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International

Economics Twelfth Edition

The Standard Theory

Of International Trade

Dominick Salvatore

John Wiley & Sons, Inc.

Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.

CHAPTER T H R E E

3

Learning Goals:

Understand how relative commodity prices and the comparative advantage of nations are determined under increasing costs.

Show the basis and the gains from trade under increasing costs.

Explain the relationship between international trade and deindustrialization in the U.S. and other advanced nations.


3.1 Introduction

Extending the simple trade model

Increasing opportunity costs

Tastes and preferences

Incomplete specialization


3.2 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.

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.



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

3.2 The Production Frontier with Increasing Costs

Reasons for Increasing Opportunity Cost and Differing PPFs

Factors of production are not homogeneous, and thus producing increasing amounts of a good requires using inputs that are less productive.

Different countries have different resource endowments, giving rise to different PPFs.

May also use different technologies.


3.3 Community Indifference Curves

Combinations of two commodities that yield equal satisfaction to the community or nation.

Negatively sloped and convex to the origin.

Cannot cross.

Slope = Marginal Rate of Substitution (MRS)

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.

The marginal rate of substitution (MRS) falls as more of good X is consumed.



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

3.3 Community Indifference Curves

Problems

The distribution of income is held constant when drawing community indifference curves, and a different income distribution could result in very different curves.

Trade can change the distribution of income significantly, and thus expansion of trade may cause intersecting indifference curves and unclear effects on social welfare.

Compensation principle: the nation benefits from trade if the winners would be better off even after compensating the losers.


3.4 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 the production constraint.

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.



FIGURE 3-3 Equilibrium in Isolation.

3.5 The 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.

Specialization will usually be incomplete, since costs of production increase in each country with greater specialization.



FIGURE 3-4 The 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 not be balanced.

In general, the greater the change from a nation’s autarky price to the post-trade price, the greater the size of the gains from trade.



The Gains from Exchange and Specialization

A nation’s gains from trade can be broken down into two components.

Gains from exchange = increase in consumption from the change in the relative price (compared to the autarky price), holding production constant. (Point T in Figure 3-5)

Gains from specialization = increase in consumption resulting from the reallocation of production towards the good in which the country has a comparative advantage, holding the world relative price constant. (Point E in Figure 3-5).



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


The switch in production of goods from autarky to the trade equilibrium also causes changes in employment of factors of production in each sector.

In industrialized countries, this implies loss of manufacturing jobs– deindustrialization.

But empirical evidence shows that most manufacturing job loss has been due to change in labor productivity and other internal causes rather than trade.


3.6 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.



FIGURE 3-6 Trade Based on Differences in Tastes.

Case Study 3-1 Comparative Advantage of the Largest Advanced and Emerging Economies


Case Study 3-2 Specialization and Export Concentration in Selected Countries


Case Study 3-3 Job Losses in High Import-Competing Industries


Case Study 3-4 International Trade and Deindustrialization in the United States, the European Union, and Japan


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



FIGURE 3-7 Isoquants, Isocosts, and Equilibrium.


FIGURE 3-8 Production with Two Nations, Two Commodities, and Two Factors.


FIGURE 3-9 Derivation of the Edgeworth Box Diagram and Production Frontier for Nation 1.


FIGURE 3-10 Derivation of the Edgeworth Box Diagram and Production Frontier for Nation 2.

Copyright 2016 John Wiley & Sons, Inc.

All rights reserved. Reproduction or translation of this work beyond

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