Chapter 1

The Basic Geometry of

Comparative Advantage and
the Gains from Trade
1.1 Introduction 1.3 Production, consumption and trade
1.2 Absolute and comparative 1.4 The gains from trade
advantage 1.5 Offer curves

1.1Introduction
Two of the basic questions that the theory of international trade has to
answer are what determines the pattern of trade and who gains from trade.
Economics does have answers to these questions ones that go back more
than 150 years - in the theories of comparative advantage and the gains
from trade. These theories, formulated around 1815, are usually connected
with the name of David Ricardo. The theory of comparative advantage
or, as it is sometimes called, the theory of comparative costs, is one of the
oldest, stillunchallenged theories of economics. Before exploring the basic
theory of comparative advantage and the gains from trade, which is
usually done geometrically, we shall take a brief look at its historical
background.
The economic doctrine that prevailed during the first two centuries of
the development of the modern nation-state - the seventeenth and
eighteenth centuries -was mercantilism. Thedoctrine of mercantilism had
many modern features: it was highly nationalistic, viewing the well-being
of the home nation as of prime importance; it favoured the regulation and
planning of economic activity as an efficient means of fostering the goals of
the nation; and it generally viewed foreign trade with suspicion.
The most important way in which a nation could grow rich, according
to the doctrine of mercantilism, was by acquiring precious metals,
especially gold. Single individuals, however, were not to be trusted: they
might also like gold, but perhaps they liked other things even more. Left to
themselves, they might exchange gold for satin and linen, spices from
India, or sugar from Cuba, or indulge in whatever private pleasures they

3
4 Theories of Inter- and Intra-Industry Trade
preferred, to the detriment of the stock of precious metals stored in the
nation. To prevent such undertakings, the nation had to control foreign
trade. Exports were viewed favourably as long as they brought in gold, but
imports were viewed with apprehension, as depriving the country of its
true source of richness precious metals. Therefore, trade had to be
regulated and restricted, no specific virtuc being scen in having a large
volume of trade.
cconomics
It was against this background that English classical and David
developed, for mercantilism was the credo that Adam Smith
Ricardo rebelled against. English classical economics was an offspring of
liberalism and the Enlightenment - of a general philosophy that stressed
the importance of the individual and viewed the nation as nothing more
than the sum of its inhabitants.
the
For Smith, as for Ricardo, the supreme subject of economics was
consumer: man laboured and produced in order to consume. And anything
that could increase consumption, or, to use Ricardo's phrase, 'the sum of
enjoyments', ought to be viewed with favour.

1.2 Absolute and comparative advantage

Adam Smith and the absolute advantage of
trade
Adam Smith saw clearly that a country could gain by trading. The tailor
does not make his own shoes; he exchanges a suit for shoes. Thereby both
the shoemaker and the tailor gain. In the same manner, Smith argued, a
whole country could gain by trading with other countries.
For example, suppose it takes 10 units of labour to manufacture 1 unit
of good X in country Abut 20 labour units in country B, and it takes 20
units of labour to manufacture 1 unit of good Yin country A but only 10
labour unit_ in country B. Country A has the absolute advantage in
producing good X,country Bthe absolute advantage in producing good Y.
If the two countries were to exchange the two goods at a ratio of one to
one, i.e. 1 unit of good Xfor 1unit of good Y, country Acould get a unit
of good Y by using 10 units of labour to produce 1 unit of good X and
trading that with Bfor lunit of good Y, whereas if it produced that unit of
good Yitself then it would have to give up 20 units of labour. The 10 units
of labour 'saved' can then be used to produce another unit of Xfor home
consumption.
The symmetry of the example makes it obvious that country Bmay
make a similar gain by producing 2units of Y, using 20 labour units, and
exportinglunit inexchange for 1unit of X, rather than using the 20 units
 Comparative Advantage and the Gains from Trade 5

of labour to produce 1 unit of X itself. The implication is clearly that both

countries could have more of both goods, with a given effort, by trading.
This is a simple and powerful illustration of the benefits of trade, and on
it Adam Smith rested his plea for non-interference - for free trade as the
best policy for trade between nations. Smith's argument seems convincing,
but it is not very deep. It was left to Torrens and Rícardo to produce the
stronger and more subtle argument for the benefits from trade contained in
the theory of comparative advantage.

