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The Pure International Trade Theory: Supply

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Chapter 9: The Pure International Trade Theory: Supply

9.1 Introduction

When an Indian purchases a Sony camera, Colgate toothpaste, or a bottle of Pepsi’s soft
drinks, obviously he or she is buying foreign products that are obviously made in and
imported from other nations. As tourists we need to exchange Indian Rupees for American
dollars, Mexican pesos, Japan yuan, euros (the new currency of the European Monetary
Union). In the era of globalization, the economic interdependence among nations has been
increasing over the years, as measured by the more rapid growth of world trade than world
production. Nations across the world have economic integrated so much so that economic
events and policies in one nation significantly affect other nations and vice-versa. For
example, if India stimulates its economy, part of the increased demand for goods and services
by its citizens spills into imports, which stimulate the economies of other nations that export
those commodities. On the other hand, an increase in the interest rates in India will attract
funds (capital) from other nations. This inflow of funds from abroad to India per se will
increase the value of India currency, which in turn stimulates imports and discourage exports.
This then leads to trade deficit, which dampens economic activity in India and stimulates
economic activity abroad. Thus, we see how different nations across the world are closely
integrated in today’s world and how government policies aimed at solving purely domestic
problems can have significant repercussions1.

All of these topics and many more are either directly or indirectly the subject matter of
international economics. International economics deals with:

1. International Trade Theory: International trade theory analyzes the basis for
mutually beneficial trade and gains from trade.
2. International Trade Policy: International trade policy examines the reasons for and
the results of obstructions to free flow of trade and new protectionism.
3. The Balance of Payments: The balance of payments measures the difference
between a nation’s total receipt from and the total payments to the rest of the world.
These involve exchange of one currency for other. Foreign exchange markets are the
institutional framework for conversion of one nation’s currency for others.
4. Adjustments in the Balance of Payments: This deals with the mechanism of
adjustment to balance of payment disequilibria. This examines how an economy of a
nation is integrated with the rest of the world under different international monetary
system.

International trade theory and international trade policies are the microeconomic aspects
of international economics because they deal with individual nations treated as single units
and mutually beneficial trade between the two nations depends on internal equilibrium
relative commodity price of an individual commodities. On the other hand, balance of
payments and adjustments in the balance of payment represent macroeconomic aspects of
1. Salvatore, Dominick, 2004, International Economics, Wiley India Pvt. Ltd.: 01-08
international economics because balance of payment deals with total receipts and total
payments with the rest of the world, and adjustment in the balance of payment deals with
adjustment mechanism and other economic policies that affect the level of national income
and the general price of the nation as a whole respectivley2.

International trade theory analyses the basis and the gains from trade. International trade
theory and policies are the microeconomic aspects of international economics because they
deal with individual nations treated as a single unit and with the (relative) price of individual
commodities. In this chapter, we examine the development of international trade theory from
mercantilists’ view on trade to the general equilibrium framework of the Heckscher-Ohlin
Theory to the economic growth and international trade. The basic questions that we seek to
answer in this chapter are:

1. What is the basis for trade and what are the gains from trade?
2. What is the pattern of trade? Pattern of trade means what commodities are trades and
which commodities are exported and imported by each nation?

We begin with the discussion of economic doctrines known as mercantilism (section 9.2)
that prevailed during the seventeenth and eighteenth centuries. We then go on to discuss the
theory of absolute advantage, developed by Adam Smith in section 9.3. After Adam Smith
we will discuss Law of comparative Advantage section 9.4), developed by David Ricardo.
Ricardo had based his explanation of law of comparative advantage on the labour theory of
value, which was subsequently rejected. In so doing, we must also reject Ricardo’s
explanation of comparative advantage, but we need not reject the law of comparative
advantage itself. The Law of comparative advantage is valid and can be explained in terms of
opportunity costs. In first part of twentieth century, Gottfried Haberler developed law of
comparative advantage theory in terms of the opportunity cost theory (section 9.5), as
reflected in production possibility frontiers, or transformation curves.

9.2 The Mercantilist’s Views on Trade

During seventeenth and eighteenth centuries a group of men (merchant, bankers, government
officials, and even philosophers) wrote essays and pamphlets on international trade that
advocated an economic philosophy known as mercantilism. Mercantilists were of the view
that the way for a nation to become rich and powerful was to export more than it imported.
The resulting export surplus would then be settled by an inflow of bullion, or precious metals,
primarily gold and silver. Thus, the government had to do all in its power to stimulate the
nation’s exports and discourage and restrict imports (particularly the import of luxury

2. Ibid., 1996,Tata McGraw-Hill: 1

consumption goods). However, since all nations could not simultaneously have an export
surplus and the amount of gold and silver was fixed at any particular point in time, one nation
could gain only at the expense of other nations. Thus mercantilists’ trade is based on
economic nationalism because they advocated strict government control of all economic
activities and believed that a nation could gain in trade only at the expense of the other
nations (i.e., trade was a zero sum game).

Mercantilists were writing primarily for rulers and to enhance rural powers. With more
gold, rulers could maintain larger and better armies and consolidate their power at home;
improved armies and navies also made it possible for them to acquire more colonies. In
addition, more gold meant more money (i.e. more gold coins) in circulation and greater
business activity. Furthermore, by encouraging exports and restricting imports, the
government would stimulate national output and employment.

Mercantilists measured the wealth of a nation by the stock of precious metals it

possessed. In contrasts, today we measure the wealth of a nation by its stock of human, man
made, and natural resources available for goods and services.

9.3 Theory of Absolute Advantage: Adam Smith

In section 9.1 we have studied that trade between two nations is possible only at the cost of
other nation. Adam Smith believed that all nations would gain benefit from free trade and
strongly advocated a policy of laissez-faire (i.e., government should less interfere in the
economy). According to Adam Smith trade between two nations is based on absolute
advantage. The absolute advantage means the greater efficiency the one nation may have over
another in the production of a commodity. This was the basis for trade between two nations
for Adam Smith. Smith argued that with free trade one nation could specialize in the
production of that commodity in which it is more efficient (or has an absolute advantage)
than the other nation. This nation should export this (absolute advantage) commodity and
import that commodity in which it is less efficient (absolute disadvantage) than the other
nation. By this process, a nation behaves like an individual, he produces only that commodity
that he can produces most efficiently and then exchanges part of his output for the other
commodity in which he is less efficient (absolute disadvantage). This way total output and
the welfare of all individuals are maximized. This theory only tells us that both nations would
gain from production and trade. This theory does not explain how the gains from trade are
divided among the trading nations. This theory also fails to determine the rate at which
commodities will be exchange between two nations.
9.3.1 Illustration of Absolute Advantage

Table 9.1: Absolute advantage

U.S. India

Wheat (Bushels/ man-hour) 8 1

Cloth (yards/man-hour) 3 7

Explanation of the illustration

1. In U.S. 1 hour of labour time produces 8 bushels of wheat.

2. In India 1hour of labour time produces 1 bushels of wheat.
3. In U.S. 1 hour of labour time produces 3 yards of cloth.
4. In India 1 hour of labour time produces 7 yards of cloth.

