CHAPTER T H R E E 3 International

In this chapter: n Production Frontier with Increasing Costs n Community Indifference Curves n

The Production Frontier with Increasing Costs n Increasing Opportunity Costs n A nation must

FIGURE 3 -1 Production Frontiers of Nation 1 and Nation 2 with Increasing Costs.

The Production Frontier with Increasing Costs n The marginal rate of transformation (MRT) increases

Community Indifference Curves n A community indifference curve shows combinations of two commodities that

FIGURE 3 -2 Community Indifference Curves for Nation 1 and Nation 2. Salvatore: International

Community Indifference Curves n The marginal rate of substitution (MRS) falls as more of

Equilibrium in Isolation n Interaction of forces of demand (community indifference curves) and supply

FIGURE 3 -3 Equilibrium in Isolation. Salvatore: International Economics, 10 th Edition © 2010

Equilibrium in Isolation n The equilibrium-relative commodity price in isolation = slope of tangency

Basis for and Gains from Trade with Increasing Costs n Relative commodity price differentials

FIGURE 3 -4 The Gains from Trade with Increasing Costs. Salvatore: International Economics, 10

Basis for and Gains from Trade with Increasing Costs n Equilibrium-relative commodity price with

Basis for and Gains from Trade with Increasing Costs n Under constant cost conditions,

FIGURE 3 -5 The Gains from Exchange and from Specialization. Salvatore: International Economics, 10

Trade Based on Differences in Taste n Even if two nations have identical PPFs,

FIGURE 3 -6 Trade Based on Differences in Tastes. Salvatore: International Economics, 10 th

Case Study 3 -1 Comparative Advantage of the Largest Advanced and Emerging Economies Salvatore:

Case Study 3 -2 Specialization and Export Concentration in Selected Countries Salvatore: International Economics,

Case Study: Badassa’s Revealed Comparative Advantage (RCA) Index n The RCA index of country

Case Study: Badassa’s Revealed Comparative Advantage (RCA) Index - Examples

Appendix to Chapter 3 n Production Functions, Isoquants, Isocosts and Equilibrium n Production Theory

FIGURE 3 -7 Isoquants, Isocosts, and Equilibrium. Salvatore: International Economics, 10 th Edition ©

FIGURE 3 -8 Production with Two Nations, Two Commodities, and Two Factors. Salvatore: International

FIGURE 3 -9 Derivation of the Edgeworth Box Diagram and Production Frontier for Nation

FIGURE 3 -10 Derivation of the Edgeworth Box Diagram and Production Frontier for Nation

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CHAPTER T H R E E 3 International Economics Tenth Edition The Standard Theory Of International Trade Dominick Salvatore John Wiley & Sons, Inc. Salvatore: International Economics, 10 th Edition © 2010 John Wiley & Sons, Inc.

In this chapter: n Production Frontier with Increasing Costs n Community Indifference Curves n Equilibrium in Isolation n Basis for and Gains from Trade with Increasing Costs n Trade Based on Differences in Taste Salvatore: International Economics, 10 th Edition © 2010 John Wiley & Sons, Inc.

The Production Frontier with Increasing Costs n Increasing Opportunity Costs n A nation must give up more and more of one commodity to release just enough resources to produce each additional unit of another commodity. n Increasing cost production possibilities frontier is concave to the origin (not a straight line). Salvatore: International Economics, 10 th Edition © 2010 John Wiley & Sons, Inc.

The Production Frontier with Increasing Costs n The marginal rate of transformation (MRT) increases as more units of good X are produced. The marginal rate of transformation is another name for opportunity cost. n The value of MRT is given by the slope of the PPF. n Salvatore: International Economics, 10 th Edition © 2010 John Wiley & Sons, Inc.

Community Indifference Curves n A community indifference curve shows combinations of two commodities that yield equal satisfaction to the community or nation. n Represent measure of taste and preference. n Characteristics of community indifference curves: n The higher the curve, the greater the utility. n Negative slope, convex to the origin. n Different curves do not cross. Salvatore: International Economics, 10 th Edition © 2010 John Wiley & Sons, Inc.

Community Indifference Curves n The marginal rate of substitution (MRS) falls as more of good X is consumed. n The MRS of X for Y in consumption is the amount of Y that a nation could give up for one extra unit of X and still remain on the same indifference curve. Salvatore: International Economics, 10 th Edition © 2010 John Wiley & Sons, Inc.

Equilibrium in Isolation n Interaction of forces of demand (community indifference curves) and supply (production possibilities frontier) determine equilibrium nation in the absence of trade (autarky). for a n Nations seek the highest possible indifference curve, given its production constraint. Salvatore: International Economics, 10 th Edition © 2010 John Wiley & Sons, Inc.

Equilibrium in Isolation n The equilibrium-relative commodity price in isolation = slope of tangency between PPF and indifference curve at autarky point of production and consumption. n Relative prices are different in Nation 1 and Nation 2 because of different shape and location of PPF’s and indifference curves. Salvatore: International Economics, 10 th Edition © 2010 John Wiley & Sons, Inc.

Basis for and Gains from Trade with Increasing Costs n Relative commodity price differentials between two nations reflect comparative advantages, and form basis for mutually beneficial trade. n Each nation should specialize in the commodity they can produce at the lowest relative price. n Specialization will continue until relative prices equalize between nations. Salvatore: International Economics, 10 th Edition © 2010 John Wiley & Sons, Inc.

Basis for and Gains from Trade with Increasing Costs n Equilibrium-relative commodity price with trade = common relative price at which trade is balanced. n Balanced trade: quantity of X (Y) Nation 1(2) wants to export = quantity of X(Y) Nation 2(1) wants to import. n Any other relative price could not persist because trade would be unbalanced. Salvatore: International Economics, 10 th Edition © 2010 John Wiley & Sons, Inc.

Basis for and Gains from Trade with Increasing Costs n Under constant cost conditions, specialization is complete. n Under increasing cost conditions, specialization is incomplete: n As production moves along PPF toward comparative advantage good, relative costs change, thus changing basis and gains from trade. Salvatore: International Economics, 10 th Edition © 2010 John Wiley & Sons, Inc.

Trade Based on Differences in Taste n Even if two nations have identical PPFs, basis for mutually beneficial trade will still exist if tastes, or demand preferences, differ. n Nation with relatively smaller demand for X will have a lower autarky relative price for, and comparative advantage, in X. Salvatore: International Economics, 10 th Edition © 2009 John Wiley & Sons, Inc.

Case Study: Badassa’s Revealed Comparative Advantage (RCA) Index n The RCA index of country i for product: n RCAij = (xij/Xi) / (xwj/Xw) where xij and xwj are the values of country i’s exports of product j and world exports of product j and where Xi and Xw refer to the country’s total exports and world total exports. n A value of less than unity implies that the country has a revealed comparative disadvantage in the product. Similarly, if the index exceeds unity, the country is said to have a revealed comparative advantage in the product.

Case Study: Badassa’s Revealed Comparative Advantage (RCA) Index - Examples

Appendix to Chapter 3 n Production Functions, Isoquants, Isocosts and Equilibrium n Production Theory with Two Nations, Two Commodities, and Two Factors n The Edgeworth Box and Production Frontiers Salvatore: International Economics, 10 th Edition © 2010 John Wiley & Sons, Inc.