Based on International Economics by Dominick Salvatore

1. INTERNATIONAL
TRADE THEORY
STANDARD THEORY
TEAM 03

2. TEAM NO. 03
REGISTRATION NO NAME
2017MS7454 D L ABEYSINGHE
2017MS7749 M L F NUSFA
2017MS7492 H E B BHAGYA
2017MS7956 M M WIJESURIYA
2017MS7887 N D SOORASINGHE

4. CONTENT
• Introduction
• Production Frontier with Increasing
Opportunity Cost
• Community Indifference Curves
• Equilibrium in Isolation
• Basis for and the gains from trade with
Increasing Opportunity Cost
• Trade based on differences in tastes
• Summary

5. INTRODUCTION
• Standard Theory connects trade with the Increasing
Opportunity cost.
• It describes how the demand and supply of a nation
determines equilibrium relative commodity prices in
absence of trade under a Increasing Opportunity cost.
• Also it reveals the comparative advantage commodity
of a nation.
• The theory helps to identify the gains by specializing in
the commodity which has a comparative advantage.

6. PRODUCTION POSSIBILITY FRONTIER
Source :
https://www.thinglink.com/scene/926132449581203458
A production possibility
frontier (PPF) shows
the maximum possible
output combinations of
two goods or services
an economy can
achieve when all
resources are fully and
efficiently utilized.

7. INCREASING OPPORTUNITY COST
• Increasing Opportunity cost is the more
realistic concept in PPF.
• It means, an economy or country should give
up more and more of one commodity in order
to produce an extra unit of another commodity.
• This results in a PPF that is concave to the
origin.
Opportunity Cost = Forgone units
Gained units

9. MARGINAL RATE OF
TRANSFORMATION (MRT)
• MRT is another name for the
opportunity cost of commodity X.
(Horizontal axis commodity)
• It is given by the absolute slope of
the PPF.
MRT = dY / dX
Eg: MRT of the economy when moving
from A to B
MRT = 100 / 100 = 1

10. REASONS FOR INCREASING
OPPORTUNITY COST
• Factors of production are not
homogeneous. (All units of the same factor
are not identical)
• Factors are not used in the same fixed
proportion in the production of all
commodities.
• Difference in the technologies used for all
commodities. Eg: Using labour intensive
technology for garments while capital
intensive for automobiles.

11. COMMUNITY INDIFFERENCE CURVES
• Production or the supply side of the economy is
shown by the PPF.
• Demand side of the economy is shown by IC.
• A community indifference curve shows the various
combinations of two commodities that yield equal
satisfaction to the community or nation. Higher
curves refer to greater satisfaction, lower curves to
less satisfaction.
• Community indifference curves are negatively
sloped and convex from the origin.
• They don’t cross each curve.

12. • Points along the same IC
curve are reflecting same
level of satisfaction.
Eg: point N,A in Nation 1
point A,R in Nation 2
• Higher level IC shows high
satisfaction than the lowest
curves.
Eg: point T,H

13. MARGINAL RATE OF SUBSTITUTION
• The marginal rate of substitution (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 reflected by the slope of the Indifference
Curve.
• MRS is diminishing along the down path of IC
curve. That’s why the IC curve has a negative slope
and convex from the origin.
• Therefore, the nation can give up less and less of Y
for each additional unit of X it wants.

14. DIFFICULTIES WITH COMMUNITY
INDIFFERENCE CURVES
• community indifference curves refers to a
particular income distribution within the nation.
A different income distribution would result in a
completely new set of indifference curves, which
might intersect previous indifference curves.
• Trade will change the distribution of real income
in the nation and may cause indifference curves
to intersect.

15. COMPENSATION PRINCIPLE
 The nation benefits from trade if the gainers
would be better off even after fully
compensating the losers for their losses. This is
true whether or not compensation actually
occurs.
Eg : The government tax enough of the gain to fully
compensate the losers with subsidies or tax relief.
Alternatively, we could make a number of
restrictive assumptions about tastes, incomes, and
patterns of consumption that would preclude
intersecting community indifference curves.

16. EQUILIBRIUM IN ISOLATION
• A policy or doctrine of trying to
isolate one's country from the
affairs of other nations by
declining to enter into alliances,
foreign economic commitments,
international agreements, and
generally attempting to make
one's economy entirely self-
reliant, seeking to devote the
entire efforts of one's country to
its own advancement.
What is isolation?

