Chapter 23 Gains from International Trade Chapter 23 Gains from International Trade

Pre-trade production and consumption possibilities Cloth (metres m) Wheat (kilos m) a Less developed Country, population 500

Cloth (metres m) Wheat (kilos m) a b Less developed country Pre-trade production and consumption possibilities

Cloth (metres m) Wheat (kilos m) a b c d e f Less developed country Pre-trade production and consumption possibilities

Cloth (metres m) Wheat (kilos m) Pre-trade production and consumption possibilities This is just like an ordinary budget constraint : Remember if M=P x X+P Y Y And the slope =-P x /P y

Cloth (metres m) Wheat (kilos m) Pre-trade production and consumption possibilities Except now it is the budget constraint of a country. GNP=2W+1C And the slope= -P C /P W =-2/1

Cloth (metres m) Wheat (kilos m) Pre-trade production and consumption possibilities 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) Pre-trade production and consumption possibilities

Cloth (metres m) Wheat (kilos m) Cloth (metres m) Less developed country Developed Country Population 300 Pre-trade production and consumption possibilities

Cloth (metres m) Wheat (kilos m) Developed country Pre-trade production and consumption possibilities Similarly the “budget constraint” of this country is : GNP=4W+8C And the slope=-P C /P W = -4/8=-1/2

Cloth (metres m) Wheat (kilos m) Developed country Pre-trade production and consumption possibilities And again tastes in this country are represented by a social indifference curve

Cloth (metres m) Wheat (kilos m) a b c d e f Cloth (metres m) g h i j k l m Less developed country Developed country Slope -2/1 Slope -1/2 Pre-trade production and consumption possibilities

Cloth (metres m) Wheat (kilos m) a b c d e f Cloth (metres m) g h i j k l m Less developed country Developed country Slope -2/1 Slope-1/2 Pre-trade production and consumption possibilities Developed countries relative pre-trade price =P c /P w =1/2 Less-Developed countries relative pre- trade price =P c /P w = 2

Cloth (metres m) Wheat (kilos m) a b c d e f Cloth (metres m) g h i j k l m Less developed country Developed country Slope -2/1 Slope -1/2 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)

Cloth (metres m) Wheat (kilos m) a b c d e f Cloth (metres m) g h i j k l m Less developed country Developed country Slope -2/1 Slope -1/2 If we now allow free trade between the two countries, the free trade price must lie between the two sets of AUTARKY prices

Cloth (metres m) Wheat (kilos m) a b c d e f Cloth (metres m) g h i j k l m Less developed country Developed country Slope -2/1 Slope -1/2 If we now allow free trade between the two countries, the free trade price must lie between the two sets of AUTARKY prices

Effect of trade on consumption possibilities Cloth (metres m) Wheat (kilos m) Cloth (metres m) Less developed country Developed country

Effect of trade on consumption possibilities Wheat (kilos m) Cloth (metres m) Wheat (kilos m) Cloth (metres m) Less developed country Developed country Slope 1/1 Possibilities have clearly risen So can’t be worse off!!

Effect of trade on consumption possibilities Cloth (metres m) Wheat (kilos m) Cloth (metres m) Less developed country Developed country Imports 600 Exports600 Imports Exports 600 x y

THE 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 trade O Good 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

Equilibrium before trade O Good 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)

Equilibrium before trade O Good m Good x Production possibility 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

Equilibrium before trade O Good m Good x Production possibility curve Slope = -MC x / MC m = -MRT

O Good m Good x Social indifference curves I3I3 I2I2 I1I1 Equilibrium before trade

O Good m Good x I3I3 I2I2 I1I1 Autarky Price ratio Slope = -P x / P m Equilibrium before trade

At P 1 C 1 MC x P x MU x = MC m P m MU m O Good m Good x I3I3 I2I2 I1I1 P1C1P1C1 Equilibrium before trade

Equilibrium with trade O Good m Good x I3I3 I2I2 World price ratio P2P2 MC x P x T = MC m P m T P1C1P1C1

O Good m Good x I3I3 I2I2 World price ratio MU x P x T = MU m P m T C2C2 P1C1P1C1 P2P2 Equilibrium with trade

O Good m Good x I3I3 I2I2 World price ratio Imports P1C1P1C1 P2P2 C2C2 MCMC MPMP D Equilibrium with trade

O Good m Good x I3I3 I2I2 World price ratio Imports Exports P1C1P1C1 P2P2 C2C2 MCMC MPMP XCXC XPXP D Equilibrium with trade

O Good m Good x I3I3 I2I2 World price ratio C2C2 P1C1P1C1 P2P2 Reason for trade IF Prices Differ Then Trade Is Profitable for All

Why might prices differ? Different technology or physical capabilitiesDifferent technology or physical capabilities –(Land/Minerals) Differences in Factor EndowmentsDifferences in Factor Endowments –Labour/Capital Different tastesDifferent tastes –(same Technology & Factors) Differences in Taxes or competitionDifferences in Taxes or competition –(Monopoly pushes prices up)