| THE THEORY OF INTERNATIONAL TRADE JAMES R. MARKUSEN JAMES R. MELVIN Universiy of Westen OntarioSporn Gan Corer Dos Mil Cig ‘Comps, Contos Bren Han Crs, Is ‘mer md Binder eR: Bowley & Sens Coop ware Cont De Han Cree, fe “THE THEORY OF INTERNATIONAL TRADE Copyright 988 by Harper & Row, Pater Ine Paton of his work wee st lated Clr The Thy fern! Trae nd a Cnadion “pewns 1984 by amr R Macon anes Re | ih crest in he Unita Stats of Amer, No pt of hi ok ‘hy twtr pede ay mote nhauoer wou ten permion, ‘icine re ganas omboled metal atissun eves ot ‘Seman nese Haye © Row, Pann, Ie 10 Es #50 Se, New York, Libay of Congres Cason In Pinta ita Poin fhe ok wee xia bi The thea foal ae nde Cs sbi nd in Hrlomwoy ie s208 Ben oacouains CONTENTS Part One TECHNICAL CONCEPTS AND THE GAINS FROM TRADE 1 INTRODUCTION 4. Wat the “Theory of Intemational Taso"? 3 2. Why “Intemational” Trede? 5 8. The importanos af Intemational rade. 8 44 The Underyng Causes of intemationalTrado. 8 5. Tha imporance of Pree Otfrences 8 6 Plan ofthe Book 10 ‘THE PRODUCTION POSSIBILITY CURVE 1. Production Functions 12 2 Rotune to Salo 15, ‘2. Equilorum for a Single Producer 18 4, Tho Two.Good, Two-Factor Model 21 5. The Shape of tha Producten Possblity Cure 22 6. Nonconstan Ret to Sala 28 17. Concixing Remarks 38 Probleme 24'= Note 95 + Relorences 35 COMMUNITY INDIFFERENCE CURVES 1. The Ully Function 96 2. Gharactorstes of Inatfronce Cuves 99 8 The Maximzation of Uy 41 ‘apregatingInvids!Prtorences 45 “5, The Deaton of CommuniyIntierence Curves 48 6 Conclusng Remaris 6 Problems, 57» Rforanoes 57 ‘THE OFFER CURVE 1. The Autarky Equlbium 58 2. The Oiler Curve: Fed Production 60 R2. The Otter Curve: Varable Producten 62 4 Equlbrum wit Two Countess 66 5 Stanly and Uniqueness 62 6 Conciusing Remarks 70 Probloms 70 = References 71 5 THE GAINS FROM TRADE. 1. The Glsed (Autry) Economy Eaulbium 72 2 The Opon (Trading) Economy Equliium 72 2. Tho Gains om Exchange 78 ‘4 The Gains trom Speciation 78 5. Tha Ditton of Gains wih Heterogeneous Tass 81 6, The Detrouton of Gains with Heterogenoous Endowments 7, Conesucng Remarks 69 Problams’ 64» Note 85 + Reforonces 85 Part Two: CAUSES AND CONSEQUENCES OF TRADE 6 THE CAUSES OF INTERNATIONAL TRADE 1. The NocTrade Model 68 2. Some Methodelogcal Consderatons 92 7 THE CLASSICAL MODEL 1. A Single Model of Prosvcton FunctonDiterences 94 2. Tho Laws of Absolute ana Comparatve Advantage 95, 1. The Production Posty Cur 00 44 The lterationl Equity 101 '5 The Deteminans of he Equlibium Price 108 Problems, 107 = Reterences. "108 8 THE ENDOWMENT MODEL ‘The Etec of Endowment Dieronces 100 ‘The Hookacher Onin Modsl 112, ‘The Factor Prce-Equatzation Thoorem 115 ‘The Rybexynshi Theor 119 ‘Te Stoipor-Samuetson Thecram 121 “6. Endowments, Outputs, and Prices 125, “7, The Factorintensiy-Reversl Case. 128 "8. A Comment on Omensicnaity 132 rR @ 109 10 " 12 9, Concudng Remarks 133 Probioms. 132" Note 194 + Reloronces. 194 ‘THE SPECIFIC FACTOR MODEL. 135 Irreducton 195 “Tha Specie Factor Model. 198 CCommosty Pica and Factor Prices 142 Endowment Changes and Fctor Price Equalization 140 ‘The Pattern of Trade 148 Conciting Remarks. 148 Problems 149 * Referoncos 149, IMPERFECT COMPETITION AND GOVERNMENT POLICIES AS DETERMINANTS OF TRADE 150 4. Ioducton 150 2. Commodity Taxes 151 8. Factor Makot Distortions 158 4 Impertct Comptiion 180 5 Procompatiive Gains rom Trado 164 6. Courotash Competion 165 7, Conesudng Remarks. 167 Problems 169 = Relornces 168 INCREASING RETURNS TO SCALE 170 1. Inrodueton 170 2 Extemal Eoonomios 171 4 nteral Economies of Scalo 174 4 Souroos of Gana from Trade wih Increasing Returns 177 5: imptestons for Tradional Results 104 Problems 186 ‘TASTES AND PER CAPITA INCOME AS DETERMINANTS OF TRADE 168 +: ntratona Taso Diferencos 108 2. Por Capita Income and Nonhomegenecus Demand. 191 8, The Under Hypothess 192 4 Combining Linder, Noohemogeneous Tastes, Sele Economies, land rode iorentiion 188 ‘Tho Product Gyle 104 6. Per Capita Income and Technology 196 7. Cycle Models snd Comparative Advantage 19713 8. Concluding Remarks, 108 Problems 108 Rerences 192 EMPIRICAL TESTS OF TRADE MODELS 200 1: Introduction 200 2 Tosts of tho Ficacsan Model 201 3. The Loontet Paradox 202 4. The Paradox in Porepectne. 205 5. Atoratve Aoproaches to Testing Model 207 6. Conctung Remarks 208 Notes 209" References 200 Heckscher Onin Part Three ALTERNATIVES TO FREE TRADE an “ 5 16 TARIFFS: 213 4. The Wella Loss fom Tatts 219 2 Argumonia in Favor of Tatts 216 8. The infantindusty Aumont 220, 4, Tarts, Tawos, and Distortions 222 5. Monopoly Power 220 6. Tho Optimum Tart 228 7, Concsng Remarks. 231 Problams 232 = Noles 290 - Reteronces. 200 QUOTAS AND OTHER NONTARIFF BARRIERS 235 1. Quotas 295 “2 Tho Reletonalp Between Tails ard Quotas 208 8. Other Nontartt Barre 24 4, Concluding Remarks. 246 Problams 247 = Noles 247 - Reterences. 247 IMPERFECT COMPETITION, INCREASING RETURNS, AND STRATEGIC TRADE POLICY 249 4. Introduction 249 2 Increasing Fetus and imperect Competition 250 3. Ront Shifing 252 44 Froo Enty 253, 5 Import Protection as Export Promotion 258 7 18 6. Concluding Romans 257 Probleme 257 " Note 258 - References 258 EFFECTIVE PROTECTION 259 1. The Concept of Ettecbve Protection 250 2 Theo Assumptions of te Model 262 ‘3. The Formal Model 264 4 Some Examples forthe Canadian Economy 28 5 Concusing Remarks. 267 Problems) 267» Noles 267 » References 267 CUSTOMS UNIONS 269 2. Trade Creation and Trade Diversion 271 8, Supsttuton in Consumption 272 4 AHeckscher Obie Approach 274 5. Concusng Remarks. 276 Problems 277 = Referonoes 27 Part Four FACTOR MOVEMENTS, GROWTH, AND THE THEORY OF DIRECT FOREIGN INVESTMENT 279 19 FACTOR MOVEMENTS 281 1. Etacts on Production 28 2 Waller Elects of Factor Movemants 285 8. Casas of Waller Gain of Losses 291 44 Temnsot Trade Etec, tho Tanstr Problem, and World Watters 204 ‘5, Factor Movements and Commessty Trade As Substitutes 205 6. Factor Movements and Commeaty Trase AS Complmants 257 7. Concuding Remarks, 208 Problems 300 Noles 300 - Reloronces 301 DIRECT FOREIGN INVESTMENT 302 1. Dect Forgn Investment Versus Portoto Investment 302 2 Technology Transfer 304 {8 Matiplant Economios of Scale 506,vu 24 4, Appropriaity and Preemptive Entry 508 +5. Tho Wola Elects of ME on Host Counties 309 ©. Conctusng Remarks 912 Problems 214 = Notes 14 + Reforonoes 914 GROWTH AND DYNAMIC TRADE 316 4. ntrtmporat Gains rom Trade and Forign Investment 916 2. Factor Aocamaton 318 8. Toctwical Change 22 4. Seale Economias and Income Bastlies 904 5. Tams Trade Effects, Otorbos, and Inmiseing Grown 227 6, Export-Lod Growth and tho "Staples Thesis” 829 7. Sobsiies for High Tech 992 1. Concluding Remarks. 333 Problems 304 - Noles $34 + Rtorences. 995, Index 337 To the Instructor “This book ie intended primarily fora conventional half-year couse in ‘nerational trade at the undergraduate level Its secondary purpose iso serve basic text and reference book in graduate courses. The analytical “xposton i agey in terms of gomety, withthe aacesary tools being ‘Gevelopd in Chapters 2 3, and 4. A half-year course in intermediate imeroeconomies would bea helpful preparation, but we have nol assumed that i 2 prerequisite forthe course. ‘Wehave tid to maintain «uniform level of analysis throughout the took. A few sections, which ate marked by an strisk, are more dificult ‘han the standard weatment of the Heekscher-Oblin model and may be ‘skipped without los of continuity, One reason fr writing this book i out peteption that competing books tended to leet certain topes suchas “eckacher-Oblin on» fil formal level and then resort to informal and snoodotal treatments of other topics such as scale economies, imperfect, ‘competion, actor mobility, and multinational corporations. In many of the relevant books, such topics are not treated at all We have included all ofthese topics and’ many eters at aleve of analysis thats approxi- nately equ to that used in the standard devclopment ofthe Heckscher. ‘Ohl snd speci factors models, Farthermore, we haveatempted 1 Use the same base “Yoo kit” over and over to avid the costs of developing tnd lesing new analytical constructions fo each new topic. 'As jst indicated, we ebieve that our book der significantly from its competitors on the criterion of breadth. We have devoted eatirechap- ters to important topics that are dealt with supertclly or not at all in other texts. They include: 1A chapter that prsens a full analytical development of the ‘spectators model and that relates that model 10 the Heckscher-Ohlin model (Chapter 8) 2, A-chaptr devoted entirely to imperfxt competition and domes- tic tax distortions. The elles of these distortions on trade ows, ‘welling and factor prices are dscssed, The important notion of Drocompettive guns from trade i developed (Chapter 10). ‘3 An entte chapter devoted to sale economies. External econo Ini intemal economies, and monopolist competition are all ‘xamined. This materials consileredinspotant for understand ing questions of industrial strategy and for explaining North ‘Ameticam EEC-Japanese trade. The implications of sale econo. ‘aes forthe gains from trade, the direction of trade and the pattern of production all eeive attention (Chapter 11).wo [Achapter on demand determinants of tade that ncudes discus ‘lon of nonbomogensous demand, the Linder hypothesis, and the poduet eyle (Chapier 12. ‘An expanded analysis of aris especially thei elatonship to ‘and eft in the presence of ther taxes, Export subsidies are iso analyzed (Chapter 1). . An entre chapter devoted to quotas and nontarif arse to ‘ade, Recent work on the noneguvalene of ais and quotas {is incorporated (Chapter 15) ‘A chapter on srategi trade policy inthe presence of sale onomies and imperfect competion. Posble welfare gains from the sirtegic tse of production and export subsidies are ‘Semonsrated. Rey asomptions are analyzed andit is shown, for ‘xample tha fice entry of fms leads to very diferent concly- ‘Sou from those forthcoming from simple dvopoly model (Chapter 16, 9. Xrmuch expanded analysis of portal factor movements, which incorporate egret deal of ew theoretical teraure, Welfare ‘fot are carefully analyzed and the relationship between com- ‘modi trade and factor ade is discunsed in detail (Chapter 19) An ene chapter devoted to direct foreign investment. Recent formal theories suet as technology transfer, mulplant econo. mnie and preemptive entry are presented, The welfare fects of ‘nultinationals on host counties are emphasized (Chapter 2). ‘Acchapter on growth and the ineriemporal gains fom trade. Much new theory is presented and old concepts such 3s the Drebich Singer hypothesis, immiseriing growth, and export {el growth are analyzed in the lpht ofthat theory (Chapter 21). James R, Markusen James R, Melvin one TECHNICAL CONCEPTS AND THE GAINS FROM TRADEcaper) Introduction 4, WHAT IS THE “THEORY OF INTERNATIONAL TRADE"? Let us tepn by situsting the study of international trade within the Alscpine of economics. International economic sa subset of the eoo- ‘nomics dicipline and therfore deals withthe same kindof questions with ‘which any stodent of even intzoductory economics is already familia. In {he most simple terms, intemational economies is concerned with how {conomie units behave. The important distinction between it and other branches of economics isthe ecchonsic unt thats being studied Interna tonal economic, rather than being primarily concerned with questions sich at how producers maximize profs, or how consumers