2. WHY DO WE
TRADE?
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
1
Why Do We Trade?
The classical theory of international trade is
concerned with the following three
questions:
1. What are the gains from trade?
 In other words, if countries benefit from
international trade, where do the gains
come from, and how are they divided
among the trading countries?
2. Why Do We Trade?
2
Why Do We Trade? continued
2. What is the structure/pattern of
trade?


In other words, which goods/services are
exported, and which are imported
What are the fundamental laws that govern
international allocation of resources and the
flow of trade?
3. What are the terms of trade?

In other words, at what prices are the
exported and imported goods exchanged?
2. Why Do We Trade?
3
The Different Trade Theories
1. Early Trade Theory: Mercantilists
2. Classical Trade Theory: Ricardian Model
(section 2.1)
3. Modern Trade Theory: Heckscher-Ohlin
Model (section 2.2)
4. New Approaches to Trade Theory
(section 2.3)
2. Why Do We Trade?
4
1. Early Trade Theory:
Mercantilists


Mercantilists believed that the purpose of
international trade was to keep exports greater
than imports and pile up gold, and when/if deficits
were created they believed that imports had to be
restricted. Mercantilists maintained that the
way for a nation to be rich or powerfull was
to export more than import.
Mercantilists assumed trade to be a zerosum game since they assumed that fixed
amounts of goods and of gold existed in the
world and that trade merely determined
their distribution among the various nations
2. Why Do We Trade?
5
Rich or
Powerful
nation was
the nation
which
hasmore
gold or
accumulates
more gold.
X should be
bigger than M.
•The aim of the goverment
X reflects the
money or
gold which
our nation
gains due to
sell our
goods..
M is opposite of X.
was to export more than import
*The international trade is zero
sum game.
Encouraged X and
restricted M
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
6
Mercantilists continued


But in the 1740s, David Hume explained that
as quantity of money (gold) changes, so also
does the price level, and the nation's real
wealth is unaffected
In 1770s, Adam Smith argued that import
restrictions would reduce the gains from
specialization and make a nation poorer
2. Why Do We Trade?
7
Asssumptions of Classical Trade
Theory:
a) two countries with fixed amount of labor,full employment
b) only two products produced (wheat and cotton) and two
nation,
c) preferences for food and clothing are same,
d)Labor theory of value
e)Transport cost is equal to zero.
f)Pure competition theory
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
8
Theory of Absolute Advantage
The advantage in the production of a product of
one country over another when it uses fewer
resources to produce than the other country
does.
If a nation produce a good efficiently or by
using less resources tahn other nations, we
concluded that nation has absolute advantage.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
9
Absolute Advantage - an
Illustration
Suppose country A and country B produce
wheat, but that A's climate is more suited to
wheat and its labor is more productive.
Country A will therefore produce more wheat
per acre than country B and use less labor in
growing it and bringing it to the market.
Country A thus enjoys an absolute advantage
over country B in the production of wheat.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
10
Example 1: Gains from Mutual
Absolute Advantage
Assume
a) two countries with fixed amount of labor
b) only two products produced (wheat and cotton),
c) preferences for food and clothing are same.
Wheat(bushels/manhour)
Cotton(yards/manhour)
US
UK
6
1
4
5
Which goods are produced with lower
Cost in US and UK?
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
11
Wheat(bushels/manhour)
Cotton(yards/manhour)
US
UK
6
1
4
5
US has Absolute Advantage in Wheat and UK
has Cloth.
Because,
6 is bigger than 1. The US’ quantity of Wheat is 6,
UK’s is 1.
The opposite is true for UK.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
12
Before Trade
Wheat
Cloth
US
6
4
UK
1
5
With Trade
Wheat
Cloth
US
6
0
UK
0
6
After Trade
Wheat
Cloth
US
9
0
UK
0
30
with opening the trade, US produce and
export
wheat and UK cloth. We assume that the
international price of the wheat and cloth is
determined.
6W=6C
US gains 2C or ½ man. If US produce 6W
by using one man hour, US produce 3 W by
using additional man hour. So total W
production
2. Why Do We increased
Trade? - 2.1 The Law of 9W.
Comparative Advantage
13
Theory of comparative
advantage
•
•
•
•
Ricardo did not bother to answer this question
If a nation produce a good efficiently or by using less
resources with respect to other nations, we concluded that
nation has a comparative advantage.
He just assumed that the differences in comparative
advantage depended on comparative difference in labor
productivity (that is, differences in technology).
The international terms of trade is given. Any
process or information did not given in the
theory. We do not How The İnternational price
occured.
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
14
Comparative Advantage an Illustration


