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Chapter Three: The Standard Theory of International Trade

Chapter Three: The Standard Theory of International Trade. 3.1 introduction. The model introduces increasing opp. costs and tastes or demand preferences with community indifference curves.

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Chapter Three: The Standard Theory of International Trade

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  1. Chapter Three: The Standard Theory of International Trade

  2. 3.1 introduction • The model introduces increasing opp. costs and tastes or demand preferences with community indifference curves. • Forces of demand and supply determine the equilibrium-relative commodity price in each nation in the absence of trade under increasing costs and will indicate the commodity of comp-adv. for each nation. • Then see how with trade, each nation gains by specializing in production and export of the commodity with which it has comp-adv. and import with which it has comp-disadv.

  3. 3.2 Production Frontier with Increasing Costs • Increasing costs mean that the nation must give up more and more of one commodity to release just enough resources to produce each additional unit of another commodity. As a result, the PPF is concave. • Illustration of Increasing Costs • In Fig. 3-1, if nation 1 wants to increase output of X (point A), it should reduce output of Y by more and more units. • If nation 2 wants to increase output of Y (point A/), it should reduce output of X by more and more units • Thus, both nations face increasing costs in the production of the two commodities.

  4. FIGURE 3-1 Production Frontiers of Nation 1 and Nation 2 with Increasing Costs.

  5. B. The Marginal Rate of Transformation (MRT) • The MRT of X for Y refers to the amount of Y that a nation must give up to produce additional unit of X. • It is another name for the opp. cost and is given by the slope of the production frontier at the point of production. • If the MRT of nation 1 at point A is ¼, this means that nation 1 must give up ¼ of a unit of Y to release just enough resources to produce one additional unit of X at this point. • If the MRT at point B is 1, a movement from A to B reflects the increasing opp. costs in producing more X

  6. 3.3 Community Indifference Curves • A community indifference curve shows the various combinations of two commodities that yield equal satisfaction to the community. • Higher curves refer to greater satisfaction. • Illustration of Community Indifference Curves • Fig. 3-2 shows 3 hypothetical indifference curves for the two nations. They differ according to tastes. • Points A and N give equal satisfaction. • Points T and H refer to higher satisfaction

  7. FIGURE 3-2 Community Indifference Curves for Nation 1 and Nation 2.

  8. The Marginal Rate of Substitution (MRS) • The MRS of X for Y in consumption refers to the amount of Y that a nation must give up for one extra unit of X and still remain on the same IC. • This is given by the (absolute) slope of the community IC at the point of consumption and declines as the nation moves down the curve. • The decline in MRS is a reflection of the fact that the more of X and less of Y a nation consumes, the more valuable Y becomes compared to X.

  9. 3.4 Equilibrium in Isolation • Illustration of Equilibrium in Isolation • Fig. 3-3 combines the production frontiers and the community IC. • IC I is the highest IC curve that nation 1 can reach with its production frontier. Thus, it is in equil when it produces and consumes at point A in the absence of trade, or autarky. • There is only one point of tangency, or equilibrium.

  10. FIGURE 3-3 Equilibrium in Isolation.

  11. Equilibrium-Relative Commodity Prices and Comparative Advantage • The equil-relative commodity price in isolation is given by the slope of the common tangent to the nation’s production frontier and the IC at the autarky point of production and consumption. • Equil-relative price of X in isolation is PA = PX / PY = ¼ in nation 1 and PA’ = PX / PY =4 in nation 2. • Relative prices are different in the two nations because their production frontiers and ICs differ in shape and location.

  12. Since in isolation PA < PA’ nation 1 has a comp- adv in X and nation 2 in Y. Both can gain if nation 1 specializes in X, and nation 2 in Y. • Forces of supply (nation’s PF) and forces of demand (nation’s IC) together determine the equilibrium-relative commodity prices in each nation in autarky.

  13. 3.5 The Basis for and the Gains from Trade with Increasing Costs • Illustrations of the Basis for and the Gains from Trade with Increasing Costs • Starting from point A, as nation 1 specializes in X and moves down its PF, it incurs increasing opp. costs (as reflected in the increasing slope of the PF). • Starting from point A’, as nation 2 specializes in Y and moves upward its PF, it incurs increasing opp. costs (as reflected in the decline in slope of the PF). • Specialization in production continues until relative commodity prices become equal in the two nations.

