PARTTWO

TRADE INTERNATIONAL AND POLICY THEORY

2 Advantage Comparative andthe Gains from Trade

THE ISSUES
This chapterintroduces nain methodsof tradetheory and usesthem to study the

. . .

Why countries trade and how they gain liom rade. How tradeaffectsihe allocaiionof domcsticresources eachtruding country. in How tariffs and other trade barriers aftect the gains tiom tade and modify the alhcatbn of resources.

The chapterbeginsby using demandand supply curlcs to Nnalyze principal effectsof the rrade. then introduces more powerful techniques.

PRICES TRADE AND PATTERNS

Differencesin prices from country to couniry are the basic causeof lrade.They ' - er c r e' r<rl eo,iin. -. im i- , r n ' ,' ,1 u ,,," " r.,ra ...r' ., rn r um ro mi ni mi ze re.r re,oLrrce rrrc production.which is the sameas sayingthat irade sen'esio maximize cosisofworldwide fte real value of production by allocating worldwide resources mosi efhcienll),.11does !o by pcmitting and encouraging producers eachtading country to specializcin those in economic&tivities that makethe bestuse of their country'sphysicalrnd hunan resources. Why shouldcosts producccars,caneras, dilTerfrom countryto country?How can Japan and conputers more cheaplythan the United States? Many peoplewould rcply that Japa' has lowcr costs becauseit has lower wage rates, and rvagesare imponnnt costs. This erplanaiionsoundsplausibleenough.but it is inadeqxate. wxge rareswerc decisivefor If .ost differcnce!and trade.Japanwould underselltheUniled Statcs cvcry productline and in trket. Yet Japanimports many products liom the Unitcd States, from aircraft to grain. a|d
l9

20

ComparalireAdvanlage and the Caitrsfrom Trade

othercountrieswith much lower wageratesthanJapanimpo( many Americanprcducts. Differences wageratesby rhemsetves in cannotexplainrrade patterns. mustlook funher We for the bas;sof trade. An enddng two-way flow of goodsmustreflect systenaticintemarionaldifferences in rrru.tar"r of costsand prices.Somethings must be cheaper Foduce ar home and wi to then be exportedto other countries.Other rhingsmusrbe cheaper Foduce abroadand to will then be imponed from other countries.This generalization krcwn as the lg! is Ef compantfie.a.fiantape andcanbe pur this way: I In a world of competitive markrs, tnde will occur and will be benffcial wheneverthere are intemational dilfernces in relative costsof production. Japancan export cars and camerasbecause endowmenrof land, labor, capiiat. and irs technology allowii roincrease ourput irs goods ofthose withthesmallesr sacrificein ouFut of other goods.The United Stares exporraircraft andgrain because caninffease its can ir outputof thosegoodswith the smallest sacritice outputof othergoods_ reat-resource in The cosisof producingali four goods-aircrafi. cameras, grain<outd be higher in cars,and Japanthan ;n the United States. cross,counrry Bur differencerin real-resource costsvary lromprodufllo producr. $e) aierhebasi\;r benerrciat Jnd nade. This chapterwill Fove $e law of comparative advantage. reasons differences The for in retatlvecostsarc exploredin Chapters and4. 3

PRODUCTION. CONSUMPTION, TRADE A SINGLE AND IN GOOD

Tbe effects of differencesin retative costs cannorbe exanined by looking at rnarkets one at a time. It is ne.ess f to look at an entire narionaleconomyand compare il wi{h other nationaleconomies. Therefore,intemationalrradetheory cannormakemuch useof panial,equilibriurnpricerheory----of ordinarydemand supplycuves. Ir must use rnd Ne\ renerdl-equrlibrium mo.roflhe rrme. enhe .urptl anddemand te*. curveran 'heoD be usedto showhow lrade in a singlegood atrecrsdomenic productionandconsumption andthen1oquandlvrhcgains ftom ftade.

Equilibrium Before Trade Opened ts

In Figure2-i, rhedomestic demand cune for cameras Ds. andrhedomestic is supply curveis Sr. \lben ftere is no inremarional tradein ameras, equilibdum will be established E. Thedornestic at priceof a camera be Op. production be OA,and will will productjonwill necessarily cqualconsumprion. diagram,however, The saysnuch more. W})endomesticmarkeisare perlecrly comperitive,the supply curve is the sum of rhe marginalcostcurvesof donestic firms. Accordingly,rhe areaunderthe supplycurvemea suresthe total cost of camera prcduction.(Siricrty speaking, measures roral variabte ir rhe cost,but fixed costplaysno role in rhis anatysis.) OAcameras produceal. If are ioial costis givenby the areaof the rriangleOAE.But total payments producen(revenues) given to are by the dreaof the rectaDgle EP. Thercfore,ihe arcaof ihe rriansle Otp measures O, Drofit or Dfoaucer sumlus.

Pmduction, Consumption,and Trade in a Single Good

2l

FIGURE 2-1 Trade a SingleGood in ihe domesti(demandcurveis Ds, th domestic supptycurueis Sr, and the domee tic pricis OPbeforetrade is opened; the quantityOA is produ(edto meet domestic demand. Whntradeiigperlrd-qLlhe world pri.e np,, production fallstoOe,.onsump, lion risestoOC andQCisimported closethe to gap.Before trade,producer surptus was OfP,and (onsumer surplurwasPEr.After trade,producer rurptusk OF p, and contumersurplus P'El'f. Hence, is producer surplus {attsby p,E,Ep, consumer but surptus rsesby P/E'EP, which is f'E,'E largerthanthe fall in producersqrpluj- is_ilth Th wel_ faregain{rom trade.ThapioituEori effict or openingtrade is eA, which.ontriburs E Kf.This welfare gain resulBfrom the substitution tow-cost of Joreiqnoutout Jor nigh-(ost domestic (E output.Th consumption efte(t isAC which(ontribuies E. Thi, welfaregain rsultsfrom inoease consumption the in causd bythe reduction price. in Theareaunderthedemand curveis meaningful,ioo. Undersomewhat restrictiveassump iions that neednot detainus, it neasuresthe cashequivatenr the urilirt rhat consumers of deriveftom 6eir purchases ofcameras.tff OAcameras consumecl, cashequivalenl are that r the areaOAEI But consumers O/EP for iheir caineras. pay Therefore.the areaof the trianglePtT measures nethenehror consunersurplus. the

Equilibrium After Trade Opened ls

Now suppose tradein carneras pemitred andihar ihe wortd's supplycurve that is is Sr. Theworld pdceof cameras OP', belowthe oid domesric is price,Op. andrhisis Ue price that must cometo plevail in ihe domesdcmarketif thereare no transponcosrs or tariffs. How will this happen? importedcaneras are less expensive As than domestic canreras, consurners cease buy domesric will ro cameras the old domesric at price,andthey Fill raisetheir total purchases well. They will movealongrheirdemand as curvefrom t to
rTherc m fiee slch asunptions: (l) Utiliq, cd bnessuEd h r,r;nal nunben, altowins us k) know lle r{. d/rhe incEasein utility confenedby m inclse jn coNunprion. not neEly lhe fact tnlt tbeE is m in.Mse. (2) The udities or individualsm nelsured in conpmble units, .lloNins ns to glve lhem comor .ash ertuivaienh (3) ThenErginai utihy of incomeis onslm| alowing us lo used rncone or cashnasDie rhal do* not emw or strint whonFjce chnses alter incones.

