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International Lecture 5

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24 views20 pages

International Lecture 5

Uploaded by

Amgad Elshamy
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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INTERNATIONAL TRADE

Dr. Nahla Azzam


Lecturer of economics
Faculty of Economic Studies
and Political Science (ESPS)
Alexandria University

Email:
[email protected]
Lecture (5)
29/10/2023
2023/2024
Part 1: International Trade Theory

Chapter (3)

The Standard Theory of International Trade


Main points:

1. Production possibility frontiers with increasing costs.


2. Community indifference curves.
3. Equilibrium in isolation: Autarky.
4. The basis for and the gains from trade with increasing costs.
5. Trade based on differences in tastes.
• In this chapter we study the standard theory of international trade based on a
more realistic assumption, that is facing increasing rather than constant
opportunity costs, while keeping the rest of our basic assumptions in action
(two nations, two commodities, perfect competition, ……. etc.)

1. Production Possibility Frontiers With Increasing Costs:

1.1 What is increasing opportunity costs?

• Increasing opportunity costs mean 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.
• Increasing opportunity costs is illustrated by a concave production possibility
frontier for both nations, which indicates that each nation incurs increasing
opportunity costs in the production of both commodities.
• In Nation 1:
➢ Starting from point A (which implies utilizing all available resources), if Nation 1
wants to produce more of commodity X, it has to give up more and more units of Y
for each additional batch of 20X.

➢ Therefore, the slope of the PPF (MRT) or the opportunity cost of X is increasing as
reflected by the slopes of the tangent lines at points A (flat) and B (steep).
• In Nation 2:
➢ Starting from point A’ (which implies utilizing all available resources), if Nation 2
wants to produce more of commodity Y, it has to give up more and more units of X
for each additional batch of 20Y.

➢ Therefore, the slope of the PPF (MRT) or the opportunity cost of X is decreasing, as
reflected by the slopes of the tangent lines at points A and B. This implies that the
opportunity cost of Y is increasing.
1.2 Reasons for increasing costs:

1. Factors of production are not used in the same fixed proportions in


production, this leads to the phenomenon of diminishing productivity as we
produce more of a certain product.

2. Resources and factors of production are not homogeneous (are not identical
or of same quality). For a nation to produce more of a commodity X, it must
utilize resources that are progressively less efficient or less suited for the
production of that commodity.Therefore, it must give up more and more of Y
to release enough resources to produce each additional unit of X, such that it
incurs higher costs.
2. Community Indifference Curves:
• Previously in the case of constant opportunity cost, the internal rates of exchange, or
the relative prices were determined solely by the slopes of the PPFs (supply
conditions).
• However, in case of increasing opportunity cost, the internal rates of exchange, or the
relative prices are determined by both the slope of the PPFs (MRT) and the slope of
the indifference curves (MRS), i.e., by both demand and supply conditions.
• Demand conditions are reflected by the community indifference curve (IC).

2.1 What is a community indifference curve?


• It is a negatively sloped curve that shows the various combinations of the two
commodities that yield the same level of satisfaction to the community or
nation. Higher curves reflects higher satisfaction, while lower curves reflects
lower satisfaction.
• The MRS of X for Y in consumption is the amount of Y that a nation is willing to
give up for one extra unit of X and still remain on the same indifference curve. It is
given by the slope of the community IC at the point of consumption.
• An indifference curve is convex to the origin, which implies that the MRS is
diminishing, where the more of X and less of Y a nation consumes, the more valuable
to the nation is a unit of Y compared to a unit of X, so it is ready to give up less and
less amounts of Y for each additional unit of X.
• Therefore, the slope of the I at point A is less than at point N, also the slope of I’ at
point R’ is less than at point A’(see tangents at these points)
3. Equilibrium in isolation (Autarky):
• Before trade, a nation is in equilibrium when it reaches the highest possible
indifference curve given its PPF.

