The Standard Theory of
International Trade
Chapter 3
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1 Introduction

Extend our simple model to
increasing opportunity costs.
 Introduce tastes or demand
preferences with community
indifference curves.
 See how these forces of
supply and demand determine
the equilibrium relative
commodity price in each
nation in the absence of trade
under increasing opportunity
costs.
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1 Introduction
Key Terms
•
•
•
•
•
Marginal rate of transformation
Community indifference curve
Marginal rate of substitution
Autarky
Equilibrium relative commodity price in
isolation/with trade
• Incomplete specialization
• Deindustialization
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2 Increasing Opportunity Costs
The increasing amounts of
one commodity that a nation
must give up to release just
enough resources to produce
each additional unit of
another commodity. This is
reflected in a production
frontier that is concave from
the origin (rather than a
straight line).
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2.1 Illustration of Increasing
Opportunity Costs
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2.2 Determinants of of PPF
What determine the
shape?
Production possibility
frontiers are different
because the two
nations have different
factor endowments or
resources at their
disposal or they use
different technologies
in production.
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2.3 Marginal Rate of
Transformation (MRT)
MRT is the amount of one commodity that a
nation must give up to produce each additional
unit of another commodity.
 It is another name for the opportunity cost of a
commodity and is given by the slope of the
production frontier at the point of production.
 If the slope of the production frontier of Nation
1 at point A is 1/4, it means that Nation 1 must
give up 1/4 of a unit of Y to release enough
resources to produce one additional unit of X at
this point.

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3 Community Indifference Curve
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3.1 Marginal Rate of Substitution
The MRS of X for Y in consumption refers to
the amount of Y that a nation could give up for
one extra unit of X and still remain on the same
indifference curve. This is given by the absolute
slope of the community indifference curve at the
point of consumption and declines as the nation
moves down the curve.
The declining MRS shows that the more of X
and less of Y a nation consumes, the more
valuable to the nation is a unit of Y at the margin
compared with a unit of X. Therefore, the nation
can give up less and less Y for each additional
unit of X it wants.
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3.2 Difficulties with CIC
A set of community indifference curves reflect a
particular income distribution in the nation. A different
income distribution would result in a completely new set
of indifference curves. The new curve may intersect the
previous indifference curve.
This happens as a nation opens trade or increases its
volume of trade. Exporters benefit but domestic
producers competing with imports will suffer.There is also
different impact on consumers. Trade will change the
distribution of real income in the nation and may cause
indifference curves to intersect.
How to solve it?
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4 Equilibrium In Isolation
In isolation, a nation is in equilibrium when it
reaches the highest indifference curve with given
production frontier. It is at the point where a CIC
is tangent to the nation’s PPF. The common slope
of the two curves at the tangency point gives the
internal equilibrium relative commodity price and
reflects the nation’s comparative advantage.
The tangency point can be on lower indifference
curves, but it would not maximize the nation’s
welfare; on higher curves, the nation would not
achieve the level of welfare with the existing
resources and technologies.
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4.1 Equilibrium In Isolation
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4.2 Equilibrium-Relative
Commodity Price in Isolation
The equilibrium relative commodity prices in each
nation in autarky are determined by the forces of supply
(as given by the nation’s production possibility frontiers)
and the forces of demand (given by the nation’s
indifference map) in each nation.
Under increasing costs: If indifference curve is of a
different shape, it would be tangent to the production
frontier at a different point and determine a different
relative price of X in Nation 1.
Under constant cost: The equilibrium Px/Py is
constant regardless of the level of output and demand
and is given by the constant slope of the production
frontier.
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5 Basis For & Gains from Trade
with Increasing Costs
The basis for mutually beneficial trade is the relative
commodity price. A difference in the relative commodity
prices reflects their comparative advantage. The nation
with lower relative price for a commodity has a
comparative advantage in that commodity.
The pattern: Each nation should specialize in the
production of the commodity of its comparative advantage
and exchange part of its output with the other nation for
the commodity of its comparative disadvantage.
Specialization incurs increasing opportunity costs and
continues until relative commodity prices in the two
nations become equal at which trade is in equilibrium.
Through trading, both nations will consume more
products than in the absence of trade.
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5.1 Basis For & Gains From Trade
PA’=1/
4
PA’=4
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5.2 Equilibrium-Relative
Commodity Price
It is the common relative commodity price in two
nations at which trade is balanced. At this relative price,
the amount of X that nation 1 exports equals the amount
of X that nation 2 imports. The amount of Y that nation 2
exports matches the amount of Y that nation 1 imports. At
other relative price, trade cannot persist because it
becomes unbalanced.
If the pretrade relative price were the same in both
nations, there would be no comparative advantage or
disadvantage in either nation and no specialization in
production or mutually beneficial trade would take place.
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5.3 Complete & Incomplete
Specialization
Under constant opportunity
costs, both nations
specialize completely in the
production of the commodity
of their comparative
advantage.
Under increasing
opportunity costs, both
nations have incomplete
specialization in the
production of the commodity
of their comparative
advantage.
Why ???
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5.4 The Gains From
Exchange & Specialization
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6 Trade Based on Different Taste
If the production possibility frontiers
are identical, is there any basis for trade?
The basis for trade is the difference in tastes
or demands. The nation with a smaller demand
for a commodity will have a lower autarky relative
price for, and a comparative advantage in the
commodity.
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6 Trade Based on Different Taste
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7 Questions for Discussion
• Why does a production frontier that is
concave from the origin indicate increasing
opportunity cost? What does the slope of
production frontier measure?
• What is the reason for increasing opportunity
costs? Why do different nations have different
production frontiers?
• Why does a community indifference curve
look like that?
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