maximize ‘ity, is concerned with the question of ow nations ean maximize some ‘measure of collective wellbeing. That i not to say, of couse, that the theory ofthe fn and the theory of consumer behavior ate unimportant in the study of iterations! economics, indeed, as we will ee, these ‘wadional economic problems will lay an extremely important roe in ‘our analysis However, rather than being the subject ofthis book, such traditional problems willbe the building Hacks on which our analysis Tnternational economics canbe conveniently divided into two parts: ‘real anaiyis or trade theory, and monetary analyis or international afinance, Real analysis, with which this book i entirely concerned assumes that all transactions are cari ou through barter. Tat is assumed that commodities are exchanged for one another without the use of money ‘sa modium of exchange, While such an assumption is clearly unrealistic fad very mucha variance withthe way in which transaction are actualy Carried out in the workd economy, and while iti clear that in some ‘Greumstances the introduction of eurency would aft some ofthe eon- ‘lsions reached the complications that would aise money were explic- introduced into the model would ot justify the increase in elim that would thereby be atsned. It must always be kept in mind that sbstractions from fealty are notin themselves undesirable indeed, the ‘whole notion of theory rests on such abstractions. Th imporiant question In alvays whether the simplifications of reality that we make in order to render 9 problem tracable significantly act the coaclusons that are reached. Foe present purposs, the introduction of money sa medium of ‘xchange would not substantially affect any of the conclusions. Indeed, tose readers who feel uncomfortable with the assumption of barter ex ‘change are fee fo assume he existence of neutral money thats used forall ransactons. "The types of problems treated by the two branches of international conomics are ite diferent. Real analysis (ade theory) concerns itself ‘with such things asthe rearons for which trade takes place, the impicn- tions for commodity and fctr prices of changes in rea variables such 8, thestock of capita and the supply of labor, the analysis the Benes that ‘accrue fom international trade, ad the welfare effects of sac things as tans and custom union. International faaace, on th ether hand, 15 ‘concerned with such isa the determination of equim exchange fates the comparison of ed and fexble exchange-rate systems, the Felaionship between interaal and extemal balance, the els of develo tions, and the question ofthe form that en efcint interational monetary fystem should take. A well at thes diferenes in subject mater, the Wo ‘ranches of interational economics also use quite diferent methodolo- ‘is Trade theory is very much in the tration of neeclasial economics, ‘where all employment i assumed and where, in general all markets are {sssumed to clea. International Aaance, on the ther hd, is mainly in the tradition of macrosconomics tis concerned with such things as the rice lvel and the level of unemployment Intemational nance typically ssumes a single aggregate output and an aggregate price level, whereas trade theory assumes at least two commodities and is concerned with relative rather than abeote prices “Athough these wo branche of international economics have evel ‘oped more of les independently so that itis possible to study one branch wrmooucron ‘ sithoutexplisit reference othe other—ar is done inthis book —neverthe- [esis clear tata complete understanding ofthe international economy ‘requires an appreciation ofboth the real and the monetary sides of the ‘model, The reader, therefore, cautioned thatthe material contained in this book represents oaly one part of the whole story 2. WHY “INTERNATIONAL” TRADE? “The subject mater ofthis bok esentialyconcers the rade in como ties that takes pace among nations. A question that naturally aries i, ‘Why ist son to be necessary t distinguish trade Between nations from trade betwen rion, or even trade between individual consumers? Sev- cal arguments have traitionally been used. Firs, a distinction is usually ‘ade wth regard to the mobility of labor. Tes argued that although it [is reasonable fo assume that witht a country Ibor is completly mobile ‘becne of such things as language, religion, socal customs, nationals land government regulation, labor mobility among counts is Severely tested, Indeed, its wsualy assume tat labor i completely immobile !mong countries, Much ofthe theory of international trade also assumes capital tobe immobile among countries and although such an assumption ny nol seth as resonable at fist glance, it should be recalled that apita” means physical equipment that is being usd for production. “Thus, while trade in capital equipments common, this trade takes place before the equipment hs become part ofthe capital stock of the counties ‘under consideration, Its not common fo observe trade in capital tock ser tein place and being used to produce commodities. AS we will, ‘the assumption ofthe ntertational immobility of factors is not necessarily ‘sever restriction on our model, for under eetsn conditions it ean be ‘Showa tha trae in commodities can bea substitute for factor mobility. "A second justification Tor considering trade among nations 36 a located to, then we would obain the outputs indicated by point Bin Figure 27. ‘Weave shown that points such as and Bin Figure2 6 are posible production points The important question, however, i whether these points are ficient or, n ther word, whether there are possible produPy ‘EOHUCAL CONCEPTS ANDTHE GANS FROM TRADE tion points outside the tne FX yeng larger outpus of both comm ties than those implied by points such a6 4 and B. tis important to remember here that we have assumed dileentpreducton functions for the two indostries. Recall from Figure 2.6 that fr a given wage-rental ratio, the capitllboreutis inthe two industries fer, nd this suggests ‘hat simply viding the two factors proportionally between the two indus tres wll not result inthe maximum smount of ouput the two cups ‘were guns and butter, t would not make much seas to allocate half of the farmland tothe production of guns. Thus in Figure 2.7 a reallocation offctors between the two industries, and in paticulr, shifting more K to the production of ¥ and more L to the production of X, wil esl in ‘larger output of both commodities than tha associated with points such ‘asd onthe line PY. After the rallocstion of factors, a production pont ‘such a4” could be possible The sae argument will apply to all points ‘onthe lie FX, withthe obvious exception of the wo points Y and X, td the resulting production possiblity loeus would be TA°X. “The preceding argument has presented an intuitive reason fr belie ing that the production possibility curve lis everywhere above the equ proportions line FX. Cuves having this shape are sid to be concave 10 {he crigin. A more rigorous demonstration of thi fact is required, how- ‘ver twill employ » construction known as the Edgeworth-Bowlcy box Giagram. This construction, shown in Figure 28, gives a concise way of ‘epresentng the information obtained in equations (2.8) to 2.8), and wll, demonstrat precisely what is meant by market efiiency In Figure 2.8 several representatives ofthe soquans forthe X indus ‘ty have been potted fom origin O,. The total avilable quantities of {HE PRODUCTION POSSILITY CORE 2s capital and labor, K and; ae alo shown in the diagram, and itis clear thatthe maximum amount of X that could be produced when all factors fr alloted tothe production of X 8 ¥. This is the same Jas shown in Figure 27. Exactly the same procedure is now employed forthe industry, except that inthis ease the isoguant diagram is turned upside ‘down end poted from 0,. Note sat the output of ¥ increases as one tmoves from, tomard Q,. From the point of view ofthe Y industry, (0, on soquantF represents the maximum pssbleamountofcommodity Y that can be produce for it represents the total allocation of K and, tothe production of commodity Y. The soguant Y thus gives the point Y of Figure 2.7. All posible allocations of capital and labor between the two indo ‘ries are represented bythe points inthe preducton box O, KO, .. Among these possible prodetion points we sek a locas of point that eicint in the sens that, for a given ouput of one commodity, the output of the ther commodity is maximized, To take a specie example, suppose an ‘output 1; of commodity Y is chosen, and that we seek to maximize X ‘bec to this contain. A posible allocation of factors between the two Industries snow represented by all points along the soguant Y, in Figure 28, and we want to nd the particular point long this euve that maxi- ‘nizes the output of X, Fist, suppose that prediction were to take place At point 4, halfway between O, and O,- Such production pint is eearly Feasible frit just exhausts the total available supply of capital and labor, ‘and such an allocation results nthe outputs of ¥ and; for industries Y and X, respectively. But while this production point is possible its clearly not effcent. Any movemeat along the soquantY; from toward point C. although not seducing the outpat of ¥, wil clearly increase the Dulput of X. Furthermore, moving beyond C along isoquant toward DD will begin to decrease the amount of X produced. Thus, given the ‘constraint that; i to be produced, the alloation of capital and labor fsssocited with pont Crests inthe maximum possible output of com Inowity X. Pot Cis the tangency point fr the two isoquants ¥, and 1X, ad thus, for «given quantity of Y, output of X is maximized at the point where the highest isoguant ie tangent to the appropriate Yio ‘ant “There was of course, no particular reason for choosing Yas the quantity of commodity ¥ to be produced. Had Y; been chose, then the ficient production point would have been B, implying an output of X; ‘of commodity X. Indeed, any level of output of Y from 0 ¥ coud have boen chosen and the output of X maximized subject to this constraint. Joining all these points would give the locus O,B0,, called the efficiency Tocus. Note that movereatsaloag ths locus from 0, toward O, implyEo “TEOHRUCAL CONCEPTS ANO THE GANS FROM TRADE increasing the amount of X produced and reducing the amount of Y ‘produced. Indes al points on this lous have the characteristic that the ‘output of one commodity cannot be increased without redocing the output ‘ofthe other Iti presily this erterion that describes the market ef- ‘iency sefered to previously. I should alo be noted that, ino restitions fe placed on the form of the production functions for X and Y, the efficiency locus ean have any shape. Under the assumption that both predvction functions ate homogeneous, however, the eficency lous will bea smooth convex locus such asthe one shown in Figo 28 ‘The production posblty curve ean now be derived quite easily {oma the information given in Figure 28. With each point onthe ficiency locus there is asccated sn output of and an output of Y, and these points, when plated in XY space, give a lous suchas AY of Figure 2.7. Figure 2. allows a more rigorous demonstration ofthe fact thatthe production posribiity curve has the shape shown in Figure 2.7 nthe ‘air aicussion ofthe production possiblity curve the factor of pro- ‘ction were arbitrarily allocated equally tothe two industries, and this five rise to the production point 4 in Figure 