From above explanation it is clear that U.S. is more efficient than, or has an absolute
advantage over India in production of wheat, while India is more efficient than, or has an
absolute advantage over U.S. in production of cloth.

Result:

1. With trade, U.S. would specialize in production of wheat and export part of it with
India cloth.
2. With trade, India would specialize in production of cloth and export part of it with
U.S. wheat.

Total output from international trade or gain/loss from international trade

What happen if U.S. exchanges 8 bushels of wheat (8W) for eight yards of India cloth (8C):

1. U.S. gains 5C (since U.S can only exchange 8W for 3C domestically). With trade
U.S. gain is equal to 5C (i.e., 8C - 3C) or U.S. could save 1.7 man-hour or more than
half an hour of labour time.

Calculation for 1.7 man-hour of labour time:

For production of 3C U.S. required------------------ 1 man-hour of labour time

For production of 1C U.S. would required------------

For production of 5C U.S. would required------------ ∗5C = 1.7

Therefore, U.S. saves 1.7 man-hour of labour time or gains 5C.

2. India receives 8W from U.S., which would require 8 man-hours of labour time to
produce in India (since in India 1 man-hours of labour time required to produce 1W).
These same 8 man-hours can produce 56 cloth (56C) in India. In India 1man-hours of
 labour time produce 7C. therefore, 8 hours of labour time can produce 56C (8hours
times 7C) .
3. Out of 56C India exchanges 8C with the U.S. India gains 48C (56C-8C) or saves 6.85
man-hour of labour time

Calculation for 6.85 man-hour of labour time:

For production of 7C India. required------------------ 1 man-hour of labour time

For production of 1C India would required------------

For production of 48C U.S. would required------------ ∗ 48C = 6.85

Therefore, India saves 6.85 man-hour of labour time or gains 48C.

It is clear from the above explanation that India gains much more than United States but
this does not matter here. This theory explains that international trade between two nations is
possible without making other nation worse off, if both nations are more efficient (absolute
advantage) in production of one of the two commodities.

9.4 Law of comparative Advantage: David Ricardo

According to Adam Smith mutually beneficial trade between two nations is based on absolute
advantage. Law of comparative advantage, developed by David Ricardo, postulates that even
if one nation is less efficient than (absolute disadvantage) the other nation in production of
both commodities, there is still a basis for mutually beneficial trade, unless the absolute
disadvantage is in the same proportion. The less efficient nation (absolute disadvantageous
nation) should specialize in the production and export the commodity in which its absolute
disadvantaged is less. This is the commodity in which less efficient nation has comparative
advantage. On the other hand the less efficient nation should import the commodity in which
its absolute disadvantage is greater (comparative disadvantage). This is the commodity of
comparative disadvantage of less efficient nation.

One must note that if one nation has comparative advantage in one commodity, then the
other nation must necessarily have comparative advantage in production of the other
commodity.

9.4.1 Assumption of Law of Comparative Advantage

Ricardo based his law of comparative advantage on following assumptions:

1. Only two nations and two commodities;

2. Free trade;
3. Perfect mobility of labour within each nation but immobility between the two nations;
4. Constant cost of production;
5. No transport cost;
6. No technical change;
 7. The labour theory of value;
8. Labour is homogeneous;
9. Cost or price of a commodity inferred exclusively from its labour content

9.4.2 Explanation of the Labour Theory of Value

Ricardo based his law of comparative advantage under the labour theory of value. According
to the labour theory of value, the value or price of a commodity depends exclusively on the
amount of labour going into the production of the commodity. Besides, labour is used in the
same fixed proportion in the production of all commodities. Law of comparative advantage is
one of the most famous and still unchallenged laws of economics. Law of comparative
advantage is criticized basically for its labour theory of value. It is assumed that labour is
homogeneous but labour is not homogeneous, it may vary greatly in training, qualification,
productivity, and wages. It was Haberler who came to “rescue” by explaining the law of
comparative advantage in terms of opportunity cost of theory, as reflected in production
possibility frontiers or transformation curves3. In this form law of comparative advantage is
sometimes referred to as the law of comparative cost.

A country’s comparative advantage is the good that it can produce relatively cheaply;
that is at lower opportunity cost than its trading partner4.

9.4.2.1 Illustration Law of comparative Advantage

Table 9.2: Comparative Advantage

U.S. India

Wheat (Bushels/ man-hour) 8 1

Cloth (yards/man-hour) 3 2

Explanation of illustration

1. The only difference between the two Table 9.1 and Table 9.2 is that India now
produces only 2 yards of cloth per man-hour (2C) instead of 7C. Thus, U.S. has an
absolute advantage in the production of both wheat and cloth. According to Adam
Smith’s Absolute Advantage Theory in this type of situation trade between two nation
is not possible since India has an absolute disadvantage in production of both
commodities i.e., wheat and cloth with respect to the United States.
2. Though India has an absolute disadvantage in production of both wheat and cloth but

3. Salvatore, op.cit.

4. Wonnacott, Paul; Ronald, 1979, Economics, McGraw-Hill Kogakusha Ltd.: 41

 her absolute disadvantage is less in cloth since India labour is 1.5 times (3÷2) less
productive in cloth and 8 times(8÷1) less productive in wheat with respect to United
States. Thus, India’s absolute disadvantage is less in production of cloth with respect
to the production of wheat. Thus, India has comparative advantage in production of
cloth.

