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Pilani Campus

Chapter 3:
The Standard Theory of
International Trade
Instructor: Prof. Geetilaxmi Mohapatra1
 Includes
• Case of Increasing opportunity cost.
• Taste and Demand Preferences.
• Supply, demand and relative prices.
• Specialization in production and
comparative advantage.
• Mutual beneficial trade with only taste
differences.

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 The PPF with
Increasing opportunity costs
• Increasing opportunity costs
–
It means that the nation must give up
more and more of one commodity to
release just enough resources to
produce each additional unit of
another commodity.
• Because of it, the PPF becomes
concave to the origin.

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 The PPF with Increasing
opportunity costs

• What is MRT of X for Y?

• MRT is another name of opportunity cost of X.
• Slope of the PPF.
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 Reasons for IoC and Different
PPFs
• What are the various reasons for
Increasing Opportunity costs?

• Why there is difference in PPFs

between nations existing?

• Reasons for shift in the PPF of a

nation?
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 Community Indifference
Curves
• As supply considerations are reflected in the
PPF
• The demand and taste considerations are
reflected in the Community (or Social)
Indifference Curves.

• What is Community Indifference Curve?

• Q: What are the Different Properties of it?

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 Community Indifference Curves

•Meaning of MRS of X for Y

•Given by the (absolute) slope of the community IC at the point
of consumption

•MRS is declining implying that CICs are convex to the origin.

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 Equilibrium in Isolation
• The production possibilities frontiers,
– reflect the production or supply conditions in a nation
– Increasing opportunity cost in production is reflected by
concave PPFs
• The community indifference curves,
– illustrate the tastes or demand preference in a nation
– Diminishing MRS in consumption is reflected by the
convex Community IC
• How these two factors determine the
equilibrium point in a nation in isolation (i.e
without trade)
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Equilibrium in Isolation.

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Equilibrium – Relative commodity
prices and comparative advantage

• The internal equilibrium relative commodity

price in isolation is given by the common
tangency of production frontier and
community IC at autarky.
• Thus the relative commodity price in isolation
is
PA = PX / PY = ¼ in N-1 and
P’A = PX / PY = 4 in N-2

• Why these relative prices are different in

different nations? BITS Pilani, Pilani Campus
Equilibrium – Relative commodity prices
and comparative advantage (contd.)

Since in isolation, PA < P’A ,

– N-1 has comparative advantage in commodity X
and N-2 has comparative advantage in
commodity Y.

This follows that

– both nations will gain if N-1 specializes in the
production and exports of X in exchange for Y
from N-2.
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Assume the case for Nation – 1 only

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Equilibrium Relative Commodity Prices with Trade

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 Gains from Trade with
Increasing Costs
• Equilibrium Relative Commodity Prices with
Trade is the common relative price in both
nations at which trade is balanced.
• At PB = PB’ = 1,
• the equilibrium relative commodity price,
trade is balanced.
• What happens when equilibrium relative
commodity price change?
• The relative price of X would always gravitate
towards the equilibrium price of 1.
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 Equilibrium Relative
Commodity Prices with Trade

As each nation specializes in the production of a

commodity of its comparative advantage, it
incurs IOC.
The process of specialization continues till
relative commodity prices become equal in
both the nation.
By then trading with each other, both nations end
up consuming more than in the absence of
trade.

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 Incomplete
Specialization
• Difference between constant cost and
increasing cost ?

• As each nation specializes in producing the

commodity of its comparative advantage,
• relative commodity prices move towards
each other (i.e. become less unequal) until
they are identical in both nations.

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 The Gains from Exchange and
Gains from Specialization

A nation gains from trade can be broken

down into 2 components:
1) The gains from Exchange and
2) The gains from Specialization
Illustration for this is given for N-1.

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The Gains from Exchange and
Gains from Specialization

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 Trade based on
Differences in Tastes only
The difference in pre-trade relative commodity prices
between N-1 and N-2 was based on the difference in
the PPF and ICs in the two countries.
– Determined the basis for comparative advantage of
each nation, leads to specialization and mutually
beneficial trade.
With increasing costs, even if 2 nations have identical
PPF, there is still a basis for mutually beneficial trade
– if tastes, demand preferences between the nations
differ.

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Trade Based on Differences in
Tastes only

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APPENDIX

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Production Function &
Isoquants
Production Function:
Isoquants:
Properties:
Comparison between Isoquants and
Indifference curves.
Marginal rate of Technical Substitution
Isocost

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 Producer’s Equilibrium
A producer is in equilibrium when it reaches the
highest IQ possible with a given isocost.
When the Isoquant is tangent to the Isocost
line.
Slope of the isoquant = slope of the isocost.
MRTSLK = (PL / PK )

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Isoquants, Isocosts, and
Equilibrium.

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Production Theory with Two Nations,
Two Commodities, and Two Factors.

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 Edgeworth Box Diagram

 The box diagram permits us to study the

 1) Interrelationships between production
functions and the total amount of factors of
production
 2) To derive the optimal factor inputs and
outputs.

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Derivation of the Edge worth Box
Diagram
LA’

KA’

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Some comments about the Box
Diagram

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Derivation of the Edge worth Box Diagram
and Production Frontier for Nation 1

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