27. Note that, in terms of Figure 2, this allocation of factors between the two industries also gives, rise to point 4, Furthermore, cause 4 Is precisely inthe center of the Edgeworth Bowley box, and because ofthe assumption of constant re- tums to sel, output X, being halfway between O, and O,, must equal ‘one-half X. Similars, ¥; uals one-half Y, and thus i is clear that in Figare27 point 4 mast lie midway between F and X. But it has already ‘ben shown that, in terms of Figure 2.8 the output associated with the allocation of factors at point isnot efficient. For example, moving rom Point to point B increases the output of Y without reducing the output ‘FX, or movement from point to point C increases the output of X without reducing the ouspu of Y. Thus the reallocation of capital and Tabor ffom a point sach as 4 to points such as Bor C will result in production pints that fi outside he line PF of Figure 2.7. The allocation ‘ot factors along the line O, AO, in Figure 28 gives rise to the production points along the stright line FY of Figure 2.7, thus the same argument {Batis used fr point 4 applies for any alloation of factors along the line (0,40, Ths all points on the production possibiliy curve must le ttside the straight line Pin Figure 27. Tt hasbeen shown that the efcient allocation of resoureas requires that production fake place at a point where a soquaat from oneindustry is tangent to an soquant fom the other, I as also been shown that, for the individual producer the maximization of production subject to the ‘cont constraint requires thatthe rato of factor prices be equal the slope ofthe foquants Since this condition steve for both industries, and since {HE FRODUCTON POSSBLITY CURVE 2 owe 29 we have seen that market eficieney requires a tangency between the FRoquants ofthe two industries, iis lear that production efeieney1e- {quires that both industries face the same wage-ental ratios. In Figure 29 the production of Xp and Yo asvociated withthe pont implies thatthe ‘ati of input prices wil be w/the ine thai jintly tangent to the two Ftoquants at point 4. Not, also, that for production at point 4, the Capa labor ratios in the two industries ace, and &, Tor industries X land F, respectively. Thus this facto box diagram can be seen an ‘ternative way of poting the information shown in Figure 2.6, but with {he additional constrain ofthe aed supply ofthe two factors of produc- tion, This addtional constraint, which Bxes the size ofthe factor bos, increases the amount of information ablained. Ic can be sen from Figre 129, for example, that for any efcient output point, suchas 4 there is ‘unigue wagerental rai. This, from Figure 27, implies that for every point onthe production posabiity curve thre is asocated a unique tragetental ratio, Ths point will prove fo be impartant in later chapters. ‘Weare now in «positon to llsteatethe production equim for cour simple economy. Fist, we note thats condition for prof maximiza- tion for a competitive industry i that marginal costs equal price. Thus for for two industries we have MC, = py and MC, = p,. Dividing one by the other yields equation (29) Ce we es In Figure 210 the slope ofthe production pesibilty curve at any point gives the rte at which one commodity can be convertad into theFoe 210 ther trough the reallocation of fictrs from ane industry tothe other. Thus the slope ofthe production possibilty curve isthe cost of one commodity in terms of the other, which is the ratio of marginal costs. ‘Then ince the slope ofthe production possibilty curveis MC, /MC,, and ven equation (2.9), the quilbrum for producers is given by pont in Figure 2.10 where the price ratio ine is tangnt to he production possi ity cue 5 NONCONSTANT RETURNS TO SCALE “Tothis pont the dscusion has assumed that both production functions were homogencous of the frst degree. The casein which production Function are homogeneous of degrees oer than one now considered. ‘The question of particular interests how homogeneity of diferent degrees ‘will fect the shape ofthe production possiblity curve. The discussion Will employ the simple argument that was intially used to demonstrate the shape ofthe production posbility curve for the constant return-t- scale case. Although 2 more rigorous demonstration could be provided, the geometry would become much more complex. Fist, consider th case in which the production functions are as- sumed 10 be homogeneous of degree greater than one, so tht increasing “TE PRODUCTIN POSBELITY CURVE » return to seale exist, The production system can sil be represented by ‘Sqations (2.5) and (28), ad the endpoints ofthe production possibility farve can be found by allocating the total amounts of capital and labor fo indatriesX and, respoctively. Thus, in Figure 2.11 the allocation ofthe entre capital and labor supply tothe Y industry would yield point Ys and the allocation ofthe ent stock of bot Factors to the X industry ‘would yield point . Now suppose that half of both factor is alloted To each industry, Because ofthe assumption of increasing returns to seale, halving the inputs to the ¥ industey will more thin halve outpat, so that swe would gt point such at. Similarly, halving the input to the Industry would eld point suchas Xy, where is ess than one-alt 1X. The resulting production point A of Figure 2.1 clearly is below the straight ine joining F and X- Other proportional allocations ofthe factors to the two industries would yield other production points, andthe locas ‘ofall such points could be a line such as PAX. Note that this is the ‘cuiproportion line for the increasing retunstoscale ease, and core Sponds to the straight ine YAY of Figure 27. Tn Figure 2.11 we have eelaned the assumption of constant returns to sale, but have retained the assompion that the production functions forthe two industries difer, and this implies that while is a possible ‘production point it will not, im general, be efcint. Indeed, a figure racy ike Figure 2.8 could be used toillstrate the increasing returnsto- Scale case, where again, point of Figure 2.8 corresponds to point A of Figure 211 Just a inthe constant returns-toseae eas, it can be shown tat moving from point Ato point such as B or C wil reslt ina large30 TECHNICAL CONCEPTS AND THE GAAS FROM TRADE gure 212 mount of one or the other of the go outputs, and would give rise to points suchas and Cin Figure 2.11. Repeating this proces fr all point ‘long the curve FAY would give rise to the production passiility curve Yack. In Figure 2.11 the production possility curve hasbeen shown tobe uniformly convex othe origin, but Figure 212 lustrates, this need not ‘necenarily be the ease With increasing etuns to scale the equipropor- tions ine must be below the straight line joining the endpoints ¥ and X, ‘but ifthe degree of homogeneity is not mich larger than one, then the ‘eqiproporion Hine need ot ier very much from a straight line, and ‘we could get the line YAY of Figure 212. Ifa the same te the capital: Tabor rates ofthe two industries der widely, then a considerable increase in ousput could be generated by rellcatng factors, resulting in the points such as’ ying outside the straight line VX Thus, even with increasing returns fo scale the production possibilty curve can be concave tothe ‘origin Chroughout most ofits length. For increasing retams 0 le, (WO factor determine the posion ofthe production possibility eurve—the degre of homogenity and the diference in factor intensities. The more the degre of homogeneity difers from on, the more we would expect the ‘guiproprtions line to be pushed toward the origin, and the greater the ‘iference in the capital intensities of the two indus, the more We ‘would expect the production possiblity eurve to der from the equipro- portions ine. The exact poston af the production possiblity eurveclearly depends on the relative strengths ofthese two forces, Tn Figure 2.12 the production possibity curve hasbeen shown tobe "Te PRODUCTION POSSIBLY CURVE at concave toward the origin throughout most fit length. However, it wll ‘be noice tha the curve becomes convex tothe origin as ether axis ‘proached, This wil always be tru a lng 2s both industries exhibit Increasing returns to scale, and although a formal demonstration of this fact x rather complex, an intuitive reason canbe suggested. “oillustrate we consider, in Figure 213, an example where there are ‘constant returns to sale nthe Y industry but increasing return to scale inthe production of X. The endpoints Y and I ofthe production posbil- ity curve ean be ound as before ntl, suppose the economy is special= ized in producing Yat V, Now suppose that oneless unit of Yisproduced, fd that the bandleof factors released is transferred tothe X industry. (Outpt in the ¥indosty willbe reduced from F to Y, andthe quantity ‘of equal t.X will be produced, Next, assume that almest the identical ‘bundle of factors is again transfered fom Y prediction to X production, resulting in an outpat of Y equal to Y; where PY; is (almost exactly) ‘ual t9Y,Y;, The question now is how wil the output of be acted, ‘Werecil that there aeincreasing returns to eae in the X industry. Thus the seoond bundle of factors wil allow the aditional production of more 1X than was produced with the fst bundle and X,., most be larger than ‘Ox;. This means that in the neighborhood ofthe Y axis the production Possibility curve mut be convex to the origin.2 TECHCAL CONCEPTS ANDTHE GANS POM TRADE ure 214 Wisinteresting that the conveit of the production possibility curve ‘occurs next othe F axis when the increasing returns to sale exit in the 1X industry, This has sometimes ben a souree of confusion in the litera- {re One final point stat while inereasingreturos in one industry and ‘constant returns inthe other can produce production posit curves with the shape shown in Figure 213, this sults by no means necessary. ‘The production possibility curve could also be convex throughout its entire length 38 shown in Figure 2.1 “The decreasing returns-o-scale case, or in other words, the casein which homogenety sof degre les than one, canbe handled in similar fashion. In Figure 214 pots F and X agnn represent the maximum amounts of ¥ and X that could be produced by allocating the entire actor Spplies to those two industries. Berause of decreasing returns (0 scl, Talvng the inputs to both industries wil les than halve output, resulting in points such as Y; nd X, and production point 4. Cleats, 4 wil ie ‘outside a straight ne joining ¥ and X. As before, while 4 is possible it isnot ecient, and more of either or both output ean be produced by a reallocation of factors Such arallcation would give rise to points such f= B and C, and thus the production possibly curve would become BCX. In this case there are again two factors determining the postion ‘ofthe production posblitycurre—the degree of homogeneity and difer- ence in factor intensities. For decreasing returns to sal, the lower the fegre of homogeneity, the more the equipropotios line, TAX, wil be pushed away from the origin, and the greater the difrence in factor Intestin, the more the production possiblity line will fer from the esuiproportions line. Sige Both factors actin the same dzetion, the tT {HE PRCOUCTIN POSSIBLY CURVE 2 proviction positilty curve will ncearily be concave to the origin hroughout ts length "Economists fer in their views ofthe relevance of decreasing returns to snl, and some argue that decreasing etaras would not be