Chapter Three:
The Standard Theory of
International Trade
3.1 introduction
 The model introduces increasing opp. costs and tastes
or demand preferences with community indifference
curves.
 Forces of demand and supply determine the
equilibrium-relative commodity price in each nation
in the absence of trade under increasing costs and will
indicate the commodity of comp-adv. for each nation.
 Then see how with trade, each nation gains by
specializing in production and export of the
commodity with which it has comp-adv. and import
with which it has comp-disadv.
3.2 Production Frontier with Increasing Costs
 Increasing 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. As a result, the PPF is concave.
A. Illustration of Increasing Costs
 In Fig. 3-1, if nation 1 wants to increase output of X
(point A), it should reduce output of Y by more and
more units.
 If nation 2 wants to increase output of Y (point A/),
it should reduce output of X by more and more units
 Thus, both nations face increasing costs in the
production of the two commodities.
FIGURE 3-1 Production Frontiers of Nation 1 and Nation 2 with
Increasing Costs.
B. The Marginal Rate of Transformation (MRT)
 The MRT of X for Y refers to the amount of Y that a
nation must give up to produce additional unit of X.
 It is another name for the opp. cost and is given by
the slope of the production frontier at the point of
production.
 If the MRT of nation 1 at point A is ¼, this means
that nation 1 must give up ¼ of a unit of Y to release
just enough resources to produce one additional unit
of X at this point.
 If the MRT at point B is 1, a movement from A to B
reflects the increasing opp. costs in producing more X
3.3 Community Indifference Curves
 A community indifference curve shows the various
combinations of two commodities that yield equal
satisfaction to the community.
 Higher curves refer to greater satisfaction.
A. Illustration of Community Indifference Curves
 Fig. 3-2 shows 3 hypothetical indifference curves
for the two nations. They differ according to tastes.
 Points A and N give equal satisfaction.
 Points T and H refer to higher satisfaction
FIGURE 3-2 Community Indifference Curves for Nation 1 and
Nation 2.
B. The Marginal Rate of Substitution (MRS)
 The MRS of X for Y in consumption refers to the
amount of Y that a nation must give up for one extra
unit of X and still remain on the same IC.
 This is given by the (absolute) slope of the
community IC at the point of consumption and
declines as the nation moves down the curve.
 The decline in MRS is a reflection of the fact that
the more of X and less of Y a nation consumes, the
more valuable Y becomes compared to X.
3.4 Equilibrium in Isolation
A. Illustration of Equilibrium in Isolation
 Fig. 3-3 combines the production frontiers and the
community IC.
 IC I is the highest IC curve that nation 1 can reach
with its production frontier. Thus, it is in equil when
it produces and consumes at point A in the absence
of trade, or autarky.
 There is only one point of tangency, or equilibrium.
FIGURE 3-3 Equilibrium in Isolation.
B. Equilibrium-Relative Commodity Prices and
Comparative Advantage
 The equil-relative commodity price in isolation is
given by the slope of the common tangent to the
nation’s production frontier and the IC at the autarky
point of production and consumption.
 Equil-relative price of X in isolation is PA = PX / PY =
¼ in nation 1 and PA’ = PX / PY =4 in nation 2.
 Relative prices are different in the two nations
because their production frontiers and ICs differ in
shape and location.
 Since in isolation PA < PA’ nation 1 has a comp- adv
in X and nation 2 in Y. Both can gain if nation 1
specializes in X, and nation 2 in Y.
 Forces of supply (nation’s PF) and forces of demand
(nation’s IC) together determine the equilibriumrelative commodity prices in each nation in autarky.
TABLE Composition of Exports and Imports of Canada, Brazil, and China
in________________________________________________________________________
2004 and Their Revealed Comparative Advantage
Canada
% of Total
Brazil
% of Total
China
% of Total___
Exports Imports Exports Imports Exports Imports
________________________________________________________________________
Primary commodities
Food
Fuels
Manufactures
Automotive products
Chemicals
Office & telecom. equip.
29.1
7.3
21.8
59.5
20.1
6.9
3.6
15.6
5.7
9.9
80.7
19.3
10.3
9.1
42.1
28.4
13.7
53.2
9.1
6.1
2.1
27.8
5.1
22.7
70.5
5.3
22.1
10.9
7.8
3.5
4.3
91.4
1.1
4.4
29.0
19.6
3.7
15.9
76.3
2.6
11.7
22.9
Textiles and clothing
1.4
3.4
1.7
2.0
16.1
3.0
________________________________________________________________________
3.5 The Basis for and the Gains from Trade
with Increasing Costs
A. Illustrations of the Basis for and the Gains from
Trade with Increasing Costs
 Starting from point A, as nation 1 specializes in X
and moves down its PF, it incurs increasing opp.
costs (as reflected in the increasing slope of the PF).
