INTERNATIONAL
ECONOMICS
XU SONG
PROFESSOR OF ECONOMICS
ANHUI UNIVERSITY OF FINANCE & ECONOMICS
ANHUI UNIVERSITY OF FINANCE & ECONOMIC
Dept. of Int’l Trade and Economics &
Business School
XU SONG
Prof. of Economics
Office: 2nd Floor (West wing), Building 4
Office Hour: Every Afternoon 2:00－5:00
Tel: 3128117(O)
1.1A Books on International Economics
Dominick Salvatore: International Economics 7th Ed. 2001
Prentice-Hall, Inc. & Tsinghua University Press
Paul R. Krugman & Maurice Obstfeld
International Economics Theory and Policy 5th Ed. 2000
Addison Wesley Longman & Tsinghua Uni. Press
Dennis R. Appleyard & Alfred J. Field. Jr..
International Economics
4th ed.
1998
The McGraw-Hill, Inc. & China Machine Press
Robert J. Carbaugh: International Economics
6th ed. 1998
The McGraw-Hill, Inc. &
Dongbei Uni. of Finance and Economics Press
Dr. Dominick Salvatore
Professor at Fordham University
of New York City
1.1B Contents of the Book
21 Chapters
Part One:International Trade Theory
Part Two: International Trade Policies
Part Three: Balance of Payments and Exchange Rates
Part Four: Open-Economy Macroeconomics and the
International Monetary System
1.1C Contents of Each Chapter
Six Sections in the text
Summary ----- 6 paragraphs
A Look Ahead--- What is to be discussed in the next chapter.
Key Terms
Questions for Review----13 Questions
Problems---- 13 Problems.
Appendix----- More advanced knowledge.
1.2A What Is International Economics?
It deals with the economic interdependence among nations.
It analyzes the flow of goods and services, payments between
nations, policies regulating the flow and their effects on national
welfare.
International trade
International trade theory
International trade policy
International Finance
Foreign exchange markets
Balance of payments
Open economy macroeconomics
1.2B International Trade and Policy
International trade theory
------- analyzes the basis for and gains from trade
(The forces that give rise to trade between nations. List some.)
(Increase in consumption from specialization.)
International trade policy
--------examines the reasons for and the effects of trade
restrictions and new protectionism.
(Tariff, quotas, license, advanced deposits on imports,
government procurement, restrictions, technical barrier,
environmental barrier, social accountability, ISO …...)
1.2C International Finance
Foreign exchange markets
----- describes the frameworks for the exchange of one
national currency for another. We exchange RMB for dollars.
Balance of payments
----- measures nation's total receipts from and total
payments to the rest of the world. For example, we try to
achieve trade balance.
Open economy macroeconomics
------ deals with the mechanisms for adjustment in
balance of payments disequilibria (国际收支失衡调整机制) as well
as the effects of the macroeconomics interdependence (宏观经济
互相依存性) among nations under different international
monetary system, and their effects on a nation's welfare.
1.2D Purpose to Study International
Economics
To predict and explain the economic events in the world.
To examine the basis for and gains from international trade.
To examine the reasons for and the effects of trade restrictions.
To understand what is gong in the world and their effects on
the world economy.
To have a better job!!! Why ?
( Because this knowledge is needed in MNCs, banking and
government organizations. )
1.3A Assumptions in International Trade
• 2×2×2 model
• No trade restrictions
• Perfect mobility of factors within nations and not
internationally
• Perfect competition
Why ?
• No transportation costs
Answer: It is easier to study international economics.
What would happen if we relax these assumptions?
Most of our conclusions can still hold. For example,
more than 2 nations and more than 2 production factors.
1.3B Foreign Trade Dependency
What is foreign trade dependency? What is the purpose?
How to measure it?
---------The ratio of imports and exports of goods and services of a
nation to its GDP.
Import  Export
 100%
GDP
What nations have the higher degree of foreign trade
dependency?
What is the trade dependency in China? Why is it like this?
Why is international trade very important to a nation?
A nation can not survive without foreign trade, such as Japan, Germany,
Belgium and others.A nation can not produce all the products it needs, for
example that US can not produce coffee, cocoa, tea, scotch and other
products, they don't have the materials.
The economies of all nations are closely related to each other.
To improve the standard of living.