observed, particularly in general equilibrium situations ofthe kind we are concerned ‘vith hee. The argument goes a follows: Suppose Hem is operating production process at some level and that a higher rate of output is ‘ested, With doreasing returns to scale present, the attempt to increase production wll increase average cost and, with piven prices, educe roi ‘Another option is available, however. Rather than increasing the seal of the existing plant, separate production facility could be constrcted that ‘would avo the decreasing returas problem. Asa specific example, when 2 firm is Taed withthe prospect of doubling outpat, rather than adding ‘more inputs that would be subject to decreasing Fetims, a new identical plant could be constructed that would allow output to be doubled. Of course, the logical extension of this argument would require that ll ms ‘with potential decreasing returns operate at unit level, for tis would ‘maximize output fr given inputs “Another argument i thatthe observation of decreasing returns is associted with mising fictors of production. Suppose, fr example, that ‘one observed tat in some agricalteral proces a doubling of the capital tnd labor inputs does not double output. Does his mean there are dereas= return to sale! Probably no, forthe rle that land plays has nt been considered, and one should ask how doubling the inputs of land, labor, ‘nd capital wil aect output. I output doubles when all inputs are dow bled, then there are constant returns to eae. While in this book we deal exclusively withthe two-factor model, in practice, production often re- (gires many inputs. And although it may nt always be posible to ‘rese allinpute, this doesnot mean that constant retums fo scale would ‘ot be observed if we could. It may aso be dificult to agreon a defiton ‘of what constitutes an input, 80 that there may well be uncertainty sut- Founding the sue of whether allinputs have bee taken into account. But ‘whatever thet views about the existence and relevance of decreasing Teturns, mort international trade theorists would agree that decreasing return to scale not of much importance for international trade theory. “Ts forthe remainder ofthis book we confine our attention to constant and to inereasng returns to sale. 7. CONCLUDING REMARKS “The purpose ofthis chapter ha bee to describe the production functions that underlie the supply side of our model, and 1 demonstrate the deriv tion ofthe production posbiity curve, Although inereasing and decreas“TEOINCAL CONCEPTS ANDTHE GAN FROM TRADE ing etaras to scale were considered, most of the analysis willbe conducted. “ander the esomplion of constant returns to seal. Th assumption that tl be made about the prodvction fonction throughout most of the re- Inainder ofthe book can thus be summarized as follows 1, The production functions ae concave increasing functions of al inputs. 2, Zero input of either factor implies zero output 5, Production functions are assumed to be homogencous of the fist degre. 4. The production functions forthe two industries are astumed to der “Throughout most of the subsoquent analysis, the production possibility curve will be asumed to be coneave othe eign as shown in Figure 2.7. ‘Unceying this prodtion posit curve willbe the assumptions tht: 1, Factors of production are in xed supply 2. The production fanetions difer between industries. ‘3. Both production functions exhibit constant returns to scale PROBLEMS 1, Soppoe the production function for commodities X and ¥areiental. How Il healt the shape of the eficincy lous? What wil the production oblity carve Took ike fo the ease of (0) constant rears 10 seal, () [Roraing retort wale, (2) dsrensingretoros Io scale! How wil the ‘flcency lot difer for thee thre ess? 2 Stppone hatin peadaton functions (25) and 2.6) theresa single factor of. Producto, sabe. What wil he predaion posit curve loo ke or The casero @) constant returns to scale, inctesng fetus to seal, () ssresag returns to cle? 4 Soppore ht the toll vale quantity of abr inernss and tht the quan tity octal aval dees, ow wil thi afer the shape and postin tf the production osbiity cure? 4 Show that for production funtion homogeneous any depres the eicieney ecu cant cross the diagonal of the for box. ‘5 Interns of igre 28 show hat the equibrium wagerental ati incresses ‘one moves from O, 0 0, along the efisieney oes. +6 @) What dows the mtapeon of cone ofthe production fonctions imply Shoot the woguans? {@) The prduton faction i to be quss-concae if for an soquant Xo, these fal apa and abo combinations a elt est as sch tpt {2 fs coner, Don gums-conity imply concavity? {ne PRCOUCTIN PoSSUITY CURVE 38 1. Suppose tht ina Sigur ach as Figure 2 the nage-ental to forthe to Indus die. This could come aout, fer example, one ator were 03 Fh one indity bt ot la the eter How woul he aif! the production posit curve? 18 Draw representative Soquants forthe X industry andthe ¥ industry such tat, whieh isles than for some wageental rats seater than 1 Tr other magenta ati Note 1. A sets ai tobe conver if fr any two pats 4 and Bin test al points ‘malic joining 4 and Bare alin he et Noe thin igure 2 he points ‘on and above the Squat” (or any sean) satis ths contin. REFERENCES. Metin, JR. (97D "On the Derivation ofthe Pradstion Posty Gre ‘Boonamia 39, 267-298 Smomick, KM. (958). "The Box Digram and the rodecton Pouiicy “Curve™ Swedish Ezonamte Journal 6, 13-197{ chapter 3 Community Indifference Curves 4. THE UTILITY FUNCTION ‘The previous chapter described the production or supply side of the traditional international sade model inthis chapter attention is focused ‘on the demand side. Fundamental othe notion ofa repeesetable demand ‘elatinship i the assumption that consumers buy commodities because these commodities prove satisiction, oF lip. The relationship be- tveen the uly derived fom such consumption and the quantities of the commodities consumed is summarized in a utlty fonction of the form ver, 0). ‘This three dimensional relationship hasan obvious similarity tothe pro- duction funedons of Chapter 2, an, indaed, several ofthe characteristics ofthe production functions described in Chapter 2 wll be assumed to hold forthe wilt function aswell. One assumption that both production and "tlt unedons have in common is that both are assumed to be increas Funtioas ofboth inputs For the uty function this implies that a ile more of either good aways increases one's wit, orn other word, that ‘ne is never satiated with a particular commodity. Thus the uty Rane- tn, lke the production fonction, can be thought of as a three-dimen sional hil such that for any point on this ila larger amount of either ‘or both ofthe two inputs wil ye higher uty COMMUNITY NDFFERENGE CURVES a “Ther, however, one important distinction betwen the production function and the wit function. For production functions there was no filial inaaching signifcance tothe level of output of a particular Commodity associated with a bundle of factor inputs. Tt was easy t0 Stmagine that for known technology a certain numberof machines com> bined withthe service of a known mumter of workers would produce a ‘welldefined level of output. This ouput could ens be measured, and the ‘lationships between the level of output and the level f inputs could be “xsly determined. Forulity functions, however, no such simple rlation- Shi exits between the inputs and the output. While the inputs to the tilt function ae easily measured, for these are jus the amount of the ommexities consumed, the level of satisfaction or wlity that this com Sumption generate is enirely subjective and inherently nonmeasurable, ‘Notonly are there no natural uit of measurement for uty, there isso no obvious way of comparing diferent levels of tity. Although itis easy ough to conelae that eating two apples yields more wtlity than eating ‘ne applet would not make much sense to say thatthe level of wit from consuming two apples was twice as great as that achieved from ‘consuming one Uslity or satisfaction is inherently an emotion, and it ‘would make no more sense to Say that utility was twice as high from Consuming a certain bundle of commodities as opposed to some other tnd than i woul to say that you ae twice as angry today as you were yesterday, or that you are only half as much in love today as you were ast yar cause specific, comparable mmbers cannot be attached to uty ‘or stisfction, geometric representations of ity aba fonction of either ‘one or two inpats are not of much intrest. Thus the geometric reprsenta- tions of tity that would correspond to Figures 2.1 o¢ 25 for production Functions will tb employed inthe present analysis. But while meanings fal numbers cannot be attached to various levels of uty, its clear chat uty levels asccated with diferent commodity bundles ean be com- pure. In general individuals wil be able to decide which of two bundles Diels more satisfaction, or that two bundles ye the same satisfaction, ving the individual “indifferent” between them. This kindof compari- son known as ondinal measurement, and it requires only that he various temativs ean he oedered or ranked, Thus although cardinal measure iment, the kind of measurement assumed for production function, ee ‘ire not only that numbers be attached to each lve of cutpu, but also that a given america diference berween levels of output always implies the same actual difeence in output, for utility functions a much less precise form of measurement must be employed. Thus, even ia specie orm of he wility function wee assumed that gave numerical indices, 8,10,20, and 3, fr thre dierent commodity bundles, such as), (), and (Oh no signileance other than order could be attached to these three inubers We know that (cis peered to (b) and (bis prefered to (3), ‘but i cannot be sid thatthe increase in uit from () to (is the same 1 the increase fom () to () ‘Although the ondnality of wtibty somewhat restricts the kinds of| ‘geometric representations tht can be employed, there is one representa tion of the three-imensonal ublty function that does not requir that, ‘ily be measurable If We think again ofthe three-dimensionl wtiity hill and imogine ourselves at some point on that hil tis clea thatthe ‘ations points on the surface of the ill can be compared, even ifwe have ‘no information about acta elevations above the ground level. Thus some points wil be higher on the surfce, some lower n the surface, and some tthe same level If points atte same level ae raced out and projected fn the YX plan locus such at of Figure 3.1 would be traced out. This isa contour ine of the uit il and therefore represents the locus of atl eombinatons of commosiesX and Y that woud yield constant evel ‘of lity. Sine the individual isasumed tobe indifferent among al points fn this loess any such locus is fered to as an indforence curve, These indiference curves are cbviosly analogous to the isoquants of Chapter 2.0f course, singe an indifference eurve can be drawn for any Ievel of ‘uly thee are an infinite numberof such indiference cures, nly three ‘of which are shown in Figure 3.1. in this gure, higher inference curves Fepresent higher level of wit, since higher indiference curves represent Contour line that are farther up the utlity surface. Note, however, that From a uty point of yew, n0 significance can be attached tothe ds: tances between the various indifference curves ‘While it has been convenient to describe the inference curves in terms of the utility surface, iis worthwhile observing that indifeence ‘curves could be derived quite independently ofthe concept of the tity incon Tlastrate consider pont 4 of Figure 31, containing 10 nits (of and 4 nits of X. Fo constret wet ofndierence curves fora cetain ‘ndvidul, we could ask her to compare the uty received from other bundles of X and Y wit the uty resived fom point 4. Its fist of Al lear tha, given the assumption that both goods yield positive wily, fny point Below and to the let of poiat 4 would ye less uty than 4. Silay, any point above and to the right of 4 would yield more ‘ity and thas be prefered. A pont such as B, however, contains more 1X but less ¥, and thus no prion judgment can be made onthe relative ‘merits of this point a compared (0 4. To find out whether or not B is prefered to 4, the individual asked whether she would be willing 0 give Up in exchange for B I the answer is yes, then B must be prefered Powe a1 to. Fora point suchas C she might respond negatively tothe trade offer, indicating that 4s prefersed to C. If postive signs ttached toa pont Irhere the inivial answers yes and a negative sign attached to every point at which the indvidoa declines to exchange, and if the individual Inere asked to compare large number of commodity bundle, tine Separating all the pluses fromthe negatives ould be drawn. This line "pould include all howe points among which the individual is indifferent, lind would produce an indiference curve such as Zin Figre 3. 