  14. FIGURE 3-4 The Gains from Trade with Increasing Costs.

  15. The common relative price (slope) with trade will be somewhere between the pretrade relative prices of ¼ and 4, at the level at which trade is balanced. In figure 3-4, this is PB = PB’ = 1. • With trade, nation 1 moves from A down to B. by exchanging 60X for 60Y with nation 2, nation 1 ends up consuming at E (70X and 80Y) on its IC III. • This is the highest level of satisfaction that nation 1 can reach with trade at PX/PY = 1. Thus, nation 1 gains 20X & 20Y from its no-trade equilibrium point. • Nation 2 moves from A’ to B’, and with trade of 60Y for 60X it ends up consuming at E’ (100X and 60Y). • Nation 2 gains 20X & 20Y from specialization/trade.

  16. Equilibrium-Relative Commodity Prices with Trade (ERCPT) • The ERCPT is the common relative price in both nations at which trade is balanced, this is PB= PB’=1. • At this relative, the amount of X that nation 1 wants to export (60X) equals the amount of X that nation 2 wants to import (60X). Similarly for nation 2 and Y. • Any other relative price could not persist because trade would be unbalanced. • The greater the desire of nation 1 for Y and the weaker is nation 2’s desire for X, the closer the equil. price with trade will be to 1/4 and the smaller will be nation 1’s share of the gain.

  17. Once equil-relative price with trade is determined, gains from trade will be known exactly and the model will be complete. • The equil-relative price of X with trade (PB= PB’=1) results in equal gains (20X and 20Y). • If the pretrade - relative price had been the same in both nations, there would be no comp-advantage or disadvantage in either nation, and no specialization in production or mutually beneficial trade would take place.

  18. Incomplete Specialization • Under constant costs, both nations specialize completely in production of the commodity of their comparative advantage. • However, under increasing costs there is incomplete specialization in production in both nations. • That is, nation 1 continues producing Y (point B), and nation 2 continues producing X (point B’). • Reason: as nation 1 specializes in X, it incurs increasing opp. costs in production of X. Similarly, as nation 2 produces more Y, it incurs opp. costs in Y (implying decreasing opp. costs of X).

  19. With specialization, relative prices move toward each other until they are identical in both nations. • At this point, it does not pay for either nation to continue expanding production of the commodity of its comparative advantage. • This occurs before either nation has completely specialized in production. • In figure 3-4, before nation 1 or nation 2 has completely specialized in production.

  20. Small –Country Case with Increasing Costs • Under constant costs, the small country completely specializes in the production of the commodity of its comparative advantage, but the large country doesn’t • However, under increasing costs, we find incomplete specialization even in the small country case. • Assume nation 1 is the small country. • With no trade, nation 1 at equil. at point A. • Suppose the equil-relative price of X on world market is 1 (PW=1), and not affected by trade with nation 1. • Since the pretrade relative price of X in nation 1 is PA=1/4 is lower than world price, it has comparative advantage in the production of X.

  21. With trade, nation 1 specializes in X until it reaches point B where PB=1=PW • Even though nation 1 is a small country, it doesn’t completely specialize in X (as under constant costs). • By exchanging 60X for 60Y, nation 1 reaches point E and gains 20X and 20Y (compared to autarky; A). • The only difference from the case discussed before is that nation 1 doesn’t affect relative prices in nation 2. • Nation 1 captures all the benefits from trade.

  22. The Gains from Exchange and Specialization • A nation’s gains from trade arise from exchange and specialization. • Fig 3-5 shows this breakdown for the small nation 1 • Suppose nation 1 could not specialize in X with trade and continued produce at A, where MRT=1/4 • Starting from A, nation 1 could export 20X in exchange for 20Y at PW =1 and end up at point T. • Although it consumes less of X and more of Y (at T) it is better off than it was in autarky because it is on higher indifference curve. • Movement from A to T in consumption measures the gain from exchange.

  23. FIGURE 3-5 The Gains from Exchange and from Specialization.

  24. If subsequently nation 1 also specialized in X and produced at B, it could then exchange 60X for 60Y with the rest of the world and consume at E. • The movement from T to E in consumption measures the gains from specialization in production. • In sum, the movement from A (on IC I) to T (on IC II) made possible by exchange only. • The movement from T (on IC II) to E (on IC III) made possible by specialization in production. • Note that nation 1 is not in equil at point A with trade because MRT < PW. To be in equil in production, it should expand production of X until it reaches point B, where PB = PW =1

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