Suppose that countries C and D both produce
wheat and corn and that C enjoys an absolute
advantage in the production of both - that is, C's
climate is better than D's, and fewer of C's
resources are needed to produce a given quantity
of both wheat and corn
C and D each need to choose between planting
land with wheat and corn
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
15
Comparative Advantage
The advantage in the
production of a product
enjoyed by one country
over another when that
product can be produced
at lower cost in terms of
other goods than it could
be in the other country.
US UK
Wheat(bushels/man- 6
hour)
Cotton(yards/man- 4
hour)
1
2
Which goods are produced with lower
Cost in US and UK?
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
16
Wheat(bushels/manhour)
Cotton(yards/manhour)
US
UK
6
1
4
2
Us has comporative Advantage in Wheat and UK
has Cloth.
Because,
6/1 is bigger 4/2,
or 6/1 is bigger than 4/2. The US’ absolute
advantage in Wheat is 6, UK’s is 2. US produced
much more wheat, US is 3 times productive in
producing wheat than Cloth with respect to UK.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
17
Before Trade
Wheat
Cloth
US
6
4
UK
1
2
With Trade
Wheat
Cloth
US
6
0
UK
0
6
with opening the trade, US produce and
export
wheat and UK cloth. We assume that the
international price of the wheat and cloth is
determined.
6W=6C
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
18
Before Trade
Wheat
Cloth
US
6
4
UK
1
2
With Trade
Wheat
Cloth
US
6
0
UK
0
6
If The US exchanges 6W for more than 4C,
IT gains more advantage due to international
trade and UK has advantage, If It give up
less than 12Cfor 6W.
4C<6W<12C
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
19
Opportunity cost



Opportunity cost is the sacrifice made
when selecting one product or service
over another.
Or OC is The quantity of good which we
give up to produce more another.
Because The resources are scarce to fulfill
the all needs.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
20
Table 2.4
Maximum
Amount
Wheat
180
150
120
90
60
30
0
US
Cloth
0
20
40
60
80
100
120
First, We determine
maximum amount of
Wheat and Cloth
produced by US
Wheat
60
50
40
30
20
10
0
UK
Cloth
0
20
40
60
80
100
120
Second, We draw a line by using
two points which are showed us
maximum quantities
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
21
US
UK
Wheat
Cloth
Wheat
Cloth
180 man-hour 120 man-hour 60 man-hour 120 man-hour
Us has comporative Advantage in Wheat and UK
has Cloth.
Because,
180/120 is bigger than 60/120,
or 3/2 is bigger than ½. The US’ advantage in
Wheat is 1.5, UK’s is 0.5. US produced wheat 1.5
times than Cloth. And UK produced wheat 0.5
times than cloth.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
22
Comparative Advantage and
Opportinity Cost
In C, We have not
enough resources to
reach it.
In D, We do not utilize
How do We understand the CA?
The distance of 0-120 is smaller than 0180 in US. The distance of 0-120 is
bigger than 0-60 in UK. US has a CA in
producing and trading W, and UK has
Cloth.
Our resources fully.
US
UK
Cloth
Cloth
120
C
120
B(40,40)
A(90,60)
PPF
D
0
180 Wheat
0
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
60
Wheat
23
N1 want to
produce more
X than it do
before
But We must
utilitize our
resources
fully. B is not
available. We
have no extra
resources for
B.
So The
production of
Y decreased.
We have a new
combination.
Y
Nation 1
60
A
B
50
30
D
5
10
20 25 27
X
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
24
Opportunity cost


Opportunity cost is the sacrifice made
when selecting one product or service
over another.
Or OC is The quantity of good which we
give up to produce more another.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
25
N1 want to
produce more
X than it do
before
But We must
utilitize our
resources
fully. B is not
available. We
have no extra
resources for
B.
So The
production of
Y decreased.
We have a new
combination.
Y
Nation 1
60
A
B
50
30
D
5
10
20 25 27
X
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
26
Constant Opportunity Cost
in A
tan  = C/W=
Cloth
tan = tan 
US
(120-60)/(90-0)=
60/90=2/3
120
in B

tan  = C/W=
60
(120-20)/(150-0)=
20
A(90,60)