2. CHARACTERISTICS OF INDIFFERENCE CURVES. ‘The inference curves for individuals have several characteristics of interest forthe subsequent analysis. Fit, the indierence curves are assumed tobe convex to the origin, a asteatedin Figure 31 or 3.2. As ‘ve will see later on, this characters is important in determining the ‘Syulsium poston for an individual consumer. The exonomic rationale {or this assumption can be seen from considering points 4B, C, and D in Figure 3.2 Since these points are all onthe indiference curve Jy the individual i, by deiniion, completly indent as 10 which of these buncles of commodities she consumes. Te our points have Been chosen so thatthe movement from A to B and the movement from C to D both fepresent a reduction of two nis of eommodity Y. The inerease inthe mount of tht most be given o this individual o persuade her to give ‘ap there two units of Y aris significantly between these two sts of” ‘TEEHUCAL CONCEPTS ANDTHE GANS FROM TRADE points, however. To persuade the individual to move from 4 to B, only ‘one unt of Xie require, while the movement from C to D requires an ‘additonal 8 units of X. The ecoaomic argument underying this assump tion is tha, for commodity bundles with relatively large quanties of Y tun small quantities of, the rection inthe ality ssiociated wi tiving up unit of ¥, the plentiful commodity, s much smaller than the Increase in uty associated with receiving an extra unit of, the saree commodity. Thus, at in Figure 3.2, the indvidal is prepared o give ‘p2 units of Yt obtain one atonal unit of X-As theindividual moves, ‘down the indierence curve, however she receives more X and less Y, and ‘this movement takes place the ext ‘nit of X wil fal, relative to the reduction in utility associated with, ‘elinguishing a unit of Y. At pent C the individual canbe persuaded to {Sve up 2 units of Y only by ofering her & units of. The slope ofan {ndiferencecurveat any point equal to the ratio ofthe marginal utities ofthe two commodities, and is clled the marginal rate of substitution in ‘onsumpron.Indiference curves exhibiting the shape of those of Figure 5 2aresaidtoehibit a diminishing marginal at of substitution, refering to the fact thatthe wiltyasccated witha unit ofX falls elaive to the Uilty asoiated with a unit of Y ax one moves down the indiference curve from A to D. “The second important characteristic of indiference curves i that uit increases as the individual moves to higher and higher inference curves. Consider, for example, the two inference cures fy and 1, (gore forthe moment the inference curve through points G and #7.) [Because we have assumed that additonal amounts of ether commodity Increase tity, it is clear that pint # on inference curve ispreferred y ‘CoMMTY NOFFERENCE CURVES “ to point A on indifference curve Zp. But how could points F and A be ‘Sompared, where point F contains more X but less than point 4? The “Isr fo this follows diretly from the definition ofa indiference curve, {orsince f and Fare both onthe indiference curve , they are equivalet {tom the individual consumer's point of vew, and thus since B is prefered to A, F ant be prefered to A as well Thus all points on higher indifference curve are preferred tall point on lower indifleence curve. “The nal important characteristic of indifereace curves isthe fact, that, for an individ no two indilerence curves can intersect. This fat {smost eal demonstrated by supposing that two inference curves do fntersct and then showing that ths x impossible by drviag a contradic tory result Thus in Figure 3.2 the indiference curve through pints G and 1 has been drawn to intersect the indiference carve y. Now consider points G and B. Since G contains larger quantity of both ¥ and X, it Fler thatthe individual would prefer pont to point B- Now pots Ean Fare on the same indifference curve and thus the individual is indiferent between them, Similars, the individual is indiferent between point G and Jf on the indiference curve I’. Thus since H i indiferent {0 G, since Gis preferred to E, and since F is indifeent co E, it must follow that is prefered to F, Bt this impossible since F contains ‘more ofboth X and ¥ than point H. Thus the intersection ofthe (Wo Indiference carves contradicts the basic assumption that more ofboth ‘ommealties is preferred, and it can, therefore, be concluded that indie 18. THE MAXIMIZATION OF UTILITY So far the dscusion of utility has been coined to the consideration of individual tastes, or relative preferences, for the various commosity bun- ‘ies, The acts choice thatthe individual mak, however, will depend fn the prices of the commodities and her income, as well as om her Underlying taste patterns. Thos the level of ullty thatthe individual an achieve wil Be constrained by the prices ofthe commodities and by her income, To ilustate how the actual consumption bundle is chosen, ‘ne assumed thatthe prices of the two comedies, p and py, and that Income, Mf, are given. Assuming forthe sak of simplicity that the indi vidual spends her entire income on purchases ofthe two commodtis, it is clear that the total expenditure on X plus the total expenditure on Y ‘ust extctly equal M. This gives the budget constrait that canbe wet Mpa 4 BY. ep2 “ECISUCAL CONCEPTS AND THE GANS FOM TRADE ‘To depict this budget constraint geometrically, or, in other words, to illustrate the set of possible consumption point, suppose that all ine ‘come spent on commodity Y. In terms of equation (1 this implies that 1X = O, and slving for Y, we obtain Y = M/p, This pints shown in Figure 33 and represents the maimom amount of that could be purchased if ll income were spent on this commodity Similarly, i all, fncome were spent on commodity X, consumption would take place at (Mp, in Figore 3.3. Furthermore, it follows that if income were divided ‘squaly between the two commeditie, we Would obtain, for Y, point ‘M/2p,, and for X, point M/2p,. This gives the midpoint om the line joining Mp, and M/p,, and its clear that any allocation of expenditure between the wo commodities wil give rie to some point on this straight Tine, Note that the slope ofthis budge constraint canbe found by dividing Mp, BY Mix to obtain p/p, “am alternative method of ploting this budget constraint would be to note that equation (1) can he saved for ¥ to obtain ya My Bey 2) mB ‘This standard form ofthe equation ofa sight in, where M/p is the interoept onthe Y axis, and where p/p isthe slope ofthe line “The indiference curve map can now be combined with the budget constraint to illustrate how the euiirium position is determined. In gure 33 COMMUNITY ROFFERENGE CoRVES| * Figure 3 thre representative indifience are forthe ini are ‘nm The ndal consumer could coon pot sch as sce ipon er bdge contri, Dut wil nt do sigs cha location of “pendire would not msinizc er welt. Ax she moverop he Dest ns so'a pin sucha, welt snr since he cross Saher ndterene carve nd tot B wee masimie, for she fs now seched the bight lve of wt cmt wth the uae Consrant Since pint # rere the tngecy etme he budget Sensrint andthe highest inaifence cov, wilt masinizod Oy ‘Sting the margin te of substituon qa the rao of comme " ‘Because international trade is concerned with general equilibrium question, we are concerned nts ch th he akmizaton ond ‘Ma ya with the conto that haste equim fre Tne commniy. To conte he inp ch cn, spp hat the unte O and are fed at Fand Y royce ond that the Sonny cons of two inviinls. Thekcs pmlc fount oth smle cet ered exact the same way 8 wat Theetccgy ous in Chapter? Inthe be Sigrm of igure we have Potted the Inference curves or he sina fom 0), athe Tnditrene cursor the son inde fm Oy- Noe hain frm FO, pant Oy represent te tl veal gant of commode SF ani" Soporte ave been ud 0 Stiga the tw Sls of inditerace cares ‘ne std of dering the cus of eutriam points fr se rwo individ sto sonar the problon of waxing the ty of one aiid ste! osome ned levlo ay ofthe erin, tothe const thatthe quan of and are fae. Suppose. for ‘sample we consnin he ond indies cnsume somewhere slang 'nifnnce cre sand mami the ity ofthe Sw nda fut ots con and fo he sont tat Y= Fand X= ‘Would te optima or consumption to take place a «pit sich x3? The answer cleo, for movements fom B toward pint 4, while leaving the second nd! heme uty level, would rel Highs and higher lvl ty forthe nina can alo be fee tht at pot theif thet india asinine wet {oe contains ve have inposed: Whe pints on higher ndierene ves woud be peered, no sh ptr can be achive ice they Soul ei tol coun fore commit than ext in Theceonomy Ths alogh he it nda! woul ly preter tate pint sch as Chin could ony be asheed by retaciog the ‘Sastunion oe econ ddl moving ino omerindieree“ TEOMA. CONCEPTS AND THE GHNES FROM TRADE ‘curve. Ths point 4 is optimal inthe sense that the ult of one indvid- tal cannot be inreased without reducing the wtlity ofthe other iii tal This the Pareto criterion of opuimality (named forthe Italian econo ‘ist, Vir Pareto), and point sucha 4 is sai to be Pareto optimal. (OF courte the choice of indiference curve F was arbitrary, and the same argument would spply equally wel fr any other indiflerence curve Suppose for example, inference curve Jj had been chosen, and the uty of theft individual maximized subject to this constraint. In this ‘ase the Pareto optimal point is, the point where [3 is tangent to the highest indflerence curve forthe fst individual. By choosing various ‘ther inference curves forthe second individual, nd maximizing wiity forthe fist subject otis constrain, the locus 0} 4; would be traced ‘out, This the locus of all Pareto optimal consumption points, and is called the comrac cure Cs important to note thatthe criteion of Pareto optimality is ctiely an efficiency condition and fas noting to do with equity, The ovement from B 19.4, o from B to F, is desirable since such movements increase the utility of one individual without reducing the uty of the “other The Pareto criterion doesnot allow a compare of points Such as F and £, however, even though moving trom F to E would substantially increase the utility ofthe fist individual while edcing that of the second Indeed, point O; on nierence curve I} is Pareto optimal, eventhough itimplcs thatthe rst individual rccves the entre available quantity of both ¥ and Y while the second individual receives nothing From Figure 3.4 we see thatthe contract curve isthe lous of| tangency points between the indference curves forthe two individuals. Commune nDrERENCe CURVES “ 11 was previously shown thatthe individual consumer is in equilibrium ‘where the commedity price rato lines tangeat to her indiference cuve 1 therefore follows that, at any point on the contract curve, the equlib- rium commodity price rato line mist be tangent to both indifeence ‘curves, such asi, /p, a pat 4A requirement for Pareto optimality is thus that both constimers face the same commodity price ratio. 