David Ricardo and the theory of comparative

advantage
Ricardo did not object to Smith's analysis. It is obvious that if one country
has an absolute advantage over the other in one line of production and the
other country has an absolute advantage over the first in a second line of
production, both countries can gain by trading. A great deal of trade,
perhaps most trade, is governed by such differences.
But what if one country is more productive than another country in all
lines of production? If country A can produce all goods with less labour
cost than country B, does it still benefit the countries to trade? Ricardo's
answer was yes. So long as country B is not equally less productive in all
lines of production, it still pays both countries to trade.
We shall spend some time elucidating this principle, as it is of basic
importance to the theory of trade. We shall start with Ricardo's own
model before going on to consider more modern means of demonstration.
Ricardo used England and Portugal as examples in his demonstration,
the two goods they produced being wine and cloth, with Portugal assumed
to be more efficient in making both cloth and wine. Table 1.1 shows how
Ricardo summed up the cost conditions in the two countries. These costs
are assumed to apply irrespective of the scale of production of a good.
According to this model, Portugal has an absolute advantage in the
production of wine as well as in the production of cloth, because the
labour cost of production for each unit of the two commodities is less in
Portugal than in England.
To demonstrate that trade between England and Portugal will, even in
the
this case, lead to gains for both countries, it is useful to introduce
concept of opportunity cost. The opportunity cost of a good X is the
amount of another good, Y, that has to be given up in order to produce an
additional unit of X. Table 1.2 gives the opportunity costs of producing
wine and cloth in Portugal and England. These costs have been constructed
on the basis of the information given in Table 1.1.
 6 Theories of Inter- and Intra-Industry Trade

Table 1.1 Cost comparisons

Labour cost of production (in hours)
1unit of wine 1unit of cloth
Portugal 80 90
100
England 120

Table 1.2 Opportunity costs

Opportunity cost of production
1unit of wine 1unit of cloth
Portugal 80/90 = 8/9 90/80 = 9/8
England 120/100,= 12/10 100/120 = 10/12

A country has a' comparative advantage in producing a good if the

opportunity cost of producing the good is lower at home than in the other
country. Table 1.2 shows that Portugal has the lower opportunity cost of
the two countries in producing wine, while England has the lower
opportunity cost in producing cloth. Thus Portugal has a comparative
advantage in the production of wine and England has a comparative
advantage in the production of cloth.
We should now further clarify the meaning of the term 'comparative
advantage'. In order to speak about comparative advantage there must be
at least two countries and at least two goods. We compare
the
costs of the production of cach good in both countries. As longopportunity
as
countries' opportunity costs for one good differ, one countrythehastwo
comparative advantage in the production of one of the two goods, whilea
the sccond country has a comparative advantage in the
other. In such a case both countries will gain from trade,production of the
fact that one of the countries might have an regardless of the
lines of production.
absolute disadvantage in both

ORicardo on the gains from trade

Let us assume that Portugal and England
do
consume in isolation - a state usually referrednotto trade but produce and
assumption that the labour input required to produceas 1autarky. Given the
unit of either good
is constant in both countries, the
prices of wine and cloth in the two
 Comparative Advantage and the Gains from Trade 7