B
100/150=2/3
90
150 180
Wheat
The OC is the slope of the PPF or The
Slope of it2.isWhyequal
to tangent
Do We Trade?
- 2.1 The Lawof
of the
Comparative
Advantage
function in some
points
like A or B.
27
Opportunity cost




Opportunity cost is the slope of the
Transformation Curve.
For US
OC= C/W=2/3
It means that US must give up 2/3 Cloth
to produce 1 Wheat additionally.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
28
Opportunity cost




Opportunity cost is the slope of the
Transformation Curve.
For UK
OC= C /W=2
It means that UK must give up 2 Cloth to
produce 1 Wheat additionally.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
29
Constant Opportunity Cost
tan = tan 
We say that The OC is constant in the every points on the line.
1.Factor of Production,
Neither perfect substitution nor used in fixed proportion.
2. The production factor has same quality.
We assume that have two production factors to produce wheat. One is the
Labor and second is the robot or machine.
The Total productivity of Labor is 100 unit and We use in production 100 labor.
The Total productivity of Robot or machine is 1000 unit and We use in
production 1.
The average productivity of robot is 1000/1=1000 and Labor is 100/100=1
And APR is bigger than Labor. So We used robot to produce wheat. The Wheat
is Machine intensive good in this situation.
But If The TPL is 100000, APL will 1000 like Robot. So in this situation Both
Robot and Labor may be used production of wheat. Both is perfect subsititues
or same quality.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
30
Relative Commodity Price
Transaction or Trade is realeased,
When The value of good bougt
and selled are equal.
In this example, We have two goods, W and C.
And The value of the Wheat is Pw*Qw and Cloth, Pc*Qc.
If the Pw*Qw is bigger than Pw*Qw, The seller of the W does not sell it. So
either Pw or Qw inceased.
And Pw*Qw is equal to Pc*Qc.
Pw*Qw =Pc*Qc.
Pw/Pc=Qc/Qw.
The price and quantitiy has negatively related. The price of the cloth is up
in the first indentity and quantity of cloth is down in the second identity.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
31
Relative Commodity Price
Cloth
US
in A
tan  = C/W=
120
(120-60)/(90-0)=
60/90=2/3
tan = Qc/Qw

And Pw/Pc or relative
A(90,60)
Commodity price.
60
90
180
Wheat
If we sell valuable good, We will want to sell less. The
relative price is negatively related with relative quantity.
For US, The prices
is Pw/Pc and Uk is opposite.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
32
Comparative Advantage and
Opportinity Cost
Before Trade
Wheat
Cloth
US
90
60
UK
40
40
After Trade
Wheat
Cloth
US
110
70
UK
70
50
70W=70C
US
Cloth
With Trade
Wheat
Cloth
US
180
0
UK
0
120
autorky
UK
Cloth
E(0,120)
120
120
60
C(110,70)
A(90,60)
F(50,70)
D(40,40)
PPF
B(180,0)
90
180 Wheat
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
60
Wheat
33
A and D
B and E
Before Trade
Wheat
Cloth
US
90
60
UK
40
40
With Trade
Wheat
Cloth
US
180
0
UK
0
120
F and C
After Trade
Wheat
Cloth
US
110
70
UK
70
50
US ‘ gain from trade may be estimate with
110-90 and 70-60, 20W and 10C are the
gain of US because of International Trade.
UK,
70-40 and 50-40, 20W and 10C.
Both Nations may consume more C and W
due to International Trade.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
34
Relative Commodity Prices
Sw(US+UK)
Pw/Pc
1
Dw(US+UK)
2/3
180
120
C
Complete
Specializati
on
240
Wheat
120
C
180 W
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
60 C
35
Relative Commodity Prices
Sc(US+UK)
Pc/Pw
1
Dc(US+UK)
1/2
120
120
C
Complete
Specializati
on
240
Cloth
120
C
180 W
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
60 C
36
US
Wheat
180 man-hour
UK
Cloth
Wheat
Cloth
120 man-hour 60 man-hour 120 man-hour
TT,
180W=180C
Wheat
US
A
180
UK
B
C
60
120
180
Cloth
The Range of Mutual Benefit is 120C 180W 360C and Total benefit is
240C, US take 60C and Uk take 180C.UK has more benefit than UK.
Which prices is close to terms of trade in international trade? US’ price is
close to TT. So US has a smaller benefit from trade. A Nation take much
2. Why Do We Trade? - 2.1 The Law of
37
more gain than the other nationComparative
When Advantage
its price is close to TT.
İmportance of Being
Unimportant
Sw(US+UK)
Pw/Pc
1
Dw(US+UK)
2/3
120
C
180
No
Complete
Specializati
on
240
Wheat
120
C
180 W
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
60 C
38
International Equilibrium with
Increasing Costs
Indifference Map and
Consumer Equilibrium
Increasing Opportunity Cost
Clothing
a) Product specific
factors.
Clothing
b) Different industries
use factors in different
proportions.
I’’’
I’’
I’
PPF
Food
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
Food
39
But We must
utilitize our
resources
fully. B is not
available. We
have already
use all
resources.
We
produce
more X
So The
production of
Y decreased.
We meet a new
combination.
Y
Nation 1
60
A
B
50
30
D
5
10
20 25 27
X
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
40
International Equilibrium with
Increasing Costs
Y
Y
Nation 1
60
Nation 2
A
B
50
C
30
D
5
10
20 25 27
X
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
X
41
Opportunity cost and MRT