4. AGGREGATING INDIVIDUAL PREFERENCES. {As note inthe previos section, we wil be concemed with preferences ‘and demands by ene counties, nd not just those ofndvidals, Unor- tunately, it turas out thatthe preferences of individuals can only be aggregated together to get national o “community” indiference curves, under special assumptions. This section provides «simplied discussion af the issues, while a more formal treatments presented in the following ‘Suppose that individuals all have preferences ofthe type described in the preceding sections, which in turn gives ris to demand functions {hat depend on prices and income. Assome that there are only two goods and that the pic rai is denoted p. The income of individual i denoted by MIF all individuals inthe economy face the same price ratio but severally have diferent incomes, then the total demand for the good ‘an be written a the FeetionD: X= DO. My Tay) oy where iti assumed that there are individuals inthe country. The ‘question of whether or not community indiference curves exist is essen~ tally the same asthe question of whether or not the demand function in ‘equation (3.3) can be writen a a funtion of agregate income (the sum ofthe individuals incomes); that, whether of not the distibaton of income affects fotal demand. The inition ere is that when we draw ‘commonity indference curves, we are saying that the country hes refer- fences over aggregate bundles of goods that depend only on prices (he Slope ofthe price ine) and toa income (the distance the pie line rom, the origin). Preferences and hence demands are independent of ow that aggregate income is distribated Special assumptions are necessary for demand tobe independent of the distribution of income. One problem that arses in aggregation is shown in Figure 3.5. Suppose chat we have tvo consumers with identical ‘but nonhomogeneous tastes. Tat, at constant relative prices, the ratio ‘of YX consumed is not independent of income, In Figure 3.5 consumers este more X eclatve to Yas income increases at constant prices.Powe 35 [Now suppose that we have two consumers with dential (but non homogeneous) tastes who are each at point din Figure 35, Now we take oa Income away from consumer I ad vet to consumer 20 that they fre now at points B and C, respectively in Figure 3.5. The chord AB is, steeper than the chord AC, and so the changes ia the consumption of the fo individuals donot balance, Even though we have not changed iter Drees or aggregate income, there wil now bea higher aggregate demand Tor and a lower aggreate demand for Y. Aggregate demand depends on the disrbution of income, and hence community indiference curves {donot exist in tis situation. "Now consider homogeneous but nonidentical tastes. This situation isshown in Figure 46. Consumer 1, who has relatively strong preference for Yi intially at 4y, while consumer 2, who has strong preference for is iially at 4, Now take income aay from consumer I and give itto consumer 2 holding prises constant. Consumer 1 moves o point By, ‘while consumer 2 moves o point B in Figure 36. Again, the changes in Consumption do no cancel (more X and les ¥ wil be demanded) even ‘though prices and total income are constant. Community indifference ‘curves do not exist when preferences dif “This analysis suggests that community indifference curves will exist, itll consumers have Menical and homogeneous tastes (and, of course, face the se prices). We wil show that thi indeed true inthe next section. This is however, a somewhat sronger assumption than we need, finda slightly weaker one is used at several pint in later chapters. An Comms NOFFERENGE CURVES a Figure 37 alternative condition i shown in Figure 3.7 where consumers are assumed to have identical but nonhomogeneous tastes. The income expansion path doesnot go through the arin tits ner and is shown as expansion path OFM in Figure 37. ‘Assume that two consumers are both at point jn Figure 37 ini tally. Now take income away fom consumer 1 and give it to consumer 2s that they move to points B, and B, respectively. Note thatthe ‘changes in ther consumption levee cancel, 0 that there fs nochange in fegregnte demand. This type of preference, sometimes called “quihomothetcity,” doss imply the existence of community indiference curves, As we wil sce in ater chapters these preferences ae useful fo ‘edlng with diferences in per capt income ross countries. Note in Figure 37 tha the ratio of ¥/¥ consumed depends on income (per capita income fora country) al constant prices. Inthe case shown the share spent ‘on increases with income. ‘Throughout tot of the book we wil assume that preferences can tbe aerepatd into community indiference curves. This permits an ess) txposton of many points that donot rely on this esummption but that feannot be shown graphically without i *5,_THE DERIVATION OF COMMUNITY INDIFFERENCE ‘CURVES “The preceding section discussed, in relatively informal terms, the problem concerning the aggregation of the tastes of individual consumers into ‘ommuniy inference curves, We noted that strong assumptions are ‘euced in order that community iadiflerence curves can be shown to txist and to possess the properties of individual indifference curves di ussed ari inthis chapter. This section presents @ more advanced ‘iscusson of this problem ‘One simple example of situation ia which a welldined commu nity indierene curve does exis is the Robinson Crusoe economy, in ‘which tis assumed tha thereis only one consumer. Uilty maximization for this simple community would proceed in the same way es would ‘manimization fr single individ, except that the consesnts would Alife. Under the sumption thatthe simple commonity posses the capacity to produce commodities using diferent production functions, Sin asting that these prodcton funetons exhibit constant returns 0 fale, then instead of the linear budget constraint of Figure 3.3, the {ndvida would be faced with a production constraint of the kind derived in Chapter 2. Thus our Robinson Crusoe economy will maximize ulties subject to the tansformation curve In terms of Figure 3.8, where TAT" Fepresents the production possiblity curve, and where three represent tive indifference curves have been include, by an argument completly analogous fo that used to demonstrate the condition necesary forthe ‘maximization of individual welfare t can be shown that uty s max ‘nized where the highest indilerence curve is tangent to the production possiblity curve. Thus in an economy in which no trae is allowed, the ‘ulibrum production and consumption points wil be peiat Ain Figure oe ‘This Robinson Crusoe eeamoniy is too simple to warrant further ‘COMMUNITY NDFFERENCE CURVES ° ‘consideration. What we seek af conditions such that preferenes for 8 [r0up of individuals can sill be represented by inference curves such ts those of Figure 3.8 To facilitate our understanding of what such ‘Conditions are, we will now construct a st of community indifference ‘curves under quite general conditions, and compare the characteristic of ‘hese with the inference curves for individual consumers. We begin wth, the case in which there are only two consumer, but twill become clear fs we proved that any number of consumes could be included "An inference curve for an individual consumer is defined asthe Iocus ofall those bundles of commodities for which wilt is some con- stant, To be consistent with this defition, the aggregate inference ‘curves for two individuals most be the locas of all thse bundles of| ‘commodities such tht the level of uty for both individuals are con- stant. We ths choose a specif inference curve for each individual and feck a method of agereeating these two indilerence curves. For the ist individual we choose the indiference curve Zj shown in Figure 39. We ‘ow choos some point on that indierence curve and cll it, the origin forthe indference curve map ofthe scond ingivdual. The inference ‘curve chosen forthe second individual x73, as shown in the figure. To ‘etermine which point on the indierence curve for the second individu sth relevant one, we real from the discussions surrounding Figure 3 thats in equilibrium, the inference curves forthe two individuals mst, have the sme slope, We thus determine the slope ofthe indiference curve forthe frst indivigual at O, and thea search along the inference curve forthe second individual Util we id a point that has the same slope Suppose thi is point in Figure 3.9, Point 4, a bundle of commodities0 “ECIICAL CONCEPTS ANDTHE GANS FROM TRADE Figure 39 conttning Yo of ¥ and Xp of X, is clearly a point in outputs space that ‘lows the individuals to have ulties asocated with the inference turves Zand 13, and thus is a pont ona community inference curve for these two individuals By placing Os at other points onthe indierence curve I) ofthe fst individual and repeating the same procedure, other, points on the community indference curve ca be found. The locus of ll ‘uch pins could be considered sa type of community indiference curve for there two ingviduas. Note that point 4 sa point onthe community inference curve, and thatthe price ratio tts point isthe same as that Oy, suggesting that the slope of the community indierence curve will, be the same as the slopes ofthe individual indiflerence curves from which that point was derived ‘Analernative way of demonstrating the aditon ofthe two indie ence curves to arrive atthe point A isto plot the indierence curves for the second indviial not fom Oy but fom A. This gives se toa box Singram, Figure 310 Ginilarto tht of Figure 34). Note cat this gure ives precisely the same information as contained in Figure 3.9, the only ‘iterene being tht we are plotting the indifeeace cures fr the second {ndvidal down fom the aggregate commodity bundle, rather than up fom point 4, asia Figur 39. n thie diagram the community inderence curve can be traced out by sing the indiflerence curve forthe second indivi! along that ofthe stand allowing the origin O, to trace ut the community indifereace curve. Thus the indference curve for the st Individual eemsins xed, ond we nd other points along this curve where the indiference curve /3 is tangent to it Another such point Would be 1B, andthe origin Tor the second individual's indierence curve map will tt nent now be 0}. The pint 0 i another point on the community inference furve, and by repeating this procedure, we ean find an entre locus of points such 8 C/Cp of Figure 3.10. Not that forall points on CIC the ‘tity levels Tor the two individuals ate constant, Since curve CIC, in Figure 3.10 isa locas such that the levels of tse