Compamtive Advantagand the Gains from Tiade

startto buy fbreigncamems, their puchasesfrom OA to OC As consumers E", increasing pdces in order to remain in business'but howcvet domesticproducerswill reducetheir they cannotdo thal wiihour cutting production.They will move aloog then supplv curve prcductbn from OA to O8. The gapbetweendomesticdemand from t to t', decreasing anil donestic supply,OC, will be filled by impo s What arc the efiects on economicwelfarc? Domestic consuneN will gain from the will openingof tradc,anddonestic producenwill lose But thegainto consumers be larger producers still comeout and allowing consumerjto compensate thelossto producers, than Accofdingly, the will be a weltke gain from tradc for the nationas a whole. The ahead. suryIus risebv P't"EP, thatproducer will that 2to textatlached Figure I shows consumer themis t'cl t. Thismeasures between wil surplus fall by P/t/6P, andthatthedifference on the welfare gain from trade.Notc 2-1 provesthat the sizeof the ga depends the size in in ihe domeslicprice andof the resultingchange inpori volume.(In this of lhe changc is is case,ihe price change PP', andihe volumechange 0C, the wholc quantitvof imports rnadeavailablcby trade.) This simplediagramis deficientin manyways lt relieson ra*rer restrictiveassunptions to measue consumersurplus.Il does not dcscribethe economiccosts and benefits of

Note 2't Measuring the wellarc Efleds of ftade and Tarifk 2-l area x Hence,lhe of 6't"E in Figure is is ofa Thedrea trianglc I x base height. = OC.theinffease importvolume(thewholeimpof in ! x E' E" x KE.Bu.tE E' price caused replacing bv yolumehere).andrt = PP'. the cbange the domesric in the pretade doneslic price with the lower world price Therefore,the increasein wlfareis

x Q Cx P P ' = + ' < ^ Mx ^ p .

where A denotes a change, M is the quanlity ofimports, and p is thc initial domestic

Sirnilarly, arcaof E'F'H' + FE"H 1n Figfie 2-2 is I t (E'F' x F'H' + the F'H' = FH = Fr. \ FH).Btlr E'F' = QQt. FE' = C'C, and. in lhedccrease welfrreis

AW

( QQ' +c' c) \P' P' .

in and in But OO + C C is thechange impons. P'Pl' is thechange pdce'whichcan I in thiscase p' x r. whercp" is theworldpriceNnd is lhedd raldEn as be written (percentage) rale.Accordingly, tuiff

AW

,!,

where AM x p,, can be inteercled as the change in impot volume valued at the

Productionand Consumption GneralEquilibrium in

P\po'ri ngor he' go, ' J . l o p a \ri { rmp o fl e d \u m e rr\l r,J y ,n,,rhrngab,,ur therer-,n,tor rh ep ri .e dr f ler en. e ha rIn d u .r, U J d e rh l h e s ,{ t;p n (f i ,i cJrne,r,r,to$er r rhunrhe prehide domeslic price. To investigalethcse ma11crs. must use gcneral_equilibrium we nrodels.Before luming to them, howe\r lct us ask how a tariffon importedcameras wiu altect the gains ftom trade.

Effects an lmport Tariff of

Consumers not voluntnrily compensate do producerswhcn consumcrsgain and producers bse. Hence, producers oftcn seek protecrion from impon comperilion. Many rncrhods be usedto provide protecrion. can and we will comparethem in Chaplcr9. Here, se cxamne the mosi common merhod.What wilt happenifdomesric producers persuade lhcrrgovemmentto imposea rariff on imporiedcameras? The principal effects of an impod 1ariff are shown in Figure 2-2, which reproiluces rhe denand and supply curvesusedin Figure 2-1 and rhe equitibrium al the world price Op,. Bcfore ihe hnffis imposcd.domeslicproducerssupptyOO cameras, donestic consunen demdndOC and import\ are OC. An imporr tffiff will rajse rhe domesticpriccs of im_ po4edcamcras, andconsumers will slop buying them.As they switch ro domesticcameras, however, thcy will bid up the prices of lhosecameras until they are cqudl io ihc prices ol cameras. rhe rariff is P,P| per camera,rhe domesricpnce will rise ro Op,,. If 'mported Donestic consumers ll reducetheirpurchases OC , donestic producers wi to rJi raile their lales to O0'. and inports will lall from OCro 0'C,. To measure the welfare effecrs of the taritl, we nusl know whal the gormment aloes \i ilh the tariff revenue. 11 collects P'P, on each imported camera and thuicotects t'' fHItl in total t]]riff revenue. Lct us assumethat ir curs some other rdx and thus rcturns thc revenue I he r e\ r z a c h e dr^ F j S U ;2 -2 ,h o q s rhJr produ(er\urptucw r ri .e b) P't'fl'P" and ihal co.sumer surylus will lal by p,E,rpl/ Thcrefore.rhe consumers, loss will exceedthe producen' gai'. even when consumersger bxck the iariff rcvenue. The diilcrencebetwccnthe consumers'loss and the producers,gain js E'F,r/, + Fo,fl, \hich mcasures the wclfare loss rcsulting ftom the tariff_ Note 2 I proves thal the size of the loss dependson the iarill rare and on the size of $e resulling changein impon

PRODUCTION CONSUMPTION GENERAL AND IN EQUILIBRIUM

Much ofintemational iladc theorycan be devetoped consfucting a very simple by S.neral-equilibriumrnodel. lr conrainstwo countriesthrt produce lwo goods usins two Iactorsof produciion.The model cannot yield tesrablehypothess about rhe cornmodity composition trade;a nore complicatedmodct. of with mllny counrricsNndgoods,js needed iitr thal purpose. Ncvenheless, simplemodetcanbc usedto ilustrate the law of comparthc rrNe advantage and show ihe gainsfrom rradc.tt also providesreslabte hyporhcses aboui the gencralcharaclcrof trade. The model is deveklped ituee steps. in Firsr,we will showhowproduction.consumption. and pncesaredeterminedwhen rhcreis no iradc. Second, wil show how rradeaffecrsa we country.Third. we wilt iook ar two counrriesrogctherro show how world nricesare 'ingle J e l (rm.I edJ nd ho$ r heg a rn .tr,,ml m d ea re.h d re db .j s een rheLaJi n! cound(,

2,4

Comparative Advantageand the Gains fmm Trade

uQ Q CCQ uant ' t y

2-2 FIGURE ATariffon a SingleGood from Figure2 1 DoDs, The demandand supplycurvs, s', and Sw,are reproducd is is OO initially,domesti(consumption OC and importsare OC A mstic oroduction priceto oP" Therefore, it domestic rariffthatadds P'P'to the import pri(e raisesthe (onsumption OC . lmports to production oQ and tdu(erdomestic to raise domestic and P initially isOH P withthetatifl Constrmer falltoOC.ProducereurpluswasOE producer rises bv surplus initiallyand is P"Hrwith the tarifi Hence, was 5urplus P'E"I thanthe whichis E'f"HH' bigger surplus by P'E"HP", {alls P'E'H'P", and consumer on P'P" of tarifi revenue each collects surplus. the government 8ut risein producer by and importedunit, or F'FHH'in totaltariff revenue, returnt it to consumers cutting H. loss tax.lherefore, netwel{are i5E'E'HHI F'FHH'.orE'F'H'+FE the some other E'F effct,contributes H', which the effect,QQ', alsocalled protective Theproduction reflectsth substilutiono{ high-(ostdomesticoutput for low-cort{oreign output the FE"H.which reflects fall in consumption Theconsumption effect,cc', contributes in by the increase Pricecaused

Supply Conditions
bv produc;ng goods be described altm 1wo can Supplyconditions a country in possibil;ties curve). shows lt catled production a cunGometimes duction trunsfomvtion lechnologv. and produce,givenits resources, lhat the outputcombinations the countrycan The economicorganization. curvem/ in Figwe 2 3 is the tansformatbn curvefor a counto try producingcanelas and grain. If the country devotedall its resources the goductjon 1l) output would be Olcameras. lf it devotedall its resources the Foduction of cameras, of grain, output would be Or' grain. If it divided its resowcesbetweenthe two actiYi output is OXr and grain output is ties, it would anive at a point suchas D, wherecamera oXz. The posilion and shapeof tbe tr:rnsfomation curve dependon tbe quantitiesof land. labot and otherresouneswith rvhich the country is endowedand on its technology lf it had more land, it could producernore grain: the distanceO?' would be longer,and the If whole transfonnationcurve would be steeper. it had a better way of making cameras. the it could producemore cameras; distanceOT would blonger,andthe banslbmation

Production and Consumption in Genral Equilibrium

;:

B'

trXtTBQua ntity

FIGURE 2.3 ]1reProdution Transformation Curve Theposition andshape ofth curv depend the country's ff' on supplies ofthe {actors of production on itstechnology. pri<e a camera givenbyrhe and Whenthe relative of is slope the line AA',the countrywill produ(eat D. ltscamera o{ output will be OX!,and i5 qrainoutpul will be OX,.Asthe slop AA'is OB'lOB XzBlX2D,and XzDequals o{ ot OX,,the relativepriceo{ a camera.an be written as XrB'lOXr.Hence. countryt the nationalpfoduct measured grain will be o& + OXj x (x,B'lOX1),ot OX2+ x2B', in vhi.h equal,08'. S;milarly, nationalproductmeasured cameras be 08. its in will is*e would be flatter Thesepossibilitiesare explorcdin Chapters dnd,l. which discuss 3 a. sources compamtive of advantage. \ote that the curve 7Z' getssieeperascanera output rises.The country must sacrilice .n.rcd\ingly quantrle, large otgrtn ourpurrn orde||o rri\er Jmera lhi.propenyha, ourpur. :!any names convexity.inueasing oppoaunitycos1. so oD.It canhavemanycauses. xnd Therc nay be decreasing returnsto scalein one or both sectrs of the economy.There :r1ar- a 6xed factor of Foduction in eachseclor which meansthat the other (variable) be (If :.i.rors will havediminishingmarginalproducts- the nunber of canerafacloriesis fixed. :or ex,rmple, hiringof moreworkers the will |aisecaneraoutputby smaller smaller and .:.:nounts.) sane resuli will obtain,howcvcr,when all frctors of productionare freely The i sicrablefrom one sectorio ihe otherbut must be combinedditrerently in eachsector '*}dre\cr thecau.e. propeny rhe appedJs be pe^asi\r. ro

