International Economics
Basics of International Trade Theory - II
Prof. D. Sunitha Raju
Trade Theory : Discussion Issues
International Economics
1. What is the basis for trade between
countries?
2. How are gains from trade defined/
measured.
3. Can theory explain the pattern of global
trade flows.
Trading under Constant Costs
(a) Basis for Trade
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• Slopes of the production possibilities schedules
give the relative cost of one product in terms of
other
• Differences in relative costs provide the basis for
mutually favourable trade
(b)
Production gains from Specialisation
• A country will specialise in the production of the
good in which it has comparative advantage
• A country will trade part of this production for the
good in which it has comparative disadvantage
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(c)
Consumption gains from Trade
• Consumption alternatives limited by the domestic production
possibilities schedules
• The exact consumption will be determined by the tastes &
preferences
• Specialization & free trade care achieve post-trade consumption
outside domestic production possibilities schedules
trade results in consumption gains for both countries
(d) Terms of Trade
• Domestic terms of trade represents the relative prices at which
goods are exchanged at home
• A country will exports/import goods internationally if the terms of
trade are more favourable than domestic terms of trade
Production Possibility Schedule
under Increasing Costs
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(i)
Increasing opportunity costs mean that more of one
commodity is to be given up (to release resources) for
additional production of another commodity
(ii)
Increasing costs result when inputs are not perfect
substitutes
Production Frontiers of Nation 1 and
Nation 2 with IncreasingYCosts
International
Economics
Nation
2
140
Y
Nation 1
B’
120
∆Y
100
-∆X
A
80
60
40
-∆Y
∆X
0
10
30
50
70
90
110
B
130
20
X
0
• Slope of the PPS (or MRT) varies at different points on the schedule
A’
Trading under Increasing Costs
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•
Supply factors and Demand factors together determine
the point at which a country chooses to consume along
the PPS.
•
In Autarky, a country is in equilibrium which the PPS is
tangent to the highest indifference curve
•
This tangency determines the equilibrium relative prices
of commodities in each country.
Y
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Nation 1
Y
Nation 2
140
.
B’
120
PA’=4
100
80
70
60
A
80
I
PA 
40
60
.
20
0
1
4
10
30
50
70
90
110
.
A’
40
B
20
X
130
140
0
I’
20
40
60
80
85
Y
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Nation 1
Y
Nation 2
140
.
120
100
.
100
E
80
.
70
60
B’
A
80
III
I
60
E’
C’
.
40
C
20
0
.
B
10
30
50
70
90
110
130
A’
40
PB=1
150
20
X
0
.
III
PB’=1
I’
20
40
60
80
100 120
Equilibrium-Relative Prices with Trade
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•
With specialisation in production & trade, each nation
can consume outside its production frontier.
•
The relative prices that balances trade (i.e. export of 1
country = import by another country)
The Equilibrium-Relative Commodity Price
PX
Panel A
PY
PX
Nation 1’s Market
for Commodity X
P1
Panel B
PY
.
PY
International Trade
in Commodity X
.
B
Exports
P3
.
.
E*
B*
D
.
A*
A
Dx
O
X O
A’
.
B’
.
.
Nation 2’s Market
for Commodity X
S
SX
.E
.
SX
A’’
P3
P2
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Panel C
PX
X
O
Imports
E’
DX
Offer Curves (Reciprocal demand curves)
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1.
Definition
 Offer curve shows how much of the import
commodity a nation demands for which it is willing to
supply various amounts of export commodity
 Incorporates both demand and supply factors:
production frontier, indifference map, and relative
commodity prices
2. Deriving a country’s offer curve
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
Trade is the difference between Production and Consumption
Exports : QX – DX
Imports : DY - QY
Y
DY
Home’s Imports
(DY – QY)
.
T
Imports
IC
.
.
Desired
Imports
T
Q
QY
PX
DX
QX
PX
PY
PY
X
Desired
Exports
Exports
DY – QY = (QX – DX) x (
PX
)
PY
Home’s Exports
(QX – DX)
Offer curve: desired imports at
various relative prices
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X
Home’s Exports
.
T2
.
T1
 Relative prices increase from T to T1 and from T1 to T2.
 When PX P rise, QX ↑, QY ↓, DY ↑ and DX ↓. Both Exports (QX – DX)
Y
and Imports (DY – QY) rise.
3. Deriving Foreign’s Offer Curve
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 Shows desired imports of Y and Exports of X vary with relative
prices.
Foreign’s
Exports
Y
(QY*  DY* )
Foreign’s Imports
( D X*  Q X* )
4. Offer Curve Equilibrium
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 World equilibrium to where Home and Foreign offer curves
intersect
X
Home’s Imports
(DY – QY)
Foreign’s Exports
.
Y
(QY*  DY* )
Home’s Exports (QX – DX)
Foreign’s Imports
( D X*  Q X* )
Determining Relative Prices
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(i)
Terms of Trade (Net barter terms of trade)
 Ratio of price of export commodity to the price of
import commodity
 Assume 2 countries :
 Home → Exports Food
→ terms of trade PF
PM

Foreign → exports manufactures
→ terms of trade PM
PF
Sources of Comparative Advantage
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a) Factor Endowments
b) Resource Allocation
c) Differences in Tastes