for both individuals are constant, it thus must bea community inference curve. But what properties dos this community indifference ‘curve have? In particular, does t have the same characteristics a did the indiference curves for individual consumers discussed in Section 2 of this Chapter? Specially, we wish fo exabish whether or aot these comma nity indifference curves could intersect, and whether higher community {ndference curves necessarily imply higher Ives of community welfare. ‘To consider these questions, we have redrawn, in Figute 311 the inital situation of Figure 3.10 and have incindd the contract curve “Another way’ of asking the question of whether community indie cence cures such as CIC intersect ist ask whether, through point Os, there could possibly be another community inference curve having & ‘ferent slope, Two points are relevant 10 this question, First a8 we previously observed, the slope ofthe community inference curve at Os [equal 10 the slope of the two indifeence curves at pont 4. Secon, the Chote ofthe two indifference curves tangent at was ently arbitrary, fnd any other pai of inference curves could haveboen chosen. Suppose, forexample, that instead offing the eel of utes forthe two individ sls equal to that associated with the indiferene curves tangent at pont‘A, we had instead chosen the two indiference curves I} and 17, tangent 1 pint 2. Te is clear that exactly the same procedure deseribed in Figure 3.10 for point 4 could now be carried out for point Band a new commu nity indiference curve could be constructed. The question now is whether ‘his new ndiference curve would be exactly the sain asindierence curve (CICy, the ove derived from point A. That this need not be the ease can ‘easily be seen by observing that thie ew indiferenc curve must have the ‘same slope at O. asthe two individual inference curves have at point, ‘Bt there is no reson thatthe slope ofthe inference curves at pot 2B need be the same atthe slope of the inference curves at point 4. As ‘the diagram hasbeen drawn, the price line at pint B i steper than the price line at point 4, and thus the community inference curve as ‘tcatd with mast be teper than hat asseiated With 4, and we would haves curve such a CIC. Furthermore, ay point on the contrat curve (0,40, could have bon chosen to derives community indiference curve ‘trough point Os, and in general ll such points would lead tom comm nity indiference curve through point Os each wth slope diferent from that of CIC, There are, then, an nfite numberof such community inditerence curves through poit O, ll having diferent slopes. “Although its certainly posible to define the curves suchas CIC snd CIC; derived in Figure 11 as community ndiference curves, hey ‘would not be very tf for illustrating the international trade propost- ‘ons chat we will subsequently drive. To give one simple example, sp- pose that in Figure 3.8 instead of the set of nonintersectingindiference carves shown, we had a eof ommniy inference curves ofthe kind rved in Tigre 311. Te ths case here would tea whole st finer. ‘ev cuves throug pont tall ving iret slopes an here woul ‘fae nfrence carves tangent tobe transform TAT" pots Ser han pint 4. In ach se mold not ea alvin which ‘Fino paula agency point would be the pop equim ms ‘ur next question is whether there are conditions that could be imposed ots lity fats of fe to fava suc that the ommuniy inifeente cree wold ot inter. Ie obvi fom ‘gure ht only ithe quip ate ine a he sae soe [ar pom onthe contact are wil thre bes snle commanty ihifefence cre hugh pit Oy Is here ay feson to exp sch condo ol? Cory nti eters and long the wlty une for the to indie we woud expec Ie slopes ofthe trum pie fie long the contact cre oie, Ths suggests ‘Ta one ero to ein tt the uty fonction ofthe two india be the same Bate sts ot fist forthe exten of nnintersting common inference res st can ee fom Fgue 3.12. ential {evel ve reo linn contact crv sha hat shown a Fe $tsbut isin lw not gare thatthe lope of he prc ato ine ata pins ont conretcave wile these: Ind sear thao be et afinifecace curves for ine wo nia have he Same spe slong amy frm the gn wl hs onion ness be Fi Thiscondon a amir on ots proche harcore {that homogeneous predation were oan t hve in Chapter igure 212os “TO-WOAL CONOEETS ANDTHE GARG FROM TRADE 2.Thasthe second conition that must he imposed on the ult anetions ‘ofthe two individuals s that they be homogeneous. Note that We ae not, ‘concerned with the degre of homogeneity, for as was Suggested air, ‘orate uility is an ordinal measure, no signicance can be attached to ‘the numbers associated with the various indiference curve. ‘With identical taste and homogeneity, the equilibrium price lines at all points on the linear contract euve of Figure 3.12 will bave identical, Slopes It then makes no difrence which point onthe contract curve is ‘chosen to derive the community indiference cures, for in all cass the slope willbe the same at point O. Furthermore, the same argument apples fr diferent initial aggregate bundles of commodities X and ¥. ‘Suppose, for exsmple, that” and Y" were avaiable for distribution ‘betwen the two individuals. Ia Figure 3.12, 05 wil be the origin for the indifference curve map of the second individual. The same procedure ‘outlined earlier could be wed to derive an indierence curve through O', and again itis obviou that there wl nly be one such curve through this point ogarless af whic ital point o the contract curve Oj is chosen. ‘Thus a whole set of community inference curves ean be derived by choosing diferent aggregate bundles of commodities to be distributed besween the two individuals, Note tha the community inference curve through 0; in Figure 3.9 wil have the same slope asthe commaity indiference carve through Oy; this demonstrates that the et of com> nity indifference curves wl also be homogeneous. thas been shown that ast of nonintersecting community indie ‘ence curves will exist for the two individual, the wit fention are (1) identical and (2) homogencous. It has been shown that dential taste ‘alone is not suificient forthe existence of noninerectiag community inference curves Iti equally clear that homogeneity by itself not, sllint, and indced, the uty unetons assumed in Figure 3.11, while ‘ot the same forthe two individuals, could easily have ben derived from homogeneous utility functions. A’ question that naturally occurs is whether there are any other ses of conditions that would give rise to ‘onintrscting inference curves. To illuseate anther possibility, we ‘nave in Figure 3.13 assumed that the ult functions for to individuals, while homogeneous, are not dential s thatthe contract curve would be (0,40;, The slope ofthe equim price line wil in general, vary along the contract euve in Figure 3.13 just sit iin Figre 811. But suppose that in some way we are resticted in our choice of points slong this ‘contract curve. In prtcular, suppose thatthe initial endowment of and Y received by the two individuals represented by point E, the point at hich both individuals receive equal quanti of the two commodities, T ‘COMMIT ROFTERENCE CURVES 55 ure 18 ecause the two individuals have dierent tastes, will not be an equils- ‘ium pointy and the two individuals will exchange with one another 89 ‘each pot 4. Indeed, itean be shown that forany endowment point there Wil bea unigue equilibrium point on the contract curve, as Jong asthe Ulty Functions forthe two individuals ee homogeneous. Thus, wth, endowment point Ether i a single point on the cntmct curve that results n uibrum for the two individuals, and thus only one comm nity inference curve cn be consractd through point O3- Ta this ease, ‘ather than inssing thatthe slope ofthe equiliium price line be the Same a all points onthe eootract curve, by specifying the iil endow. tment point, we have restricted the possible equilibrium positions to the single point ‘A second charstristic ofthe uty funtions for individuals was that higher indiflerence curves represented higher levels fut, we now ‘want to consider whether community inference curves have this same Characteristic, Speiclly, we wish to know whether being on a higher {ndference care rel in an unambiguous improvement in community ‘welfare inthe sense tat both individuals wil be bester of An examina- tion of Figure 3.12 shows that without further restrictions this wil noe necesariy be the case, Suppose thatthe indieence curve CIC had been ‘erived from point 4, and tha the total endowment ofthe two commodi- tis i nereased such that the new origin forthe isoquants ofthe second individual i 05, The new community indifference eure CIC) can now ‘be constructed, and as we saw earirthis same curve wil be derived regardless of which ntl point on the contact cuveis chosen. In partic- ‘lar, point Could be the equilibrium position fortis new endowment,nd although theuility forthe second individuals much higher at point C than at point 4, the level of uty enjoyed by the fist inva is Substantially lower. OF cours, is possible for both individuals to be ‘beter off with this new endowment, Since the foal avalable quantity of both X and Y has inreased, and te allocation of some of this increase {o both individuals wil certainly make them both better of. The pot is {hat without some restriction on how his increase the output ofthe two ‘commits isallocted between the two individuals they need not nces- Sarily both be better of. While such an inreas in outpat is potentially ‘Superior for both individu, it wil actually be superior only if some fesirictions are imposed on the distribution of commodities between the {vo individuals Thus, ifeommanity indifference curves are to be am inden ff community welfare, the dstbution af commodities between the ine ‘iva must be restricted so that both receive some fixed share of total foutpet 18. CONCLUDING REMARKS Tc hasbeen shown that set of nonintersecting community inference curves can be amumed 1 exist ifthe uty functions for the individu ‘re homopencous and if ether (1 the tity functions are identical or 2) the dsibution of incomes fixed For the case of identical and homogene- ‘ous uty functions, commusityindiference curves give unambiguous ‘elfare comparisons only if he distbution of income is also fixed. While {hese conditions may seem somewhat severe, it should be noted tht the conditions requited for aggregation im any area of economics are very resritve. Indeed, it can be shown that exactly the same conditions ‘equred for the existence of community indiereace curves are required for the existence of aggregate consumption functions, that from a theoretical point of view the aggregate consumption function wsed so widely in materocconomics is as unrealistic” sare the community indi. {rence curves that wll be employed inthis analysis. Tt should also be noted tat forthe mest part, community indie. ence curves will be usd only fr illsteaive purposes, and that most of {he conclusions we reach can be derived eve i community indiflerence curves do not ens. Commonity indiference curves are thus employed mainly because of thir hears value ‘Although our discussion has been restricted to the swo-individul ‘xs, our conclsions wil be tre for any numberof edviduals. Ths in the discussion of Figure 3.12 any numberof individuals coud have been assumed andthe community indiference curve CICy derived as Tong as all were identical with homogencous preferences COMMNITY NOFFERENCE CoRVES o7 PROBLEMS. 