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:
 Production Frontier with Increasing Costs
 Community Indifference Curves
 Equilibrium in Isolation
 Basis for and Gains from Trade with
Increasing Costs
 Trade Based on Differences in Taste
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
The Production Frontier with Increasing Costs
 Increasing Opportunity Costs

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.
The Production Frontier with Increasing Costs
 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.
Community Indifference Curves
 A community indifference curve shows
combinations of two commodities that yield
equal satisfaction to the community or nation.

Represent measure of taste and preference.

Characteristics of community indifference
curves:

The higher the curve, the greater the utility.

Negative slope, convex to the origin.

Different curves do not cross.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-2 Community Indifference Curves for Nation 1 and
Nation 2.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Community Indifference Curves
 The marginal rate of substitution (MRS) falls
as more of good X is consumed.

The MRS of X for Y in consumption is the amount
of Y that a nation could give up for one extra unit
of X and still remain on the same indifference curve.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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.
Equilibrium in Isolation
 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.
Basis for and Gains from Trade with
Increasing Costs
 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.
Basis for and Gains from Trade with
Increasing Costs
 Equilibrium-relative commodity price with
trade = common relative price at which trade
is balanced.
 Balanced trade: quantity of X (Y) Nation 1(2)
wants to export = quantity of X(Y) Nation 2(1)
wants to import.
 Any other relative price could not persist
because trade would be unbalanced.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Basis for and Gains from Trade with
Increasing Costs
 Under constant cost conditions, specialization
is complete.
 Under increasing cost conditions,
specialization is incomplete:

As production moves along PPF toward
comparative advantage good, relative costs
change, thus changing basis and gains from
trade.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 3-5 The Gains from Exchange and from Specialization.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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.
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.