1.4A China GDP and Foreign Trade
Dependency
Year
GDP
(bill. ￥)
Exp+Imp
(bill. $)
Exp+Imp
GDP
1997
7477.2
325.16
36.0%
182.79
20.3%
142.37
15.7%
+404.2
1998
7834.5
323.95
33.7%
183.71
19.1%
140.24
14.6%
+434.2
1999
8206.7
360.63
36.4%
194.93
19.7%
165.70
16.7%
+292.3
2000
8944.2
474.30
44.0%
249.20
23.0%
225.09
21.0%
+241.1
2001
9593.3
509.77
45.0%
266.15
24.0%
243.61
21.0%
+225.4
2002
10239.8
620.80
50.3%
325.57
26.4%
295.22
23.9%
+303.5
2003
851.21
2004
Data source:China Customs
Export
(bill. $)
438.37
Export
GDP
Import
(bill. $)
412.84
Import
GDP
Balance
($)
+255.4
1.4B Reasons for the High
Dependency
GDP is smaller than it should be. Many values created are
not included in the GDP. For example, the pigs, cattle and some
others in the countryside are not included. The real GDP is
much higher, three times higher than it is.
Processed products take up too much percentage in the
exports. In the last several years, the value of processed goods
is more than 50% in the exports.
RMB was depreciating all the years before 1994. In 1984,
the exchange rate was US$1.00 for ￥2.32. In 1990, it was
USD1.00 for ￥4.72. In 1994, USD1.00 for ￥8.62.
What will happen in the future to
China trade dependency ?
1.4C Foreign Trade Dependency in Some
Nations
1970
1980
1990
1993
Developing countries
India
3.5
5.0
6.0
8.6
Indonesia
11.5
28.1
24.2
23.2
Korea
9.3
27.5
25.6
24.8
Pakistan
4.0
11.1
14.0
12.9
Tailand
10.0
20.1
26.9
29.5
Advanced countries
Japan
9.5
12.3
9.8
8.6
Canada
19.8
25.7
22.5
26.6
America
4.2
8.3
7.2
7.4
France
12.5
17.5
17.6
16.5
Germany
18.6
23.8
27.4
19.9
Italy
12.3
17.3
15.6
16.9
United Kingdom
15.7
20.5
19.0
19.3
Australia
12.1
13.7
13.3
14.8
1.5A Basic International Trade Data
1.5A Basic International Trade Data(2)
1.5A Basic International Trade Data(3)
1.5A Basic International Trade Data(4)
1.5A Basic International Trade Data(5)
1.6 Some Questions
1. Import/GDP has _______in recent years.
(risen, fallen, remained steady)
(From
15.7 % in 1997 to 23.9 % in 2002.)
2. Export/GDP has _______in recent years.
(risen, fallen, remained steady)
(From 20 % in 1997 to 26.4 % in 2002.)
3. Which nation is our largest trading partner?
( Japan:133.57 billion dollars in 2003 )
4. Which is the second largest trading partner?
( U.S. 126.33 billion dollars in 2003 )
1.6 Some Questions (2)
1.The purpose of trade is to_______.
a. improve consume well-being.
b. create jobs.
2. Work is a ________.
a. cost
b.benefit
3. Exports are ________.
a. cost
b.benefit
4. The objective of international trade is to __________.
a. get goods cheaply
b.create jobs
5. NAFTA has had a greatest impact on the _____ of U.S.
a. inflation rate
b.unemployment rate
( All of “a” are correct. They are consistent with standard economic theory.
All of “b” are wrong, but they are consistent with old economic theory. )
International economics is not always what you think it is!!!
1. People trade to improve their well-being. Creating jobs is a means to an end.
2. Would you like to work for free?
3. Exports: you make it but don’t consume it.
4. Trade is great at cost-cutting but no net impact on jobs.
5. NAFTA reduces goods prices.
Chapter 2
The Law of
Comparative Advantage
2.1 Introduction
In this chapter, we will examine the development of trade
theory from the 17th century to the first half of the 20th century.
This historical approach is useful not because we are
interested in the history of economic thoughts but because it is
a convenient way of introducing the concepts and theories of
international trade from the simple to the most complex and
realistic.
We will use 2X2X1 model and start from absolute
advantage, to comparative advantage and to opportunity costs
and production possibility frontiers.
2.2 Mercantilists’ Views on Trade
Mercantilism ---- Some people wrote articles on international
trade. Their philosophy was known as mercantilism.
