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Title: Mankiw 5e Chapter 1: The Science of Macroeconomics


1
International Trade Theory Chapter 3. The
Standard Theory of International Trade
  • Hyun-Hoon Lee

2
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

3
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.)

4
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.
5
3.2 The Production Frontier with Increasing Costs
  • Figure 3.1. Production Frontiers of Nation 1 and
    nation 2 with Increasing Costs

6
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.

7
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

8
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.

9
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)

10
3.3 Community Indifference Curves
3.3A. Illustration of Community Indifference
Curves
Figure 3.2. Community Indifference Curves for
Nation 1 and nation 2.
11
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!)

12
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.

13
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.

14
3.4 Equilibrium in Isolation
3.4A. Illustration of Equilibrium in Isolation.
Figure 3.3. Equilibrium in Isolation.
15
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

16
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
17
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.)

18
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)

19
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
20
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).

21
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.

22
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
23
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?)

24
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

25
Appendix
A3.1. Production Functions, Isoquants, Isocosts,
and Equilibrium - continued
FIGURE 3-7 Isoquants, Isocosts, and Equilibrium.
26
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.
27
FIGURE 3-9 Derivation of the Edgeworth Box
Diagram and Production Frontier for Nation 1.
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