3. United States has an absolute advantage in production of both wheat and cloth with
respect to India, but since its absolute advantage is greater in wheat (8:1) than in cloth
(3:2). The United States has a comparative advantage in production of wheat.
4. The comparative advantage depends on opportunity cost of a commodity in a nation.
For example, in Table 9.2 in India, one worker can produce one units of wheat (W) or
2 units of cloth (C). Thus, the opportunity cost of 1W in India is 2C. In U.S. one
worker can produce 8unit of wheat or 3 units of cloth. Thus, the opportunity cost of
1W in U.S. is therefore = 3/8 =0.37 units of clothing. (Notice how we calculate this
opportunity costby taking the ratio of the figures in the U.S. column, just as we
calculated the cost in India 2/1)
5. In point 4 we have seen that the opportunity cost of 1W in the U.S. is 0.37, which is
less than the opportunity cost of wheat in India. Thus, the U.S. has comparative
advantage in producing wheat
6. The opportunity cost of cloth in India is 0.5 (1W/2C) and in U.S. is 2.6 (8/3). Since
the opportunity cost of cloth in India is less than in the U.S., India has a comparative
advantage in cloth and specialises in this good.

Result:

1. With trade, U.S. exchanges wheat with India cloth.

2. India export cloth to U.S and import wheat from U.S.

Total Output and Gains from Trade in terms of Cloth:

1. We have seen a short while ago that both nations would gain by exchanging 8W for
8C. However, this is not the only rate of exchange at which mutually beneficial trade
can take place.
2. United States exchanges 8W for 3C domestically for both requires1 man-hours to
produce. U.S. would gain if it could exchange 8W for more than 3C from India.
3. India exchange 8W for 16C since both requires 8 man-hours to produce. India would
gain if it could give up anything less than 16C to obtain 8W from the U.S.
4. To summarize, U.S. would gain if it receives more than 3C for 8W from India, and
India would gain if it can give up less than 16C for 8W. Thus, the range for mutually
advantageous trade is 3C < 8W < 16C.
5. The spread between 3C and 16C is 13C, which represents total gains from trade
available to be shared by the two nations by trading 8W.
6. We have seen that by exchanging 8W for 8C, U.S. gains 5C, and India gains 8C (16C-
8C)
 7. There may be another exchange ratio for example, if U.S. exchanges 8W for 13C.
U.S. would gain 10C (since U.S. exchanges 8W for 3C domestically) and India would
gain 3C.

So far, the gains from specialization in production and trade have been measured in
terms of cloth. In section 9.5.2, and 9.5.3 we will see how the gains from trade could also be
measured in terms of both wheat and cloth and how actual rate of exchange will be
determined in the real world by demand as well as supply considerations. The rate of
exchange will also determine how the total gains from trade are actually shared by the trading
nations. Up to this point, all we have to prove is that mutually beneficial trade between two
nations is possible even if one nation is less efficient (absolute disadvantage) in production in
both commodities5.

9.5 Law of Comparative Advantage in Terms of the Opportunity Cost Theory:

Haberler

Gottfried Haberler has explained the law of comparative advantage theory in terms of
opportunity cost theory. He has relaxed the assumption of labour theory of value while
explaining law of comparative advantage based on opportunity cost. Opportunity cost of a
first commodity is the amount of a second commodity that must be given up to release just
enough resources to produce one additional unit of the first commodity. For example, if in the
absence of trade the United States must give up 3/8 of a unit of cloth (in U.S. 8W = 3C; cost
of 1W = 3/8C) to release just enough resources to produce one additional unit of wheat
domestically, then the opportunity cost of wheat is 3/8 of a unit of cloth (i.e., 1W = 3/8 C) in
the United States (See Table 9.2). India is producing 1bushels of wheat and 2 yards of cloth 1
man-hours of labour time domestically i.e., domestically exchange ratio inIndia between
wheat and cloth is 1W = 2C ( See Table 9.2). If we convert this into cost i.e., 1W = 2C, which
represents opportunity cost of 1unit of wheat is 2 unit of cloth in India. This means that India
must give up 2 units of cloth to obtain 1 unit of wheat. In a two nations, two commodities
world, India would then have a comparative advantage in cloth and United States would have
comparative advantage in wheat.

According to opportunity cost theory India should specialize in producing cloth and
export some part of it in exchange for U.S. wheat. This is exactly what we concluded earlier
with Ricardo’s Law of comparative advantage theory based on the labour theory of value, but
now our explanation is based on Haberler’s opportunity cost theory.

9.5.1 Opportunity Cost and Production Possibility Curves

Opportunity cost relates to the opportunities of alternatives foregone to produce one more
unit of a commodity. Opportunity cost can be construed with the production possibility curve.
A production possibility curve (sometimes called a production possibility frontier or a
production transformation curve) is graphical representation of the various combinations of

5. Salvatore, 2004, op. cit,: 37

two commodities that a nation can produce by fully utilizing all of its factors of production
with the best technology available. The slope (mathematically, a slope measures steepness of
a straight line, or that of a curve, at a given point. It is calculated as height divided by base or
with reference to axis, slope is equal to vertical axis divided by horizontal axis) of the
production possibility curve then refers to the marginal rate of transformation (MRT).
Suppose there are two commodities viz; wheat and cloth. We want to produce one additional
unit of wheat at the cost of cloth. In economics terminology, this can be written as MRTwc.
The MRTwc read as marginal rate of transformation of wheat for cloth, the MRTwc
measures the amount of cloth that the nation must give up in order to get one more unit of
wheat. Thus, MRT is another name for opportunity cost. There are three types of
opportunity cost viz., constant opportunity cost, increasing opportunity cost and decreasing
opportunity cost. Constant opportunity cost and decreasing opportunity cost are not realistic.
Constant opportunity cost is discussed only because they serve as a convenient introduction
to the more realistic case of increasing opportunity cost.

Opportunity cost can be illustrated with the production possibility curve (sometimes
called a production possibility frontier or a product transformation curve. The production
possibility frontier is a curve that shows the alternative combinations of two commodities that
can be produced when all resources are fully and efficiently employed by a nation with the
best technology available to it.

9.5.1.2 Constant Opportunity Cost

Constant opportunity cost arises when:

1. When all units of the same factor are homogeneous or of exactly same quality, and

2. Factors of production or resources are perfect substitute or used in same fixed proportion in
the production of both commodities

The production possibility curve under opportunity cost takes the shape of a
downward straight line from left to right. It is called linear curve. It reflects constant
opportunity cost in the sense that the same amount of one commodity must be given up to
produce each additional unit of the second commodity. The production possibility curve
under constant opportunity cost is illustrated through Table 9.3.This Table 9.3 is graphically
presented in Figure 9.1. The production possibility schedules of one nation (such as India) for
wheat and cloth is given in Table 9.3 is graphed as production possibility frontier in Figure
9.1.

