Kinh Te Quoc Te Vu Thanh Huong Chapter 03 The Standard Theory of International Trade

Chapter 3
The Standard Theory of

International Trade
1
Last lecture review

Basis for trade/ Gains from trade/ Pattern of trade
Mercantilism/ Zero –sum game/ Government intervention/Trade
surplus
Absolute advantage/Theory of absolute advantage
Laissez-faire
Comparative advantage/Theory of comparative advantage
Labor theory of value
OC/Formula
PPF
Constant OC
PPF under constant OC/Identify Comparative Advantage based
on PPF
Internal relative commodity prices (pre-trade relative commodity
price – autarky relative commodity price)
The range of relative commodity price for mutual benefits
Complete specialization
Consumption and production points before and after trade
2
Lecture overview
PPF with increasing opportunity costs
Community Indifference Curve
Equilibrium in Isolation
Gains from trade with increasing costs
1
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PPF with increasing
opportunity costs
Increasing Opportunity Costs (IOPs)

Concept of IOCs
IOCs means that the nation must give up more and more
of one commodity to release just enough resources to
produce each additional unit of another commodity.
E.g: country A
Wheat Cloth
(million ton/year) (million meter/year)
180 0
30
150 20
40
110 40
50
60 60
60
0 80
Reason for IOCs

Factors of production are not homogenous
Factors of production are not used in the
same fixed proportion or intensity
E.g: learning and playing
E.g: rice and milk production
2
Illustration of IOCs
PPF is concave from the origin
Compare to constant OP?
Y Y
140 B’
Nation 1 120 Nation
100 2
A
80
60
40 A’
B
20
50 70 90 110 130 140 X
• For each additional batch of 20X N1 must give

up more and more Y.
• For each additional batch of 20Y N2 must give
up more and more X. 7
Marginal Rate of Transformation (MRT)
MRT of X for Y: the amount of Y that a

nation must give up to produce each
additional unit of X
MRT = OCs of X
OCs of X = absolute slope of PPF at
the point of production
MRT = (absolute) slope of PF at the
point of production
Marginal Rate of Transformation

(MRT) – cont.
E.g: Nation A
Y
Opportunity
Nation 1 Costs
MRTA = ¼ Increasing
A
B MRTB = 1
50 70 90 110 130 140 X
3
(MRT) – cont.
Y MRTB’ = 1
Nation 2 Opportunity
140 B’ Costs
120 Increasing
100
80
60
40
20 A’ MRTA’ = 4
X
10

(MRT) – cont.
MRTY/X = OC of producing X
∆Y Figure 3.1
MRT =
∆X
Y/X Y
a
MRTX/Y = ∆Y=1
∆X=1 b
OC of producing Y ∆Y=2
∆X ∆X=1
MRT X/Y =
∆Y X
11
COMMUNITY INDIFFERENCE CURVE
12
4
Concept of CICs
Community Indifference curves (CICs):
various combinations of two commodities that yield equal
satisfaction to the community or nation.
Y II
I Satisfaction
at point A
and B
10 •A
5 • B
6 8
X
13
Characteristics of CICs
CIC refers to level of satisfaction
Higher CIC means higher or greater level of satisfaction.
CICs are negatively slope
CICs are convex from the origin.
CICs must not cross.
III
Y II
I
Pay
•D off
Level of
•A •C satisfaction
increasing
• B
X 14
Illustration of CICs
Why are CICs of two nations different?
15
5
Marginal Rate of Substitution
How to identify the amount of Y a Nation musts give up in order to
consume one additional unit of X so that the satisfaction remains
the same ?
Marginal Rate Of Substitution (MRS)
• MRS of X for Y (MRSY/X) in consumption: the

amount of Y that a nation could give up for one extra
unit of X and still remain on the same indifferent
curve.
• MRSY/X = 1.5???
16
Marginal Rate of Substitution (cont.)

MRS is measured by the (absolute) slope of CIC at
the point of consumption
When moving from left to right, how will MRS

change?
MRS declines as the Nation moves down the curve.
What doest it means?
as more of X is consumed, each additional unit becomes worth
less in consumption
as less of Y is consumed, each additional unit becomes worth
more in consumption
CIC is convex from the origin
Compare with PPF and MRT?
17
EQUILIBRIUM IN ISOLATION
18
6
A = Equilibrium Reach the highest A Nation is in
of N1 CIC possible given Equilibrium
its PPF
Maximum social A
welfare 70
60
20
Reflection of supply- 50 130 X

demand relation
PPF - supply
CICs - demand 19
Only one point of

equilibrium
FIGURE 3-3 Equilibrium in Isolation.
20
Equilibrium – relative commodity price and

comparative advantage
The equilibrium - relative commodity price of a Nation is
given by the slope of the common tangent to its PPF and
its highest IC at the autarky point of production and
consumption.
Identify equilibrium – relative commodity price of
Nation 1?
PA = PX/PY = 1/4
Nation 2?
PA’ = PX/PY = 4
Which country has comparative advantage in producing

good X? good Y?
Nation 1: good X
21
Nation 2: good Y
7
Gains from trade with increasing costs
22
Basis for and Gains from trade

Difference in relative commodity price: a reflection of
their comparative advantage => basis for mutually
beneficial trade PA1 and PA2 :
pre-trade
PA1 (PX/PY)1 < PA2 (PX/PY)2 relative
prices
N1 has CA in X N2 has CA in Y
N 1 specializes in N 2 specializes in
production of X production of Y
N 1 exports X N2 exports Y
What happens next?

