INTERNATIONAL

1
INTERNATIONAL ECONOMICS XU SONG PROFESSOR OF
ECONOMICS ANHUI UNIVERSITY OF FINANCE ECONOMICS
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ANHUI UNIVERSITY OF FINANCE ECONOMIC
Dept. of Intl Trade and Economics
Business School XU SONG Prof. of
Economics Office 2nd Floor (West wing),
Building 4 Office Hour Every Afternoon
200-500 Tel [phone](O)
3
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
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Dr. Dominick Salvatore Professor at Fordham
University of New York City
5
1.1B Contents of the Book
21 Chapters
Part OneInternational 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
6
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.
7
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
8
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 ...)
9
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
(??????????) as well as the effects of the
macroeconomics interdependence (?????????) among
nations under different international monetary
system, and their effects on a nation's welfare.
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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. )
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1.3A Assumptions in International Trade

• 222 model

• No trade restrictions

• Perfect mobility of factors within nations and
  not
• internationally

• Perfect competition

• 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.
12
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.
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.
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(No Transcript)
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1.4A China GDP and Foreign Trade Dependency
Year GDP (bill. ?) ExpImp (bill. ) ExpImp GDP Export (bill. ) Export GDP Import (bill. ) Import GDP Balance ()
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 851.21 438.37 412.84 255.4
2004
Data sourceChina Customs
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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 US1.00 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 ?
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1.4C Foreign Trade Dependency in Some Nations
1970 1980 1990 1993
Developing countries Developing countries Developing countries Developing countries 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 Advanced countries Advanced countries Advanced countries 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
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1.5A Basic International Trade Data
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1.5A Basic International Trade Data(2)
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1.5A Basic International Trade Data(3)
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1.5A Basic International Trade Data(4)
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1.5A Basic International Trade Data(5)
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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?
( Japan133.57 billion dollars in 2003 )
4. Which is the second largest trading partner?
( U.S. 126.33 billion dollars in 2003 )
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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 dont consume it. 4. Trade is great at
cost-cutting but no net impact on jobs. 5. NAFTA
reduces goods prices.
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THANK YOU !
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Chapter 2The Law of Comparative Advantage
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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.
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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 ---- Englands 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 nations 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.
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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.
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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.
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2.3 Adam Smiths Trade Theory
----------- Absolute advantage
The basis for trade
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.
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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.
32
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).
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2.3e Illustration of Absolute Advantage
U.S. U.K.
Wheat(bushels/man-hour) Cloth(yards/man-hour) 6 1 4 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.?
34
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.
It can not even explain the trade between
advanced countries because their productivities
are almost the same.
35
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.
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2.4b Illustration of Comparative Advantage
U.S. U.K.
Wheat(bushels/man-hour) Cloth(yards/man-hour) 6 1 4 2
What should U.S. or U.K. produce?
At what rate should they exchange their
commodities?
37
2.4c Gains from Trade

• Rate of Exchange U.S. Gains UK Gains

0C 8 C
6W4C
2C 6 C
6W6C
4C 4 C
6W8C
6C 2C
6W10C
8C 0C
6W12C
Trade range
4Clt6Wlt12C
Conclusion
The closer the rate of exchange is to
4C6W, 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
6W12C, the greater is the gain of the United
States relative to that of the United Kingdom.
38
2.4d Exception to Law of Comparative Advantage
U.S. U.K.
Wheat(bushels/man-hour) Cloth(yards/man-hour) 6 3 4 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.
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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) Cloth(yards/man-hour) 6 1 4 2
6 per hour ?1 per hr
in U.S., in U.K.,
Exchange rate ?1.002.00
U.S. U.K.
Unit Price of Wheat Unit Price of Cloth 1.00 2.00 1.50 1.00
40
2.4f Price of Wheat and Cloth in U.S. U.K.
Exchange rate ?1.001.00
U.S. U.K.
Unit Price of Wheat Unit Price of Cloth 1.00 1.00 1.50 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 ?1.002.00, instead of
?1.001.00.
Exchange rate ?1.003.00
U.S. U.K.
Unit Price of Wheat Unit Price of Cloth 1.00 3.00 1.50 1.50
U.K.cant 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 ?1.002.00, instead of ?1.003.00.
41
2.5 Assumptions for Comparative Advantage
22model-----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.
42
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
1/2W 1C
3/2W 1C
43
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.
44
2.5d Production Possibility Schedules for Wheat
and Cloth in U.S. U.K.
45
2.5e PPF in U.S U.K
46
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.
47
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.
Realistic?
48
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.
49
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 Wheat90W40W130W
Cloth60C40C100C
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
Wheat110W70W180W Cloth70C50C120C
50
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 PriceMRT
51
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.
52
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.
53
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.
54
2.7b Labor Productivity and Comparative Advantage
55
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.
56
2.8 Problems
57
A2.1 Comparative Ad with More Than Two Commodities
?6 ?4 ?3 ?2 ?1
2 4 6 8 10
12 8 6 4 2
6 4 3 2 1
18 12 9 6 3
What is the dollar price of pound for US to
export at least one commodity?
?6.00gt 2.00, ?1.00 gt 0.33
What is the dollar price of pound for UK to
export at least one commodity?
?1.00lt 10.00
Range of Exchange Rate
0.33 lt ?1.00 lt10
58
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 1ltPw/Pc lt5
What would happen if Pw/Pc 3, Pw/Pc4 and 2?
59
THANK YOU !
60
Chapter 3The Standard Theory of International
Trade
61
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.
62
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?
63
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.
64
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.
65
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.
As the supply of factors or technologies
changes over time, a nations production
possibility frontier may also change, such as the
production frontiers in Japan in 1950s and 1990s.
China production possibility frontier will also
change.
66
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.
67
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.
68
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.
69
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 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.
70
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 nations
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 nations comparative
advantage.
The tangency point can be on lower
indifference curves, but it would not maximize
the nations welfare on higher curves, the
nation would not achieve the level of welfare
with the existing resources and technologies.
71
3.4b Equilibrium In Isolation
72
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
PAlt 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 nations
production possibility frontiers) and the forces
of demand (given by the nations 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.
73
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.
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3.5b Illustrations of the Basis for and Gains
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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 1s desire for Y(the
commodity exported by Nation 2) and the weaker is
Nation 2s 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 1s
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.
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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.
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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 (Pw1), and it is not affected
by trade with small Nation 1. In absence of
trade, the relative price of X in Nation 1
(PA1/4) 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
PB1Pw. Nation 1 does not specialize completely
in the production of X.
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3.5f The Gains from Exchange Specialization
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3.6 Trade Based on Difference in Taste

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.
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3.6 Illustration of Trade Based on Different Taste
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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
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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.
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A3.2b Illustration of Isoquant
84
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 PK10 and
PL5, how to allocate it?
3K or 6L can be used in production or other
combination. The absolute slope of the isocost of
3/61/2 gives the relative price of L, that is
PL/PK 5/10 1/2
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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)
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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/L1/4 ratio in producing X.
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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).
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A3.6 Edgeworth Box and Production Frontier for
Nation 1
89
A3.7 Edgeworth Box and Production Frontier for
Nation 2
90
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.
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