Prices, Outputs, and National Product

Wben donestic marketsarc prfectly competiiive and lirms maximize plofits. '-'r. economywill rnaxiniTe its national product measured real ielms, and the comin prices.u plovethese by To staremenrs. .-rjirion ot'Foduclionwill bedetemined relative
rThis l,{ or conditionsis not complete.T$o orhes Mdrc ancntion in advdced tade theory: (l) 'l herccanb. no td or subsily on the ouipul ofone goodor useofone faclori taxesandsubsidies musl be unifonn. (2) Uncetxinty xboutrururedces nu$ not afrec1 ploduceG od consums\' resp.nse\

26

Gsins from Trade Comparative Aalvantageand the

ibe determines output ol eacn

arbitrarily and show how it let us choosea ser of prices

9oi1,.,.,,ri". ";::,T::H: p.i""u."-"11 a camert or t',t::':::::fi:|ilil: j:*Tfiffi givenup to purcbase grainthat must be
2 line Ba'in Figure 3:

nn"" : ffi "'""".""." ""'^U""

rs g\en Drcducr An algehaic dmons$aion

:il.Tu:ff lilltr J:i;*:;[ T'fJilill+;'ilT: "fl',-:":i:: :iTinil':: i:: t*:#;i;'ruiirltl*'*:,nml' ;:"?'i-:i$ . *"9**i:'t"l*'"1*::i:iil"''"I#:ii "hfu
product' oa'andihus ma(imzesthenational measuedat their marketPnces: valueof nationalProduci = grain ourput x price of $a a camera + cameraoutput x price of of glain' we nave Dividing both sidesbv the ptice r ourput \alueofnaronalprod cr --grarnourpur camera pnce ot gfarn pl5ll]jryon* rr* "r

in grain nationalproductmeasured output x relativeprice ot d camera = grain output+ camera

"'Xi; ;li#: :iljl:T t i::'#"11"'H:1$1";l:::1".1ffi "?f

. outpulis OXr Therefore, I4 in measurcd grain= ox'z+ oxr " produci national = ox' * x'n' = ou' '

H::'J':*XT:"4;i:trt ti:ir:x'l'liJ"?H"XT:1fl x':*"ffi

Production and ConsumDtion GeneralEouilibrium in

27

:!

B'

T'

L,

xi

Xl

IAB

Quanl i l y

FIGURE 2{ Efficiencyin Dolnertic Production When the r elat iv epr ic eo fa (a me ra i s g i v e n b y th e e l opeolth l i ne A A ' ,producti onat D is efficienl and production at H is not. Both points lie on the same transformation curve but do nol yield the same levels o{ real national product. When the economy producesat D, camera output is OXr, grain output is OXr, and real national product i, OB in terms o{ cameras.When the economy produces at H, .amera output is OXi grain output is OX:, and real national product is only OA in terms of Gmera5. or morc directly. Divide the national product measured in grain by the relarive pncc of a

produ(t nrrional mea\urcJ in.amerr.:

nattunal product measued grain in

relative pdce of a carnera

OB

.oB =oB x og=oB.

It is aclual camera outpul plus the camera equivalent of actual grain output. To show that production at D ma{mizes real national product. whether it is measured in carturas or grain. let us perform an experiment using Figure 2,4. As before. the tansforma tion curve is n'. and the relative price of a camera is given by the slope of the LineBB'. Bul suppose that productionstartsat 11, noi ,. and draw the line A,4' passingthrough fl and parallclto BF: This line marksoff the distances and OAl, which measu.e OA real national product in c4meras and grain. respectively, when fl is thc output point. Clearly, these are smallerthan OA and OB'. which measure real nationalproductwhen il is the output poinl.
rThAeLtuaiun lo!s rom rhcri.rrhar fv
mtional pmduct nDasured in canerd i pnce of a cdem T r io m p r cd r .r I fo \u r e n i n. mi , ti .r, f"'di , narional pnrdu.r ne$uEd in cmeras ' ed. rred D antr 0i .c ol c .i l

- rJ ,vaJr ptuLru.

28

Comparative Advantagand the Gains from Trade

ress grarl Competirile tums will nol stay at l/ Thev lvill prcduce more cameras and of D' They wjll do moving the economy along the tansfomation curve in the direclion this be;ause it will increase their profirs (The line A'4' is sieepcr than the aansformatiotr value of cuNc at t/ . Therefore, the Yaloe of an increase in canera output will exceed the l moreo\er' i rm) , he .o n e ' | ' ' n d i n g ,l .c re J ' e i n e rrrnoul pul ' B ymo\i ngi nl hi tdi recl i on get to D' The gaps'48 and A'B raisereal;ational product,and they maxinize il when thev moved disappear. If firms weni beyond ,. rhey would reduce rcal national product lf thev too' to H'. tbr example. il would fall again to OA nnd OA' But profits would fall' md stav at D' where the relatile pnce oi a In briel a competirive economy will arrive al c am .rdri e q u rl l o rh e s l o p e o fl h e Lrun' formdri oncur\e ' oIno$nJ' rheD dryi ' d/r' ' '

Conditions Demand
a Denand conditionsin a countrv consumingtwo goodscan be describedbv from individuals' indifferencemaps'wltcb co/Nnunit! inaijfercncemaL It is consiructed ofgoodsa collcclions various individuals.ank showhowthose

in Figurc An inditrcrence map is nra neup of inrlilleme c ner' Two of them are shown and acollectionofgood!' OCr cameras OC2grain The indifferenc' 2'5. The point P defines into thrce groups Thosc that lic below Ur are infbrid cu|ac Ur divides all such collections that lic abo\t to the colledion at Pi thev fumish lowcr levels of utility (satisfaction) Those utilitv And those thar Ur are superior to the collection at P; ihev fumish higher levels of level of utilir\" [; righi on Ur are equivalenr to the collection at P; &ev fumish the same themwhichis whv the consumerissaidto be indifferentwhen askedto chooseamong camera! replace gain in the colleclroD Note that the indillerence curves get flatter as thc theorv ol con' of goods. This property can be derived from a fundamental axiom in increase rn lhe sumer behavior-the law of diminilhing marginal ulilitv It savs that each l con' umpri oo o lon .u m p rro n l o n e g o o d )i c l d ' J ' mal l efI' Jdrrrono uri l rr) The l arP erhe ' obtnined bv adding one more camera Bl of cameras. tne smutter the increale in utjlity

rc consumption in will requirc largerandlargcr increases camera implication, a consumer ron'umplion in de. oh.crcucce\\ive reaset grJin

consumeF To show how jndifference curves describe demmd condiiions, suppose that and thai lhe relative price of a canera is grve' hrvc OB of real income mensured in cameras cameras and grar! br- the slop ot' the line Ba' Consumers can buv rnv combination of and OC: grain and will then wind uP at.R oD li;mg on BB'. They can hale oci carneras will thed t'r," inaine'ence cuwe uo. They can also have ocr cameras and OC, srain and and the) $ inclup at P on the indjfferencecurve Ur. Consumenwill chooseP' of coursc' are cu^e $heo ci ' n' umers i . . r a . r" b c rre r Ir l ;e ' !' n rh e h ighenanai ndbl endrl l ercnce conslmincdby thc LineBa' li's ot Because the role thar lhe line BB' plays in Figure 2-4 it is otten called a 'd8r the the that controntconsumers: incomesthey can spendand h deoiclsrhe lwo constrainls
tnaps onenu$ tnak a nunE 'T(, bu,ld a con.urity indi llercncenxp frcn individud rndifrsncc rhanthoseonend$ nake to n*su onsund surplur est or asrnp(tuns. but ;de dc Less ictive i'dividoals tr ro It ij no1nccessary adopt a cddnrd neasuF ol nlilitv lo m4su the urilities or utiliq of inc'nc constdl lt is sfhcjentlo dsme dd rr" narginrl o t ...p."br. "r' dcrund e utur-l ha* ilt ,;dNidurl-ir'. - lhe srne irdilTdcne naPs a'd rhal inconc elasriciliesor a I percentin'nmeinlhe denandfor eah goodl nrcENenreal ncone cluses (lh! a I perceDr oI ha!' idenh'xlsou'ces rn'ome ro it Alrcmaiively. is sufhcicnl !*une ihxt rll ildividuals