countries must then be determined by their respective costs of production

(i.e. by their labour inputs).
If in England it takes 120 hours of labour to produce 1 unit of wine,
while it takes 100 hours to make 1 unit of cloth, wine must then be more
expensive per unit than cloth -1unit of wine willcost 120/100or 1.2 units
of cloth. If in Portugal it takes 80 hours of labour to make 1 unit of wine
and 90 hours to make 1unit of cloth then cloth will be more expensive
than wine - 1 unit of wine will cost 80/90, or 0.89, units of cloth. Let us
now introduce the possibility of trade. If England could import 1 unit of
wine at a cost of less than 1.2 units of cloth then she would gain by doing
so. If Portugal could import more than 0.89 units of cloth in exchange for 1
unit of wine then she too would gain. Therefore, if 1 unit of wine can be
exported to England from Portugal in exchange for something between 1.2
and 0.89 units of cloth, both countries will gain from trading.
Let us assume that in the international market 1 unit of wine exchanges
for 1unit of cloth. It is then advantageous for England to exxport cloth and
import wine, because in the absence of trade England would have to give
up the production and consumption of 1.2 units of cloth in order to
produce and consume cach additional unit of wine she wants. By trading,
she need only give up 1 unit of cloth in order to consume that additional
unit of wine, and can either consume the additional 0.2 units of cloth
herself,or export some of it in order to consume more imported wine, or
can enjoy the same levels of consumption of cloth and wine as under
autarky while the workers enjoy more leisure.
Portugal willalso gain by trading. In isolation she would have to use 90
units of labour to produce 1 unit of cloth. Now she can make 1 unit of
wine with 80 hours of labour and exchange this unit of wine for 1 unit of
cloth in the international market. Every 10 hours of labour freed by this
process can then be used for either increased production and consumption
or increased leisure.
Thus trade offers cach country the opportunity of specialising in the
production of the good in which it has the comparative advantage and then
exchanging some of this production for the good in which it has the
comparative disadvantage. Both countries can reallocate their labour to the
line where their comparative advantage lies, export this good and import
the other. In short, with a given amount of labour resources each country
can consume more by trading than in isolation. This possibility is usually
referred to as the gains from trade.
Note that in working through this example we have not found it
necessary to introduce money into the system, nor have we considered the
question of the wages paid to workers. Furthermore, we have not asked
how such trade flows will arise - we have implicitly treated each country
as though it were an individual, rather than a group of individuals. Neither
 8 Theories of Inter- and Intra-Industry Trade

have we made any explicit assumptions about the way in which the
markets, if any, operate within our two countries. Finally, we have
assumed that there is only one factor of production - labour - and that the
average product of labour is constant in both sectors in cach country.
In the simple two-country, two-good, onc-factor world we have been
considering, national currencies are in effect irrelevant, and as we shall see
later, all we need assume concerning wages is that so long as a country is
producing both goods then allworkers in both industries are paid the same
money wage. We may demonstrate the irrelevance of national currencies
and of the money wage rate under autarky, while providing onc possible
explanation of why trade in the directions suggested may occur, by
introducing them into the model. To simplify the presentation, we shall,
for the moment at least, also assume perfect competition in all markets.
Suppose that the wage rate in England under autarky is £1 per hour.
Given our assumptions, the cost of producing 1unit of cloth, and hence its
price, willthus be E100, while the cost and price of 1unit of wine will be
£120. Note that 1 unit of wine would then exchange for 1.2 units of cloth,
as in our original example. Suppose also that under autarky the wage rate
in Portugal is 2 escudos per hour, so that the cost and price of 1 unit of
wine is l60 escudos and of 1 unit of cloth is 180 escudos, so that again 1
unit of wine costs 0.89 units of cloth.
Consider now an individual in Portugal with l600 escudos and the
opportunity to export and import goods. He can use that money to
purchase 10 units of wine, which he can then export to England. There, he
can sell those 10 units of wine for £1200, and can then use that sum of
money to purchase 12 units of cloth at English prices. If he then imports
those 12 units of cloth to Portugal he can sellthem at Portuguese prices for
2160 escudos, making a profit of 560 escudos. This is of course an example
of arbitrage between two markets with different (relative) prices. Such
profits are of course an inducement to trade!
It should be obvious that doubling the wage rate in England would not
alter the essential details of this transaction; that we could equally well
have started by assuming an individual in England with money to invest in
such trade; and that we have no need to make any assumption about the
exchange rate between the two currencies. It should be equally obvious
that an individual exporting cloth from Portugal to England and wine from
England to Portugal must make a loss in money terms.
It is also apparent that this example raises other questions which we
must seek to answer. The additional demand for wine in Portugal arising
from its export will tend to increase its price in Portugal, with the same
happening for cloth in England, while the additional supply of cloth in
Portugal and of wine in England due to their import must reduce thelr
prices in those countries. However, as long as there is a difference in
 Comparative Advantage and the Gains from Trade 9