Opportunity cost is the slope of the
Transformation Curve. MRT has same meaning.
For Nation 1.
From A to B, OC= Y/X=60-50/20-10=1
From C to D, OC= Y/X=30-5=27-25=12.5
The Opportinity cost increased, When we moves
right over the PPF. The slope of PPF is called as
MRT.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
42
Community Indiffrence Curve
Indifference Map
The CIC which is far from the orgin signs more
social welfare than other.
The slope of CIC equal to MRS.
Y
Clothing
I’’’
I’’
I’
X
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
Food
43
International Equilibrium with
Increasing Costs
Px/Py = terms of trade in US
Px/Py=1/4, and X is chepear than Y.
And Px/Py is 4, and Y is chepar than X in Uk.
PA is smaller than PB in isolation.
Y
Clothing
Pb=1/4
A(50,60)
Pa=4
B(40,80)
I’
X
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
Food
44
General Equilibrium
in a Small Open Economy
Y
İn A, 50,60
I'
I''
80
İn B, Incomplete Specialization
130,20
E
130-60=70 X (Exp)
A
20+60= 80 Y.(Imp)
60
20
O
C
P0
Before Trade
Wheat
Cloth
US
50
60
B
With Trade
Wheat Cloth
US
130
20
After Trade
Wheat
Cloth
US
70
80
X
50 70 130
T
T'
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
45
General Equilibrium
in a Small Open Economy
Y
İn D, 80,40,
İn A, Incomplete Specialization
40,120
I''
A
120
60
40
O
120-60=60 Y (Exp)
I'
40+60= 100 X.(Imp)
Before Trade
Wheat
Cloth
US
80
40
B
C
D
40
80 100
With Trade
Wheat
Cloth
US
40
120
After Trade
Wheat
Cloth
US
100
60
X
T
T'
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
46
General Equilibrium
in a Small Open Economy
Y
İn A, 50,60,
Production does not change.
İn T, 30,80
T
80
So The consumption of Y
increase. Gains from exchange
E
A
60
But in A The slope of the PPF is
smaller than TT.
So B and E
O
60 imp, 50 exp.
B
20
30
50 70
130
X
T
T'
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
47
Same Production Technique in
Both Countries, Trade Based on
Different
Taste
Figure 2
Clothing
America
Britain
Food
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
48
Trade Based on Different Taste
continued

Figure 2: Trade based on different tastes. America and
Britain share the same production frontier MN. In
autarky, America produces and consumes at A, and
Britain at B. With free trade, both countries produce at
Q, but America consumes at A’ and Britain at B’. Trade
triangles A’VQ and QSB’ are identical.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
49
General Equilibrium
in a Small Open Economy
Y
Y
I'
I''
80
80
E
A
60
A
60
20
20
O
C
P0
O
B
C
P0
B
X
50 70 130
T
T'
X
50 70 130
T
T'
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
50
What are the ultimate
determinants of comparative
advantage?
•
•
Ricardo did not bother to answer this
question
He just assumed that the differences in
comparative advantage depended on
comparative difference in labor productivity
(that is, differences in technology), but he
did not explain the basis for these
differences. Implicit reason in his example
was climate...
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
51
What are the ultimate determinants
of comparative advantage?
continued