Pmduction and Consumption in General Equilibrium

ci

FIGURE 2-5 TheIndifference Mao All collections goodsthat tie on one indifferen(e of curveyietd equattevets utitity of katidaction), any(ollection U. iesuperior anyco ectionon Uo.When but on to in(om; rt un me^asured cameras, rhe retative In and pri(e ot a (amerais givenby the stopeof rne Ine 6d . (onsumer{ chooee (o ctiongivenat p, comprising cameras wi the OC, andOCl9rain. Thatcollection issuperiorto othrono, betow dny BB,;(h dstheone pncesat which they canspendthem_ Therefore,ihe outcomeshownar p canbe dcscribed by sayingthat the composinon denand is Sivenby the point on rhebudgetlinat which of its slopeis equalio rhe slopeof an indifferencecurve,alsoknown as the ,,ar"iudt /rr? of

Equilibrium the Closed in Economy

Whenwe examined singtemarketandrherewasno rrade,wetookedfor rheDrice a at which the domesricrnarkercle.red-where domesticaemana.as eqJ to aomjstic supply. wasgivenby thepoint E in Figure It 2-1.When$e examine markets two rosether. wemusrlook f,tr thepoinrar whichboh murkerclear.tr i, lhe poinrL rn rigure :i, ( Let us seewhat happens rhere. W}len production rakes place E, rhesuppty cameras OOr andthesuppty grain at of is of n OOr. ln a compentiveeconomy,however productjonwi remain at t only when the relanveprice of a camerais equrt to the stopeof the transfonnarioncurve at E and rhus equal thestop the lineBBl_Whenrhjscondition satislied, to of is moreovet narional the productneasuredin cameras Or. and it must equal ihe narionatincomein is ihis sirnple economy (wherc make adjustmenrs we no fordeFeciation, indirecr taxes. etc.). Thevatues of the goodsproducedat E musr equal ihe wages,renrs.and profits paid to rhe i.actors ol producbon. Theretorc.lhe AA mu{ be he budfer tine tine. consumen eoro ard wr r. becau.e i, rhehighe.r.ndifierence U. cuNe!he' can,eachshen rtey arecon.U,in",t by that budgetline. Ihe demandfor cameras will be OCr and win equalrhe supply.The demand srain will be O0, and wj equalthe suppty. for

JO

Comparative Advanfage and the Gaim from Tfade

B'

T'

a,

FIGURE 2.6 in Economy Equilibrium the Closed at outputwill willbeestablished E Camera rond Undrcompetitive itiont equilibrium Grain demand {orcameras. outputwillbeOQ,andwill equal andwillequalthe be OQt will equalthe slopeof the line the demandJor grain.The relat;vepriceof a camera in BE',and real nationalproductwill bOB measured .ameras

T'ro leaturesof this equilibrium deserlc specialattentnrn:

L we can locate E withoul Inowing the rclative price of a camera. when finns maxiinizeprolitsandconsumenmaximizeutilily, equilibriumin a closede.onomv is esrrblished at ihe /drget.l bclween the transfo.maiion curye and an inditrerence cuNe, iust as equilibrium in a single narket is established at the interseclon bets,ecn the supply and demNnd curves. The lnarginal Iate of transtbmation is equatcd to ihe marginal ratc of substitution, and each of then must equal the rclativc price of a camera. We can, in fact. infcr that price from the slopes of the two ourves ai iheir tangency; we can draw a8' xfter linding E. 2. When onc markel clears. ihe olhcr must clear. too. W}ten we have found ihe relative pdce that clears ihe cameramarket, we have found the one that clears the grain a two-good narket. too- In oiher words. there is only one independent market '. Appcndix A nodel. This importanipoint is provcd algebaically in Section I of what would happcnil, by chance,the relative pice of I camerawere different from of ihat the pricc iell below the one given by the sloPes the the equilibdum pricc? Suppose Firms would move to the no(hwesi along the transformation curvc. reducing curves at t. through the the supply of camcrasbelow O0r. Consumcn would nove ro the southeast indifference map, raising the demand for cxmelas above O0!. There would then be an eress denund fot cameras,which would r.tise ihe relative pnce of a camera, moving the economyback to E. Hence, t is the only equilibrium point for the closedeconony.

Trade in General Equilibrium TRADE GENERAL IN EQUILIBRIUM

31

Whenanalyzing tradein a single good,usingFjgure2-1,we asked wharwoutd bappen the world price of a canera was lower thanihe donesric price prevaitingbefore if Fade Llus adfuessthe samequestioD the two-goodcconomy.How doestradeaftect ro xoducrron..,,n.ump anJ on. economic wetfare when retari\ pric;;t ;..umera to$c, rhe e is n the world marketthanin the domesric markerbeforetradeis opened?

Equilibrium the OpenEconomy in

Thc effects of irade are shown in Figure 2-7. Before rade. rhe economyis in atuilibrium at E, just asit wasin Figue 2-6. The relativeprice of a camera g;venby the is Eopesof thetransfoffnarion curve lrl andrheindifferencecurve Ur. Ghe budgerline BBl Liomittedfrcm dis andlaterdiagmms. because would clutterthediagrarnunne.essarily.) it Suppose that the relarive price of a carnerais lower jn rhe outsideworld. Represenr :i b! the slopeof the line FFl. When tradeis opened(andthereare no rransportcostsor

t2

xt

ar

FGURE 2-7 Eqrrilibrium the OpenEconomy in Bcloretrade,production and consumption take ptaceat E/ andthe rel4iye priceof (ahera h givnby the slopeof-!E rransfornElloncurveat E. Whentrade is opened tt a lowerworld price,givenby the slopeof the tineFF, production moves D and to 6nsumption moves P. Camera to output Jalls OXr,consumption to rises OCj, and to XLC,of camera imports{jllJhe gap.Grainproduction rises OX),consumprion ro falh io Oa-,, andc. & of grainexdoilTemovethe surptus. qain Consumefe bv movinofiom on the indifieren(e(urve Ur to P on the higherindifterence iurve i,l. proOuction drd onsumption effectsare readilyidenti{ied.Lookingfirsr at came.aimports,the production ffectisthe decrease domestic ppty,er Xj, and the consu ption effect in su m 6 the in(rease domestic in demand,OrCr.Together, they deJine totat imports,XC, or MP.Lookingnextat grain exports, production the effectisthe incrase domestic in supply, Or&, and th consumption effect is the decrease domestic in demand,erCr. Together they definetotal exporrs, C2X2 MD. ot

32

Comparative Advantage and the Gains from Tfade

price Guidedby theworld price,profit' the tarifft, ihe world pncercplaces earlierdomestic maxirnizinglims wil move the oulput point to D, $'hrethe slopeof ihe transformanon in will be Ol'' curveis equalto the slopeof fF'. The nadonalFoduct measured cameras line Accordinglv' consumers it will equalthe nationalincome,andFr' will be the budget of will maximize utility by moving to the poinl P. whereihe slop the budgetline equals the slopeof the indifferencecurve Ur' If the economywere closed,therc would be an excessdemandfor canems (equalto wouldnot be The new situation supplyof grain(equalto C?X2)XrCr) andan excess however it can satisfy When the economycan tade with the outsideworld' sustainable. by its exccssdemandfbr camer.N imponing Xr Cr and selt off its excesssupplv of grain $irh con'umprion ar.P becau'e ar b) c\ponrngC.Xr. Prodll{iion D can be reconciled liader\beneDcrar.moreover lorcame'as by can d,'mesric murl'cls becleded u?ding Erain line any can corsumers choose collectionof goodslying on the budget fF' andthus because the cuNe Ur. They areDolconpelled to choose paaicularcollection reachthe inditrerence given ai t by the tangencybetwenthe transfbrmationculve and the lower indifterence in The;rain erpot! sbojryn Figure 2 7 3re just ldrge enoughto pav for tbe camera intpo.s. This is Foved algehaically in SectionI of AppendixA. and it canbe iUustated geometricallyby looking at two triangles,OFF' andMPD The legsof OFF' neasurethe relativeprice of a camerain lhe world market:
relalive pfce of a camera =

price of a carnera price of grain

OF'

oF'

as But OFF' is simil.r to MPD, identifiedhereafter ihe trade timgle.'fhercforc, OF' /OF equalsMrlMP. Furthemore, MD equalsCzXr, the quantitv of grain exports,a'd MP impots. Therefore, equalsXlCr, tbe quantityof carnera pice of a camera pdce of grain
and