relative prices between the two countries there must be opportunities for
individuals to gain by trading, so that the volume of trade will continue to
grow. Moreover, the price changes and the ensuing changes in the
profitability of producing the two goods must cause the expansion of the
export sector and the contraction of the import sector in both countries,
with labour having to move from the latter to the former. Will then the
new state of affairs lead to an equilibrium situation, and if so, what will be
the characteristics of that cquilibrium?
We may deduce that in an equilibrium we must have the same relative
pricés in both countries, as otherwise the volume of trade willchange, but
with our present assumptions we cannot determine what that equilibrium
price ratio will be. We know that in each country the import industry will
contract, but will it disappear so that the country specialises completely in
the production of its export good? In either event, what will be the volumes
of trade in cloth and wine? We know that labour must move from the
import-competing sector to the export sector, but what will happen to its
money wage or, more importantly, to its real wage? Finally, while we have
seen that some individuals may profit fromn arbitrage between the two
markets, does this mean that other individuals may lose, and if so, can we
say that the country is better off?
A wider set of questions concerns the extent to which our conclusion
that countries gain from free trade is dependent upon the particular
assumptions we have made. We shall extend this original classical model
to cases where there are two or more factors of production, and in
particular examples to cases where there are more than two countries and
more than two goods, and we shall consider what happens when markets
are not perfectly competitive. In order to do so we shall go deeper into the
questions of what determines which country has a comparative advantage
in a given good, and how we can judge whether a country does gain from
trade. In most cases we shall conclude that free trade is superior to
autarky.
For the moment we shall examine how the differences in opportunity
costs between the two countries, and the possibilities of gains from trade,
may be analysed geometrically using the concepts of the production
possibility curve and the community indifference map, without attempting
to tackle these wider questions.

1.3 Production, consumption and trade

0 The production-possibility curve
The quantity of each good a country produces will depend on her factor
endowments and on her technical knowledge. By 'factor endowments' we
 10 Theories of Inter- and Intra-Industry Trade

mean the amounts of factors of production the country possesses - usually

assumed to be fixed. If we were to continue thinking in Ricardian terms,
there would be only one factor of production - labour - and the
technology assumption would be that cach additional unit of labour
produces the same increase in output - constant marginal and average
products. This would ensure that the opportunity costs of production
would be constant. We shal pursue the development of this Ricardian
model in Chapter 2. Here we shall consider the nore general case of the
increasing opportunity cost or concave production-possibility curve.
The production-possibility curve is the boundary of all those
combinations of the two goods which the country can produce. By
definition then, the country can, with its given factor endowments and
technology, produce anywhere inside or on the production-possibility
curve, but cannot produce outside it. An example of a concave production
possibility curve is given in Figure 1.1. A country producing inside its
production-possibility curve, say at point F, must be using its resources
inefficiently, since by moving out towards the boundary, to point E for
example, it could produce more of at least one good. The conditions
necessary for the efficient use of resources (the Pareto efficiency conditions)
are discussed later. For the moment we shall assume that these conditions
are met.

Suppose now that the country is producing at point E, on the

production-possibility curve. It can increase its output of cloth only by
switching factors of production from the wine sector to the cloth sector,
and if it does so efficiently then it will move along the production
possibility curve from E to, say, E. The opportunity cost of increasing its
WINE

AW

E'

-AC CLOTH
Figure 1.1 A concave production-possibility curve
 Comparative Advantage and the Gains from Trade 11

cloth production is of course the reduction in wine production, and we

would measure this by the slope of the line drawn from E toE', AW/AC.
If we consider only very small increases in the production of cloth then
we would measure the opportunitycost of cloth production at point E by
the slope of the tangent to the production-possibility curve at that point.
Note that since the production-possibility curve in Figure 1.1 is concave the
opportunity cost of cloth increases as we increase the production of cloth
(che slope of the production-possibility curve is greater at Ethan at E). A
concave production-possibility curve, frequently assumed in trade theory,
is referred to as an increasing cost production-possibility curve. Such a
relationship could arise in an economy with only one factor, say labour, if
some workers are especially efficient in the production of cloth, others in
the production of wine, and we transfer workers so that we obrain the
greatest increase in the output of cloth for a given reduction in the output
of wine. Alternatively, we could obtain such a production-possibility curve
with two or more factors even if the factors are homogeneous, as in the
Heckscher-Ohlin model discussed in Chapter 3.
As we shall see in Chapter 2, the assumptions of the Ricardian model are
such that the production-possibility curve is a straight line - the constant
opportunity cost case. We may under certain conditions, such as strongly
increasing returns to scale, obtain a decreasing cost production-possibility
curve, which must then be convex towards the origin. Discussion of this
case is postponed until Chapter 4.
The shape of the production-possibility curve may differ between the
short and the long run if some factors are more difficult to move between

