QUESTIONS FOR REVIEW
1. By extending our simple trade model in this chapter, the material is more realistic than that of chapter
2.
2. Tastes or demand preferences are introduced with community indifference curves.
They needed because we can see how these forces of supply and determine the equilibriumrelative commodity price in each nation in the absence of trade under increasing cost. This will
also indicate the commodity of comparative advantage for each nation.
3. Because 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.
The slope of the production frontier is called the marginal rate of transformation (MRT)
As the nation produces more of the commodity measured along the horizontal axis, ………
4. Increasing opportunity costs arise because resources or factors of production (1) are not homogeneous
and (2) are not used in the same fixed proportion or intensity in the production of all commodities.
The difference in the production frontiers of different nations is due to the fact that the nations
have different factor endowments or resources at their disposal and/or use different technologies
in production.
5. A community indifference curve measures the tastes, or demand preferences in a nation.
Its characteristics are that:
- Higher curves refer to greater satisfaction, lower curves to less satisfaction,
- they are negatively sloped and convex from the origin
The slope of an indifferent curve measure the amount of Y that a nation could give up for one
extra unit of X.
It declines as the nation consumes more of the commodity measured along the horizontal axis
because the more of X and the less of Y a nation consumes, the more valuable to the nation can
give up less and less of Y for each additional unit of X it wants.
6. Trade affects the income distribution within a nation and can result in intersecting indifference
curves.
This difficulty can be overcome by the compensation principle, which states that the nation gains
from trade if the gainers would retain some of the gain even after fully compensating losers for
these looses. Alternatively, some restrictive assumptions could be made.
7. The equilibrium relative commodity price in isolation is Interaction of forces of demand (community
indifference curves) and supply (production possibilities frontier)determine equilibrium for a nation
in the absence of trade (autarky)
The equilibrium-relative commodity price in isolation = slope of tangency between PPF and
indifference curve at autarky point of production and consumption.
It defines the nation’s comparative advantage:
Nation1:(PX/PY)=PA=1/4
Nation2:(PX/PY)’=PA’=4/1
i.e.,(PX/PY)<(PX/PY)’
Nation 1 has a comparative advantage in good X and
Nation 2 has a comparative advantage in good Y.
8. Because each nation specializes in producing the commodity of its comparative advantage and faces
increasing opportunity costs, specializations in production proceeds until relative commodity prices in
the 2 nations are equalized at the level at which trade is in equilibrium.
The equilibrium relative commodity price with trade is determined by the common relative price
in both nations at which trade is balanced:
i.e.,(PX/PY)e=(PX/PY)=(PX/PY)’
i.e. Pe=PB=PB’=1
9. The reason for incomplete specialization under increasing costs is that: As each nation specializes in
the production of the commodity of its comparative advantage, the relative commodity price in each
nation moves toward each other (i.e., become less unequal) until they are identical in both nations. At
that point, it does not pay for either nation to continue to expand the production of the commodity of
its initial comparative advantage. This occurs before either nation has completely specialized in
production
The results under increasing costs are different from the fixed- costs case: Under constant costs, each
nation specializes completely in production of the commodity of its comparative advantage (i.e.,
produces only that commodity). The reason is that since it pays for the nation to obtain some of the
commodity of its comparative disadvantage from the other nation, then it pays for the nation to get all
of the commodity of its comparative disadvantage from the other nation (i.e., to specialize completely
in the production of the commodity of its comparative advantage)
10. The gains from trade can be broken down into gains from exchange and gains from specialization in
production.
11. With increasing costs, even if two nations have identical production possibility frontiers ( which is
unlikely), there will still be a basis for mutually beneficial trade if tastes, or demand preferences, in
the two nations differ. The nation with the relatively smaller demand or preference for a commodity
will have a lower autarky- relative price for, and a comparative advantage in that commodity.
12. Only if the production frontier and the difference curves are identical in both nations (or the
difference in the production frontiers is exactly neutralized, or offset, by the difference in the
difference curves) will the pretrade- relative commodity prices be equal in both nations, ruling out the
possibility of mutually beneficial trade.
PROBLEMS
1. a.
b. The slope ofthe transformation curve increases as the nation produces more of X and
decreases as the nation produces more of Y. These reflect increasing opportunity costs as the nation
produces more of X or Y.
2. a. We have drawn community indifference curves as downward or negatively sloped because as
the community consumes more of X it will have to give up some of Y to remain on the same
indifference curve.
b. The slope measures how much of Y the nation can give up by consuming one more unit of X
and still remain at the same level of satisfaction; the slope declines because the more of X and the less
of Y the nation is left with, the less satisfaction it receives from additional units of X and the more
satisfaction it receives from each retained unit of Y.
c. III > II to the right of the intersection, while II > III to the left. This is inconsistent because an
indifference curve should show a given level of satisfaction. Thus, indifference curves cannot cross.
3. a.
b. Nation 1 has a comparative advantage in X and Nation 2 in Y.
c. If the relative commodity price line has equal slope in both nations.
4. a.
b. Nation 1 gains by the amount by which point E is to the right and above point A and Nation 2
by the excess of E' over A'. Nation 1 gains more from trade because the relative price of X with
trade differs more from its pre-trade price than for Nation 2.
5. a. S refers to Nation 1's supply curve of exports of commodity X, while D refers to Nation 2's
demand curve for Nation 1's exports of commodity X. D and S intersect at point E,
determining the equilibrium PB=Px/Py=1 and the equilibrium quantity of exports of 60X.
b. At Px/Py=1 1/2 there is an excess supply of exports of R'R=30X and Px/Py falls
toward equilibrium Px/Py=1.
c. At Px/Py=1/2, there is an excess demand of exports of HH'=80X and Px/Py rises
toward Px/Py=1.
6. The Figure in Problem 5 is consistent with Figure 3-4 in the text. From the left panel of Figure 34, we see that Nation 1 supplies no exports of commodity X at Px/Py=1/4 (point A). This
corresponds with the vertical or price intercept of Nation 1's supply curve of exports of
commodity X (point A).
The left panel of Figure 4 also shows that at Px/Py=1, Nation 1 is willing to export
60X(point E). The same is shown by Nation 1's supply curve of exports of commodity X.
The other points on Nation 1's supply curve of exports in the figure of Problem 5 can also be
derived from the left panel of Figure 4, but this is shown in Chapter 4 with offer curves.
Nation 2's demand curve for Nation 1's exports of commodity X could be derived from the right
panel of Figure 4. What is important is that we can use the D and S figure in Problem
5 to explain why the equilibrium relative commodity price with trade is Px/Py=1 and why
the equilibrium quantity traded of commodity X is 60 units in Figure 4.
7.