Analysis of Trade Under Constant Cost of Production

in Each country

Consider two commodities Cloth (C) and Wheat (W)

C Two Countries UK and USA
Pr(UK) Assumptions: Constant cost of
production and countries are
approximately of same size.

Pr(USA)
USA has comparative advantage in
production of wheat and UK in
W cloth.
International exchange ratio will be determined
somewhere in between two domestic price lines. In
this case the dotted lines.
 C
Pdn UK’s Import
(UK)
UK’s Export
US Consumption Point

US Import
W
Pdn(US)

US Export
UK’s Consumption Point
World is One Market: Movement of Relative Price
The Equations of Exchange
Demand =D, Production =x
Equilibrium Two products f, c; home country price: Pc and Pf,
foreign country price: P*c and P*f, relative price= p

Each Country’s aggregate demand is restricted,

and equal to the value of endowment

Home country is importing food; left side is

import demand and right side exports

Terms of trade is price of f divided by price of c; p is relative

price of food (f); p is also world market clearing price

Free trade market equilibrium ensures

world demand and supply are equal

Free trade equilibrium ensures value of home

country import is equal to value of foreign
country imports.. BoP is in equlibrium
Effect of Country size

•When countries are of unequal size, then even though the small
country completely specialises in one commodity, (say cloth) it
will not be in a position to satisfy the total world demand for
cloth, specially the demand for cloth by the large country.
•So even after trade opens up the larger country will have to
continue producing both the goods at the prevailing cost
condition domestically.
•International terms of trade is expected to coincide with the
domestic pre-trade exchange ratio of the large country. As a
result the large country will be the price maker in the
international market while small country acts as a price taker.
Relative demand, Relative Supply and Price difference in two
countries
Effect of Country size • As country size differs small country
derives the whole gain from international
trade and large country derives no gain
C •This is however an extreme case. In
general we can make the proposition that
Pdn(UK)
as country size differs the international
D price line happens to remain closer to
domestic price line of the larger country
C Pdn(US)and small country derives more gain from
trade.
A
W
A= Autarky position in UK
C= Consumption of UK after Trade
D= Consumption of US after Trade
Trade under Increasing Cost of Production

•In this case each country will tend to specialise

incompletely in the production of the good in which it has
comparative advantage. This may be due to the fact that as
the country increases the output of the commodity in
which it specialises, its cost of producing that commodity
will increase. It may happen that due to sharp rise in the
cost of production, the country loses its comparative
advantage before complete specialisation. So, both the
countries will continue to produce both the commodities.
 Trade under Increasing Cost of Production

C C

F D
M
E B
A

W W
A: Pre trade Equilibrium B: Pre trade Equilibrium
M: Post Trade Production Point D: Post Trade Production Point
E: Post Trade Consumption Point F: Post Trade Consumption Point
 Gains from Trade

•Total Gains= Gains Due to Exchange +Gains due to

Specialisation

An exchange gain is possible as trade enables the

country to modify the consumption bundle than
autarky.

Specialisation gain is possible as trade facilitates

change of production pattern and therby
specialisation in Production.
Gains from Trade D: Autarky Point
C P= Post Trade Production Point
E1 E
E= Post Trade Consumption Point
D to E is total gain from Trade
D E 1
= Post Trade Consumption point
when change in production is not
possible.
To understand Exchange gain let
P us assume factors of production
are completely immobile among
W sectors. So the production point is
still D after the opening up of trade
Now, relax the assumption. and country is facing the
Country will change its international price ratio. So, E1 will
production pattern; produce at P be new consumption point.D to E1
and consume at E. E1 to E is is exchange gain.
specialisation gain.
Immiserising Growth Hypothesis
By J. Bhagwati
Computers (Import)

B
D

A
tt2
tt1

Coffee(export)