Mankiw 5e Chapter 1: The Science of Macroeconomics

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International Trade Theory Chapter 3. The
Standard Theory of International Trade

• Hyun-Hoon Lee

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OUTLINE

• 3.1 Introduction
• 3.2 The Production Frontier with Increasing
  Costs
• 3.3 Community Indifference Curves
• 3.4 Equilibrium in Isolation
• 3.5 The Basis for and the Gains from Trade
  with Increasing Costs
• 3.6 Trade Based on Differences in Tastes

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3.1 Introduction

• This chapter extends our simple trade model to
  the more realistic case.
• That is, we will introduce the case of increasing
  opportunity costs production frontier.
• Tastes or demand preferences are also introduced
  community indifference curves
• We will then see how these forces of supply and
  demand determine the equilibrium-relative
  commodity price in each nation in the absence of
  trade (i.e., the comparative advantage of each
  nation.)

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3.2 The Production Frontier with Increasing
Costs

• 3.2A. Constant opportunity costs vs. increasing
  opportunity costs

(1) Constant opportunity costs Regardless of
the level of output, the nation must give up the
same amount of one commodity to produce each
additional unit of another commodity. ?
Production frontier is a straight line.
(2) Increasing opportunity costs the nation
must give up more and more of one commodity to
release just enough resources to produce each
additional unit of another commodity. ?
Production frontier is concave from the origin.
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3.2 The Production Frontier with Increasing Costs

• Figure 3.1. Production Frontiers of Nation 1 and
  nation 2 with Increasing Costs

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3.2 The Production Frontier with Increasing
Costs

• 3.2B. The Marginal Rate of Transformation (MRT)

• MRT of X for Y refers to the amount of Y that a
  nation must give up to produce each additional
  unit of X.
• the opportunity cost of X.
• the slope of the production frontier at the
  point of production.

• With increasing opportunity costs, the MRT (i.e.,
  the slope of the production frontier) increases,
  as the production point moves from A to B.
• e.g., MRT 1/4 at point A.
• MRT 1 at point B.

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3.2 The Production Frontier with Increasing
Costs
3.2C. Reasons for Increasing Opportunity Costs
and Different Production Frontiers

• Reasons for Increasing opportunity costs
• (1) factors of production are not homogeneous.
• (2) factors of production are not used in the
  same fixed proportion or intensity in the
  production of all goods.
• Examples

• Reasons for different production frontiers
• (1) different factor endowments
• (2) different technologies in production

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3.3 Community Indifference Curves

• Recall (individual) indifference curve
• Definition a curve that shows the various
  combinations of two goods that yield equal
  satisfaction to an individual consumer.

• Characteristics
• (1) downward sloped
• (2) convex from the origin
• (3) a higher curve refers to a higher level
  of satisfaction
• (4) difference curves do not cross each
  other.

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3.3 Community Indifference Curves

• Community indifference curve
• Definition a curve that shows the various
  combinations of two goods that yield equal
  satisfaction to the community or nation.

• Characteristics
• (1)
• (2)
• (3)
• (4)

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3.3 Community Indifference Curves
3.3A. Illustration of Community Indifference
Curves
Figure 3.2. Community Indifference Curves for
Nation 1 and nation 2.
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3.3 Community Indifference Curves
3.3B. The Marginal Rate of Substitution (MRS)

• MRS of X for Y in consumption refers to the
  amount of Y that a nation could give up for one
  extra unit of X and still remain on the same
  indifference curve.
• the slope of the community indifference
  curve.

• The MRS (i.e., the slope of the community
  indifference curve) decreases as the consumption
  point moves from N to A.
• e.g., MRS at point N.
• MRS at point A.

• Reasons for the decreasing MRS (Explain!)

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3.3 Community Indifference Curves
3.3C. Some difficulties with community
indifference curves

• A different income distribution would result in a
  new set of indifference curves, which might
  intersect previous indifference curves.
• Explain!
• With compensation principle, we can still assume
  that the indifference curves do not intersect
  each other.

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3.4 Equilibrium in Isolation

• In the absence of trade (or autarky), a nation is
  in equilibrium when it reaches the highest
  indifference curve possible given its production
  frontier.
• i.e., A nation is in equilibrium at the point
  where a community indifference curve is tangent
  to the nations production frontier.