 Starting from point A’, as nation 2 specializes in Y
and moves upward its PF, it incurs increasing opp.
costs (as reflected in the decline in slope of the PF).
 Specialization in production continues until relative
commodity prices become equal in the two nations.
FIGURE 3-4 The Gains from Trade with Increasing Costs.
 The common relative price (slope) with trade will be
somewhere between the pretrade relative prices of ¼
and 4, at the level at which trade is balanced. In figure
3-4, this is PB = PB’ = 1.
 With trade, nation 1 moves from A down to B. by
exchanging 60X for 60Y with nation 2, nation 1 ends
up consuming at E (70X and 80Y) on its IC III.
 This is the highest level of satisfaction that nation 1
can reach with trade at PX/PY = 1. Thus, nation 1
gains 20X & 20Y from its no-trade equilibrium point.
 Nation 2 moves from A’ to B’, and with trade of 60Y
for 60X it ends up consuming at E’ (100X and 60Y).
 Nation 2 gains 20X & 20Y from specialization/trade.
B. Equilibrium-Relative Commodity Prices with
Trade (ERCPT)
 The ERCPT is the common relative price in both
nations at which trade is balanced, this is PB= PB’=1.
 At this relative, the amount of X that nation 1 wants
to export (60X) equals the amount of X that nation 2
wants to import (60X). Similarly for nation 2 and Y.
 Any other relative price could not persist because
trade would be unbalanced.
 The greater the desire of nation 1 for Y and the
weaker is nation 2’s desire for X, the closer the
equil. price with trade will be to 1/4 and the smaller
will be nation 1’s share of the gain.
 Once equil-relative price with trade is determined,
gains from trade will be known exactly and the
model will be complete.
 The equil-relative price of X with trade (PB= PB’=1)
results in equal gains (20X and 20Y).
 If the pretrade - relative price had been the same in
both nations, there would be no comp-advantage or
disadvantage in either nation, and no specialization
in production or mutually beneficial trade would
take place.
C. Incomplete Specialization
 Under constant costs, both nations specialize
completely in production of the commodity of their
comparative advantage.
 However, under increasing costs there is incomplete
specialization in production in both nations.
 That is, nation 1 continues producing Y (point B),
and nation 2 continues producing X (point B’).
 Reason: as nation 1 specializes in X, it incurs
increasing opp. costs in production of X. Similarly,
as nation 2 produces more Y, it incurs opp. costs in
Y (implying decreasing opp. costs of X).
 With specialization, relative prices move toward each
other until they are identical in both nations.
 At this point, it does not pay for either nation to
continue expanding production of the commodity of
its comparative advantage.
 This occurs before either nation has completely
specialized in production.
 In figure 3-4, before nation 1 or nation 2 has
completely specialized in production.
D. Small –Country Case with Increasing Costs
 Under constant costs, the small country completely
specializes in the production of the commodity of its
comparative advantage, but the large country doesn’t
 However, under increasing costs, we find incomplete
specialization even in the small country case.
 Assume nation 1 is the small country.
 With no trade, nation 1 at equil. at point A.
 Suppose the equil-relative price of X on world market
is 1 (PW=1), and not affected by trade with nation 1.
 Since the pretrade relative price of X in nation 1 is
PA=1/4 is lower than world price, it has comparative
advantage in the production of X.
 With trade, nation 1 specializes in X until it reaches
point B where PB=1=PW
 Even though nation 1 is a small country, it doesn’t
completely specialize in X (as under constant costs).
 By exchanging 60X for 60Y, nation 1 reaches point E
and gains 20X and 20Y (compared to autarky; A).
 The only difference from the case discussed before is
that nation 1 doesn’t affect relative prices in nation 2.
 Nation 1 captures all the benefits from trade.
E. The Gains from Exchange and Specialization
 A nation’s gains from trade arise from exchange and
specialization.
 Fig 3-5 shows this breakdown for the small nation 1
 Suppose nation 1 could not specialize in X with
trade and continued produce at A, where MRT=1/4
 Starting from A, nation 1 could export 20X in
exchange for 20Y at PW =1 and end up at point T.
 Although it consumes less of X and more of Y (at T)
it is better off than it was in autarky because it is on
higher indifference curve.
 Movement from A to T in consumption measures
the gain from exchange.
FIGURE 3-5 The Gains from Exchange and from Specialization.
 If subsequently nation 1 also specialized in X and
produced at B, it could then exchange 60X for 60Y
with the rest of the world and consume at E.
 The movement from T to E in consumption measures
the gains from specialization in production.
 In sum, the movement from A (on IC I) to T (on IC
II) made possible by exchange only.
 The movement from T (on IC II) to E (on IC III)
made possible by specialization in production.
 Note that nation 1 is not in equil at point A with
trade because MRT < PW. To be in equil in
production, it should expand production of X until it
reaches point B, where PB = PW =1