WINE
>

C
E

B CLOTH
Figure 1.2 Long- and short-run production-possibility curves
12 Theories of Inter- and Intra-Industry Trade

sectors than others. We shall explore this in more depth in Chapter 4,

where we consider the Specific Factors Model as a shorter run version of
the Heckscher-Ohlin model. Here it is sufficient to note that the short-run
production-possibility curve may lie inside the long-run curve, as in Figure
1.2, where AB is the long-run, CD the short-run production-possibility
curve and point E shows the current output mix. We would expect such an
outcome if in the short run the adaptability of the economy is low, say
because it is dificult to transfer capital between sectors or because workers
are specialised, so that we would have to give up a large amount of wine in
order to obtain a given increase in cloth production (the move from E to F
in Figure 1.2). If the adaptability is higher in the long run, because, say,
capital is now more easily transferred or workers may be retrained, then
less wine may need be foregone in order t¡ obtain the given increase in
cloth production (the move from E to G in Figure 1.2).
Relative commodity prices will determine the production mix, i.e. where
we are on the production-possibility curve. If we assume perfect
competition in the factor markets then we may show that the economy
will operate on the production-possibility curve, and that the slope of the
curve at any point is the ratio of marginal costs at that production mix
(and of course the opportunity cost of production). If there is also perfect
competition in the goods market then firms will produce where price is
equal to marginal cost. Hence, for any given price ratio for the two goods
we know that production must take place at that point on the production
possibility curve where it has slope equal to the price ratio for the two
goods. Thus, if the ratio of the price of cloth to the price of wine is that
shown by the (negative of) the slope of the line PoPo in Figure 1.3, the
production mix must be the point shown as A.

WINE
P
Po

AW
P

Po
AC CLOTH
Figure 1.3 The role of shifting prices
 Comparative Advantage and the Gains from Trade 13

If the relative price of wine increases to that shown by the slope of the
line PiP then the production mix must move to that shown by. point B.
Production of wine has increased and of cloth has decreased, with factors
moving from cloth to wine production, the marginal cost of wine
increasing, and the marginal cost of cloth decreasing.

DCommunity indifference curves

If we are referring to the demand of only one consumer then we can use
indifference curves to illustrate the demand conditions and as a measure of
the well-being of that consumer. In international trade however we are
concerned with a whole community or nation, and matters become more
complicated. As it isnot possible to draw any easy analogy in going from
curves can be used
one consumer to many, we cannot say that indifference
to illustrate the demand conditions of a whole nation, let alone the well
being of that nation, in the same way that they can be used for a single
used. We shall deal
consumer, unless some very restrictive assumptions are
with this problem in more depth in Chapter S, but for the moment we shall
summarise the standard results.
Consider the simplest case, that of two consumers, each given an initial
endowment of cloth and wine. If the two consumers are free to exchange
wine and cloth then they will do so as long as at least one of them can gain
gain from
from the exchange and the other does not lose. Once neither can
cease and
any further exchange without the other losing then exchange will is P, in
they will be at an 'efficient' point. Suppose this efficient point wine
cloth and
Figure 1.4, where the axes show the total amounts of
amounts of cloth
available to the two individuals. At point P, the available