Representative ----- Thomas Munn (1571-1641)
Works ---- England’s Treasure by Foreign Trade
Wealth: The way for a nation to become rich and powerful
was to export more than it imported. The resulting surplus
would then be settled by an inflow of bullion. The more gold
and silver a nation had, the richer and more powerful it was.
What kind of policy should be adopted?
The government had to do all in its power to stimulate the
nation’s exports and discourage and restrict imports.
What is the nature of the trade?
One nation could gain only at the expense of other nations.
It is called a zero-sum game.
2.2b Different Views on National
Wealth
Mercantilists attached importance to bullion.
But today we pay attention to the stock of human
resources, man-made and natural resources available for
producing goods and services. The greater this stock of
useful resources, the greater is the inflow of goods and
services to satisfy human wants and the higher the
standard of living in the nation.
2.2c Purposes of Mercantilists’ Trade
Theory
To maintain larger and better armies with more gold
and silver and consolidate their power at home;
To acquire more colonies with improved armies and navies;
To do more business with more money;
To stimulate national output, develop national economy
and increase employment.
2.3 Adam Smith’s Trade Theory
The basis for trade ----------- Absolute advantage
If one nation is more efficient than another nation in the
production of one commodity, the nation has absolute advantage
in that commodity.
The pattern of trade
------- both nations can gain by each specializing in the
production of the commodity of its absolute advantage and
exporting part of its output with the other nation for the
commodity of its absolute disadvantage.
Policy: Free trade policy should be adopted to make better
use of resources and maximize world welfare.
2.3b Where Do the Gains Come From?
By specialization, resources are utilized in the most
efficient way and the output of both commodities will rise.
The increased output measures the gains from specialization
in production available to be divided between the two
nations through trade.
2.3d Difference Between Mercantilists &
Adam Smith
According to mercantilists’ view, one nation could only
gain at the expense of another nation and each government
should take strict control of all economic activities and trade.
They should adopt protectionist measures to stimulate
exports and restrict imports.
But according to Adam Smith, all nations could gain from
free trade and each nation should adopt a laissez-faire policy
(free trade policy).
2.3e Illustration of Absolute Advantage
Wheat(bushels/man-hour)
Cloth(yards/man-hour)
U.S.
6
4
U.K.
1
5
U.S. has greater efficiency in production of wheat (absolute
advantage) and it should specialize in the production of wheat
and exchange for cloth , while U.K. has greater efficiency in
production of cloth and it should specialize in the production of
cloth and exchange for wheat (absolute advantage).
What happens if U.S. exchanges 6W for 6C with U.K.?
2.3f Comments on the Absolute
Advantage
It can only explain small part of world trade today, but it
can not explain most of the trade between the developed and
the developing countries.
Can we use the theory to carry out
foreign trade?
It can not even explain the trade between
advanced countries because their productivities are
almost the same.
2.4a The Law of Comparative
Advantage
Representative ----- David Ricardo (1772-1823)
Works ---- Principles of Political Economy and Taxation
It explains how mutually beneficial trade can take place
even when one nation is less efficient than ( has an absolute
disadvantage) the other nation in the production of all
commodities. The less efficient nation should specialize in and
export the commodity in which its absolute disadvantage is
smaller (this is the commodity of its comparative advantage),
and should import the other commodity.
2.4b Illustration of Comparative Advantage
Wheat(bushels/man-hour)
Cloth(yards/man-hour)
U.S.
6
4
U.K.
1
2
What should U.S. or U.K. produce?
At what rate should they exchange their commodities?
2.4c Gains from Trade
Rate of Exchange
U.S. Gains
UK Gains
6W:4C
0C
8C
6W:6C
2C
6C
6W:8C
4C
4C
6W:10C
6C
2C
6W:12C
8C
0C
Trade range:
4C<6W<12C
Conclusion:
The closer the rate of exchange is to 4C=6W, the smaller is the
share of the gain going to the United States and the larger is the
share of the gain going to the United Kingdom. On the other hand,
the closer the rate of exchange is to 6W=12C, the greater is the
gain of the United States relative to that of the United Kingdom.
2.4d Exception to Law of Comparative
Advantage
Wheat(bushels/man-hour)
Cloth(yards/man-hour)
U.S.
6
4
U.K.
