Class Outline

1
Class Outline

• Increasing Marginal Costs
• PPC with Increasing Marginal Costs
• Community Indifference Curves
• Production and Consumption Together
• No Trade
• Free Trade
• The Gains from Trade
• The Heckscher-Ohlin (H-O) Theory (Introduction)

2
Increasing Marginal Costs

• Modern theories of International Trade assume
  Increasing Marginal Costs
• As one industry expands at the expense of others,
  increasing amounts of the other products must be
  given up to get each extra unit of the expanding
  industrys product.
• PPC curves looks bowed out

3
PPC with Increasing Costs
Wheat (billions of bushels per year)
U.S. Production Possibility Curve
80
S0 Slope1 bushel per yard
50
S1 Slope2 bushel per yard
S2 Slope3 bushel per yard
Cloth (billions of yards per year)
20
40
60
Cost of an extra yard (bushels per year)
Rising Opportunity Cost for producing Cloth in
the U.S.
3.0
2.0
Supply curve for cloth in the United States
(opportunity cost curve, or marginal cost curve)
1.0
Cloth (billions of yards per year)
60
40
20
4
Increasing Cost

• Marginal Cost of producing Cloth
• 20 billion yards?extra yard1 bushel of Wheat
• 40 billion yards?extra yard2 bushels of Wheat
• 60 billion yards?extra yard3 bushels of Wheat
• Marginal Cost of producing Wheat
• 0 billion bushels?extra bushel1/3 yard of Cloth
• 50 billion bushels?extra bushel1/2 yard of Cloth
• 80 billion bushels?extra bushel1 yard of Cloth

5
Whats Behind the PPC?

• Several kinds of factor inputs (land, skilled
  labor, unskilled labor, capital)
• Different products use factor inputs in different
  proportions
• Example Wheat uses relatively more land and less
  labor than cloth. This basic variation in input
  proportion can set up an increasing cost
  production possibility curve.

6
Community Indifference Curves

• We need to describe the demand side of the
  economy
• Individuals receive well-being from the
  consumption of goods and services
• In order to measure the level of well being
  economists use Indifference Curves

7
Indifference Curve

• Indifference curve shows the various combinations
  of consumption quantities (wheat and cloth) that
  lead to the same level of well-being of happiness.

8
Indifference Curve
Bushels of wheat consumed
A
80
Better
60
B
40
C
Worse
20
Yards of cloth consumed
20
40
100
9
Consumer Budget Constraint
Example Assume that Y/Pw100 and Pc/Pw1.25,
then ...
10
Budget Constraint
Bushels of wheat consumed
100
Yards of cloth consumed
80
11
Indifference Curve
Bushels of wheat consumed
I2
I1
I0
100
80
D
60
40
20
Yards of cloth consumed
20
40
80
12
Problems of Indifference Curves

• First Shapes of Indifference curves vary from
  individual to individual
• Second the concept of national well-being or
  welfare is not well defined. Levels of
  satisfaction are difficult to compare between
  individuals

13
Production and Consumption
Wheat (billions of bushels per year)
I2
Without Trade
I1
I0
80
50
Cloth (billions of yards per year)
40
20
14
Production and Consumption
I2
Wheat (billions of bushels per year)
Wheat (billions of bushels per year)
I1
I1
C1
I2
80
55
S1
50
C1
S0
30
40
S0
15
S1
20
40
60
Cost of an extra yard (bushels per year)
60
80
100
Cloth(billions of yards per year)
Cloth(billions of yards per year)
SUS
3.0
3.0
DF
SF
2.0
A
Cloth Exports
B
1.0
1.0
Cloth Imports
DUS
0.67
20
40
60
60
80
100
Cloth (billions of yards per year)
Cloth
15
Gains from Trade

• First Both countries consume more than during
  no-trade (C1 compared with S0)
• Second Both communities can reach a higher
  community indifference curve (I2 compared with
  I1)
• Third how much is the gain of trade depends on
  the relative international prices.
• Higher price for exports relative to imports
• International term of trade (Price of
  Exports/Price of Imports)

16
Heckscher-Ohlin (H-O) Theory

• The Heckscher-Ohlin theory predicts that a
  country exports the product(s) that use its
  abundant factor(s) intensively and imports the
  product(s) using its scarce factor(s) intensively.

17
Heckscher-Ohlin (H-O) Theory

• A country is relatively labor-abundant if it has
  a higher ratio of labor to other factors than
  does the rest of the world
• A product is relatively labor-intensive if labor
  costs are a greater share of its value than they
  are of the value of other products

18
Heckscher-Ohlin (H-O) Theory

• In our example,
• the H-O theory predicts that the U.S. exports
  wheat and imports cloth because wheat is
  land-intensive and cloth is labor intensive and