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
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 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
Production Frontiers of Nation 1 and Nation 2 with Increasing Costs.
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
FIGURE 3-2 Community Indifference Curves for Nation 1 and
Nation 2.
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
FIGURE 3-3 Equilibrium in Isolation.
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 terms of trade are measured by PB Px/Py
– 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.
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
1. Identify the most popular two export and import
items of the countries you selected.
2. 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
Corn
MP3
a.
b.
•
a.
b.
c.
2
12
Australia
8
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?