WINE
lo

Pidlla
P2
Pa

CLOTH

Figure 1.4 Community indifference curves

 14 Theories of Inter- and Intra-Industry Trade

and wine have been distributed in a particular way betwcen the two
individuals, giving individual 1 a utility level of u, say, and individual 2 a
utility level of uz.
wine available in the
Suppose now that we reduce the amount of
we choose these two
economy but increase the amount of cloth, and that
two individuals
changes so that, after making any exchanges they wish, the point be P2. We
this
are exactly as welloff as they were at point P, and let
between being at P, or
may assume that since each individual is indifferent
individuals is also
at P> then the community consisting of those two
indifferent between being at P, or P2. We may say that P, and P2 are points
Figure 1.4.
on the same community indifference curve, shown as lolo in wine and
amount of
But suppose now that we had taken the same total
cloth as those which gave us the efficient point P,, but gave initially more
individual 2.
wine and cloth to individual 1 and therefore less of both to
We have changed the distribution of income in favour of individual 1, and
even after the two individuals have exchanged until they reach an efficient
point it is unlikely that that point will yield the same levels of utility to
both individuals as they had in our first example. Individual 1 will have
more utility, say u (>ui) and individual 2 will have less, say u; (<u). In
generalwe cannot claim that the well-being of the community is the same
with this new distribution of income as it was with the initialdistribution.
Thus, point P, may be consistent with two different levels of well-being for
the community.a n
Moreover, with our second distribution of income, it is unlikely that the
reduction in the initial stock of wine in the economy assumed in obtaining
our move from P, to P, along curve lolo can be balanced exactly by the
same increase in the initial amount of cloth available. Suppose that more
cloth is needed to compensate for the loss in wine with our new income
distribution. The bundle of goods needed to give both individuals the same
level of utility as they enjoy at P, may now be that shown by point Ps. As,
with our new income distribution, both individuals have exactly the same
level of utility at P, and P3, these two points must lie on the same
community indifference curve, shown as IËlj.
We therefore have the problems that in general any point in our diagram
may show different levels of well-being (or welfare) for the community as a
whole, and that community indifference curves for different income
distributions may intersect one another. These problems can only be
resolved by making the assumption that we can judge a given reduction in
the utility of one individual to be exactly compensated for by
a given
increase in the utility of the other (employing a social welfare function).
The commonly made assumptions that all consumers have
the same
preferences and that these preferences obey the mathematical restriction
known as homotheticity are not sufficient in themselves to resolve the
 Comparative Advantage and the Gains from Trade 15
WINE

CLOTH

Figure 1.5 Community indifference curves assuming optimal income

redistribution

problems, nor is the assumption that the distribution of income can in

some way be held constant. If, however, we are prepared to assume that
redistribution is costless and that any given bundle of goods can be
allocated between consumers so that welfare is maximised according to
our social welfare function then we derive a set of community indifference
curves where no two curves intersect, and the further a curve is from the
origin then the higher the level of national welfare it represents. Such a set
of indifference curves, derived on the assumption of this optimal
redistribution of income, is shown in Figure 1.5.
These assumptions are heroic, and when we come to consider the
question of the gains from trade in more depth we shall abandon them.
Until then however we shall employ them in order to benefit from the
convenience the community indifference curves offer in setting out the
various models of international trade we shall develop in the following
chapters.

1.4The gains from trade

0 The gains from trade restated
We can now restate the meaning of the gains from trade by combining the
supply side of the economy (the production-posibility curve) and the
demand side (the community indifference curves). If there is perfect
competition then the economy concerned reaches equilibrium under
 16 Theories of Inter- and Intra-Industry Trade
WINE

Q CLOTH

Figure 1.6 Equilibrium under autarky

autarky at the point where the production-possibility curve istangential to
acommunity indifference curve. This point, shown as E in Figure 1.6, is an
optimum since the indifference curve l, is the highest that can be obtained
given the constraint shown by the production-possibility curve. At E the
marginal rate of substitution in consumption (the slope of the indifference
curve) is equal to the opportunity cost in production (the slope of the
production-possibility curve). The price ratio that would be produced by
such an equilibrium is shown by the slope of the common tangent RR.
The possibility of trading means that the country can produce and
consume at prices that differ from those prevailing in isolation. Suppose
that the international terms of trade are given by the price line TT in
Figure 1.7, so that cloth is relatively more expensive in the international
market than it is in the home market. Domestic producers will take
advantage of this fact and move some factors of production from wine to
cloth. The reallocation of factors of production will continue until the
production point has moved to P, where the price line TT is tangential to
the production-possibility curve. This means that the marginal rate of
transformation in production equals the international terms of trade. With
production at P, cloth can be exported and wine imported in any
combination along the price line TT.
The highest possible indifference curve that can be reached given this
new, less restricting, constraint is I at point C, where the indifference
curve is tangential to the price line. The marginal rate of substitution in
consumption is thus also equal to the international terms of trade. Given
the production-possibility curve and the international price ratio, point C
 Comparative Advantage and the Gains from Trade 17

