Chapter 23 Gains from International Trade

Chapter 23Gains from

International Trade

Chapter 23Gains from

International Trade

Pre-trade production and consumption possibilitiesPre-trade production and consumption possibilities

Cloth (metres m)

Whe

at (

kilo

s m

)

0

200

400

600

800

1000

0 200 400 600 800 1000

a

Less developedCountry, population 500

Less developed country Developed country

Wheat(kilos m)

Cloth(metres m)

Wheat(kilos m)

Cloth(metres m)

abcdef

1000 800 600 400 200 0

0100200300400500

ghIjklm

12001000 800 600 400 200 0

0 400 8001200160020002400

Cloth (metres m)


Wheat(kilos m)

Cloth(metres m)

Wheat(kilos m)

Cloth(metres m)

abcdef

1000 800 600 400 200 0

0100200300400500

ghIjklm

12001000 800 600 400 200 0

0 400 8001200160020002400

Whe

at (

kilo

s m

)

0

200

400

600

800

1000

0 200 400 600 800 1000

a

b Less developedcountry


Cloth (metres m)


Wheat(kilos m)

Cloth(metres m)

Wheat(kilos m)

Cloth(metres m)

abcdef

1000 800 600 400 200 0

0100200300400500

ghIjklm

12001000 800 600 400 200 0

0 400 8001200160020002400

Whe

at (

kilo

s m

)

0

200

400

600

800

1000

0 200 400 600 800 1000

a

b

c

d

e

f

Less developedcountry


Cloth (metres m)

Whe

at (

kilo

s m

)

0

200

400

600

800

1000

0 200 400 600 800 1000


This is just like an ordinary budget

constraint :

Remember if M=PxX+PYY

And the slope =-Px/Py

Cloth (metres m)

Whe

at (

kilo

s m

)

0

200

400

600

800

1000

0 200 400 600 800 1000


Except now it is the budget constraint of a

country.

GNP=2W+1C

And the slope= -PC/PW=-2/1

Cloth (metres m)

Whe

at (

kilo

s m

)

0

200

400

600

800

1000

0 200 400 600 800 1000


And just like with a consumer we can

represent a country’s tastes by indifference

curves (social indifference curves).

Cloth (metres m)


Wheat(kilos m)

Cloth(metres m)

Wheat(kilos m)

Cloth(metres m)

abcdef

1000 800 600 400 200 0

0100200300400500

ghIjklm

12001000 800 600 400 200 0

0 400 8001200160020002400

Whe

at (

kilo

s m

)

0

200

400

600

800

1000

0 200 400 600 800 1000


Cloth (metres m)


Wheat(kilos m)

Cloth(metres m)

Wheat(kilos m)

Cloth(metres m)

abcdef

1000 800 600 400 200 0

0100200300400500

ghIjklm

12001000 800 600 400 200 0

0 400 8001200160020002400

Whe

at (

kilo

s m

)

0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Whe

at (

kilo

s m

)

Cloth (metres m)


DevelopedCountry

Population300


0

200

400

600

800

1000

0 200 400 600 800 1000

Cloth (metres m)

0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Whe

at (

kilo

s m

)

Developedcountry


Similarly the “budget constraint” of this

country is :

GNP=4W+8C

And the slope=-PC/PW=-4/8=-1/2

Cloth (metres m)

0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Whe

at (

kilo

s m

)

Developedcountry


And again tastes in this country are represented by a social indifference

curve

0

200

400

600

800

1000

0 200 400 600 800 1000

Cloth (metres m)


Wheat(kilos m)

Cloth(metres m)

Wheat(kilos m)

Cloth(metres m)

abcdef

1000 800 600 400 200 0

0100200300400500

ghIjklm

12001000 800 600 400 200 0

0 400 8001200160020002400

Whe

at (

kilo

s m

)

a

b

c

d

e

f0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Whe

at (

kilo

s m

)

Cloth (metres m)

gh

ij

kl

m


Developedcountry

Slope -2/1 Slope -1/2


0

200

400

600

800

1000

0 200 400 600 800 1000

Cloth (metres m)

Whe

at (

kilo

s m

)

a

b

c

d

e

f0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Whe

at (

kilo

s m

)

Cloth (metres m)

gh

ij

kl

m


Developedcountry

Slope -2/1 Slope-1/2


Developed countries relative pre-trade price =Pc/Pw=1/2

Less-Developed countries relative pre-trade price =Pc/Pw= 2

0

200

400

600

800

1000

0 200 400 600 800 1000

Cloth (metres m)

Whe

at (

kilo

s m

)

a

b

c

d

e

f0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Whe

at (

kilo

s m

)

Cloth (metres m)

gh

ij

kl

m


Developedcountry


So C is relatively cheap in the Developed countries (it has a comparative advantage in cloth)