MD

quantityof grarnexPorts q"-dty c.-"t" tt"pottt' "f

quantityof canera impons x price ol a camera : quantity of grNinexportsx price ol grain The country'sforeign tradeis balanced.

from Trade the Decomposing Gains

The text attached to Figure 2-7 divides the effecls of trade into production and consumption effecis, but there is a better way io decomposethe effects of trade in a general_
5The frcm tade canbe nluslratedwithourcvendrawingi.difrEne c!fles As the budgetline Cains FF' lics nr 1henonhest of ti old equilibrium poi E. n irchdes colldioN oI g@dsconlaining moE cmeas a.d noE g.ain. Unlessonsune^' denmds cat be ra,i.rd bv nni quaniilies of (co$men nav E@ds.dese collectionse necessdly superift to the collecrion d6rcd b] E DErerthc.olleclion delinedby P, ontaining noE cus$ bd lcsssFin, but .ould navecol@tions c.nraidnr more of ,,r, 8oods.)

Tlade in General Equilibrium

33

trURE 2.8 O.@mposing Gain5 the trom Trade _t*9ain from ;nte.nationaexcha ismeasured holdingthe output point at E and I nge by t-awingthe HH'through AsHH'is line parallelto itsstope E. FF', measuresth relative t-(e of a camerain the world market,and the distance measures national OH reat ;toduct in cameras; is pretradecarnera it plusthe camera output, OQ1, equivatent oJ ;tEtradegrain output, OOr.As OH ako measures income, reat HH, is the budgettine ..n E is the output point, and consumers mov p,, which tieson an indifference to 1trYehigherthan Ur but lowerthan Ur. The ga;nfrom inrernational specialization is *5ned by allowingthe output point to shift{rom E to D. this permilstheadditional r''t of <onsumption from P'to P, which lieson the indifference curveUr. +rnbnuor modet.Figure 2 8 replicatesthe trading equilibrium shownin Figure 2 ? and n', iJ.r the increase economicwelfareinio rwo parts. in Tbe firs! part can bmeasured supposing by rnomentarilyrhat the ourBulpoinr remains r f e\ enaftertradeis opened. Drawthe line flfll throught andparatlelto FF,, sothatthe iit?e of fffl' measures relativeprice of a camera the world inarket-As the distance the in t}It measurs incomein caneras,consumers movero P' andreachan indifference real will .ate higherthanUr but lower thanUr. The rnovement consumplion of from E to pris the g;^ ion intemational ex.hanqe. Ile second canbe meaiured rela.aing assumprion producrion 6xedat ,, parr by the thar is E dlo$ ing the outputpoint to moveliom ro D. NarioDal productandnarionalincone '' !s nom Ofl to OF. Consunersmove fron P' to P and reach rhe higher indifference !\ Lr. The movementof consumprionfrom P/ to P is be sain fnn inkrnationat {tru/i.dng4. madepossibleby ihe shift in the compositionof production.6

is often uFd in i.de thcory ro ddsnbe a linitinS cN in whicb a counbt 'The Em src.i,li,hb, d.\otes il ils EsouEcs to prodDciiondf the exporr good md doesnor Irqruce dy of rhe inpon.o.pcnng good.We will encountcr sucb, .ase in lbe nexlchaptc. tn ths bool, specidizarionis used morebrcadlyro dsqibe themovenntofproductionawly ion thepEtradepoint.The limiring case s l bdcsc.ibod as.onDl.r. sDecialization.

34

Compamtive Advantage and the Gains from ,llade

DETERMINATION INTERNATIONAL OF PRICES

ho$suppr) Jemund rd (undrrinn, delermjne dome5r,; pdc$ l."jll::',1: li* "*i r\4o si,od\.ue ha\e.hounbo$ rhf econom) recpoDds :'].d.j :...:11' "::ucing -.*
We have conpteted lwo of the three srepsrequired to pove rhe law of compffanve

ai wortd prices. Whenan economyis vcry small,its rradedoesnot affect wortdpricc!. Ljke an individual produrer con\umer a comperirr\( or In domesric marr.,.,, ."" **,*. _i Ur"""rrli grain for themnespondingquaftity ofcameras without ane"ting .aat;,e p,;ces;n tre worra mffkel.WhenJn econom)r. norrhar "malt,ho

::11w:: exchanged lhey were

,o slope srain ;"*,;, #:ff#]ffififf:Tr.."ilHH' ihe ofFF,, batTced gratn ",.0.", exports werc.iusr rarge enousn pay ro

we canni,q tdrethehnat.lepj\ho$ hn$ wlrfld tflce, areAerenrunel trourtrey ana redecr intemaiionaldifferences cost andpfiae strucrures. in ThetraderriangtcwasMpD in Figu 2-7.Wl

ffi;;'Hl;:#.,:*1']: ; ;:;,,tillTt;.iilT FiiT: :,"Ji;#

ror camera imporrs when

ar(rco. cnrngrnts \uppt) oifgraio e\pon, lbe Jnd lhe demandtbr camerr impon,. r , o\ ^c an$ e b e5 u re a rr p a n rc u tff u d er ri angte D u depi cr. tu fl ed8ed a equj t,brrumthc I c undit ionsd nb r rd e n ri h ee a ,i b b ) to o U D g . d urd.j orp1.," . * * ra., * orfa,_i .,. ( dm c om pe rrrrre e v e n w h e n l h e re a rc o n t l l $,,counu_re\.ftenumberoi counl nesdocr -_a not mdtier jf each counrry.s markets are compehuve ano govemment! do nor monopoliz thr countries' foreign rrade. Trade unjres rhe counmes . competjrive markets, and the sums of compelitive markets are likewise competirive_l

0,,."" *,'i ;fi ;:, ;",::Jillll#:ilL:i:il.I:.: ",."..*."1,.,, :l:

Equilibrium with Trade Between TwoCountries

jte]$o..ounrresaredesc,ibdbl Fisure thedome,rjc 2_q. r,dnsr,rmra,ioD Lune , , - . l\ ,, fne rorergn rransrormddon i\ r,r cu,\e A, Or i, tdrger ttan Or; andOT smalterthanozl, thereis an obviousseiseir) ;hiJh *" a","q"o" t, 0"L to produce grarn rhan camera". compared Lhe "ul", ro tbreign e.;om1. "*"._y ro empha,ize Influenre co,r condirions rhe of on inremarionat Lrad.. ruo rountne. rne areassurnedbhaveidenlical demand conditions.represcnred rhecommonindiffennce by curvesUo,Ur, and U9: Look firsr at ihe inlernat e4uitibrja bcfore tr:

"'trj# where'the culve{/0. rn the forejsncconomy, takeplaceat E_. they 'ndift.erence :: cuN:.1rl is tangenr thatsame to indir*** *,,".' cr"*ty, ,r," ..r,,i," :r:1to:natlon pnce01a camera higher thedomesnc is in economy in iheforeign than cconony, whichis
' I , a -,k- o .,u m .d o r r h r .e b ..d r Jn r h e .d e r t,h .ren..!w r tf,..pa,t..,t',..h."enL l n p , D tr r ,l d g - m Jn d h ! .o n lu ".n . oJtr0 In m , c q, i k senemt aur Int .onmor t?/ or T o n n,r.ccrF,.hd.i.pe.,dtpopn),har.,tutabrirpond,rrbc,vtnrrr.qedonJintr\d 1 e .T \e n !n n a n .,d e ., I d ., r a d re r,rJ. cevn.h. Jt\.po,",..,..*. ...p" .,:;; r Jnu / he on r rrtughr hne h,m rhc u.Ern..fhtr Drco.dvpr\er"ornrrj 't' i rom o8udcr . e m dn - ,o ftti" o n .d d ,e tJ,\e p ""r'' "

producriornnd d;;';; ;;;, ;;fi f" ;::T,lj:,*; consumpri"" dr:

f nT*

Dtermination of International prices

I
Equilibrium a Two-Country in Wortd

FTGURE 2-s

Su8:iiiJ'"'

xii:l:#ii1;#:'#',,,,:::'.rifl ,ii;N1r,r;::ht1;l:',ti1 f,Iljf l"';;:*{l*rru"x::,,;r.}.#'iilr:i+:i"f i',:T"':"'".liiilf.ll jJ";i,"ii.Tl;:y*n ji*hl:i^',ru ;ll';e ;:H 5:il:,:li:
consumption moves p, and domestrc to conru

rormatron cutuerrfi. Consumers both coul in

:rji",^,ji,*t. fiiiliii: +Te1"!ffi1::ir:i"T3"T::Hfi';l*[f"r:.x.