Table 9.3 Production Possibility Schedules for Wheat and Cloth in India

Quantity of Wheat 180 160 140 120 100 80 60 40 20 0

(million bushels
/year)
Quantity of Cloth 0 15 30 45 60 75 90 105 120 135
(million yards /
year
Table 9.3 gives the (hypothetical) production possibility schedules of wheat (in million
bushels/year) and cloth (in million yards/year) that India can produce.. We observe that India
can produce 180 W and 0C, 160W and 15C, or 140W and 30C, 30C, down to 0W and 135C. For
each 20W thatat the India gives up, just enough resources are released to produce an additional
15C. This explains that in India 20W is exchanged for 15C.ThatThat is, 20W = 15C (in the sense
that both require the same amount of resources). Thus, the opportunity cost of 1W = 15/20C
or 3/4C.

The combination of the production of wheat and cloth in India is shown by production
possibility curve PP1 in Figure 9.1. This production possibility curve is a straight line
because for each one additional unit of production of wheat the amount require to be satisfied
in terms of cloth remains the same i.e., 1W = 3/4C. On each point of production possibility
frontier/curve PP1, the
he slope of the production possibilities curve then refers to the marginal
rate of transformation (MRT) or to the amount of a commodity
commodity that the nation must given up
in order to get one more unit of the second commodity. Thus, the marginal rate of
transformation of wheat
eat for cloth (MRTwc) may be defined as the magnitude of the slope of
the frontier at each point. The MRTwc measures how much clothing must be given up to
produce one additional unit of wheat.. In the Figure 9.1 3/4C must be given up to produce one
additional unit of wheat.

In Figure 9.1 moving downward on production possibility curve from point A to Point
D constant unit of cloth requires to give up for each additional unit of wheat.

9.5.1.3 Increasing Opportunity Cost

Generally, in real world, it is more likely for a nation to face increasing opportunity cost or
MRT in producing more units of a commodity. The marginal rate of transformation of wheat
for cloth (MRTwc) refers to the amount of cloth that nation must give up to produce each
additional unit of wheat. Thus, MRT is another name for opportunity cost. Increasing
opportunity cost means that the nation must give up more and more of one commodity to
release just enough resources to produce each additional unit of another commodity. As a
result, production possibility curve under increasing opportunity cost results in a production
frontier that is concave from the origin.This is shown by a production possibility curve that is
concave to the origin. This is illustrated in Table 9.4. This Table 9.4 is graphically presented
in Figure 9.2. In the Figure 9.2, production possibility curve, PP2 is concave to the origin
because as we move downward point A to E more unit of cloth are required to give up to
produce one additional unit of wheat. In other words, cost of producing one additional unit of
wheat in terms of cloth is increasing.

Table 9.4 The Production Possibility Schedules for Wheat and Cloth in India

Quantity of Wheat 0 20 40 60 80 100 120 140 160 180 200

(million bushels
/year)
Quantity of Cloth 550 540 520 490 450 400 340 270 190 100 0
(million yards / year

600
P
A
500 INDIA
B
Quantity of Cloth

400
C
300

200 D

100 E

0 P2
0 50 100 150 200 250
Quantity of Wheat

Figure: 9.2 The Production Possibility Curve under Increasing Opportunity Cost

Table 9.4 gives the (hypothetical) production possibility schedules of wheat (in
million bushels/year) and cloth (in million yards/year) that India can produce. We observe
that India can produce 0W and 550C, 20W and 540C, or 40W and 520C, down to 200W and
0C. For producing 20 units of wheat, India requires to give up 10 units of cloth i.e., 20W =
10C. For another 20 unit of wheat, India requires to give up 20 units of cloth i.e., 20W = 20C.
Therefore, we can say that in case of concave production possibility curve, PP2 the cost of
producing one additional unit of wheat in terms of cloth is increasing as we move downwards
on concave production possibility curve. In other words, we can say that MRTwc is
increasing as shown in Figure 9.2 and Table 9.4.1.
 Table 9.4.1 Calculation of Cost on Concave Production Possibility Frontier/Curve

1 2 3 4
Quantity of Wheat Quantity of Cloth Exchange Ratio Increasing
(million bushels (million yards / year Opportunity Cost
/year) (MRTwc)
0 550
20 (20) 540 (10) 20W = 10C 1W = 10/20C
40 (20) 520 (20) 20W = 20C 1W = 20/20C
60 (20) 490 (30) 20W = 30C 1W = 30/20C
80 (20) 450 (40) 20W = 40C 1W = 40/20C
100 (20) 400 (50) 20W = 50C 1W = 50/20C
120 (20) 340 (60) 20W = 60C 1W = 60/20C
140 (20) 270 (70) 20W = 70C 1W = 70/20C
160 (20) 190 (80) 20W = 80C 1W = 80/20C
180 (20) 100 (90) 20W = 90C 1W = 90/20C
200 (20) 0 (100) 20W = 100C 1W = 100/20C

9.5.1.4 Decreasing Opportunity Cost

The production possibility curve become convex to the origin when cost of producing one
unit of wheat in terms of cloth decreases as shown in Table 9.5. This Table 9.5 is graphically
presented in Figure 9.3. Table 9.5 explicitly states that for each additional unit of wheat, cost
in terms of cloth is decreasing. In other words marginal rate of transformation of wheat for
cloth (MRTwc) is decreasing. For example, when we move from 0 unit of wheat to 20 unit of
wheat; sacrificed unit of cloth is 40 unit (220 - 180); cost of 1W=2C (20W = 40C). Thus,
MRTwc is 2. For another additional 20 unit of wheat (180 - 160) the unit sacrificed in terms
of cloth is 8 units (12 - 4), the MRTwc = Pw/Pc = 0.4. As we producing more and more unit
of wheat, opportunity cost (MRTwc) is decreasing. This is also clear from the production
possibility curve PP3, which is convex to the origin because the cost of producing each
additional unit of wheat in terms of cloth is decreasing. For example, at point C, 70W =
100C, here, opportunity cost of 1W = 1.42 (or at point C MRTwc = Pw/Pc = 10/7). When we
move from point C to point D on PP3 curve as shown in Figure 9.3, for additional unit of
wheat,40W (110-70) = 50C (100 - 50); i.e., 40W = 50C, opportunity cost of one wheat is
1.25 (or at point D, MRTwc = 5/4). The MRTwc is 10/7 at point C and it decreases to 5/4 at
point D.

