18 September 2023
International Economics
Session 02-03
1
18 September 2023
In todays session we shall…
▪ What is the basis for trade?
▪ What are the gains from trade?
▪ What are the effects of trade on production and consumption in each
country?
▪ What are the distributional effects of trade in each nation?
2
Production with Increasing Marginal Costs
▪ Increasing marginal costs: As one industry expands at the expense of others, increasing
amounts of the other products must be given up to get each extra unit of the expanding
industry’s product.
▪ A country’s production-possibilities curve (ppc) shows the combinations of amounts of
different products that a country can produce, given the country’s available factor resources
and maximum feasible productivities.
3
3
Production
Possibilities under
Increasing Costs
4
4
What’s Behind the Bowed-Out Production
Possibilities Curve?
▪ Why are increasing-cost curves (bowed-out in shape) more realistic than
constant-cost (straight-line) production possibility curves?
▪ A country’s ppc is derived from information on both total factor (resource)
supplies and the production functions that indicate how factor inputs can be
used to produce outputs in various industries.
5
5
What’s Behind the Bowed-Out Production
Possibilities Curve?
▪ The explanation for the realism of increasing costs (and the bowed-out
shape)
There are several kinds of factor inputs (land, skilled labor, unskilled labor, capital, etc.)
Different products use factor inputs in different proportions
6
6
What Production Combination Is Actually
Chosen?
▪ It depends on the price ratio that competitive firms face.
▪ Suppose that the market price of cloth in terms of wheat is 2 W /
C . If you are a competitive firm vying with other firms around you,
you will see one of these three conditions at any production point:
7
7
What Production Combination Is Actually
Chosen?
If the opportunity cost of producing another unit of cloth is….
▪ less than the 2 W / C that you can sell it for, then try to make more cloth (and take
resources away from wheat). The opportunity cost is less (the slope of the ppc is flatter)
than 2 W / C .
▪ more than the 2 W / C that you can sell it for, then try to make less cloth (and shift resources
into growing wheat). The opportunity cost is greater (the slope of the ppc is steeper) than 2
W/C.
▪ equal to the 2 W / C that you can sell it for, then you are producing the right amount. There
is no reason to shift any production between cloth and wheat.
8
8
Community Indifference Curves
Indifference curves show the various combinations of consumption
quantities that lead to the same level of well-being or happiness (utility).
Community indifference curves purport to show how the economic well-
being of a whole group depends on the whole group’s consumption of
products.
9
9
Indifference Curves
Relating an Individual’s
Levels of Well-Being to
Consumption of Two
Goods
10
10
Indifference Curves
Indifference curves are:
▪ individual specific
▪ downward sloping
▪ concave to the origin
▪ There are infinite indifference curves (indifference map)
▪ Indifference curves cannot intersect
11
11
Community Indifference Curves
Community indifference curves are useful. Still, economic theory raises
difficult questions about community indifference curves:
▪ The shapes of individual indifference curves differ from person to person.
There is no clear way to “add up” individuals’ indifference curves to obtain
community indifference curves.
▪ The concept of national well-being or welfare is not clearly defined.
12
12
Production and Consumption Together
▪ Without trade the US must be self-sufficient and find the
combination of domestically produced wheat and cloth that will
maximize community well-being.
▪ With trade the US imports cloth from the rest of the world and
exports wheat to the rest of the world.
13
13
Indifference
Curves and
Production
Possibilities
without Trade
14
14
Two Views of
Free Trade and
Its Effects
15
15
Gains from Trade
▪ Trade allows both countries to reach a higher level of economic well-being
than before trade.
▪ A country’s gain depends on the price ratios before trade (autarky price) and
after trade
▪ Trade affects both production and consumption patterns in both countries
16
16
Trade Affects Production
The opening up of trade has two types of implications for production
1. Within each country output expands for the product in which the country
has a comparative advantage. The expanding industry (export sector)
acquires factor resources from other industries in the economy. The import-
competing sector reduces its domestic production (the shrinking sector)
17
17
Trade Affects Production and Consumption
2. The shift from autarky to free trade results in more efficient world production
as each country expands output of the product in which it is initially the lower
cost producer.
18
18
Trade Affects Consumption
▪ Substitution effect: In each country the relative price of the
importable product declines, so consumers tend to buy more of
the importable product and less of the exportable product.
▪ Real income effect: In each country real incomes rise, so
consumers have more buying power and tend to buy more of
both products.
19
19
Trade Affects Consumption
Opening up of trade alters the quantities consumed of each
product.
▪ In each country the quantity consumed of the importable product
will increase.
▪ In each country the quantity consumed of the exportable product
can decrease, stay the same, or increase. (It depends on the
sizes of the negative substitution effect and the positive income
effect.)
20
20
What Determines the Trade Pattern?
The immediate basis for the pattern of international trade is that the relative
product prices differ between the two countries if there were no trade. But why
do product prices differ?
Possible causes for relative price differences are:
▪ Production conditions differ (supply-side factors)
▪ Demand conditions differ (demand-side factors)
▪ Some combination of these factors may cause price differences(supply and
demand side factors)
21
21
Thank you
for your attention!