1. Show tat, foraninvdulconsumer maximizing wiry sujet tothe badge entity the oii poston wil a nese be ugh nes the Inaierence curves are convex tothe orig 2, Show tha fcommentyindiferense curv att, there could be many 41 In Figre 13 tse out oe of eansumpin points as the pic of fal “4 The consnucton of nonitersecing community Indif[eeace curves ia Figure [E12 was ilustated fortwo indvsuae. Show thatthe procedure spe ually wal fr tree or more inhi REFERENCES: Chipman, JS. (1968). “A Survey of the Theory of Iteration Trade Part 2, "The Neo-Clasal They” Exoromenica 38, 68-760, “Mavi. Re (1973). "On the Equivalence of Community Inference and the ‘Antremte Consmpion Function.” Bonomica #2, 44-445 Samson, PA. (950), "Socal Inference Cures” Quarterly Joural of ‘Booms 64 268-289 Scion, T (192) "A Reconsideration of the Thor of Tait." Review of "Feo Suds 9, 89-10,chapter 4 The Offer Curve 4. THE AUTARKY EQUILIBRIUM In Chapter 2 the production possibilty curve, or the supply side of the model, was developed, and in Chapter 3 community indiference curve, ‘one mth of representing aggregate demand conditions, were derive, Tin this chapter thee two construct wll be used to deriv the offer eure nother peometric device that mill prove usefl in subsequent analysis. First ofall, however, tis necessary formalize the notion of equiletum, in thisaggregte model. niall, we assume closed economy, or in other ‘words, an economy in which no international ade takes place. This, povtrade situation is commony referred to as auarky Tn Figute 41 the production possiblity curve TAT” has been drawn; thre representative community indiference curves are also shown Tis ‘lear that the polenta welfare ofthe economy is maximized at point A, the point at which the highest commonit adierence curves tangent 10 the production poesiiity curv. But we have not yet demonstrated that the market mechanism would lead tothe establishment ofthis point as the ‘equilibrium, To show dat this wil, im fat, be the eas, suppose that Wally the economy found tlt at pot B. Tt has already Been estab lished that for this to be an equilibrium for consumers, the commodity rice ratio, py/oy, must be tangent to the community indiferenee curve at this point To simplify notation, we will deine the ratio py/p, = B Tr gure 41 ‘hroughout the remainder f the book. Thus at point B the rice ratio tine ‘aust be tangent othe community inference curve. The existence of {his price ato implies that consumers are prepared to exchange com Imodities X and Yat this ratio, Note, however, thatthe slope of the ‘production passiility curve at B represents the fat at which one com todity can be transformed int the other Tn ater words, this slope shows the amount of Y that must be given up in order to get another wnit of 1 through production. Ofcourse, this transformation of Y ato X docs ‘ot tean thin some mysterions way one commodity is actually being Converted into the other it simply means that a reallocation of factors, from one production funtion to the other would gives o this kind of shift in aggrepate production levels. We have sen tat the slope of the indiflerece curve at point 3 is the consumer price ratio, and that the slope of the transformation curve isthe rate at which commodities can be transformed fom one othe other through production Its now easy tose that point B could not exist as ‘sv euilibrium poston. At point B predcers Would aoe that consumers fare apparently wiling o exchange elatively small quantity of for a rge quantity of Y. They would further not, from the rae of product transformation, that by foregoing the production ofa small quantity of Y they could produce a elatively large quantity of X. As proi-maximiz- ing producers, they thus perceive that by producing more X atte cost tovthem of a relatively small amount of Yand by exchanging this X at the price ratio py they could obtain a larger quantity of Y- Thus the production pont wil end to move along the production possibility curve© “TENA CONGEETS NO THE GANS FROM TRADE from B toward A. It is clear that this same argument could be made at all points between J and 4, ad that only at will there no longer be fn incentive to produce larger quantities of X. At point the price which consumers are prepared to exchange is exactly the same rate Iwhichcommediies ca be tansformed in production. ts abo clear that hod we begun ata point rach as C, the story would have been precisely the sme, except that inthis case producers would have had an incentive to produce larger quantities of Y- Thus market forces will establish A 28 te autarky equilibrium postion. The equilibrium price line asociated ‘vith this point i the line p, the line jostly tangent to the production postibiliy curve and the community iadierence curve. 2, THE OFFER CURVE: FED PRODUCTION Point 4 of Figure 4.1 is the equilibrium poston that would exist in a situation in which there was no possibility of interational trade: The ‘major concer ofthis book, however, swith situations in which this kind ‘ofexchange does ake place, and we wish to examine the conditions ander ‘which such international trade would occur. It is clear from Figure 4.1 that even ifthe model were expanded to include other countries, no international trade woud take place the price rato remained at p, This price ratio pressly equates the quantities of X and Y thatthe industries trish to produce and the quantities of X and Y that the consumers wish Toconsume, Iti obvious, however, that atemational trade cam take place ithe word price ratio difers rom pp. We now tuen to an examination ‘ot how domestic rovders and consumers would behave when faced with, ‘rive ratios tht ifr from the autarky price ratio of Figure 4.1 “The alm of this chapters to lustate the derivation of an offer curve forthe most general cae in which ther is substation in both consump- tion and production, Asan inl step, however, itis instructive to begin tithe simpler model in which production is fed, such that the same Sraregate production pont i relevat fo all rice ratios. Ths in Figure {42 the point A with Yo and Xo of commodities ¥ and X, respectively, isthe only possible production point, Thee wil be some price line, 54, >, such that consumers demand quantities Xp and Yo. Thi is equivalent {o the autarky positon of Figure 41. (To avoid confusion, the indiference ‘curve tangent fo py at as not been included.) "We now suppose that prodacers and consumers inthis country are faced with & new price line py, implying 2 relatively higher price for ‘commodity Y. Both producers and consumers are assumed to maximize {utpat and wit, respectively) see to thi constraint, so that produ tion remains at point and consumption moves to pint C. Note that, Figure 42 both A and C must fe on the price line p, for while we are no longer ‘isting thatthe same quantities of he to goods be consumed as those ‘that are produced, we do insist that the value ofthe consumption bundle ‘beequal othe value ofthe production bundle. Consumption at C, would ‘be posible this country could ind some other economy that was willing tw accept the quantity of ¥, Yo — Yiy in exchange forthe amount Xy = Xj of commodity X- For the moment, however, we are nt concerned with the question of whether p willbe an equilibrium price ine, but only ‘with the question of how producers and consumers in this country would react when faced witha variety of diferent commodity prise ratios. ‘Suppose the economy were faced with the pric rato line pn this ‘tation consumption would take lace at pint C, wit production again fat A, and fora pice ratio in ps, consumption would beat Cs. Note that inal thes ase consumers maximize uty by moving to the point where this pice line is tangent to the highest community indilerene curve. IF this procedure wore carried out fra large numberof suc price lines, the ‘equiriam consumption points would race out the lineAC\C3C3P. This ie type of ofr curv, rciproal demond cure. “The pont along the olfer curve AF in Figure 42 were derived by ‘considering the price ratio lines whose slopes became progressively ess ‘steep. tis clear, however, that exactly the same procedare could be used for price lines that are steeper than py. In Figure 42 only one such price Hine, p, implying production at 4 snd consumption at C', has been included. Ia variety of such pice lines were used, then the curve AC\F* ‘ould be traced out. Its important to note chat if atention i eticted to those situations n which domestic consumers and producers fice the2 “TEOAMCAL CONCEPTS NO THE GANS FROM TRADE same relative prices, the locus FAP! shows all posible equilitium points that coud exist for this economy. ‘3. THE OFFER CURVE: VARIABLE PRODUCTION ‘Asnilar procedure that shown in Figure 42 canbe used when produc {ion posbiliies are represented by the locus TAT" of Figure 4.1 this ase for every dilleent price, producers ag well as consume wil aust, “Guanes produced so gs to remain in equllrium. Such a stution is Showin Figre 43, where point 4 sth autarky point from Figure 4 [Now for price line py consumers will move to C and producers will, choose Q where py is tangent to TAT", This would again require an achange of Yo ~ Y, of ¥forXy —Xq of X itis isto be an equilibrium, Inthe sme askin, the production and coasumptio pints fr price ines is pyran p' can be derived asin Figure 43. As before, the locus of {ulibeam consumption points FAP can be constructed and willbe 3 ‘esion of the offer curve or reciprocal demand curve Tn certain circumstances itis convenient to show the relationship depicted by FAF" of Figures 42 and 43 without specifically including the production possibilty curve and the inference curves. We have, in Figure 43 HE OFFER CURVE «3 Fioue 44 ‘igure 44, reproduced the relevant information from Figure 4.3 but have Jet out the indiference curves inorder to avoid clutter. Iii we wll, consider only those price lines thats les step than the autarky prise lin angen at point For the thee price ine illustrated we have drawn, in thesrade tangles. Thus iprice py prevail, the economy would wish 10 export Bj} of commodity Y and import BC, of commodity 1. Similarly, 8:Q; and B,C, would be the desired exports and imports of ‘commodities ¥ and X,respctivly, i the price were ps. Not tht these ‘quantities OFX and Y are just the excess demands and excess supplies that ‘would prevail inthe economy a these various price line, ‘To illustrate more clealy the way’ in which the trade bundles vary as prices change, we have, in Figure 45, plotted only the exports and {imports associated withthe various pric ines of Figure 4.4. We ave, in other words, ploted the trade triangles from Fighre 4.4 all forn the common origin in Figure 45, such that By, and BC; of Figure 44 ‘become OQ; and OC; of Figure 45, resulting nthe point Ey. The trade angles for pp and py are plotted in exactly the same fashion, giving Bs and E in Figure 4.8. Had other price lines ben considered, ater points in Figure 4.5 could have bees found, and thee would have resulted in he locus OF. It's this locus that is commonly refered to a8 the ofr cure. Figure 4.5, while the axes are the same as in Figure 44, the ‘quantities Being measbred ae not etal production and total consumption, hut are, rather, excess demands and ekcess supplies. In other word, We are plating the desired exports andthe desired nsports for variows pons ‘ble commodity price lies, Note tha in Figure 4.5, for any point Eo the ‘fer curv, the line from the origin to this pont represents the commodity