It remained to Heckscher and Ohlin to
offer an explanation for comparative
advantage
And this theory has become, since
1930s, the orthodox explanation of the
ultimate cause of international trade
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
52
What are the ultimate determinants
of comparative advantage? continued

Their basic idea is:
1. Commodities differ in their factor
requirements
2. Countries differ in their factor
endowments
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
53
What are the ultimate determinants
of comparative advantage? continued
A country has comparative advantage in those
commodities that use its abundant factors
intensively.
•
This is why labor-abundant countries, such as
India, China and Korea export footwear, rugs,
textiles, and other labor intensive commodities;
and land-abundant countries, such as Argentina,
Australia, and Canada, export meat, wheat, wool,
and other land-intensive commodities
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
54
The Basic Assumptions of the
Heckscher-Ohlin Model:
1. Number of countries, factors, and
commodities are all two (often referred
to as the 2 x 2 x 2 model)
2. Technology is the same in both
countries
3. Constant returns to scale
4. Strong factor intensity
5. Incomplete specialization
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
55
The Basic Assumptions of the
Heckscher-Ohlin Model
continued:
6. Perfect competition
7. Factors are perfectly mobile within each
country but perfectly immobile between
countries
8. Tastes are largely similar between
countries
9. Free trade
10. Transportation costs are zero
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
56
Heckscher-Ohlin Theorem with
a Single Technique
•
The structure of trade, in general, can be
traced back to differences in
factor endowments, technology and
tastes
•
Since Heckscher-Ohlin theory assumes that
technology and tastes are similar between
countries, it attributes the comparative
advantage to differences in factor
endowments
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
57
Heckscher-Ohlin Theorem with a
Single Technique continued
In summary, the capital-abundant country
exports the capital-intensive commodity, and
the labor-abundant country exports the laborintensive commodity.
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
58
Example 1: Factor Endowments
and Production-Possibilities


One country
Required inputs per unit of output
Cloth, Y
Steel, X
Endowments
Labor
4
2
900
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
Capital
1
3
600
59
Example 1: Continued
Cloth
• M
600
Capital Constraint
225 •
150
J
•
E
Labor constraint
• V
•
0
150
G
H
•
200
450
Steel
Figure 3
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
60
Example 1: Continued

Figure 3: Derivation of the production-possibilities
frontier. If the economy had an unlimited supply of
capital (labor), it would be able to produce along the
labor constraint JG (capital constraint MH). When the
supplies of both factors are limited, both constraints
become binding and the production frontier coincides
with the heavy kinked line JEH. Because steel is capital
intensive relative to cloth, the capital constraint is
steeper than the labor frontier.
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
61
Heckscher-Ohlin Theorem
with a Single Technique
Cloth
Figure 4
Steel
Steel
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
62
Heckscher-Ohlin Theorem
with a Single Technique

Figure 4: Production frontiers JQH and J*Q*H* reflect
the fact that America is endowed with more capital
than Britain, while Britain is endowed with more labor
than America. Before trade, America produces and
consumes at R, and Britain at Q*. With free trade,
America shifts production to Q and consumption to C.
Britain maintains production at Q* but shifts
consumption to C*. Trade triangles CQV and Q*C*V*
are identical. America exports steel, and Britain cloth.
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
63
Heckscher-Ohlin Theorem
with Many Techniques
Cloth
Figure 5
Steel
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
64
The equilibrium- Relative Commodity Prices
Px/Py
P3
Sw
P2
Exports or
ExcessSuppl
y
International
market for X
EP
Dw
P1
Px/Py
P3
P2
Sx
Px/Py
F
Sx
B
P1
E
C
Imports or
Excess
Demand
D
A
Dx
Nation 1’s
market for X
X
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
Dx
Nation 2’s
market for X
65
Derivation of Offer Curves and
the International Equilibrium



The offer curve of a nation shows how much of its import commodity the
nation demands for it to be willing to supply various amounts of its
exports commodity. The offer curve Nation 1 records the quantities of
good X that country 1 supplies to the world market for export and the
quantities of good Y that it demands from the world market as imports,
for all prices.
The exports is excess supply of nation 1. And Import is the excess
demand of the nation 2.
So The Nation 1 export or sell the difference supply or excess supply to
nation 2 with international trade or opening of trade. And Nation 1
imported nation 2’s good which it called y. So it is seen that Nation 1 must
export x to be able to import y.
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
66


