International Economics Prof. D. Sunitha Raju Basics of International Trade Theory - II

International Economics Trade Theory : Discussion Issues 1.What is the basis for trade between countries? 2.How are gains from trade defined/ measured. 3.Can theory explain the pattern of global trade flows.

International Economics Trading under Constant Costs Basis for Trade Slopes of the production possibilities schedules give the relative cost of one product in terms of other Differences in relative costs provide the basis for mutually favourable trade Production gains from Specialisation A country will specialise in the production of the good in which it has comparative advantage A country will trade part of this production for the good in which it has comparative disadvantage (a) (b)

International Economics Consumption gains from Trade Consumption alternatives limited by the domestic production possibilities schedules The exact consumption will be determined by the tastes & preferences Specialization & free trade care achieve post-trade consumption outside domestic production possibilities schedules trade results in consumption gains for both countries Terms of Trade Domestic terms of trade represents the relative prices at which goods are exchanged at home A country will exports/import goods internationally if the terms of trade are more favourable than domestic terms of trade (c) (d)

International Economics Production Possibility Schedule under Increasing Costs (i)Increasing opportunity costs mean that more of one commodity is to be given up (to release resources) for additional production of another commodity (ii)Increasing costs result when inputs are not perfect substitutes

International Economics 0 0 Nation 1 Nation 2 Production Frontiers of Nation 1 and Nation 2 with Increasing Costs ∆X∆X -∆Y A B X Y ∆Y∆Y -∆X A’ B’ Y Slope of the PPS (or MRT) varies at different points on the schedule

International Economics Trading under Increasing Costs Supply factors and Demand factors together determine the point at which a country chooses to consume along the PPS. In Autarky, a country is in equilibrium which the PPS is tangent to the highest indifference curve This tangency determines the equilibrium relative prices of commodities in each country.

International Economics 0 0 Nation 1 Nation A B X Y A’ B’ Y I I’ 85 P A’ =4

International Economics 0 0 Nation 1 Nation A B X Y A’ B’ Y I I’ III E 150 P B =1 C III E’ C’ P B’ =1

International Economics Equilibrium-Relative Prices with Trade With specialisation in production & trade, each nation can consume outside its production frontier. The relative prices that balances trade (i.e. export of 1 country = import by another country)

International Economics Exports Imports E*E* S D E A B P3P3 P2P2 P1P1 SXSX International Trade in Commodity X Nation 1’s Market for Commodity X Nation 2’s Market for Commodity X SXSX A’ E’ B’ A’’ DXDX P3P3 B* A* XXOOO The Equilibrium-Relative Commodity Price Panel APanel B Panel C DxDx

International Economics Offer Curves (Reciprocal demand curves) 1.Definition  Offer curve shows how much of the import commodity a nation demands for which it is willing to supply various amounts of export commodity  Incorporates both demand and supply factors: production frontier, indifference map, and relative commodity prices

International Economics  Trade is the difference between Production and Consumption Exports : Q X – D X Imports : D Y - Q Y.. DXDX QXQX Exports X Y Q IC T DYDY QYQY Imports. T Desired Exports Home’s Exports (Q X – D X ) Home’s Imports (D Y – Q Y ) D Y – Q Y = (Q X – D X ) x ( ) 2. Deriving a country’s offer curve

International Economics Offer curve: desired imports at various relative prices  Relative prices increase from T to T 1 and from T 1 to T 2.  When rise, Q X ↑, Q Y ↓, D Y ↑ and D X ↓. Both Exports (Q X – D X ) and Imports (D Y – Q Y ) rise... T1T1 T2T2 Home’s Exports X

International Economics 3.Deriving Foreign’s Offer Curve  Shows desired imports of Y and Exports of X vary with relative prices. Foreign’s Imports Foreign’s Exports Y

International Economics 4.Offer Curve Equilibrium  World equilibrium to where Home and Foreign offer curves intersect Foreign’s Imports Foreign’s Exports Y. X Home’s Imports (D Y – Q Y ) Home’s Exports (Q X – D X )

International Economics Determining Relative Prices (i)Terms of Trade (Net barter terms of trade)  Ratio of price of export commodity to the price of import commodity  Assume 2 countries :  Home → Exports Food → terms of trade  Foreign → exports manufactures → terms of trade

International Economics Sources of Comparative Advantage a)Factor Endowments b)Resource Allocation c)Differences in Tastes