Table 9.5 The Production Possibility Schedules for Wheat and Cloth in India

Quantity of Wheat 0 20 40 60 80 100 120 140 160 180 200

(million bushels
/year)
Quantity of Cloth 220 180 144 112 84 60 40 24 12 4 0
(million yards / year
 250
P
200 A
India
150 B
Cloth

100 C

50 D

0
P3
0 50 100 150 200 250
Wheat
Figure: 9.3 The Production Possibility Curve of India under Decreasing Cost

9.5.2 The Basis for Trade and Gains from Trade under Constant Opportunity Cost

In autarky or the absence of trade, a nation can only consume the commodities that it
produces. Consequently, in absence of trade production possibility frontier of a nation
represents its consumption frontier. Note that in the case of constant costs, Pw/Pc, or internal
equilibrium of a nation is determined exclusively by production, or supply conditions in each
nation. Demand considerations do not enter at all in the determination of relative commodity
prices.

With trade, each nation specializes in the production of the commodity of its
comparative advantage, exchange part of this for the commodity of its comparative
disadvantage and end up consuming more of both commodities than without trade. This is
construed though example given below.

Example: Suppose the maximum amount of wheat or cloth that India and U.S.could produce
if they fully utilized all the factors of production at their disposal with the best technology
available to them. This is shown in Table 9.6

Table 9.6

Items/Particulars India United States of America

(U.S)
Wheat (millions of bushels/year), W 180 80
Cloth (millions of yards/year), C 90 160
Table 9.6 states that India could produce either 180W and 0C or 90C and 0W if she
decides to produce either of the two commodities. If we combine 0C and 180W with 0W and
90C we get the production possibility curve of India as shown by PP1in part (i) of Figure 9.4.
Similarly, the production possibility curve of U.S. is the combination of 0C, 80W and 0W,
160C, as shown in part (ii) of Figure 9.4. To understand the mutually advantageous trade
between two nations (here we have taken India and U.S. as two nations), we have to consider
the following:
 I. Internal equilibrium (domestic exchange ratio) of each nations;
II. Nation’s comparative
omparative advantage in producing commodities
III. Mutually advantageous trade between the two nations;
IV. Mutually advantageous trade between the two nations is possible within the
limits of the slope of the production possibility curve or marginal
ma rate of
transformation (MRT).
(MRT) Whether the production possibilities curves are straight
lines or concave to the origin, there is a basis for the mutually advantageous
trade whenever there is difference in the pre-trade
pre trade relative commodity price
betweenn the two nations;
V. Gains from trade.
In the absence of trade, production possibility curve or frontier also represents its
consumption frontier (i.e., the nation can consume only a combination of commodities
that it can produce). The production possibility curve of India and U.S. is shown by PP1
in part (i) and (ii) of Figure 9.4 respectively, which is a straight line. The straight line
production possibility curve shows that the opportunity cost of producing wheat and cloth
in each nation is constant. Note that each point on the production possibility curve
represents one combination of wheat and cloth that the nation can produce. For example,
India’s equilibrium is shown at point E, where in the absence of trade, India is consuming
60W and 60C, i.e., India is exchanging 60W for 60C. Similarly, the internal equilibrium
point of the U.S. is at point E, where U.S. in the absence of trade is exchanging 60W for
40C. The more of one commodity the nation produces, the less it is able to produce of the
other (i.e., the curves are negatively sloped). Internal equilibrium that is point E in both
nations is determined exclusively by tastes or demand conditions in each nation.

After assuming that India and U.S. are exchanging 60W for 60C and 60W for 40C
respectively in the absence of trade, then we will determine comparative advantage of
each nation in producing commodities. Comparative advantage of each nation in
producing cloth will be determined by the slope of the production possibility curve (PPC)
or marginal rate of transformation (MRT). The slope of the PPC for India is:
& " '(&) +, 45
slope =
!" #"$
= *' (*)
= -,
= . = /0123 = 4
and remains constant. For
6, 45
the U.S. the slope is = 2 = /0123 = and remains constant. MRTwc is read as
-, 4
marginal rate of transformation of wheat for cloth. This shows the amount of cloth that
45
must be required to give up to produce one additional unit of wheat. 4 indicates ratio of
price of wheat and price of cloth.

In India, comparative cost for cloth and wheat will be calculated as,

90C = 180W
-,
1C = 8, 1; = 28
+,

Thus, opportunity cost of 1C is 2W in India;

180W = 90C
+,
1W = ;, 18 = . ; <= 18 = 0.5C
-,

Thus, opportunity cost of 1W is 0.5C in India. We can say that in the absence of trade
internal equilibrium in India is Pw/Pc = 1/2. This is relative commodity price of wheat in
India that is price of wheat in terms of cloth in India is Pw = 1/2C and internal
equilibrium in U.S. is Pw/Pc=2. This is relative commodity price of wheat in U.S. that is
price of wheat in terms of cloth in U.S. is Pw/Pc = 2C. A difference in relative
commodity prices between two nations is reflection of their comparative advantage and
forms the basis for mutually beneficial trade. The nation with the lower relative prices for
 a commodity has a comparative advantage in that commodity and a comparative
disadvantage in the other commodity, with respect to the other nation.

In U.S. comparative cost for wheat and cloth will be calculated as follows,

160C = 80W
-,
1C = 8, 1; = 8 <= 1; = 0.58
6, .

Thus, opportunity cost of 1C is 0.5W in U.S.

80W = 160C
6,
1W =
-,
;, 18 = 2; <= 18 = 2;.

Thus, opportunity cost of 1W is 2C

Calculated opportunity cost for wheat and cloth in India and U.S are given in Table

Table 9.7

India United States of America

1C = 2W 1C = 0.5W
1W = 0.5C 1W = 2C
Trade between India and United Nation of America

Table 9.7 explicitly states that the opportunity cost of producing one unit of wheat in India
is less (i.e., 1W = 0.5C). Therefore, India has a comparative advantage in producing wheat.
United States of America has comparative advantage in producing cloth as the opportunity
cost of producing one unit of cloth is less (i.e., 1C = 0.5W). Since, there is difference in pre-
trade relative commodity prices (such as, pre-trade relative commodity price of wheat in
India = Pw/Pc =90/180= ½ and pre-trade relative price of wheat in U.S.=Pw/Pc=160/80=2)
between the nations, mutually beneficial trade is possible. With trade, India should specialize
in the production of wheat (the commodity of its comparative advantage) and United States
of America should specialize in the production cloth. With trade, India is producing 180W
and 0C at point P1and U.S. is producing 160C and 0W at point P (see part (i) and (ii) of
Figure 9.4). Both nations could specializes in the production of commodity of its comparative
advantage and exchange part of this for the commodity of its comparative disadvantage and
consuming more of both commodities as shown in part (i) and (ii) of Figure 9.4 at point E1.