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3.4 Equilibrium in Isolation
3.4A. Illustration of Equilibrium in Isolation.
Figure 3.3. Equilibrium in Isolation.
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3.4 Equilibrium in Isolation
3.4B. Equilibrium-Relative Commodity Prices and
Comparative Advantage

• The equilibrium relative prices before trade
• Nation 1 (PX/PY) PA 1/4
• Nation 2 (PX/PY) PA 4/1
• i.e., (PX/PY) lt (PX/PY)
• ? Nation 1 has a comparative advantage in good X
  and Nation 2 has a comparative advantage in good
  Y.

• Case Study 3-1 CA of the U.S., the E.U., and
  Japan

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3.5 The Basis for and the Gains from Trade with
Increasing Costs
3.5A. Illustrations
Figure 3.4. The Gains from Trade with Increasing
Costs
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3.5 The Basis for and the Gains from Trade with
Increasing Costs
3.5B. Equilibrium-Relative Commodity Prices with
Trade

• is the common relative price in both nations at
  which trade is balanced.
• i.e., (PX/PY)e (PX/PY) (PX/PY)
• i.e., in Figure 3.4, Pe PB PB 1

• 3.5C. Incomplete Specialization
• Under constant costs, both nations specialize
  completely in the production of the good of their
  CA. (Recall Figure 2.2 in Chapter 2.)

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3.5 The Basis for and the Gains from Trade with
Increasing Costs

• Under increasing opportunity costs, there is
  incomplete specialization in production in both
  nations. (See Figure 3.4.)
• Case Study 3-2 Specialization and Export
  Concentration in Selected Countries.

• 3.5D. Small-Country Case with Increasing Costs
  (Skip)

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3.5 The Basis for and the Gains from Trade with
Increasing Costs
3.5E. The Gains from Exchange and from
Specialization
Figure 3.5. The Gains from Exchange and from
Specialization
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3.6 Trade Based on Differences in Tastes

• The difference in pretrade-relative commodity
  prices between Nation 1 and Nation 2 (i.e. the
  comparative advantage of a nation) is based on
  the difference in the production frontiers and
  indifference curves in the two productions.
• Thus, either the production frontiers or
  indifference curves can affect the
  pretrade-relative commodity prices (i.e. the
  comparative advantage of a nation).

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3.6 Trade Based on Differences in Tastes

• The cases when the production frontiers are
  different while the indifference curves are
  identical
• (1) The Recardian Model due to the different
  technology
• (2) The Heckscher-Ohlin Model due to the
  resource endowment
• The case when the community indifference curves
  are different while the production frontiers are
  identical The present case.

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3.6 Trade Based on Differences in Tastes
3.6A. Illustration of Trade Based on Differences
in Tastes
Figure 3.6. Trade Based on
Differences in Tastes
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Appendix
A3.1. Production Functions, Isoquants, Isocosts,
and Equilibrium

• Production function a technical function that
  gives the maximum quantities of a commodity that
  a firm can produce with various amounts of factor
  inputs.

• Isoquant a curve that shows the various
  combinations of two factors, say, capital (K) and
  labour (L), that a firm can use to produce a
  specific level of outputs.
• - negatively sloped (why?)
• - convex from the origin (why? decreasing
  MRTSLK)
• - do not cross.(why?)

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Appendix
A3.1. Production Functions, Isoquants, Isocosts,
and Equilibrium - continued

• Marginal rate of technical substitution of labor
  for capital (MRTSLK) the amount of K that the
  firm can give up by increasing L by one unit and
  still remain on the same isoquant.

• Isocost a line that shows the various
  combinations of K and L that a firm can hire for
  a given expenditure.

• Equilibrium

• Expansion path, homogeneous of degree 1, constant
  returns to scale

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Appendix
A3.1. Production Functions, Isoquants, Isocosts,
and Equilibrium - continued
FIGURE 3-7 Isoquants, Isocosts, and Equilibrium.
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Appendix
A3.2. Production Theory with Two Nations, Two
Commodities, and Two Factors
FIGURE 3-8 Production with Two Nations, Two
Commodities, and Two Factors.
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FIGURE 3-9 Derivation of the Edgeworth Box
Diagram and Production Frontier for Nation 1.