price of X in Nation 1. Under constant cost: The equilibrium Px/Py is constant regardless of the level of output and demand and is given by the constant slope of the production frontier.

5 Basis For & Gains from Trade with Increasing Costs The basis for mutually beneficial trade is the relative commodity price. A difference in the relative commodity prices reflects their comparative advantage. The nation with lower relative price for a commodity has a comparative advantage in that commodity. The pattern: Each nation should specialize in the production of the commodity of its comparative advantage and exchange part of its output with the other nation for the commodity of its comparative disadvantage. Specialization incurs increasing opportunity costs and continues until relative commodity prices in the two nations become equal at which trade is in equilibrium. Through trading, both nations will consume more products than in the absence of trade.

5.1 Basis For & Gains From Trade PA’=4 PA’=1/4

5.2 Equilibrium-Relative Commodity Price It is the common relative commodity price in two nations at which trade is balanced. At this relative price, the amount of X that nation 1 exports equals the amount of X that nation 2 imports. The amount of Y that nation 2 exports matches the amount of Y that nation 1 imports. At other relative price, trade cannot persist because it becomes unbalanced. If the pretrade relative price were the same in both nations, there would be no comparative advantage or disadvantage in either nation and no specialization in production or mutually beneficial trade would take place.

5.3 Complete & Incomplete Specialization Under constant opportunity costs, both nations specialize completely in the production of the commodity of their comparative advantage. Under increasing opportunity costs, both nations have incomplete specialization in the production of the commodity of their comparative advantage. Why ???

Exchange & Specialization 5.4 The Gains From Exchange & Specialization

6 Trade Based on Different Taste If the production possibility frontiers are identical, is there any basis for trade? The basis for trade is the difference in tastes or demands. The nation with a smaller demand for a commodity will have a lower autarky relative price for, and a comparative advantage in the commodity.

6 Trade Based on Different Taste

7 Questions for Discussion Why does a production frontier that is concave from the origin indicate increasing opportunity cost? What does the slope of production frontier measure? What is the reason for increasing opportunity costs? Why do different nations have different production frontiers? Why does a community indifference curve look like that?

THANK YOU !