;?i,Tiijlj #"

equ!l quJnrrr) . !merre\p,,ns lhc ot ,upptied theorher. thesdme by dnd equctiry h,rrd mu\l ior hrd<rn graLn.lfceomeLricatty. counr rle rwo

a'"-a s,obo, ri.s*inlu );.;;;il;#:'tl'J"ii:::lT:H,i::ili,",ili:l:

mrkrr tie, berseenrhe price\ thdL pret;il

Dhatwe woutdexpect. because dornestic ronomy be er suited producing th e( rs to grain than cameras. Look oextartbe effects opening of trade. Whentrade unifies twocounrries, the narkets, m:.lre!:ir.anJrhcr muncrea'he md,ker,. un,ne,r n..,,"i*,;";:i. ::yi:r T:e, qare h,r condjri^n: lhr. I L Gt,,hal cumeru ourpur. den*a ,. ,f,.*rn, ,,r.,*o.,"n,1.,: outpurs, mustequal gt()bal the demand camer fo.

,aans,e.r ft,e.ec,,nd,,on\ onr) \e can tu,6,,i,,fi:Ii:lill#:J:i;:il:l:lli: $orld

is klwer than the old domesticprice). Thev arc

riT.r,'1,f,:tffi.iilm:l"l.n*:nxiniill;:j i.:
sreeper than the slopeof thar indifierence
rllt eqnndcnce of$esc r!,o condjrions denon(mted section is in I ofAppendnA.

36

Comparative Advantage and the

Gains from :llad

price) commo, is,he ffi ;:fr i'::.::i'":ffi: lfi::'jXl-t:"",.Li1gn rhe price

As thc openjngot' lradc reducesthe retal

*****#+t**+t* :5#: Hli: ;:H!: r::,""* #.i;:; .-"*;l;*i,"Tix';ru

:s***$***,**qr
TheTerms Trade of and Gains from Trade
nrponsfrom theother. reducrion A in iherclar

*i$"j*f;"*L:,:,,;i,:*;T*

;.i";3s*[-tl',,"ro
Comparative Advantage Once Again

fi .*."r,:ff iil.j,"r;ff --*u$ffig*i+ru

:; i:,1: l;.l;iil;#li'll'l "lll;li:u;i::lllm'"',:'Y;

xru;,;*'t rx$**jj"lji,,::1:".1jft'r:ilj nthT#f jti ;,:';.;,,l;;;,m,*;":';*.;iiT:';i,;,"#. l*r$,

?;::'",::,:"il:#ff;f fi ,,*ffi: .ff:::ffi ::::":.H,li:i:"":ii::

;",l: r;;'"il ":;'i.r :r{rilTlri;;:1ii- ;;::i::':i, n: ;l;rlitxiiJ:F :.: ,ru;lxr;::l*r lrj*

Offer Curves and Internationat Equilibrium

'nus reacl the higher indifferencecune Ur. Finally, it illusrratesrhe law of comoarative ,JrJntdtse If *le two countriesshownin Figule 2 9 hadidenticaltransfomation curves.there coutd :t no lrade betweenrhen. The poinrs t and E' would coincide, and the rwo counrrieJ xrces wouldbeidenticalbeforerade wasopened. Hence, unifcarion ofnaiional markets rhe rould bc withourconsequence, jt becarse wouldnor akerrelarjve prices. Eachcountrv,s im. s'flrd sr,r) r. Jnd each ci , fon,umers $outa.ra1 rhere. lnremrt ro,,. ,uootie, 'unrr) ruLld.dristl inremal dcmatrds eJcb in counry\cpararcly. rhere ard woutdbenoearn irom rlemari,,nal \pecralTJ|ionh,rmrntemudonat or e).LhanAe. u henthecounrne\' form,ioncunes dRerenl. unihcarion rrans r ae the ol nar;\rnal mar (eG cturnges relative prices.affectingprodricrionand consumption eachcountry.Both in .rountrie' gdn fium .peciatr,/arion er!hange. and Norein paniculrrrte n,nfe ol rtrega;n ::om ntemaaionalspecializarion_ donesric cconomyis better suitedto produce The smin *Jn .dnera,. comparcd theforejgn lo economy. rheoprning ,rude. c\ptoirr Wirh ot ir ;t, .imparative advantage. Reaciingro the fa[ in rheretarive price ofa carncra, domestic firms :.:-lducemoregrain and fewer cameras, ihe economyrhusr,ends srreciatize and io in srain :nrdLcri,,n. lorergn t}le econom) a ci,mparatire hr, adranrage cajner!producrion_ in rhc rror imageof the donestic economy'sidvantagein grain producrion .nd also exploils ::i .omparanveadvanlage. Reactingro the rise in the relative price of lt camera, foreign :r-msproducemore cameras less grain. and the cconomythus rendsto specialize and in :5r(rd I'roduflion. Lookingal these same responses hom another standpojnr. cansayrhattade offsetsthe we j.-dirence rclauve jn ,crrciue,.Betore r,lde is opened. camem: retdri\ety lre ,carce rhc In a-oestic economy. wbich is no1welt suitedto producethem.Tradediminishes rclarive rhis r:"rcity. Similariy. grajn is relatively scarce the foreign economy. tradediminishes in bur Err relat'vescarcity. B hendernand condirions idenrical, in Figure2 9,adiftbrercein relativescarcities arc as is t.iffilyduetoaditrerencei,supplycondinons.Iicoutdbedue.however.toadjfference x .rmrnd condirions.If rwo counrrieshaveidcnricattransformationcuNes but different lnitrcnce nraps,their relativepriceswill dilTerbelbretrade,but tradewjlt equatiz iheir =-:rii e pdces be beneticiat consumels. and to Tr lale account ofthis lasrpossibiliiy. law ofcomparaiive rhe advanragean resraied be 11Brms of price ditfcrencesratherrhancost dif;.cnces: In a world of competitive merkets, trade *ill occur and will be benffcial whenevercountries' relative prices would be diffrnt without rrad. I:E driierencein Fet.ade pricescanbe due ro a difierencein septy (cost)con{tirions, a :derencein demand condirions, a combination rhetwo. or of

OFFER CURVES INTERNATIONAL AND EQUILTBRIUM

How do narker processes estabtish sort of trading equilibrium described the by .!,-!re l'9? This questioncanbe answered mosreasilyby rteriving an ofer czrueto surn iirue rhe relevanlcoDdirjons eachcounrry and rhenputtjng rhe rwo countri;s, in offer

38

Comparative Advantageand the Gains from Trade

Deriving OfferCurve an
An oifcr curlc for the donestic econony is shown h the upper pan of Figurc 2 10. Thc horizonrrl axis shows its tfade in cameras. The vertical axis showsits rade iD grain. The otl.r curlc ./(:).,f uscsinf(trmationaboutrelaiive pricesio comect rhe rwo trade llo\rs. When the reladvcprice ofa c4mefais equ3lto the slopeof the lrre Fl.'. the donestic econony denands Oyofcarncra inrpots and suppliesyW of grain exporis. The oliercurve is dcnvcd lron the aansformarion curve and the indifference nap. Look back arFigure 2-9. When thc rclativeprice ofacamen is equalto the slopeofU0 alt, fte domestrc economydocsnot make any export oflir. This point conesponds the origin oi to the otler cun e in Figurc 2 I 0. The slopeof the ofier cun at its origin, givenby the dashcd lire tangentto it. corresponds the slopeof U0 at t. When rhe relaiive pdce ofa camera to price al E in Figure 2-9. the economy ofters grain exports in exchange is lower than the fbf canera inports. When the price i! equal ro the slope of Pr. for illsiance. it ofters MD of grain expofs and demrnds MP of camerannpofis. Thesequantiriesare reFoduced in Figure2-10.The line FF'has the sane slopeasPD in Figxre 2-9. The oiler ol grainexpods is yW, the demand 1br canrcr! iml)olls is (]y. and the trade triangle Ol4{r is idenlicrl 1()thc rade triangle MPD in Figtrrc 2 L Each point on the otler curvc JOJ producesone such iriangle.Those in the soxthwesl quadrant genelated are whcn thc relativepriceofa camenis lo$er thanthe one gi!en by thc slopeofthe dashed line. The economyoffers gran exponsin exchange canera irnports. lbr Thoseh the no heaslquadrlDtare genernred when rhe relaiiveprice ofa camerais highcr than the one gilen by thc sklpc of lhe dashedline. The economyoflers camcr.rcrpons in exchange grain imporrs.' ibr Eachpoinl on r cotrntrl,s olTcrcune conesponcls uniquely|o a produclionpoint on thc tanslbrllalion curve lrnd a consumption poinl on an inditlerencecurve.Orcr curlcs, said one economisl.rcsemblcthc hrnds ofa clock. They conveymuch inlbrmrftm in N snnple fashionbut are drilen by lt complex nechanismhidden behind then. The ofter curve lbr tbc turcign economy is shown in rlre lower parr of Figurc 2 10. It is llatier it itsprigin thaDthc donesiic otler curvc bccauscU0 is nrtlcr at L' than at ti in Figure 2-9. Funhermorc,thc line fF' inte^ech thc forcign ollcr curlc in the nothe.$r quadrani.The lbreign cc(nuny suppliesOyr of canrcrr crpor6 and dcmrnds y'W+ of graurimports, and the tiidc triangle Oy'W' is identicd lo |he tradc lrianglc M'D* Pl in Figure 2-9.

