Dominic Salvator CHP 3

CHAPTER T H R E E
3 International Economics
Eleventh Edition
The Standard Theory

Of International Trade
Dominick Salvatore
John Wiley & Sons, Inc.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
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.
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).
FIGURE 3-1 Production Frontiers of Nation 1 and Nation 2 with
Increasing Costs.
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.
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.
FIGURE 3-2 Community Indifference Curves for Nation 1 and
Nation 2.
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.
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.
FIGURE 3-3 Equilibrium in Isolation.
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.
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.
FIGURE 3-4 The Gains from Trade with Increasing Costs.
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.
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.
FIGURE 3-5 The Gains from Exchange and from Specialization.
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 2013 John Wiley & Sons, Inc.
 All rights reserved. Reproduction or translation of this work beyond

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information herein.

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CHAPTER T H R E E

The Standard Theory

 Understand how relative commodity prices

 Increasing Opportunity Costs

 Increasing cost production possibilities

 The marginal rate of transformation (MRT)

 A community indifference curve shows

 The marginal rate of substitution (MRS) falls

 Interaction of forces of demand (community

 Nations seek the highest possible indifference

 The equilibrium-relative commodity price in

 Relative prices are different in Nation 1 and

 Relative commodity price differentials

 Each nation should specialize in the

 Equilibrium-relative commodity price with

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

 Under constant cost conditions, specialization

 Even if two nations have identical PPFs, basis

 Nation with relatively smaller demand for X

 Production Functions, Isoquants, Isocosts and

 Production Theory with Two Nations, Two

 The Edgeworth Box and Production Frontiers

 All rights reserved. Reproduction or translation of this work beyond

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