Chapter 23 Gains from International Trade

1. Chapter 23 Gains from International Trade

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

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

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

5. Pre-trade production and consumption possibilities This is just like an ordinary budget constraint : Remember if M=PxX+PYY And the slope =-Px/Py Wheat (kilos m) Cloth (metres m)

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

7. 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). Wheat (kilos m) Cloth (metres m)

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

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

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

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

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

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

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

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

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

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

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

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

20. 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:

21. Equilibrium before trade 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 Good m O Good x

22. Equilibrium before trade 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) Good m O Good x

23. Equilibrium before trade 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 Good m Production possibility curve O Good x

24. Equilibrium before trade Slope = -MCx / MCm = -MRT Good m Production possibility curve O Good x

25. Equilibrium before trade Social indifference curves Good m I3 I2 I1 O Good x

26. Equilibrium before trade Good m I3 Slope = -Px / Pm I2 I1 Autarky Price ratio O Good x

27. Equilibrium before trade At P1C1 MCxPxMUx = = MCmPmMUm Good m P1C1 I3 I2 I1 O Good x

28. Equilibrium with trade MCxPxT = MCmPmT Good m P1C1 I3 P2 I2 World price ratio O Good x

29. Equilibrium with trade MUxPxT = MUmPmT C2 Good m P1C1 I3 P2 I2 World price ratio O Good x

30. Equilibrium with trade C2 MC Good m Imports P1C1 I3 MP P2 D I2 World price ratio O Good x

31. Equilibrium with trade C2 MC Good m Imports P1C1 I3 MP P2 D I2 Exports World price ratio O XP XC Good x

32. Reason for trade IF Prices Differ Then Trade Is Profitable for All C2 Good m P1C1 I3 P2 I2 World price ratio O Good x

33. Why might prices differ? • Different technology or physical capabilities • (Land/Minerals) • Differences in Factor Endowments • Labour/Capital • Different tastes • (same Technology & Factors) • Differences in Taxes or competition • (Monopoly pushes prices up)