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 4307Homework 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 AustraliaCorn 2 8MP3 12 2

a. Which country has the absolute advantage in producing Corn and MP3 production?

b. 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.

a. If both countries have 100 Labor, draw and show the production possibilities frontier for both countries.

b. If each country specializes on the product with comparative advantage show the amount of gains from trade.

c. What will be the range of possible level of terms of trade for each good?