17.  The value of economy’s
consumption equals the
value of its production.
Py*Qy + Px*Qx
=
Py*Cy + Px*Cx

18. What is it?
• Gains from trade is known as
the net benefit to economy
from being allowed
an increase in
voluntary trading with each
other.
• In technical terms, they are
the increase of consumer
surplus plus producer surplus
gained by liberalizing trade
across countries.
BASIS FOR GAINS FROM TRADE

19. GAINS FROM TRADE WITH INCREASING COST
WITH TRADE:
• NATION 1 SPECIALIZES IN X.
• NATION 2 SPECIALIZES IN Y.
THEREFORE:
• NATION 1 - MOVES FROM A TO B
• NATION 2 – MOVES FROM A’ TO B’
• PB = PB’ = 1 EQULIBRIUM RELATIVE
PRICE

20. AFTER TRADE….
• Both Nations gain 20X & 20Y.
• Increasing opportunity cost incurred: nation
1 while moving downwards along the slope
and nation 2 while moving upwards along
the slope.
• Slope in both production frontiers MUST
equal, till then specialization occurs.
• For nation 1 point E, and for nation 2 point
E’ become the consuming points.
• With trade both nations can consume
outside production frontier.

21. EQUILIBRIUM RELATIVE COMMODITY PRICES
• Common relative price in both nations where trade is
balanced.
• Here,
– Nation 1 X exports = Nation 2 X import
requirements.
– Nation 2 Y exports = Nation 1 Y import
requirements.
• The desire levels of products of nations 1 & 2 impacts
relative commodity prices.
• If pre-trade relative prices were equal in nations 1 & 2
- No specialization would take place.

22. INCOMPLETE SPECIALIZATION
• Under constant opportunity cost
both nations specialize completely
in production of commodity that
they have comparative advantage.
• But under this model with
increasing opportunity cost ,there
is incomplete specialization.
• Reason is as each nation specialize
in producing the commodity of its
comparative advantage, relative
commodity prices move toward
each other until they are identical
in both nations.

23. SPECIALIZATION AND EXPORT
CONCENTRATION OF COUNTRIES
• Due to increasing opportunity cost ,none of the
nations fully specialized in producing one commodity.
country commodity (%)
USA Chemicals 14.8
European union Chemicals 15.8
Japan Automotive products 19.4
Korea Office and telecommunication equipment 25.7
China Office and telecommunication equipment 28.5
Argentina Food 49.5
Kuwait Fuels 92.1

24. SMALL-COUNTRY CASE WITH INCREASING
COST
• We cannot see complete specialization in
production that occurs in the small
country.
• Small nations only produce goods that
they have comparative advantage.
• The large nations continue producing both
goods even with the trade, because the
small nation could not satisfy all of the
demand for imports of the large nation.

25. THE GAINS FROM EXCHANGE AND FROM
SPECIALIZATION
• A nations gains from
trade can be broken
down into two
components
1.The gains from exchange
2. The gains from
specialization

26. • If Nation 1 could not specialize in
producing X, and produce at point A
• Point A to point T – Gains from
exchange
• If Nation 1 subsequently specialize
in the production of X, and produce
at point B
• Point T to Point E- Gains from
specialization

27. If PPF is identical for home and abroad,
can trade happen???
How possible?
TRADE BASED ON DIFFERENCES IN TASTES
With increasing costs, even if two nations have
identical production possibility frontiers, there
will still be a basis for mutually beneficial trade if
tastes, or demand preferences, in the two
nations differ.

28. TRADE BASED ON DIFFERENCES IN TASTES
• Nations have a basis for mutually beneficial trade if tastes or
demand preferences in the two nations differ.
• When trade is based solely on taste differences, the patterns of
production become more similar as both nations depart from
autarky.
• Autarky is the characteristic of self-sufficiency; the term usually
applies to political states or to their economic systems. Autarky
exists whenever an entity survives or continues its activities
without external assistance or international trade. beneficial trade
can be based exclusively on a difference in tastes between two
nations.

29. • Nation 1 specializes in
the production of X
• Nation 2 specializes in
Y
• Px/Py= 60/60=1
• Trade is balanced
• Both nations ends up
with consuming at
difference curve E
• Both countries gain
20X and 20Y

30. SUMMARY
• Concerned on increasing opportunity cost and
indifference curves. Moreover interaction of these
two curves with comparative advantage of two
nations.
• Slope of the production frontier (MRT) and reasons
for increasing opportunity cost to become concave to
the origin.
• Facts on indifference curve and slope of indifference
curve (MRS)
• Equilibrium of two nations when its absence of trade
• Equilibrium of two nations with the presence of trade
• Trade based on differences in tastes even two nations
have identical production possibility frontiers.

31. THANKYOU!
QUESTIONS ARE WELCOME
THE ONLY WAY IN WHICH A DURABLE PEACE CAN BE CREATED IS BY
WORLD-WIDE RESTORATION OF ECONOMIC ACTIVITY
AND INTERNATIONAL TRADE.