3
2
Even if one nation has an absolute disadvantage with respect
to the other nation in the production of both commodities, there
is still a basis for mutually beneficial trade, unless the absolute
disadvantage is in the same proportion for the two commodities.
This kind of exception is rare.
2.4e How Can They Trade?
How can they trade if one nation is in absolute disadvantage
in the production of both commodities?
They can still trade when the wage is sufficiently lower in one
nation than it is in the other nation and when both commodities
are expressed in terms of the same currency.
U.S.
U.K.
Wheat(bushels/man-hour)
6
1
Cloth(yards/man-hour)
4
2
Exchange rate:
￡1.00=$2.00
Unit Price of Wheat
Unit Price of Cloth
$6 per hour
in U.S.,
U.S.
$1.00
$1.50
￡1 per hr
in U.K.,
U.K.
$2.00
$1.00
2.4f Price of Wheat and Cloth in U.S. &
U.K.
Exchange rate: ￡1.00=$1.00
Unit Price of Wheat
Unit Price of Cloth
U.S.
$1.00
$1.50
U.K.
$1.00
$0.50
U.S.cannot export wheat to U.K. But U.K. can continue to export cloth
to U.S. The trade will become unbalanced. The dollar price of pound will
have to rise to ￡1.00=$2.00, instead of ￡1.00=$1.00.
Exchange rate: ￡1.00=$3.00
U.S.
U.K.
Unit Price of Wheat
$1.00
$3.00
Unit Price of Cloth
$1.50
$1.50
U.K.can’t export cloth to U.S. But U.S.can continue to export
wheat to U.K. The trade becomes unbalanced. The dollar price of
pound has to fall to ￡1.00=$2.00, instead of ￡1.00=$3.00.
2.5 Assumptions for Comparative
Advantage
2×2model-----Two nations, two commodities and one factor
Free trade.
Perfect mobility of labor within each nation but immobility
between the two nations.
Constant costs of production.
No transportation costs
No technical change
The labor theory of value.
2.5b The Opportunity Cost Theory
It is the amount of a second commodity that must be given up
in order to release enough resources to produce one additional unit
of the first commodity (comp. cost stresses the opportunity cost).
The nation with lower opportunity cost in the production of a
commodity has a comparative advantage in that commodity and
a comparative disadvantage in the second commodity.
Opportunity Costs of Wheat in Terms of Cloth
1W
2/3C
1W
2C
Opportunity Costs of Cloth in Terms of Wheat
3/2W
1C
1/2W
1C
2.5c Production Possibility Frontier
It is a curve showing the various alternative combinations
of two commodities that a nation can produce by fully utilizing
all of its resources with the best technology available to it.
2.5d Production Possibility Schedules
for Wheat and Cloth in U.S. & U.K.
2.5e PPF in U.S & U.K
2.5f Features of PPF
Each point on a frontier represents one combination of
wheat and cloth that the nation can produce.
Points inside the PPF are possible, but are inefficient. It
means that the nation has some idle resources or it is not using
the best technology available to it. Points outside the PPF are
not possible because the nation does not have enough
resources to produce at those points.
The downward slope of the PPF indicates that when it wants
to increase the production of the first commodity, it has to give
up the second commodity
The straight line reflects the fact that the opportunity cost is
constant----constant opportunity costs.
2.5g Constant Opportunity Costs
It means that the constant amount of a commodity must be
given up to produce each additional unit of another commodity.
We have constant opportunity cost when
(1) resources or factors are either perfect substitutes for
each other or used in fixed proportion in the production of both
commodities;
(2) all units of the same factor are homogeneous or exactly
the same quality.
2.5h Consumption Frontier
It shows the combination of consumption that the nation
actually chooses to consume.
In the absence of trade, the production possibility frontier is
also the consumption frontier.
2.6 Basis for and Gains from Trade under Constant Costs
Before trade: U.S. produces at Point A and consumes at point A( 90W and 60C);
U.K. produces at Point A’ and consumes at point A’(40W and 40C).
Total output & consumption: Wheat=90W+40W=130W Cloth=60C+40C=100C
With trade: U.S. produces at Point B (180W), exchanges 70W for 70C with U.K.
and consumes 110W & 70C (gain 20W and 10C) ;
U.K. produces at Point B’(120C), exchanges 70C for 70W with U.S.
and consumes 70W & 50C (gain 30W and 10C) .
