(2)
Trade under
Increasing Cost
43 | P a g e
44 | P a g e
1- Trade under Increasing Cost Condition:
(1) The production possibility curve with
increasing opportunity Cost  supply side.
 It is more realistic for a nation to face
increasing cost rather than constant
opportunity Cost. Increasing opportunity
Cost mean that the nation must give up
more and more of one commodity to get
one more unit from another commodity.
 The PPC will be concave from the origin
(rather than a straight line).
U.S
U.K
C
C
6
5
50
47
40
4
3
D
C
B
A
30
5
6
7
8
U.S must give up more
and more of (C) to get one
more unit of (W)
45 | P a g e
w
55 758590
U.K must give up more
and more of (W) to get
one more unit of (C)
w
 The difference in the shape of PPC due to:
(1) Difference in factor endowments.
(2) Use different technology in production.
(2) The community
Demand side:
indifference
curves

 The tastes or preference are given by
community (or social) indifference curves.
 A community indifference curves show the
various combinations of two commodities
that give the community or a nation the same
level of satisfaction.
C
I
I
I
C
I
I
I
W
W
This nation is more favor
This nation is more favor
for cloth
for wheat
The higher curves refer to greater satisfaction.
46 | P a g e
(3) Equilibrium in isolation:
Before trade
 We will now see how the interaction between
the demand forces (indifference curves) and
supply side (ppc) determines the equilibrium
point. (Point of maximum social welfare in a
nation).
 A nation is in equilibrium when it reaches the
highest indifference curve possible given its
ppc. This occurs when the ppc is tangent to
the highest indifference curve.
 The common slop of the two curves at
tangency point gives the internal equilibrium
( relative price ) in the nation and reflects the
nations comparative advantage.
U.S
U.K
C
Internal
A
P
A
Internal
rate
rate
P
A
A
/
W
47 | P a g e
W
Note:
1. The smaller the slope of the PA (the flatter the
relative price line), the more the nation has a
comparative advantage in the production of the
commodity on horizontal axis (w) in U.S.
2. The higher the slope of the PA (steeper the
relative price line) the more nation has a
comparative advantage in the production of the
commodity on the vertical axis (c) in U.K.
 PA < PA in Isolation
U.S has s comparative advantage in wheat and will
specialize in wheat.
U.K has a comparative advantage in cloth and will
specialize in cloth.
48 | P a g e
After Trade
 Specialization is not complete (incomplete),
because as each nation specializes in
producing the commodity of its comparative
advantage it incurs increasing costs.
 The difference in relative price (internal
rate) between the 2 nations is reflection of
their comparative adv and form the basis
for beneficial trade.
U.S specialize in W and
moves from point (A) down
to point (B). Therefore, there
is incomplete specialization.
49 | P a g e
U.K specialize in C and move
from point A up to point (B).
Therefore, there is
incomplete specialization.
In this case, the nation have the
different factors endowments
(different ppc) and have different
tastes (different indifference curve(.

So trade
is
possible
The gains from trade:
It is measured in terms of consumption
Consumption after trade – Consumption before trade.
U.S
Gains in wheat
OM -
OL
=
LM
Gains in cloth
OP
-
ON
=
NP
U.K
Gains in wheat
OM -
OL
=
LM
Gains in cloth
OP
ON
=
NP
-
Trade triangle:
U.S  ECB
50 | P a g e
U.K  E/C/B
Ex:
Draw identical ppc under constant opportunity Costs
condition for two nations (N1, N2). Assume different
community indifference curves for N1, N2
1. Indicate the equilibrium in isolation for N1, N2.
2. Do you think a mutually beneficial can take
place between N1, N2 why or why not?
C
Equilibrium
before trade
N1
Equilibrium
before trade
N2
W
(1)
N1 : produce and consumes at point A before
trade.
N2: produce and consumes at point B before trade.
(2)
Mutually beneficial trade cannot take place
between N1 and N2 under constant cost since
the relative prices (opp. Cost) are the same for
both nations.
51 | P a g e
2- Trade based on differences in tastes:
With increasing costs, even if the two nations have
identical ppc. There will still be a basis for mutually
beneficial trade if tastes or demand preferences in the
two nation are different.
 The nation with relatively smaller demand or
preference for a commodity will have a lower
relative price for that product and has comparative
adv in that product.
E Consumption PT after trade
A
in U.S
U.S
C
Exports
Exports
P
A
Imports
C
C
B = Production PT after trade
B/
Imports A
E Consumption PT after trade
in U.K
U.K
P
A
52 | P a g e
W
U.S
Is less preference to wheat  so, it has
lower price for (w) and has comparative
advantage in (w). However, it is more
preference to cloth  so, it has higher
price for (C) and has comparative
disadvantage in (c).
U.K
Is less preference to cloth  so, it has
lower price for (c) and has comparative
advantage in (c). However, it is more
preference to wheat  so, it has higher
price for (w) and has comparative
disadvantage in (w).
Before Trade
U.S Produce and consume at point (A) 
(equilibrium point)
U.K Produce and consume at point (A/) 
(equilibrium point)
The internal exchange rate: Relative price
of wheat
In U.S: PA is flatter  so, it has comparative
advantage in (w)
In U.K: PA is steeper  so, it has comparative
advantage in (c)
53 | P a g e
After Trade
U.S  Specializes in wheat and produce at point B
U.K  Specializes in cloth and produce at point B/.
Note:
The production point is the same in both
nation, because they have the same ppc.
By exchanging (w) for (C) with each other:
U.S  End up consume at E  more consumption
of w and (c)  gains  higher
indifference curve.
