International Economics: The Standard Theory of International Trade

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.
Learning Goals:
Objective of Ch.3: To Extend the Simple Model of Ch.2 to

the More Realistic Case of Increasing Opportunity Costs
Considering both sides of production and consumption, we

figure out the equilibrium to explain trade patterns.
Production (Supply) Side:

Production Possibility Frontier
(PPF)
Equilibrium
Consumption (Demand) Side:
Community Indifference Curves
The Production Frontier with Increasing Costs
Increasing Opportunity Costs: The opportunity costs of

producing a good are increasing when an economy decides
to produce each additional unit of the good.
 Increasing amounts of another item must be given up in

order to release sufficient resources to produce one more
unit of a given item.
 In this case, the Production Possibility Frontier (PPF) is

concave from the origin (or the PPF is bowed out).
 Compare this case with the case of constant opportunity

costs which have a linear PPF.
 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.
What leads to increasing opportunity costs?

 Resources or factors of production are NOT
homogeneous.
 In other words, all units of the same factor are
not identical.
 In addition, resources or production factors are
NOT used in the same fixed proportion in the
production of all commodities.
 Therefore, an economy must give up more and
more of the second commodity to release just
enough resources to produce each additional unit
of the first commodity.
 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 at the production point.
 MRT = (Change in Y)/(Change in X)
 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.
 Negatively sloped, convex to the origin.
 Different curves do not cross.
FIGURE 3-2 Community Indifference Curves for Nation 1 and
Nation 2.
Y Marginal Rate of
Substitution (MRS): The
amount of one commodity that
a nation could give up in
exchange for one extra unit of
a second commodity and still
III
remain on the same
II
indifference curve
I
The marginal rate of
X substitution (MRS) falls as
 The MRS is given by the more of good X is consumed.
slope of the community The MRS is the amount of one
indifference curve at the point commodity that must be given
of consumption. up as one gains additional
units of another commodity.
 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
 Autarky: The Absence of Trade or Isolation

 Self-sufficient economy
 Interaction of forces of demand (community
indifference curves) and supply (production
possibilities frontier) determine equilibrium for a
nation in the absence of trade.
 Nations seek the highest possible indifference curve,
given the production constraint.
 This will occur when one community indifference
curve is tangent to the PPF.
For the indicated case, the

equilibrium occurs at the Y
tangency of community
indifference curve II and the
PPF.
III
Given the convex, downward II
sloping, and non-intersecting I
nature of community
indifference curves, only
one such tangency will exist.
X
The equilibrium relative

commodity price in isolation
(or autarky) is given by the Y
slope of the tangent line.
The slope of this tangent is
Px/PY or the price of good X
divided by the price of good II
Y.
This slope also gives the
opportunity cost of producing
X in terms of foregone units
of Y. X
At the equilibrium in
isolation (or autarky), the
nation is producing at point Y
A, X1 of good X and Y1 of
good Y.
Y1 A
In addition, the nation is also
consuming at point A, X1 of II
good X and Y1 of good Y.
At the equilibrium in isolation

(or autarky), the production
point is identical to the X1 X
consumption point.
FIGURE 3-3 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.
 Trade in the standard model is driven by differences
in the opportunity costs of production.
 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
In this case, the slope of the tangent for Nation 1 in isolation

is less than that for Nation 2 (in absolute terms) so the
opportunity cost of producing X in Nation 1 is less than the
opportunity cost of producing X in Nation 2.
 In other words, Nation 1 has a comparative advantage in

the production of X.
 Similarly, Nation 2 has a comparative advantage in the

production of Y.
Increasing Costs
The comparative advantage of Nation 1 in X will lead it to

produce more of X.
Similarly, since Nation 2 must have a comparative advantage

in Y it will produce more of Y once it begins to specialize and
trade.
The movement of production and trade will move production

from point A to point B in Nation 1 and from point A’ to point
B’ in Nation 2.
Increasing Costs
At the new production point, both countries will be able to

trade to a final consumption point on a higher community
indifference curve than the original curve (point C).
At point C, Nation 1’s exports of X are matched by Nation

2’s imports of X.
At the same time, Nation 2’s exports of Y are matched by

Nation 1’s imports of Y.
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.
Increasing Costs
Neither country completely specializes in the

production of X or Y.
 Complete specialization is an outgrowth of constant

opportunity costs: Graphic analysis is helpful to understand.
 Since constant opportunity costs do not hold, complete

specialization is unlikely to be seen.
FIGURE 3-5 The Gains from Exchange and from Specialization.
Increasing Costs
At the final production points (B) and

consumption points (E), the marginal rates of
transformation and marginal rates of
substitution are the same in both economies.
 This entails that relative prices in both nations

are the same after trade.
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.
Specialization and Trade
The specialization in production that takes place with

international trade involves producing more of the
commodities in which the nation has a comparative
advantage and less of the commodities in which the nation
has a comparative disadvantage.
 It implies that specialization and trade will result in job

losses in some sectors, but job gains in others.
 Job losses in manufacturing sectors of the United States,

and in agricultural sectors of Korea.
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

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CHAPTER T H R E E

The Standard Theory

 Understand how relative commodity prices

Objective of Ch.3: To Extend the Simple Model of Ch.2 to

Considering both sides of production and consumption, we

Production (Supply) Side:

Increasing Opportunity Costs: The opportunity costs of

 Increasing amounts of another item must be given up in

 In this case, the Production Possibility Frontier (PPF) is

 Compare this case with the case of constant opportunity

 Increasing Opportunity Costs

 Increasing cost production possibilities

What leads to increasing opportunity costs?

 The marginal rate of transformation (MRT)

 A community indifference curve shows

 The marginal rate of substitution (MRS) falls

 Autarky: The Absence of Trade or Isolation

For the indicated case, the

The equilibrium relative

At the equilibrium in isolation

 The equilibrium-relative commodity price in

 Relative prices are different in Nation 1 and

 Each nation should specialize in the commodity they

 Specialization will continue until relative prices

In this case, the slope of the tangent for Nation 1 in isolation

 In other words, Nation 1 has a comparative advantage in

 Similarly, Nation 2 has a comparative advantage in the

The comparative advantage of Nation 1 in X will lead it to

Similarly, since Nation 2 must have a comparative advantage

The movement of production and trade will move production

At the new production point, both countries will be able to

At point C, Nation 1’s exports of X are matched by Nation

At the same time, Nation 2’s exports of Y are matched by

 Equilibrium-relative commodity price with

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

 Under constant cost conditions, specialization

Neither country completely specializes in the

 Complete specialization is an outgrowth of constant

 Since constant opportunity costs do not hold, complete

At the final production points (B) and

 This entails that relative prices in both nations

 Even if two nations have identical PPFs, basis

 Nation with relatively smaller demand for X

The specialization in production that takes place with

 It implies that specialization and trade will result in job

 Job losses in manufacturing sectors of the United States,

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