Total consumption: Wheat=110W+70W=180W Cloth=70C+50C=120C
2.6b Relative Prices and Comparative
Advantage
It is the price of one commodity divided by the price of
another commodity. This equals the opportunity cost of the
commodity and is given by the absolute slope of the production
possibility frontier (sometimes it is called marginal rate of
transformation).
Relative Price of Wheat: PW/ PC =2/3 in U.S. , Pw/ Pc =2/1 in U.K.
Relative Price of Cloth: PC/ Pw =1.5 in U.S. , Pc/ Pw =0.5 in U.K.
A nation has a comparative advantage if the relative price of
a commodity is lower than that in the other nation.
Opportunity Cost = Relative Price＝MRT
2.6c Equilibrium Relative Commodity Prices With D & S
At PW /PC =2/3, U.S. Produces 180W; At PW /PC =2, U.K. produces 60W.
At PC /PW =1/2, U.K. produces 120C; at PC /PW =3/2, U.S. produces
120C.
2.6d Large Country and Small
Country
Large country is a country that its trade can influence the
world price.
Small country is country that its trade can not affect the
world supply and demand. Small country case is the situation
where trade takes place at the pretrade-relative commodity
prices in the large nation so that the small nation receives all of
the benefits from trade.
2.7 Empirical Test of Ricardian Trade
Model
The first empirical test of the Ricardian trade model was
conducted by MacDougall in 1951 and 1952 using 1937 data.
The results indicated that those industries where labor
productivity was relatively higher in the United States than in
the United Kingdom were the industries with the higher ratios
of U.S. to U.K. exports to third markets. These results were
confirmed by Balassa using 1950 data, Stern using 1950 and
1959 data, and Golub using 1990 data. Thus, it can be seen that
comparative advantage seems to be based on a difference in
labor productivity or costs, as postulated by Ricardo.
However, the Ricardian model explains neither the reason for
the difference in labor productivity or costs across nations nor
the effect of international trade on the earnings of factors.
2.7b Labor Productivity and Comparative Advantage
2.7c Comments on Comparative
Advantage
Ricardian trade model has to a large extent been
empirically verified, but it has a serious shortcoming in that it
assumes rather than explains comparative advantage. That is,
Ricardo in general provided no explanation for the difference in
labor productivity and comparative advantage between nations
and they could not say much about the effect of international
trade on the earnings of factors of production. These were left
for Heckscher-Ohlin model.
2.8 Problems
A2.1 Comparative Ad with More Than Two
Commodities
Commodity Price in U.S. Price in U.K. $ price in U.K. $ price in U.K. $ price in U.K.
A
B
C
D
E
$
￡
￡1=$2
$2
$4
$6
$8
$10
￡6
￡4
￡3
￡2
￡1
$12
$8
$6
$4
$2
￡1=$1
$6
$4
$3
$2
$1
￡1=$3
$18
$12
$9
$6
$3
What is the dollar price of pound for US to export at least one
commodity?
￡6.00> $2.00, ￡1.00 > $0.33
What is the dollar price of pound for UK to export at least one
commodity?
￡1.00< $10.00
Range of Exchange Rate:
$0.33 < ￡1.00 <$10
A2.2 Comparative Ad with More Than Two Nations
What is the range of Pw/Pc if there is trade between the nations?
Range of Pw/Pc:
1<Pw/Pc <5
What would happen if Pw/Pc =3, Pw/Pc=4 and 2?
Chapter 3
The Standard Theory of
International Trade
3.1 Introduction
This chapter will extend our simple model to the more
realistic case of increasing opportunity costs.
Tastes or demand preferences are introduced with
community indifference curves.
We then will 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.
3.1b Review
What is opportunity cost? And constant opportunity cost?
Under what condition can we have constant opportunity cost?
What is production possibility frontier?
What does the production possibility frontier look like with a
constant opportunity cost?
3.2a 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).
?
1.Resources or factors of production are not
homogeneous. It means that as the nation produces more
of a commodity, it must utilize resources that become
progressively less efficient or less suited for the
production of that commodity. As a result, the nation
must give up more and more of the second commodity to
release just enough resources to produce each additional
unit of the first commodity.
2. They are not used in the same fixed proportion or
intensity on the production of all commodities.