Combining OfferCurves
Figurc 2 l0 could be used to locrle equilibnun. We could rotate rhe line FF' rhrough crch origin until we generaiedthc natching pair of trade triangles Ol\y and Ol'-ll'. \!t cln locatc equilibdum more easily, howclcr, by putring both ofier cuns Thi\ i\ donc in Figurc 2 Ll. The fbreign of|cr curlc J'OJ' i! drawn as befbre. The done\tic o[.r.ur!eJOJ hasbeenflippedovcr The pnft appedring the northeasr quadranl in no$ lhou s the domesticdemandfor carncraimpofs and domestjclupply of gran expors.

"Th. onia cnn. .rnn.r pa$ rhrough nonhw.$ quadrant rhe ivh.n rxdis balrceJr the ecoDmy crnnordenandcaDcrxxndeiaininpon!limultuneously.ll]ccuFccannorpasthroughrhe$Lrh qurdfunr etreri rhee.onony.an ot ollercrnernrxl gnin exporls sinnlraNonsly

Olfer CurvesandInternatioul F,quilibdum

39

gvLJ = r.4Pb CSs

at lt exportsupply and impon demand ,oJ isthe domestic offer curve. shows is !t ol prices. Whenthe relativepriceo{ a camera equalto the slopeof the line willsupply yl/y of grain exports and demandOyof camefa domestic economy TfietradetriangleOyl4lcorresponds the trade triangleMPDin Figure2-9. to line,corresponds the slope to of the curveat itsorigin,shownby the dashed will hdifferen(curveUoat E in Figure2-9;the economy not offer or demand good whn world and domestic pricesare the same.ThcurveJtO./' is the. it offer curv.Whenthe relativepriceof a camera equalto the slopeof FF'.exports and demandy'vl^ of grain e(onomywill supplyOy' of camra M'D'P' in Figure Thtradetriangle OV't ^ correspondstothetradetriangle

40

Comparative Adyantage and the Gains ftom Tfade

F'!

dd

ForeignClnera Expors Donesric Canra lnporls

FIGURE 2-11 l"oGtingEquilibrium with Offer curves Thforeign offr curve,./'O./", is drawn as in Figure2-10.Ihe domestic ofier curv, lOJ, is redrawnwith axe revrsd. intEectionof th ofier curvs Wdfines The at The prircof a camra the worldmarkt giv6-by the trading equilibrium. rlative in is grain exports the elopeof FF, drawn from the oriqin through the point \ry.Do_melti( are eq;alto foreign_drain impo.ts,a-nd impo(5 ar; equ:lto to;eign domeiic <arirera camera exports.lf the relativepriceof a came.a were given by the slopeof HH'. the domesti(economy would be at z and the foreign economy would be at z'. Ihe domestic economywould demand {ewercameras n the {oreigneconomy tha would offer, and threlativepri(e of a camera would {all until it wasequalto the slopeof FF'.

This is doneso lhat thehorizonlal axisof the diagramcanbe used1() measure domestic the demand camera for impons alongwith the foreign supplyandthc lenical axis canbe used to measure domesdc the supply ofgrainexports demand. akrngwith theforeign lf therwooftercurves thesame had slopes ihe origin,thcywouldbe tangeni each at to otherand wouldnor intersect elsewhe.e Fieure2 I L This repeals slalement in a made befo.e. Whentwo counries'inlemalp.jces identicrlbcfore trade opened, wilt is they are not engage tradewhenfieir markets unified.If the curves in havedifferent slopes, are however, theywill nlwaysinlerscctat someotherpoinr. This repea$ihe law of comparative advantage. When iwo countries'prices ditrer beforc bade is opened,they will engage in tradewhenmarketsare unilied. tn Figue 2-11. the domesiicoffer curve is steeper the origin than the foreign ofter at qxadrant. curve.sothe two curvesinterse.l at W in thenonheast World prices(the tems of point. trade)aregivenby the slopeof the line drawnfrorn the origin throughtheintersection It is labeledFF' asusual.Ihe domesticcconomydcmands of camerrimpons, ,nd the Oy foreign economysuppliesthem.The foreign economydemands of gain imports, and vW the domesticeconomysuppliesthernpresented Finally, Figue 2-11 repeats exercise an eadier It showshow world pricesare established. Suppose lhat the world price of a camerawere higher than the one given by the slopeof FF'. The foreign econornywould supply morecameraexpor|s,the domestic eoDomy would demandlewer cameraimpots, and therewould be an excesssupply of

Offer Curves and International Equilibrium

4l

cameras theworld market.This woulddrive downtherelaliveprice of acanera,reducing on expod supply.raising import demand,and thus reducingthe excesssupply.The Focess was equalto the slopeof FF'. would end whenthe rclative price ofa camera

of and the Effects an lmport Tariff Offer Curves

chaplersio show how demandconditions' Offer curves a.reused in subsequent affect thc distribution of the gains fton trade growth, and other phenomena economic They arc alsousedto analyzetbe effecisof tarjff When we used demandand suPplycurvesto study the effects of an impod tadtr' we OP' simplificd ihe problem by lixing the price of a cameraon the world narket. (lt wa-s do that hereby lixing the rcladve pice of a cameraon $e wortd in Figure 2-2.) We can m{ker. It is the slopeof the line OJ" in Figure 2 I 2 The initial equilibrium occursat W. whereOJ* intersectsOJ. the domesticoffer curvc, andthe domesticprice of a camcrais will raisetheir domesticprice l-er equalto the world pnce. A tariff on impodedcameras pnce be givenby the slopeof the line OJr- Noic 2'2 provesthat the lariff rate canbe that

Note 2-2 Measuring the Levelof a Tafiff be l-et theworldpdceof a camera 2i andtheworldpnceof gain bep: - ff therariff
raie on an imported camera is ,. the domestic price of a camera is p ,-tl - ttr' .

As there is no tariff on grain, its donestic price is equal to ils world price (i e.. p, : pj). Dividing both sidesof the prcviousequationby pi, we have p f ' = tl -tta = tl tt7

hr;

in wherep is the relativeprice of a camera the domesticmarkelandp* is its relative price in the world ma.rket. cameras' pay consumers W'v'grain for Ov' imponed In Figure2 12,domestic gain for Ov' cameras. r,* is so Z'v' receive suppliers so p is W'v'lOV'. Foreign Z' V' I Ov'. Accotdingty.