With trade both nations consume more of both commodities at point E1 as shown in
Figure 9.4. How is this equilibrium point E1 derived? For this, we have to know the
possibility of mutually advantageous trade between the two nations. Since in the absence of
 & " '(&) 45 & " '(&)
trade AB<CD = = /0123 = = in India while AB<CD = = /0123 =
*' (*) 4 . *' (*)
45
4
= 2. Mutually advantageous trade is possible between the differences in the internal or
pre-trade relative commodities prices of the two nations. Thus, mutually beneficial trade is
45 45
possible within the limits: < < 2. if is stabilized at 1 with trade. With trade India
. 4 4
moves from point E to point P1, where India is producing 180W and 0C as shown in part (i)
of Figure 9.4. From point P1 India moves to point A at 180C. This curve P1A is international
45
trade price line. On this international trade price line, P1A, is stabilized at 1 (i.e., slope =
4
& -, 45
= = 1 =MRTwc = = 1). Now, with this trade India can move from point E to point
* -, 4
E1, where India consumes 90W and 90C as shown in part (i) of Figure 9.4. At this
equilibrium point E1, India consumes only 90W of 180W. India exchanges remaining 90W
of its total 180W produced at point P1 for 90C from the U.S. (with trade U.S. produces 160C
and consumes only 70C, so remaining 90C is exchanged for 90W with India) and end up
consuming at point E1. At this equilibrium point E1 India gains 30W (90W – 60W) and 30C
(90C – 30C) as shown in part (i) of Figure 9.4. Similarly, with trade U.S. can move from
point E to point E1, where U.S. consumes 90W and 70C as shown in part (ii) of Figure 9.4.
At this equilibrium point E1, U.S. consumes only 70C of 160C. U.S. exchanges remaining
90C of its total 160C produced at point P for 90Wfrom the India. (with trade India produces
180W and consumes only 90W, so remaining 90W is exchanged for 90C with U.S.) and end
up consuming at point E1. At this equilibrium point E1 U.S. gains 30C (70C – 40C) and 30W
(90W – 60W) as shown in part (ii) of Figure 9.4. Gains from trade is illustrated in Table 9.8

Table 9.8 Gains from Trade

Items India United States of America

Before After Gains Before After Gains from
Trade Trade from Trade Trade Trade
Trade
Wheat 60 90 30 60 90 30

Cloth 60 90 30 40 70 30

9.5.3 Relative Commodity Prices with Trade

In this section we will see how the rate of exchange is actually determined in the real world
by demand as well as supply consideration. This rate of exchange will also determine how the
total gains from trade are actually shared by the trading nations. This is shown in part (i) and
part (ii) of Figure 9.5. In part (i) of Figure 9.5 total quantity of wheat is shown on X axis and
price of wheat on Y axis. In part (i) of Figure 9.5, total quantity of supply of wheat for both
India and U.S. is 180 and 80 respectively. Total quantity of wheat is the combined supply
curve for wheat of India and U.S., which is shown by Sw = India + U.S. (260 = 180 + 80) at
point P. It shows that India could produce a maximum of 180W = AB at price, Pw/Pc = 1/2 =
0.5 (180W=90C) while U.S. could produce a maximum of 80W = CD at price, price Pw/Pc =
2(80W=160C).. This shows that India could produce with complete specialization in wheat
production at constant opportunity cost of Pw/Pc=1/2(in
Pw/Pc= 2(in India, 180W = 90C just as in part (i)
of Figure 9.4 ). U.S. could produce a maximum quantity of wheat at constant opportunity cost
of Pw/Pc = 2 (In U.S., 80W = 160C just as in part (ii) of Figure 9.4)). Thus, 260 is the
maximum combined total quantity of wheat that India and U.S could produce at Pw/Pc=1/2
and Pw/Pc=2 respectively if both nations used all of their resources and technology available
at their disposal. As a result, the supply curve of both nations, Sw=India+U.S. is vertical at
260, shown by PS curve. This vertical supply curve, Sw=India+U.S. comprises AB+CD or
AB+RP or 0R+RP = 180+80=260.

Suppose that, with trade the combined demand curve for wheat in the India and the
U.S. is Dw = India + U.S. as shown in part (i) of Figure 9.5. India has a comparative
advantage in producing cloth. Therefore, with trade wheat is produced only in India, and
India specializes completely in the production of wheat. Total demand curve, Dw =
India+U.S.
U.S. intersects total supply curve, Sw = India+U.S. at equilibrium point, E at price 1 at
180W with trade (the same as in part (i) of Figure 9.4).
9.4). Note that, with trade total quantity of
wheat i.e.,180W(as
(as shown at point R in part (i)of figure 9.5) is produced in India only.

We can do the same for cloth. In part (ii) of Figure 9.5 total quantity of cloth is shown on X
axis and price of cloth on Y axis. In part (ii) of Figure 9.5, total quantity of supply of cloth for
both U.S. and India are 160 and 90 respectively. Total quantity
quantity of cloth in the U.S. and India
is the supply curve for cloth of U.S. and India,
India which is shown by Sc=U.S. U.S.+India (250C =
160C + 90C)) at point P. It shows that U.S. could produce a maximum of 160C 1 = AB at price,
Pc/Pw = 1/2 = 0.5 (160C=80W) while India could ould produce a maximum of 90C = CD at price,
Pc/Pw = 2 (90C=180W).. This shows that U.S. could produce with complete specialization in
cloth production at constant opportunity cost of Pc/Pw=1/2(in
P U.S., 160CC = 80W just as in
part (i) of Figure 9.4). India could produce a maximum quantity of cloth at constant
opportunity cost of Pc/Pw = 2 (In India, 90C = 180W just as in part (ii) of Figure 9.4). Thus,
2500 is the maximum combined total quantity of cloth that U.S. and India could produce at
Pc/Pw=1/2 and Pc/Pw=2 =2 respectively if both nations use all of their resources and technology
available at their disposal. As a result, the supply curve of both nations, Sc=
S U.S.+ India is
vertical at 250,
0, shown by PS curve. This vertical supply curve, Sc=U.S.+
S U.S.+ India comprises
AB+CD or AB+RP or 0R+RP = 160+90=250.
1

Suppose that, with trade the combined demand curve for cloth of the U.S. and the India is
Dw=U.S+India, as shown in part (ii) (i ) of Figure 9.5. India has a comparative advantage in
producing cloth. Therefore, with trade cloth is produced only in the U.S.,, and U.S. specializes
completely in the production of cloth. Total demand curve, Dw=U.S+India India intersects total
supply curve, Sc= U.S. +IndiaIndia at equilibrium point, E at price 1 at 160C
1 with trade (the same
as in part (ii)) of Figure 9.4). Note that, with trade total quantity of C i.e.,160C(as
i.e.,1 shown at
point R in part (ii)of
)of figure 9.5) is produced in U.S. only.