3.2a The Increasing Opportunity Costs(B)
Concave PPF reflect increasing opportunity costs in each nation
in the production of both commodities. Nation 1 must give up more
and more Y for each additional batch of 20X that it produces. This
is illustrated by downward arrows of increasing length. Similarly,
Nation 2 incurs increasing opportunity costs in terms of forgone X
for each additional batch of 20Y it produces.
3.2b Determinants of Different Shape of
PPF
What determine the shape of production possibility frontiers?
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.
Can they change?
As the supply of factors or technologies changes over
time, a nation’s production possibility frontier may also
change, such as the production frontiers in Japan in
1950s and 1990s. China production possibility frontier
will also change.
3.2c Marginal Rate of Transformation
(MRT)
Marginal rate of transformation (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.
The marginal rate of transformation of X for Y refers to the
amount of Y that a nation must give up to produce each
additional unit of X. Thus, MRT is another name for the
opportunity cost of X 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.
3.3a Community Indifference Curve
It shows the various combinations of two commodities that
yield equal satisfaction to the community or nation.
Higher curves refer to greater satisfaction;
Lower curves refer to less satisfaction.
Negatively sloped and convex from the origin,
Not cross each other.
3.3b 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.
For example, the slope of indifference curve I is greater at point
N than at Point A.
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.
Comparison: While increasing opportunity cost in production
is reflected in concave production frontier, a declining MRS in
consumption is reflected in convex community indifference
curves.
3.3c Difficulties with Community
Indifference
Curves
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 increase its volume of
trade. Exporters benefit but domestic producers competing with
imports will suffer.There is also differential impact on consumers.
Trade will change the distribution of real income in the nation
and may cause indifference curves to intersect.
Compensation Principle:
-------- the nation will benefit from trade
How to solve it?
if the gainer would be better off even after
fully compensating the losers for their losses.
The government can compensate the losers through
transfer payment, tax, subsidies and other means.
3.4 Equilibrium In Isolation
In isolation, a nation is in equilibrium when it reaches the
highest indifference curve possible given its 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 (equilibrium point
in isolation) 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.
3.4b Equilibrium In Isolation
3.4c Equilibrium-Relative Commodity Price in
Isolation
The equilibrium relative commodity price in isolation is a
price at which a nation is maximizing its welfare in isolation. It is
given by the slope of the common tangent to the nation's PPF and
CIC at the autarky point of production and consumption. Since
in isolation PA< PA’, nation 1 has a comparative advantage in
commodity X, and nation 2 in Y.
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.
3.5 Basis for & the Gains from Trade with
Increasing Costs
The basis for mutually beneficial trade is the relative
commodity price. A difference in the relative commodity prices
between the two nations 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 it
will continue until relative commodity prices in the two nations
become equal at the level at which trade is in equilibrium.
Through trading, both nations will end up consuming more
products than in the absence of trade.
3.5b Illustrations of the Basis for and Gains
3.5c 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.
The greater is Nation 1’s desire for Y(the commodity exported
by Nation 2) and the weaker is Nation 2’s desire for X (the
commodity exported by Nation 1), the closer the equilibrium price
with trade will be to the pretrade equilibrium price in Nation 1
and smaller will be nation 1’s share of the gains.
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.
3.5d Complete and 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.
The reason is -----increasing opportunity cost!!!
Specialization incurs increasing opportunity
cost. The relative commodity price move toward
each other until they are identical in both nations.
Nation 1 specializes in the production of X, it
incurs increasing opportunity costs in producing
X. The same is true for nation 2.
3.5e Small Country Case with
Increasing
Costs
Under constant
opportunity costs, the only exception to
complete specialization in production was in the small country
case. The large nation continued to produce both commodities
even with trade, because the small nation could not satisfy all of
the demand for imports of the large nation.
Under increasing opportunity costs, both nations have
incomplete specialization in the production of the commodity of
their comparative advantage, even if it is the small nation.
The equilibrium relative price of X in the world market is 1
(Pw=1), and it is not affected by trade with small Nation 1. In
absence of trade, the relative price of X in Nation 1 (PA=1/4) is
lower than the world market price, Nation 1 has a comparative
advantage in X. With trade, Nation 1 specializes in X until it
reaches point B on the production frontier, where PB=1=Pw.
Nation 1 does not specialize completely in the production of X.
3.5f The Gains from Exchange & Specialization
3.6 Trade Based on Difference in Taste
If the production possibility frontiers
are identical, is there any basis for trade?