Y2- :6., ;z!ov' ' '' ov" w'v

z ,v I Btt W, Vt : WtZt + Zt V' \o W' V, / Z, V' = | + Wt Z, /Z' V', and

w'z'
' i5z tv t '

42

Comparative Advantage and the Gains fmm Trade

FIGURE 2-12 A Tarifi in a Two-Goodworld the is when an economy too smallto affectworld prices, foreignoffr curvebecomee on price camera theworld ofa relative measuresthe anditsslope line thestraight O./', offer O./, whre O-l' intrsects the domestic at ;quilibrium occurs W initially, market. pric vvygrain,andthe domstic and importsOvcameras exports The curue. conomy importsraisetthe domestic ir of a camera equalto its world price.A tariff on camra pricebe givnby the priceo{ a camera abovethe world price Letthat new domestic will fall to Ov', the supplvo{ grain ;lope of OJr. Thdemandfor cameraimports to equivalent will will fall to v'W, and the government collecttariff revenu exports on will but pointmustlieon O-l', it5locarion depnd Th z'il grain. newequilibrium on the l{ spends tariff revenue. it spends revenue grain, the the w;y the government andpayior importov'cameras consumers will thnew equilibrium be at Z', where has afterthe government bought them with v'z'grain {theamounto{ grainremaining will be the on the spends revenue cameras, new equilibrium z'r4l). lJthe government pay for them with V Z gtair' atld and import ov' cameras at Z', where consumeE for and importsy'v" cameras pays them with z"W'grain As v'Z'and the oovernment are v'2", \otal grainexports just largeenough zdd up\o v'w', at\dv'w' equals Z'd to payfor totalcameraimports

will ldll lromOt Io Ov ll'e lor b] meJ.ured l,t ,/ 7 V. fte Jcm:rnd rrmerdrmP'rls willcollect taritr will of supply grainexporrs fall from vw to v'w'. andthegovemment in to equivalent value Z'W'ofgraiDrevenuc mustlie on OJ',1hc tbeign oftbr curve To locateit preciselv, The new equilibrium howevcr.we must know how the govemmcntspendsthe tariff rcvenue lf il spendsrhc of will the on revenuc grain. newequilibrium occurat Z' Thesupplv gain expor$wil1be to by Z'w' andthusfall to v'Z', but thisis just cnoxgh pry fbr Ov" of camefa reduced will occura1Z" The the on the inpofts. Ii it spends revenuc cameras, new equilibrium to 2"V ", andthisisjustenough wil ofgrainexporls renainat v']v'. whichequals supply govemmenr will par for Ov" of cameraimpots (Consumers buv Ov', asbefore,andthe io the it will buy tv'Z". thenumber cltnbuvwith Z'tv' of grain'raising lotaldemand Ov " ) wereuscdin Figurc2-2 to illustaie tbe impactof a denandcurves when supply and be Thal rnd cun'Lrmpuon produLrion r lff. $c.uuld.ee h"'\ rberurilfdilecred 'rnor

Recommended Readings

4J

to done in Figure 2 12, which doesnor showwhat happens productionor consumplion. io helptul in anotherway. By showingwhat happens relative prices, But offer curvesarc gain, aswell astradein cameras. Calne|aimpo[s rheyiell us how the tffifl affectstradein is Grainexports on fall to OV'or Ov" (depending thc way in whicb the revenue spent). fal:tto V'Z' or v" 2". We wil retum to thesemattersin Chapter9, wherewe k)ok more Ihoroushlvat the effecisof tariffs.

SUMMARY
Trade arises and is mutualy beneficial whenever there are intemational difierences in relative costs ofproduction. This is dre ldu .y'.,-Pdldtire ddrd'?rdae and the tundamental proposition of tade theory. Trade restrictio's, such as tarifts. tend to reduce ihe gains fron Ordinary supply and demand cufles can be used to illustate the main effects of trade When the world pdce of a good is lower than its donestic price, tradc raises the quantity denanded by dornestic consumersand reducesthe quantity supplied by domestic producersTte resulting innease in consumer surplus excceds ihe desease in producer surplus. and the difference measues tte welfare gain frorn lrade. Supply and demand curves can also be used to illustrate the majn effects of a taritr, which reduces the quantity demaDdedby domestic consumers and raises the quantity supplicd by domestic pmducers The resulting decreasein consumer surplus cxceeds the inci:ase in producer surplus, and the difference measuresthe welfare cost of the tariff: But trade involves a two way flow of goods and can be analyzed cornpletelv onlv bv using general-equilibnum models. The simplest model of this son contains two goods. Supply conditions are represented by a aansformadon curve Demand conditions are represenied by an indifference map. In a closed economy. the markets lbr the two goods cannot clef unless productbn and consumptbn take place at a coirnnon point ln an open economy, ihey can clear when production and consumptioD tate place at ditrerent points deGning a lrade triangle- The gains frorn trade are represented by the movement to a higher inditerence curve Thev can be decomposed into gains from intemational exchange and gains ftom intemational A two country model is requhed to show how the terms of trade are established The quantity of expons offered by one country must equal ihe quanlity of impofts demanded by the other (The r,'o countries tade triangles must be identical ) The terms of trade detemine how the gains ftom trade are disiribuGd Offers curves can be used 1oillustrate the determination of thc terms of trade in a two-good model and show how tiriffs aftbct the

READINGS RECOMMENDED
On transfomationcu.ves,idiffercnce curves,dd tradePdlems. *e Wassilvw Leontiel -ThcUseoflnditrerencc ofForeiSn Ttude: QMx.rU JoUML.t E onDhics. h Curves tbeAnalysis in (May I 933)rreprinlcdin Americu Econonic Associano!, Reddinss theIheor!- .t Inlenationat 24 Bli*iston, 1949).ch. I 0. For dolhcr derivalionof the offer curle andextensve rrade ( Philadelphia:

44

Comparative Advantage and the Gains from Trade

ap![catiors. seeJamesE. Meade.A Geontetn oI Ihterutonal Zfade (London: Alle! & Unw]n, 1952). i v. chs. Fd d way ro illusraLerhe gainslrom tmdewnhoul usingcontuunily indilTerence curles. seePeterB. Kenen. 'Or the G@netry of Wefm ftononLs:' Qwn. r Jotmnl oJ Econonns, 7l (Aueu( 1957)i rcpdnted in P B. Kenen,,rrals n lrterutiobal Economics\tuircero\ N.J.: Pnncelon Pns. 1980). Universiry The moslgeneralrestalenemof theeainsfiom tr2de,going beyondLhe lwo-goodmodel.is Sivenby PaulA. Smuelson. 'The Gainsfrom IntemarionalTmdeOnceAgrin," Ec,,,ni. ./odlel, 72 (December 1962).

AND PROBLEMSIO QUESTIONS

(l) Adapt FigDre2-l io show fia! a oounq/ rill export a good {hen the world price is higher than thc prctradedomesdcprice. Identify lhe quanrily ol expons.the changcsin domestic ptuducLion consumption. cha.gesin prcducerdd consums surplus,and the net choge in and the (2) Adapt Figw 2 1 10showhow a lall jn the wodd pricc of a cameraaffectsd economt imponing canens. ldentily thc effects or the qumtities prod&ed, .onsumed.dd imported, on F)duce. and consmer surplus,md on &onomic wettbrc. (3) Use your answerto (2) to showftrr an impoft trif| can be uwd ro prevert domesric productionfroD chdging in responk b a ibll in the world priceofa camera. tdenrily thetrifrate dd ttuiff revenue. effectson qlannties consunedand inported, andthe cffect on economicwelfsrc, rhe conpared to condinonslrevaiiing belbre od aier rhe fau in price. would you favor o! opposeihis policy? Explain(4) Adapt FigDre2'7 to showhow d incmse in the rctllive price of a cmera atT6rs d econotDy exlorting cameras. Identif tbe elt@tson the qua.iities of caDe6 andgrainlrodued and consuned,on thc qudlities erporredald impofled, dd on economicwelfde. (5) Adapt Figurc 2 910 prcve the statemertin rhe reir that countdeswirh idenlical tru$ fomtion cun cs can gain froh rradeif rheyhavediftbrcnrilditrerence maps.rdentify rhequanlities produced consunedbeforeandafterthe openingof trade.the quaDrities and traded,andthc effecron economicwelfm in eachcounrf. Explainhow your diagrm illustratesthe restarenenr lhe law of of compardtivc advant2ge, *hich saysthat benelicialtradewill ecur whencver two counfied rclative p.ices would be differenrwithoul trade. (6) Fig!.e 212 was said to represenr eff@ls of a tdiff on importodceeras, andNole the 2 2 shovedthat the trilf cte is equalto W,Z'/Z,V,. ShowrharFigure2 12 cd be saidb represenl Lnee fl e c r.o ra L l ri tro n e i p o n rd g ru equdtr,v Ot rnd Lhdr c\ponrtui firr r. equJro t rhrs I neim p o n l ,a re . rrri (7) When descnbin8the ellects of a. increale in the relative price of a camera,the rext saidthat fifN will producenore cmeras ed lessgrain. But lims rbat grow gGin do nol nomally mate camel?l.Hetrce. would be mde accumre saythar Rrms it to growinSBnin will contEct astheir pront fall dd lirms mabrg caheEs will expandastheir profrs nse. To complelethis story explain how the behavlorof investos could force nms producire grain ro .ont at ad allow nnns makina

lusec AFFndlx

C for oullines of esqer

ro the even-nunbeE!

quesons.