The offer curve Nation 1 records the quantities
of good X that country 1 supplies to the world
market for export and the quantities of good Y
that it demands from the world market as
imports, for all prices.
Offer curve N2 is similarly defined for country 2,
except that the directions of trade for it are
reversed. That is, it records quantities of good Y
that 2 will export in exchange for various
quantities of imports of good X.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
67
General Equilibrium
in a Small Open Economy, Nation 1
Y
Y
Pa=1
I'
I''
80
E
60
H
60
imported
A
F
G
20
C
Pb= 1/2
20
B
Pg=1/4
exported
O
X
50 70 130
T
40
60
X
T'
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
68
General Equilibrium
in a Small Open Economy, N 2
Y
Pa=4
Pb= 2
Pg=1
Y
60
I''
exported
I'
120
60
D
F
C
E
G
H
40
O
40
imported
A
40
80
100
X
T
20
60
T'
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
69
X
The nation
1 has a
excess
supply.
With opening
of trade, The
nation want to
import some
another good,
y.
How does
nation 1
import y? Is it
required that
nation 1 must
give x to
nation 2 for
trading or
importing y?
So we say that
The OC
includes
demand and
supply. .
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
The import of
the y by nation
1 is demand for
the y of nation
1. And the
export of x by
nation 1 is
70
In equilibrium, of course, it
must
import what 1 exports and
vice versa, which is why
equilibrium
is found where the two
curves intersect, at E.
By representing both good
X and good Y in a single
diagram in this way, the
intersection of the two offer
curves depicts equilibrium in
both markets simultaneously,
something that is possible
(indeed necessary) because
of Walras' Law.
Pa=4
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
Pb= 2
Pg=1
Pa=1/2
Pb= 1/4
71
From A to
B
The exporting
X is increased
and importing
y icreased
too.
Pa=1
Y
A
B
X
The quqntity of X used
by nation 1 decreased
because of export.
MU of x up,
Mu of y
down.
Pb= 1/2
Tangent(slope) of A is
bigger than, tangent of
B.
So we say that the price
of x increased by
moving from left to right
over OC.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
72
Y
E
F
The quantity
of X imported
by nation 2
The quantity
of Y exported
by nation 2
D
X
The quantity
of X exported
by nation 1
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
The quantity
of Y imported
by nation 1
73
Pa=1
Y
E
Pb= 1/2
Dx
Sx
F
P=1
D
P=1/2
X
40
120
Excess
supply
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
74
107-prob7
Pa=1
Y
Pb= 1/2
A
Tngent of A is smaller
than, tangent of B.
B
X
So we say that the price
of x is bigger. And
nation2 obtained less
gain from trade.
Because the willigness
of the n1 for y is small.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
75
Terms of Trade

TT=Price of Exported Good/ Price of
Imported Good
The Pe=100 to 120
120/100*100=120 20 percent.
For Y
100/120*100=83
Deteriotaded.
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
76
2. Why Do We Trade? - 2.1 The Law of
Comparative Advantage
77
Derivation of Offer Curves and the
International Equilibrium continued

Figure 6: Derivation of America’s offer curve. At the
Autarkic relative price of food (p), assumed to be equal
to 2, America produces and consumes at E in panel (a),
and trades at the origin of panel (b). At p=3, America
shifts production to Q and consumption to S in panel
(a), and trades at S in panel (b). Similarly, at p=4,
America produces at R and consumes at K in panel (a),
and trades at K in panel (b). Trade triangles SVQ and
KGR are identical to triangles SJO and KLO,
respectively. The locus of all trade points (such as S and
K) in panel (b) is America’s offer curve.
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
78
Derivation of Offer Curves and the
International Equilibrium
Clothing
America’s imports
Britain’s exports
Figure 7
Food
America’s exports
Britain’s imports
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
79
Derivation of Offer Curves and the
International Equilibrium continued

Figure 7: International equilibrium
International equilibrium occurs at K, where the
offer curves intersect. America exports OL units of
food to Britain and imports OL* units of clothing
from Britain. The slope of terms-of-trade line TOT3
gives equilibrium terms of trade OL*/OL.
2. Why Do We Trade? - 2.2 Modern
Trade Theory: Heckscher-Ohlin Model
80
End of Fun!
On next lecture:
2. WHY DO WE TRADE?
- Part II
2. Why Do We Trade?
81