U.K  End up consume at E  more consumption
of w and (c)  gains 
higher
indifference curve.
Trade Triangle:
For U.S
ECB
for U.K
E/ C/ B/
Exports of U.S (CB) = Imports of U.K (C/ E/)
Imports of U.S (CE) = Exports of U.K (C/ B/)
In this case, the two nations have the same factor
endowment (identical PPC) but have different tastes
(different indifference curve). So  they have different
relative prices and trade between them is possible.
54 | P a g e
3- Trade based on the difference in PPC:
 In the case of increasing opportunity Cost, even if
the two nation have the same demand condition
(have the same tastes or preference), trade can be
beneficial if the supply side (ppc) is different in
both nation.
Cloth
P*
Exports
U.K
P/A
B/
Import
C s
Imports
E=E/
C
II
A
PA I
B
Exports
U.S
Wheat
 When the two nations have the same demand
condition, this means they have the same
indifference curve.
55 | P a g e
 When the two nations have different supply
condition, this means that they have different
shape for PPC.
Note:
The difference in the shape of PPC may be due to:
(1) The difference in the technology level.
(2) The difference in factor endowment.
(3) (1) and (2).
Before Trade
U.S Is more efficient in the production of wheat
than U.K so, it has comparative advantage in
wheat.
U.K Is more efficient in the production of cloth than
U.S so, it has comparative advantage in cloth.
(1) The Equilibrium Point:
U.S Produce and consume at point A.
U.K Produce and consume at point A/.
56 | P a g e
(2) The internal exchange rate:
U.S PA is flatter. Therefore, it reflects a lower price
for wheat. Therefore, U.S has comparative
advantage in (W).
U.K PA is steeper. Therefore, it reflects a higher
price
for
wheat.
Therefore,
U.K
has
comparative advantage in (C).
Therefore, the difference in supply conditions make
the relative prices different in both nation.
After Trade:
[1] The international exchange rate must be between
the two internal exchange rate (P*). It is steeper
then PA and flatter than PA.
[2] Production and Consumption points:
U.S Will
specialize
incompletely
in
wheat
production point = B, Consumption point = E
U.K Will
specialize
incompletely
in
cloth
production point = B/, Consumption point = E/
Note: The consumption point is the same because
the two nation have the same tastes.
57 | P a g e
[3] The gains from trade:
For U.S
It moves from point A  Point E on the
higher indifference curve. This means
 the higher satisfaction level (gains).
For U.K
It moves from point A  point E/ on the
higher indifference curve. This means
 the higher satisfaction level (gains).
For U.K
It moves from point A  point E/ on the
higher indifference curve. This means
 the higher satisfaction level. (gains).
Trade Triangle:
For U.S
exports = CB , Imports = CE ,  Trade
triangle CBE
For U.K
exports = C/B/, Imports = C/E/ ,  Trade
triangle C/B/E/
In the case of two nations the:
 exports of U.S (CB) = imports of U.K (C/E/)
 imports of U.S (CE) = Exports of U.K (C/ B/)
In this case, the 2 nation have different ppc, but have
the same tastes (same I.C). so, the relative price is
different and trade is possible.
58 | P a g e
4-The gains from substitution and the
gains from specialization:
 The gains from trade = gains from substitution +
gains from specialization.
C
P2
U.S
International
exchange rate
P/2
Has comparative
advantage in wheat
B
70
F
60
50
C
A
E
70 90 110
180
A = Production and consumption before trade.
E = Production after trade.
B = Consumption after trade.
59 | P a g e
W
 Until now our analysis was static, where we
assume that production side will react
immediately which is not true because production
needs time to change. also we assume that
consumption will increase after trade from A to B
which is not true because such point are possible
after long period of time.
 So, we will study the behavior of production and
consumption through time. This called dynamic
analysis.
I- The gains from substitution:
(1) In the case of free trade, the consumption will
react faster than the production to change in
prices. So, we assume in the short-run the
change in welfare will due to the change in
consumption and the gains in short-run come
from the substitution effect.
(2) To show the gains from substitution. We draw
a parallel line P2 to P2 (international price)
passing through point (A). This means that the
production of wheat and cloth did not change
and what changed only is relative price of w
and c.
60 | P a g e
(3) The new international price p2 means that the
international price of wheat will be higher than
the domestic price.
 So, the U.S consumers will decrease their
consumption of wheat from A  C (excess
supply of w).
 And the international price of cloth will be
lower than the domestic price. So, the
consumers will increase their consumption
of cloth from C  F (excess demand for c).
(4) They can export the excess supply of (w) and
import the excess demand for (c).
So, the trade triangle in the short – run is (ACF)
exports = AC imports = CF
(5) The gains from substitution is reflected by
moving from point A  point F. the nation
moves from indifference curve to higher I.C.
this means higher level of satisfaction (gains).
So
The trade is possible in short-run even if the production
side is inaction
61 | P a g e
Assignment (3)
Study the following graph
P*
y
P1
E
A
B = B/
C
C
E
A
P2
X
(1) Determine the equilibrium point of consumption and
production before trade in both nations.
(2) Determine the production and consumption points in
both nation after trade.
(3) Determine exports and imports of N1.
(4) Determine exports and imports of N2.
(5) Do you agree that P reflects a higher price for X than
the internal price in N1?
(6) Do you agree that P reflects a lower price for y than
the internal price of N2? And why?
(7) Do you agree that CB equals CB and CE equals CE
and why?
(8) Determine the gains from trade for both nation.
62 | P a g e