And relatively expensive in the Less-Developed countries where wheat is relatively cheaper (and it

has a comparative advantage in wheat)

0

200

400

600

800

1000

0 200 400 600 800 1000

Cloth (metres m)

Whe

at (

kilo

s m

)

a

b

c

d

e

f0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Whe

at (

kilo

s m

)

Cloth (metres m)

gh

ij

kl

m


Developedcountry


If we now allow free trade between the two countries, the free trade price must lie between the

two sets of AUTARKY prices

2

1

P

P2

TW

TC

0

200

400

600

800

1000

0 200 400 600 800 1000

Cloth (metres m)

Whe

at (

kilo

s m

)

a

b

c

d

e

f0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Whe

at (

kilo

s m

)

Cloth (metres m)

gh

ij

kl

m


Developedcountry


If we now allow free trade between the two countries, the free trade price must lie between the

two sets of AUTARKY prices

1P

PSuppose

TW

TC

0

200

400

600

800

1000

0 200 400 600 800 10000

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Effect of trade on consumption possibilitiesEffect of trade on consumption possibilities

Cloth (metres m)

Whe

at (

kilo

s m

)

Whe

at (

kilo

s m

)

Cloth (metres m)


1P

PSuppose

TW

TC

Effect of trade on consumption possibilitiesEffect of trade on consumption possibilitiesW

heat

(ki

los

m)

0

200

400

600

800

1000

0 200 400 600 800 10000

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Cloth (metres m)

Whe

at (

kilo

s m

)

Cloth (metres m)


Slope 1/1 Slope 1/1

Possibilities have clearly risen

So can’t be worse off!!

0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

0

200

400

600

800

1000

0 200 400 600 800 1000

Effect of trade on consumption possibilitiesEffect of trade on consumption possibilities

Cloth (metres m)

Whe

at (

kilo

s m

)

Whe

at (

kilo

s m

)

Cloth (metres m)


Imports

600

Exports600

600

Imports

Exports

600

x

y

THE ADVANTAGES OF TRADETHE ADVANTAGES OF TRADE

• The law of comparative advantage

– specialisation as the basis for trade

– the gains from trade based on comparative advantage

A more solid and general way of looking at this is by looking at Production Possibility Frontiers:

• The law of comparative advantage

– specialisation as the basis for trade

– the gains from trade based on comparative advantage

A more solid and general way of looking at this is by looking at Production Possibility Frontiers:

Equilibrium before tradeEquilibrium before trade

O

Go

od

m

Good x

Previously could switch workers from cloth to

wheat at the same rate

e.g. in Developed Country at rate of 8 cloth to 4

wheat


O

Go

od

m

Good x

But more likely the productivity of workers would decline as more

and more were switched

From Cloth

(Export good x)

to wheat

(import good M)


O

Go

od

m

Good x

Productionpossibility curve

So rate declines as output of cloth falls and

wheat rises

So shape of country’s

production possibilities is

not a straight line but a curve


O

Go

od

m

Good x

Productionpossibility curve

Slope = -MCx / MCm = -MRT

O

Go

od

m

Good x

Socialindifference

curves

I3

I2

I1


O

Go

od

m

Good x

I3

I2

I1Autarky Price ratio

Slope = -Px / Pm


At P1C1

MCx Px MUx= =

MCm Pm MUm

O

Go

od

m

Good x

I3

I2

I1

P1C1


EquilibriumEquilibrium with with tradetrade

O

Go

od

m

Good x

I3

I2

World price ratio

P2

MCx PxT

= MCm Pm

T

P1C1

O

Go

od

m

Good x

I3

I2

World price ratio

MUx PxT

= MUm Pm

T

C2

P1C1

P2


O

Go

od

m

Good x

I3

I2

World price ratio

ImportsP1C1

P2

C2MC

MP D


O

Go

od

m

Good x

I3

I2

World price ratio

Imports

Exports

P1C1

P2

C2MC

MP

XC XP

D


O

Go

od

m

Good x

I3

I2

World price ratio

C2

P1C1

P2

Reason for tradeReason for trade

IF Prices Differ IF Prices Differ Then Trade Is Then Trade Is

Profitable for AllProfitable for All

Why might prices differ?Why might prices differ?

• Different technology or physical capabilitiesDifferent technology or physical capabilities– (Land/Minerals)(Land/Minerals)

• Differences in Factor EndowmentsDifferences in Factor Endowments– Labour/CapitalLabour/Capital

• Different tastes Different tastes – (same Technology & Factors)(same Technology & Factors)

• Differences in Taxes or competitionDifferences in Taxes or competition– (Monopoly pushes prices up)(Monopoly pushes prices up)

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Chapter 23 Gains from International Trade