WINE

CLOTH

Figure 1.7 Equilibrium under free trade

the move from
represents the best point the society can achieve, and
indifference curve l, to indifference curve l; may be interpreted as the gain
to be obtained from the move to free trade.owD
of
It is sometimes useful to think of the gains from trade as consisting
the other on the
two parts: one depending on the possibility for exchange, reason the country
possibility for specialisation in production. If for some
could not change its pattern of production, it would have
to continue
exchanging
producing at point E. It could stillhowever gain from trade by
cloth for wine at the international price ratio, its consumption point
parallel
moving from E to C on indifference curve I, (the price line EC is than I,.
level of welfare
to TT), Indifference curve l, represents a higherfrom exchange.
We refer to this increase in welfare as the gain
because the
This, however,, would not represent an optimal situation, transferring
marginal rate at which wine can be transformed into cloth by
factors of production within the economy differs from the marginal rate at
market. The
which wine can be traded for cloth in the international
production of wine,
cconomy can make further gains by reducing its
cloth through
increasing its production of cloth, and exchanging wine for production
trade. It can maximise its gain from such specialisation in by
moving to point P.
DThe flaw in Ricardo's argument
such as
It is important to remember that community indifference curves
redistributed
the ones in Figure 1.7 can be constructed only if income is
 18 Theories of Inter- and Intra-lndustry Trade

optimally. When moving production from

E to P the income distribution
favour of the factors of production especially well suited to
will move in will move
production of cloth, the country's export good, while it owners of
the to the production of wine. The
against those factors more suited
therefore gain by the move to free
trade,
some factors of production will Only if
income distribution will change.
but others will lose, and the the
can we say unambiguously that the
income is redistributed optimally that Ricardo and
society gains from free trade. This was the point benefits of
their argument about the
classical economists overlooked in
although they did recognise that trade would change the income
trade, increase in welfare for everyone
distribution. Free trade leads to a potential for
this increase can only be realised
(the national income increases), but appropriately.
each individual if income is redistributed of economic liberalism.
proponents
This result causes problems for the
free trade is beneficial for the
Either they must accept that while community must lose, or they
community as a whole some members of the
through intervention.
must accept a policy of redistribution accomplished

1.5 Offer curves

Before concluding this chapter, we shall also introduce another standard
tool of analysis in international economics, the offer curve.
We have seen how, when countries trade with each other, the
international terms of trade are established by the interaction of supply
and demand in each country. Another way of stating this interaction is by
the use of offer curves, first used by Edgeworth and Marshall, and since
then often used in international economics, especially for pedagogical
purposes. The derivation of a country's offer curve from its production
possibility curve and its community indifference curves is moderately
complicated, but offer curves will prove of use when we discuss the theory
of tariffs ina later chapter, and so we shall consider one way of deriving
them here.
Figure 1.8 shows a production-possibility curve and a set of community
indifference curves for acountry. Autarkic equilibrium would be at point
E. If the country is able to trade at the international price ratio shown by
the line T; then it will produce at point P, and consume at point C; on
indifference curve lz. Exports of cloth will be O,P2, and imports of wine
will be O,C,. Ifthe terms of trade were to increase to those shown by the
line T,T; then production would shift to P3, consumption to C3, with cloth
exports becoming OsPs and wine imports changing to OCj, and the
country would reach the higher indifference curve l3.
 Comparative Advantage and the Gains from Trade 19

WINE

Pa Pa
T2

CLOTH

Figure 1.8 Equilibria under international trade

Figure 1.9 shows the exports of cloth plotted against the importsof wine
at these two terms of trade. At the terms of trade shown by the line OT,,
the country exports OX; of cloth (equal to O,P, in Figure 1.8) and imports
trade
OM, of wine (equal to O,C, in Figure 1.8). At the higher terms of
shown by the line OT;, the country exports OX, of cloth (equal to O;Ps)
and imports OM, of wine (equal to O,C,). The set of all such points
defines the country's offer curve. The offer curve therefore shows how the
country's exports of cloth and imports of wine would change as the
price
ratio obtainable on the international market changes.
The form of the offer curve depends on the forms of the country's
production-possibility curve and community indifference curves. Note that
the offer curve drawn in Figure 1.9 starts off with a positive slope as we
move from the origin, but becomes negatively sloped if the world price
ratio increases sufficiently. Initially, as the country starts trading it is
prepared to offer more cloth in exchange for more wine as the relative
curve is
price of cloth increases. In such cases we would say that the offer
elastic.
As the volume of trade increases however the country may be prepared
to offer less cloth at the margin in exchange for wine imports. If trade
continues to increase then the country could become so unwilling to accept
any more wine imports that it reduces its cloth exports, even though the
then
terms of trade are becoming more favourable, and the offer curve
 20 Theories of lnter- and Intra-Industry Trade

