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CHAPTER T H R E E

3 International
Economics
Tenth Edition

The Standard Theory


Of International Trade
Dominick Salvatore
John Wiley & Sons, Inc.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
In this chapter:
 Production Frontier with Increasing Costs
 Community Indifference Curves
 Equilibrium in Isolation
 Basis for and Gains from Trade with
Increasing Costs
 Trade Based on Differences in Taste

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
The Production Frontier with Increasing Costs

 Increasing Opportunity Costs


 A nation must give up more and more of one
commodity to release just enough resources to
produce each additional unit of another
commodity.

 Increasing cost production possibilities


frontier is concave to the origin (not a straight
line).

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-1 Production Frontiers of Nation 1 and Nation 2 with
Increasing Costs.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
The Production Frontier with Increasing Costs

 The marginal rate of transformation (MRT)


increases as more units of good X are
produced.
 The marginal rate of transformation is another
name for opportunity cost.
 The value of MRT is given by the slope of the
PPF.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Community Indifference Curves

 A community indifference curve shows


combinations of two commodities that yield
equal satisfaction to the community or nation.
 Represent measure of taste and preference.
 Characteristics of community indifference
curves:
 The higher the curve, the greater the utility.
 Negative slope, convex to the origin.
 Different curves do not cross.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-2 Community Indifference Curves for Nation 1 and
Nation 2.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Community Indifference Curves

 The marginal rate of substitution (MRS) falls


as more of good X is consumed.
 The MRS of X for Y in consumption is the amount
of Y that a nation could give up for one extra unit
of X and still remain on the same indifference curve.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Equilibrium in Isolation

 Interaction of forces of demand (community


indifference curves) and supply (production
possibilities frontier) determine equilibrium for a
nation in the absence of trade (autarky).

 Nations seek the highest possible indifference


curve, given its production constraint.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-3 Equilibrium in Isolation.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Equilibrium in Isolation

 The equilibrium-relative commodity price in


isolation = slope of tangency between PPF
and indifference curve at autarky point of
production and consumption.

 Relative prices are different in Nation 1 and


Nation 2 because of different shape and
location of PPF’s and indifference curves.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Basis for and Gains from Trade with
Increasing Costs

 Relative commodity price differentials


between two nations reflect comparative
advantages, and form basis for mutually
beneficial trade.

 Each nation should specialize in the


commodity they can produce at the lowest
relative price.
 Specialization will continue until relative
prices equalize between nations.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-4 The Gains from Trade with Increasing Costs.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Basis for and Gains from Trade with
Increasing Costs

 Equilibrium-relative commodity price with


trade = common relative price at which trade
is balanced.

 Balanced trade: quantity of X (Y) Nation 1(2)


wants to export = quantity of X(Y) Nation 2(1)
wants to import.
 Any other relative price could not persist
because trade would be unbalanced.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Basis for and Gains from Trade with
Increasing Costs

 Under constant cost conditions, specialization


is complete.
 Under increasing cost conditions,
specialization is incomplete:
 As production moves along PPF toward
comparative advantage good, relative costs
change, thus changing basis and gains from
trade.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-5 The Gains from Exchange and from Specialization.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Trade Based on Differences in Taste

 Even if two nations have identical PPFs, basis


for mutually beneficial trade will still exist if
tastes, or demand preferences, differ.

 Nation with relatively smaller demand for X


will have a lower autarky relative price for,
and comparative advantage, in X.

Salvatore: International Economics, 10th Edition © 2009 John Wiley & Sons, Inc.
FIGURE 3-6 Trade Based on Differences in Tastes.
Salvatore: International Economics, 10th Edition © 2009 John Wiley & Sons, Inc.
Appendix to Chapter 3

 Production Functions, Isoquants, Isocosts and


Equilibrium

 Production Theory with Two Nations, Two


Commodities, and Two Factors

 The Edgeworth Box and Production Frontiers

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-7 Isoquants, Isocosts, and Equilibrium.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-8 Production with Two Nations, Two Commodities, and
Two Factors.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-9 Derivation of the Edgeworth Box Diagram and
Production Frontier for Nation 1.
Salvatore: International Economics, 8th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-10 Derivation of the Edgeworth Box Diagram and
Production Frontier for Nation 2.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.