CHAPTER T H R E E
3
International
Economics
Tenth Edition
The Standard Theory
Of International Trade
Dominick Salvatore
John Wiley & Sons, Inc.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
In this chapter:
3.1. Introduction
3.2. Production Frontier with Increasing Costs
3.3. Community Indifference Curves
3.4. Equilibrium in Isolation
3.5. Basis for and Gains from Trade with
Increasing Costs
3.6. Trade Based on Differences in Taste
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
3.1 Introduction
 This chapter extends our simple trade model to the
more realistic case.
 That is, we will introduce the case of increasing
opportunity costs: production frontier.
 Tastes or demand preferences are also introduced:
community indifference curves
 We will then see how these forces of supply and
demand
determine
the
equilibrium-relative
commodity price in each nation in the absence of
trade (i.e., the comparative advantage of each nation.)
3.2. The Production Frontier with Increasing
Costs
3.2A. Illustration of Increasing Opportunity
Costs
Constant opportunity costs: Regardless of the level of output,
the nation must give up the same amount of one commodity to
produce each additional unit of another commodity.
 Production frontier is a straight line.

Increasing opportunity cost: A nation must give up more and
more of one commodity to release just enough resources to
produce each additional unit of another commodity.
 Increasing cost production possibilities frontier is concave to
the origin (not a straight line).

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-1 Production Frontiers of Nation 1 and Nation 2 with
Increasing Costs.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
3.2. The Production Frontier with Increasing
Costs
3.2B. The marginal rate of transformation (MRT)
increases as more units of good X are
produced.