23
For trade to
take place Basis for and Gains from trade
and benefit
both International Trade
countries,
how much N1 exports good X N2 exports good Y
the common
relative
price?
PA1 PA2
How do Each Nation faces IOCs
relative price
of good X in
Relative Price in both
Nation 1 and
Nations are equal
Nation 2
change ?
International trade
are in equilibrium
Both Nations consume more

than without Trade 24
8
Illustration of the basis for
and gains from trade
Y
140
120 B'
60
40 A'
40 80 100 X
With trade N2 moves from point A’ to point B’ faces IOCs in

production additional unit of Y. The slope of PPF is smaller.
25

and gains from trade
Nation 1 Nation 2
Y
Y
140
PA = 1/4
80
120 B' PB’= 1
A
60
60
A'
B PB=1 40 PA’ = 4
20
50 70 130 150 X 40 80 100 X
The process of specialization continues until the relative prices of two

nations are equal. At that price international trade is in equilibrium. =>
PB = PB’ = 1
26

and gains from trade (cont.)
For trade to take place and result in mutual
benefit, what is the range of common relative
price?
What is the common relative price that yields
equal benefit?
What are the production points before and after
trade of each nation?
What are the consumption points before trade of
each nation?
On which lines/curves do two consumption
points after trade of each nation lie?
27
9
Y
I
E
80
A III
60
C
20 B PB=1
50 70 130 150 X
BE: trade line.

With trade N1 moves from point A (50X, 60Y) -> point B (130X, 20Y).
Then N1 exchanges 60X for 60Y of N2 => N1 consumes at E (70X, 80Y)
on the CIC III. N1 gains 20X and 20Y
28

Y
140
120 B' PB’= 1
60 E'
40 A' III'
40 80 100 X
B’E’: trade line.
With trade, N2 moves up from point A’ -> point B’ (40X, 120Y).
Then N2 exchanges 60Y for 60X => N2 consumes at E’ (100X,
60Y) on the CIC II’I. N2 gains 20X and 20Y
29

With trade, consumption of two Nations

increases.
With trade, each Nation can consume at
the point that above its PPF
30
10
Equilibrium – Relative Commodity Prices
with Trade
The equilibrium – relative price with trade
is common relative price in both nation at
which trade is balanced
There is only one price at which trade is
balanced.
PB = PB’ = 1?
31
Equilibrium – Relative Commodity Prices

with Trade
Trial & Error method
Trial: suppose equilibrium relative price with trade is
Px/Py = 2
N1 wants to export more X
N2 wants to import less X
=> Px/Py reduces toward Px/Py= 1
Trial: suppose Px/Py = ½
N1 wants to export less X
N2 wants to import more X
=> Px/Py increases towards Px/Py= 1

=>> International trade is balanced at Px/Py =1
32
Key words
Increasing OCs
MRT
Community Indifference Curve
MRS
Autarky
Equilibrium in isolation
Equilibrium – relative commodity price in isolation (Pre-trade relative
price)
Equilibrium with trade
Equilibrium – relative commodity price with trade (common relative
price)
The range of possible common relative prices
Trade is balanced
33
11
END OF THE CHAPTER
THANK YOU
34
12

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Chapter 3

The Standard Theory of

Last lecture review

Increasing Opportunity Costs (IOPs)

Reason for IOCs

50 70 90 110 130 140 X

• For each additional batch of 20X N1 must give

Marginal Rate of Transformation (MRT)

MRT of X for Y: the amount of Y that a

Marginal Rate of Transformation

50 70 90 110 130 140 X

Marginal Rate of Transformation

COMMUNITY INDIFFERENCE CURVE

Why are CICs of two nations different?

Marginal Rate Of Substitution (MRS)

• MRS of X for Y (MRSY/X) in consumption: the

Marginal Rate of Substitution (cont.)

When moving from left to right, how will MRS

Reflection of supply- 50 130 X

Only one point of

FIGURE 3-3 Equilibrium in Isolation.

Equilibrium – relative commodity price and

Which country has comparative advantage in producing

Basis for and Gains from trade

What happens next?

Both Nations consume more

With trade N2 moves from point A’ to point B’ faces IOCs in

Illustration of the basis for

50 70 130 150 X 40 80 100 X

The process of specialization continues until the relative prices of two

Illustration of the basis for

BE: trade line.

Illustration of the basis for

Illustration of the basis for

With trade, consumption of two Nations

Equilibrium – Relative Commodity Prices

=> Px/Py increases towards Px/Py= 1

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