IOFMWIPONRTES

M3

EXPORTS OF CLOTH

Figure 1.9 Offer curve for the cloth exporting country

referred to as being
becomes negatively sloped. The offer curve is usually
inelastic in such cases.
terms of trade
When we derived the offer curve, we argued as though the
then derived the shape of
were changing for some exogenous reason, and
be misunderstood.
the curve. This was a pedagogical device, and must not determined
The offer curve is a general equilibrium concept. The curve is
jointly by production and consumption conditions in the country have
concerned, and we cannot determine the terms of trade until we
the equivalent information for the other country concerned.
We can construct an offer curve for country B by analogous reasoning.
We would expect it to have the same general shape as the offer curve tor
country A, being positively sloped at low volumes of trade, bending away
from the exports axis as trade yolumes increase, and possibly becoming
negatively sloped at high terms of trade. We must remember of course that
for country B the export good will be wine.
With that in mind, we might expect the offer curve for country B to look
something like the curve OB in Figure 1.10. Curve OA is of course country
A'soffer curve. The offer curves of the two countries intersect at point E.
This point defines the free trade equilibrium for the two countries.
Country Awill export OC of cloth, which country Bis prepared to import
in exchange for exporting OW of wine to country A, precisely the amoun'
of wine that A wishes to import. The international terms of trade will o
given by the slope of the line OT.
 Comparative Advantage and the Gains from Trade 21
WIINTRANDE

TRADE IN CLOTH

Figure 1.10 Free trade equilibrium shown with offer Curves

In Figure 1.10 the free trade equilibrium is where country A's offer curve
is inelastic but country B's offer curve is elastic. Suppose A were to become
more willing to trade at any given terms of trade, perhaps because her
production-possibility curve had moved out due an improvement in
technology. We would show this by moving A's offer curve outwards. A
would find it possible to increase both her exports and her imports,
although her terms of trade would deteriorate. If on the other hand B's
offer curve were to move outwards then not only would her terms of trade
become worse, she would also find that her increased exports of wine
would only exchange for a lower volume of cloth imports.
The position of a country facing an elastic offer curve from its trading
partner is therefore quite different in some respects to that of a country
facing an elastic offer curve when it comes to increasing exports. However,
in both the cases discussed an expansion of exports brought about a
worsening of the terms of trade.
There is however one particular case where this does not happen, and
that is where the country concerned is so small in terms of its partner's
market that it can increase its exports and imports without affecting the
prices at which it trades. The small country is said to face a perfectly elastic
offer curve, which must be a straight line through the origin. Such a
situation is shown in Figure 1.11. Whether country A's offer curve moves
those
In to or away from the origin, the terms of trade it faces will remain
given by the slope of OB. Of course, if B's offer curve changes then the
terms of trade facing A will change. If country A is small then it has to take
the international terms of trade as given.
22 Theories of Inter- and lntra-Industry Trade
WINE
TRADE
IN
B

W E

C TRADE IN CLOTH

Figure 1.11 Free trade equilibrium for a small country

ONotes
1 David Ricardo (1772-1823) accumulated a fortune during the Napoleonic wars
as a member of the London stock exchange. He then retired, turning to
theoretical economics, and in 1819 became a Member of Parliament. In 1817 he
published his main work, Principles of Political Economy and Taxation, which
contains the first rigorous exposition of the classical theory of value and
distribution; in Chapter 7, "On Foreign Trade', Ricardo expounds the theory
of comparative advantage.
2 Adam Smith (1723-90) was Professor of
Moral Philosophy at Glasgow
University. The first major figure of classical economics, he introduced the
theory of value and taught the blessings of
invisible hand'). His major work, The Wealth the of
unhampered market (the
1776. Nations, was published in
3 Robert Torrens (1780-1864), an
officer in the British Army during the
Napoleonic wars, later turned to economics and published a pamphlet in
Essay on the External Corn Trade,
which contains what seems to bel81,
carliest formulation of the theory of comparative the
significant contributions advantage. He also made
became a Member of to classical monetary theory and policy. In 1831 ne
4 For a Parliament.
justification of this statement in modern
and McFadden (1972), pp. analytical terms, see Grandmont
l09ff.