• The common slope of the 2 curves at the tangency point gives the equilibrium
relative commodity price in isolation.
• At equilibrium: Production = consumption
MRT = MRS = Opp. Cost of X = Px/Py,
• If the slope of the PPF of Nation1 at point A (PA = Px/Py) is ¼ (Opp.cost of
X), while the slope of the PPF of Nation2 at point A’ (PA’ = Px/Py) is 4 then:

• Since PA < PA’ (flatter) then N1 has a comparative advantage in commodity


X and N2 has a comparative advantage in commodity Y.
• Then mutually beneficial trade can occur if N1 specializes in producing the
commodity of its comparative advantage X, while N2 specializes in the
production of the commodity of its comparative advantage Y.

• As specialization takes place nations incur increasing costs, therefore


specialization continues until relative commodity prices in the two nations
become equal at the level of equilibrium trade.

• Notice that:
Forces of supply (PPF) together with forces of demand (indifference curve
map) determines the equilibrium relative commodity price.
4. Specialization and gains from trade with increasing costs:

4.1 specialization:
• N1 specializes in X, it moves down its PPF from point A to point B, while N2
specializes in Y, it moves up its PPF from point A’ to point B’ (incomplete
specialization in both nations) why?
• Specialization will continue till both nations reach an equilibrium relative
commodity price PB = P’B = 1 (the international exchange rate or the price
at which the trade is balanced).

• If N1 exchanges 60X for 60 Y with N2, therefore:


N1 exports 60X (130 -70) and imports 60 Y (80-20), (▲BCE)
N2 exports 60Y (120 -60) and imports 60 X (100-40), (▲B’C’E’)

• At the equilibrium relative price ( also called the equilibrium terms of trade
TOT) PB = PB’ = 1 trade is balanced, that is:
N1 exports of X = N2 imports of X
N2 exports of Y = N1 imports of Y
4.2 Gains from trade:
➢ N1 ends up consuming at point E (70X and 80Y) on indifference curve III,
which is the highest IC it can reach at Px/Py =1.
➢ N1 gains 20X and 20Y (comparing the two-consumption points A & E).

➢ N2 ends up consuming at point E’ (100X and 60Y) on indifference curve III’,


which is the highest IC it can reach at Px/Py =1.
➢ N2 gains 20X and 20Y (comparing the two-consumption points A’ & E’).

4.3 Gains from exchange and from specialization:


➢ A nation’s gains from trade can be broken into two components: gains from
exchange and gains from specialization.
• Gains from exchange:

• With the opening of trade N1 could not


specialize in the production of X but continued
to produce at point A (at the autarky price line,
PA =1/4 and indifference curve I).
• At the international exchange rate PB =1, N1 can
export 20X in exchange for 20Y at the prevailing
world price and end up consuming at point T on
indifference curve II.
• Now N1 consumes less of X (30X) and more of
Y(80Y) at point T, it is better off than it was in
autarky by moving to a higher indifference curve
II.
• Gains from exchange is represented by moving
from point A to point T.
• Gains from specialization:

• If after that N1 specialized in the


production of X producing in point B, it
could then exchange 60X for 60Y and
consume at point E on indifference curve
III.
• Now N1 consumes more of X (70X) and
same amount of Y(80Y).
• Gains from specialization is represented
by moving from point T to point E.
Total Gains from Trade =
gains from exchange + gains from specialization
5. Trade based on differences in tastes:

• Previously, differences in the autarky relative commodity prices between N1


and N2 was based on the differences in both the PPFs and the ICs in the two
nations, such that it indicates comparative advantage, specialization and
mutually beneficial trade in both nations.

• However, under increasing opp. Costs even if two nations have identical
production possibility frontiers, there is still basis for mutually beneficial
trade between them based on different tastes or preferences (ICs).

• Where, the nation with the relatively smaller demand or preferences for a
commodity (smaller MRS) will have a lower autarky relative price for that
product and a comparative advantage in its production.
Before trade:
• N1 produces and consumes at A and N2 produces
and consumes at A’.
• Since the slope of indifference curve I is flatter
than the slope of indifference curve I’ (PA < PA’),
then N1 has a comparative advantage in X and
N2 has a comparative advantage in Y.

• After trade:
• N1 specializes in X and produce at point B, and
N2 specializes in Y and produce at point B’ = B.
• Exchanging at the equilibrium exchange rate PB,
N1 and N2 ends up consuming more of both
commodities at point E and E’ respectively.
• Exports and imports are balanced as reflected by
the two triangles of trade ECB and E’C’B’.

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