Yes. 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.
Assumptions:
Identical production frontiers in the two nations.
3.6 Illustration of Trade Based on Different Taste
A3.1 Appendix to CH3
Isoquants, isocosts and equilibrium
Illustrations of these concepts for 2 nations, commodities and
2 factors
Edgeworth box diagram and the production frontier
Change in the ratio of resource use in the specialization
A3.2a Isoquant
It is a curve showing the various combinations of 2 factors (K
and L) that a firm can use to produce a specific level of output. It
has the same general characteristics as indifference curves.
Higher isoquants refer to larger outputs and lower ones refer
to smaller outputs.
They are negatively sloped because a firm using less K must
use more L to remain on the same isoquants. The absolute slope
of the isoquant is called the marginal rate of technical
substitution of labor for capital in production (MRTS) and
measures how much K the firm can give up by increasing L by
one unit and still remain on the same isoquant. As a firm moves
down an isoquant and uses more L and less K, it finds it more and
more difficult to replace K with L. MRTS is diminishing. It
makes the isoquant convex from the origin.
They do not cross because an intersection means the same level
of output on the two isoquants.
A3.2b Illustration of Isoquant
A3.3 Isocost
Isocost is a line showing the various combinations of two
inputs (K, L) that a firm can hire for a given expenditure at
given factor prices.
If the total expenditure is $30 and PK=$10 and PL=$5, how to
allocate it?
3K or 6L can be used
in production or
other combination.
The absolute slope of
the isocost of 3/6=1/2
gives the relative
price of L, that is
PL/PK =$5/$10 =1/2
A3.4 Equilibrium and Expansion
Path
When a producer maximizes output for a given cost outlay,
that is, reaching the highest isoquant possible with a given
isocost, he is in equilibrium.
When an isoquant is tangent to an isocost (MRTS= PL/PK) we
have equilibrium.
Expansion path is the straight line from the origin
connecting equilibrium points, such as A1 and A2.
A production function shows that increasing inputs in a
given proportion results in output increasing in the same
proportion.
Q= f (K, L)
A3.5a Isoquants, isocosts and equilibrium
Isoquants 1X and 2X give the
various combinations of K and L
that the firm can use to produce one
and two units of X, respectively.
Isocosts are the lines from 3K to 6L and from 6K to 12L, the absolute
slope measures the PL /PK =1/2.
Equilibrium is at points A1 and A2, the highest isoquants possible for a given
total expenditure.
The expansion path gives the constant K/L=1/4 ratio in producing X.
A3.5b Production with Two
Nations, Two Commodities and
Two Factors
Y is the K-intensive commodity in both nations. The K/L ratio is
lower in Nation 1 than in Nation 2 in both X and Y because PL/PK
is lower in Nation 1. Since Y is always the K-intensive and X is
always the L-intensive commodity in both nations, the X and Y
isoquants intersect only once in each nation(discussed in CH5).
A3.6 Edgeworth
Box and
Production
Frontier for
Nation 1
A3.7 Edgeworth Box
and Production
Frontier for Nation 2
A3.8 Some Important Conclusions
The movement from point A to point B on Nation 1's contract curve refers
to an increase in the production of X (the commodity of its comparative
advantage) and results in a rise in the K/L ratio. This rise in the K/L ratio is
measured by the increase in the slope of a straight line (not drawn) from origin
Qx to point B as opposed to point A. The same movement from point A to
point B also raises the K/L ratio in the production of Y.This is measured by the
increase in the slope of a line from origin Oy to point B as opposed to point A.
The rise in the K/L ratio in the production of both commodities in Nation 1
can be explained as follows. Since Y is K intensive, as Nation 1 reduces its
output of Y, capital and labor are released in a ratio that exceeds the K/L ratio
used in expanding the production of X. There would then be a tendency for
some of the nation's capital to be unemployed, causing the relative price of K
to fall (i.e., PL/PK to rise).
Nation 1 substitutes K for L in the production of both commodities until all
available K is once again fully utilized. Thus, the K/L ratio in Nation 1 rises in the
production of both commodities. This also explains why the production contract
curve is not a straight line but becomes steeper as Nation 1 produces more X ( it
moves farther from Ox). The contract curve would be a straight line only if
relative factor prices remained unchanged, and here factor prices change.