The marginal rate of transformation is another
name for opportunity cost.
The value of MRT is given by the slope of the
PPF.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
3.2 The Production Frontier with Increasing
Costs
3.2C. Reasons for Increasing Opportunity
Costs and Different Production Frontiers
 Reasons for Increasing opportunity costs:
(1) factors of production are not homogeneous.
(2) factors of production are not used in the same fixed
proportion or intensity in the production of all goods.
 Examples:
 Reasons for different production frontiers:
(1) different factor endowments
(2) different technologies in production
3.3 Community Indifference Curves
3.3A.Illustration of Community Indifference Curves
(CIC)
 Recall: (individual) indifference curve
 Definition: a curve that shows the various combinations of
two goods that yield equal satisfaction to an individual
consumer.
 Characteristics:
(1) downward sloped
(2) convex from the origin
(3) a higher curve refers to a higher level of satisfaction
(4) difference curves do not cross each other.
3.3 Community Indifference Curves
3.3A.Illustration of Community Indifference Curves
(CIC)
 Community indifference curve:
 Definition: a curve that shows the various combinations of
two goods that yield equal satisfaction to the community
or nation.
 Characteristics:
(1)
(2)
(3)
(4)
FIGURE 3-2 Community Indifference Curves for Nation 1 and
Nation 2.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
3.3 Community Indifference Curves
3.3B. The Marginal Rate of Substitution (MRS)
 MRS of X for Y in consumption refers to the amount of
Y that a nation could give up for one extra unit of X and
still remain on the same indifference curve.
= the slope of the community indifference curve.
 The MRS (i.e., the slope of the community indifference
curve) decreases as the consumption point moves from
N to A.
e.g., MRS at point N.
MRS at point A.
 Reasons for the decreasing MRS: (Explain!)
3.3 Community Indifference Curves
3.3C. Some difficulties with community indifference
curves
 A different income distribution would result in a new set
of indifference curves, which might intersect previous
indifference curves.
 Explain!
 With compensation principle, we can still assume that
the indifference curves do not intersect each other.
3.4. Equilibrium in Isolation
3.4A. Illustration of Equilibrium in Isolation
 Interaction of forces of demand (community
indifference curves) and supply (production
possibilities frontier) determine equilibrium for
nation in the absence of trade (autarky).
a
 Nations seek the highest possible indifference
curve, given its production constraint.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-3 Equilibrium in Isolation.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
3.4. Equilibrium in Isolation
 In the absence of trade (or autarky), a nation is in
equilibrium when it reaches the highest
indifference curve possible given its production
frontier.
 i.e., A nation is in equilibrium at the point where
a community indifference curve is tangent to the
nation’s production frontier.
3.4. Equilibrium in Isolation
3.4B. Equilibrium-Relative Commodity
Prices and Comparative Advantage
 The equilibrium-relative commodity price in
isolation = slope of tangency between PPF and
indifference curve at autarky point of production and
consumption.
 Relative prices are different in Nation 1 and Nation 2
because of different shape and location of PPF’s and
indifference curves.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
3.4 Equilibrium in Isolation
3.4B. Equilibrium-Relative Commodity Prices and
Comparative Advantage
 The equilibrium relative prices before trade:
Nation 1: (PX/PY) = PA = 1/4
Nation 2: (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.
 Case Study 3-1 CA of the U.S., the E.U., and Japan
3.5. Basis for and Gains from Trade with
Increasing Costs
3.5A. Illustration
 Relative commodity price differentials between two
nations reflect comparative advantages, and form
basis for mutually beneficial trade.
 Each nation should specialize in the commodity they
can produce at the lowest relative price.
 Specialization will continue until relative prices
equalize between nations.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-4 The Gains from Trade with Increasing Costs.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
3.5 The Basis for and the Gains from Trade
with Increasing Costs
3.5B. Equilibrium-Relative Commodity Prices with Trade
 is the common relative price in both nations at which
trade is balanced.
i.e., (PX/PY)e = (PX/PY) = (PX/PY)’
i.e., in Figure 3.4, Pe = PB = PB’ = 1
3.5C. Incomplete Specialization
 Under constant costs, both nations specialize
completely in the production of the good of their CA.
(Recall Figure 2.2 in Chapter 2.)
3.5 The Basis for and the Gains from Trade
with Increasing Costs
 Under
increasing opportunity costs, there is
incomplete specialization in production in both
nations. (See Figure 3.4.)
 Case
Study 3-2: Specialization
Concentration in Selected Countries.
and
Export
3.5D. Small-Country Case with Increasing Costs (Skip)
3.5 The Basis for and the Gains from Trade
with Increasing Costs
3.5E. The Gains from Exchange and from Specialization
Figure 3.5. The Gains from Exchange and from Specialization
3.6. Trade Based on Differences in Taste
 Even if two nations have identical PPFs, basis
for mutually beneficial trade will still exist if
tastes, or demand preferences, differ.
 Nation with relatively smaller demand for X
will have a lower autarky relative price for,
and comparative advantage, in X.
Salvatore: International Economics, 10th Edition © 2009 John Wiley & Sons, Inc.
3.6 Trade Based on Differences in Tastes
 The difference in pretrade-relative commodity prices
between Nation 1 and Nation 2 (i.e. the comparative
advantage of a nation) is based on the difference in
the production frontiers and indifference curves in the
two productions.
 Thus, either the production frontiers or indifference
curves can affect the pretrade-relative commodity
prices (i.e. the comparative advantage of a nation).
3.6 Trade Based on Differences in Tastes
 The cases when the production frontiers are different
while the indifference curves are identical:
(1) The Recardian Model: due to the different
technology
(2) The Heckscher-Ohlin Model: due to the resource
endowment
 The case when the community indifference curves are
different while the production frontiers are identical:
The present case.
FIGURE 3-6 Trade Based on Differences in Tastes.
Salvatore: International Economics, 10th Edition © 2009 John Wiley & Sons, Inc.
Appendix to Chapter 3
 Production Functions, Isoquants, Isocosts and
Equilibrium
 Production Theory with Two Nations, Two
Commodities, and Two Factors
 The Edgeworth Box and Production Frontiers
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-7 Isoquants, Isocosts, and Equilibrium.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-8 Production with Two Nations, Two Commodities, and
Two Factors.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-9 Derivation of the Edgeworth Box Diagram and
Production Frontier for Nation 1.
Salvatore: International Economics, 8th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-10 Derivation of the Edgeworth Box Diagram and
Production Frontier for Nation 2.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.