Finally, note that with trade under constant opportunity cost both nations enjoyed
complete specialization in production of the commodity of their comparative advantage. With W
trade both nations specializes in the production of commodities of its comparative advantage
such as India specializes in the production of wheat and U.S. in the production of cloth. The
equilibrium relative commodity price of each commodity is between the pre-tradepre relative
commodity price in each nation as shown in part (i) and part (ii) of Figure 9.5. For example,
equilibrium relative commodity price of wheat in India is 180W=90C=
180W=90C Pw/Pc=1/2 and in
U.S. is 80W=160C= Pw/Pc=2. Thus, pre-trade
pre trade relative price of wheat between India and U.S.
is determined as ½<Pw/Pc<2. Similarly, pre-trade
pre relative price of cloth in the U.S. is
160C=80W=Pc/Pw=1/2 and in India is 90C=180W=Pc/Pw=2. Thus, pre- pre-trade relative price
of cloth between U.S. and India is determined as ½<Pc/Pw<2. However, it must note here
that if trade between India and U.S. would take place at pre-trade relative price of wheat
Pw/Pc=1/2; demand curve, Dw=India+U.S. intersects supply curve, Sw=India+U.S. between
A and B on the horizontal axis of the supply curve, Sw=India+U.S. In this situation, U.S.
would receive all the gains from trade. This would occur if U.S. were a small country that
specialized completely in the production of cloth and the India were a larger country and did
not specialize in the production of wheat. This is known as small country case and shows the
importance of being unimportant. This benefit, however, is not without cost since the small
nation faces the risk of a possible future reduction in demand for the only commodity it
produces6.

Student must note here that in case of constant opportunity cost, only small nation
specialized completely in production of the commodity of its comparative advantage. The
large nation continued to produce both commodities even with trade (See Figure 9.5) because
the small nation could not satisfy all of the demand for imports of the large nation7.

9.5.4 The Basis for Trade and Gains from Trade under Increasing Opportunity Cost

This section extends our simple model to the more realistic case of increasing opportunity
cost because we know that cost increases as production increases. The basis for trade and
gains from trade under increasing opportunity cost requires the following:

1. The production possibility curve;

2. The slope of the production possibility curve;
3. The marginal rate of transformation (MRT)
4. Tastes or demand preferences in a nation are given by community (or social)
indifference curves;
5. The marginal rate of substitution (MRS);
6. Determination of internal equilibrium relative commodity price in each nation in the
absence of trade under increasing opportunity cost;
7. Find out the comparative advantage in production of commodity of each nation;
8. Find out mutually beneficial trade between the two nations; and
9. Gains from trade.

First three points are already discussed in the section 9.5.1. Now, we will introduce tastes
or demand preferences with community indifference curves. An indifference curve shows
the various combinations of two commodities that yield equal satisfaction or utility to the
consumer. Similarly, community indifference curve shows the various combinations of
the two commodities that yield equal satisfaction to the community or nation. The slope
of the community indifference curve then refers to the marginal rate of substitution

6. Salvatore, 2004, op. cit,: 47

7. Salvatore, 2004, op. cit,: 71

(MRS) in consumption just like marginal rate of transformation (MRT) in production.
The marginal rate of substitution of wheat for cloth (MRSwc) in consumption refers to
the amount of cloth that a nation could give up in order to gain one extra unit of wheat
and still remains on the same indifference curve. This is given by the (absolute) slope of
the community indifference curve (or, indifference curve) at the point of consumption and
declines as the nation moves down the curve. This is illustrated in the Figure 9.10. As we
move down on community indifference curve, I (as shown in Figure 9.6) from point A to
point B or to point C, the MRSwc diminishing but satisfaction
satisfaction or utility remains the same.
This shows that consumer/nation remains indifferent on any point of community
indifference curve, I. A higher indifference curve, III as shown in Figure 9.6, shows a
greater amount of satisfaction and a lower one (indifference
(indifference curve, I as shown in Figure
9.6) less satisfaction. Thus, community indifference
indifferenc curve shows an ordinal rather than
cardinal measure of utility. Community indifference curves exhibit three basic
characteristics:

1. They are negatively sloped;

2. They aree convex to the origin; and
3. They cannot intersect (cross) each other.

Readers familiar with a consumer’s indifference curves will note that community
indifference curves are almost completely analogous. Declining marginal rate of
substitution (MRS) means that community indifference curves are convex from the
origin. Thus, while increasing opportunity cost (MRT) in production is reflected in
concave production possibility curve, a declining MRS in consumption is reflected in
convex community indifference curve.
curve. Thus, MRT reflects supply forces and MRS
reflects demand forces.
 Illustration of the basis for and the gains from trade with increasing cost is shown in
Table 9.9

Table 9.9

On X axis 0 10 20 30 40 50 60 70 80 90 100

(Quantity of Wheat, W)

On Y India 60 59 57 54 50 45 39 32 24 14 0
axis
(Quantity United 85 80 74 65 55 42 00 -- -- -- --
of Cloth, States of
C) America

The Table 9.9 is shown graphically in Figure 9.7. Part (i) and part (ii) of Figure 9.7 shows
India’s production possibility curve as PP1, which moves downward from 60C on Y axis to
100W on X axis and United States of America’s production Possibility curve PP1, which
moves from downward from 85C on Y axis to 60W on X axis.
Now, from here, we will try to understand the basis for and the gains from trade with
increasing opportunity cost stepwise:

1. First draw a production possibility curve for both nations, here India and U.S.;
U.S.
2. Find out comparative advantage in producing commodities for both nations.
Production possibility curve of India shows that India has comparative advantage in
producing wheat as India produces 60C or 100W, and production possibility curve cu of
U.S. shows that U.S. has comparative advantage in producing cloth as U.S. produces
85C or 60W as shown in part (i) and (ii) of Figure 9.7;
3. Point 2 gives only rough idea;
4. We have to find out internal relative commodity prices between two nations because
beca
internal relative commodity prices between two nations is a reflection of their
comparative advantage and forms the basis for mutually beneficial trade;
5. Internal relative commodity price of a nation depends on slope of the production
possibility curve and slope of production possibility curve then refers to marginal rate
of transformation (MRT);
! H' JK $ L "F &
& " ' (&)
6. Slope of the production possibility curve = = JK = MRTwc =
I $ L "F *' (*)
4 "F *' (45)
;
4 "F & " ' (4 )
7. Suppose that in the absence of trade internal equilibrium relative commodity price in
India is, Pw/Pc = 1/4, which is shown at point A (the equilibrium point in isolation of
India),as
as shown in part (i) of Figure 9.7;
8. At point A, production possibility curve and community indifference curve are
touching each other on a slope.
9. In the absence of trade, India is producing and consuming both commodities at point
A (Pw/Pc = 1/4), where India is consuming 30W and 54C,, as shown in part (i) of
Figure 9.7;
10. In the absence of trade, U.S. is producing and consuming both commodities at point A
(Pw/Pc = 4), where U.S. is consuming 20C and 56W, as shown in part (ii) of Figure
9.7;
11. Since in the absence of trade Pw/Pc= 1/4 is lower in India than the U.S. Thus, India
has comparative advantage in wheat and the U.S. in cloth;
12. Mutually advantageous trade is possible within the limit 1/4<Pw/Pc<4;
13. India specializes in the production of wheat and for that India moves downwards on
its production possibility frontier from Point A to point B, as shown in part (i) of
Figure 9.7;
14. U.S. specializes in production of cloth and for that U.S. moves upwards on its
production possibility frontier from point A to point B, as shown in part (ii) of Figure
9.7;
15. When India specializes in the production of wheat, it incurs increasing opportunity
cost in production of wheat (i.e, higher MRTwc). This is reflected in the increasing
slope of its production possibility curve (see part (i) of Figure 9.7);
16. Similarly, when U.S. specializes in the production of cloth, it incurs increasing
opportunity cost in production of cloth (i.e, higher MRTcw). This is reflected in the
decline in the slope of its production possibility curve (a reduction in the opportunity
cost of wheat, which means a rise in the opportunity cost of wheat) (see part (i) of
Figure 9.7);
17. The slope plays an important role in not only determining internal equilibrium relative
commodity prices but also in determining how long the process specialization in
production continues;
18. The process of specialization in production continues until relative commodity prices
(the slope of the production frontiers) become equal that is Pw/Pc = 1;
19. With trade India moves from point A down to point B, where slope = MRTwc =
Pw/Pc = 1;
20. At point B, total production of wheat in India is 86W and 18C. India moves to
consume at point E, where slope is tangent to community indifference curve, CII.
India is consuming only 40W of total 86W at point E. By exchanging 46W (86W –
40W) for 46C with U.S. India ends up consuming 40W and 64C (18C in India + 46C
imported from U.S.) at point E; this is the highest level of satisfaction that India can
reach with trade, Pw/Pc = 1(see part (i) of Figure 9.7).
21. Before trade, India was consuming 30W and 54C at point A. With trade, India is
consuming 40W and 64C at point E. Thus, India gains 10W and 10C trade (see part
(i) of Figure 9.7);
22. With trade U.S. moves from point A upward to point B, where slope = MRTwc =
Pw/Pc = 1;
23. At point B, total production of cloth in U.S. is 76C and 20W. U.S. moves to consume
at point E, where slope is tangent to community indifference curve, CII. U.S. is
consuming only 30C of total 76C at point E. By exchanging 46C (76C – 30C) for
46W with India. U.S. ends up consuming at 30C and 66W (20W in U.S + 46W
imported from India ) at point E; this is the highest level of satisfaction that U.S. can
reach with trade, Pw/Pc = 1(see part (ii) of Figure 9.7).
24. Before trade, U.S. was consuming 20C and 56W at point A. With trade, U.S. is
consuming 30C and 66W) at point E. Thus, India gains 10W and 10C trade (see part
(ii) of Figure 9.7);
25. In summary gains from trade is shown in table 9.10

Table 9.10

Commodities India United States of America

Befor After Trade Gains from Before After Trade Gains from
e Trade Trade Trade
Trade

P/C P C P C P/C P C P C

Wheat 30 86 40 +56 +10 56 20 66 –36 +10

Cloth 54 18 64 –36 +10 20 76 30 +56 +10

Total 84 104 104 +20 +20 76 96 96 +20 +20

Note: P = Production; C = Consumption.

26. With trade India is exporting 46 wheat to U.S. in exchange for 46 cloth from
U.S.Similarly,U.S. is exporting 46 cloth in exchange for 46 wheat from India.
27. With trade under constant opportunity cost nations have complete specialization in the
production of the commodities. This is shown in Figure 9.4. With trade, India is
producing 180W and 0C at point P1and U.S. is producing 160C and 0W at point P
(see part (i) and (ii) of Figure 9.4).
28. With trade under increasing opportunity cost nations have incomplete specialization
in the production of the commodities. This is shown in Figure 9.7. After having
specialization in production of wheat, India is also producing small quantity of cloth
along with wheat, 86W and 18C at point B. Similarly, U.S. has specialization in the
production of cloth but producing small quantity of wheat along with cloth, 76C and
20W (see Figure9.7).
29. When relative commodity prices are equal in the two nations (Pw/Pc=1, as shown in
Figure 9.7), both nations will consume/ gain in the same proportion. This is shown in
Figure 9.7 and Table 9.10, where India gains 10W and 10C at point E as shown in
part (i) of Figure 9.7. Similarly, U.S. also gains 10W and 10C at point E as shown in
part (ii) of Figure 9.7.
30. We must remember that international trade between the two nations is balanced. This
means that the total value of each nation’ exports equal the total value of nation’s
import. This is shown in Figure 9.7, where India export 46W to U.S. and import 46C
from U.S. Similarly, U.S. export 46C to India and import 46W from India.
Key Concepts

• Mutually Advantageous Trade: Mutually advantageous trade is possible

between the differences in the internal or pre-trade relative commodities prices of
the two nations.
• Labour Theory Of Value: According to the labour theory of value, the value or
price of a commodity depends exclusively on the amount of labour going into the
production of the commodity. Besides, labour is used in the same fixed proportion
in the production of all commodities.
• Marginal Rate of Transformation of Wheat For Cloth (MRTwc): The
marginal rate of transformation of wheat for cloth (MRTwc) refers to the amount
of cloth that nation must give up to produce each additional unit of wheat. Thus,
MRT is another name for opportunity cost.

Important points

• International trade theory and international trade policies are the microeconomic
aspects of international economics because they deal with individual nations
treated as single units and mutually beneficial trade between the two nations
depends on internal equilibrium relative commodity price of an individual
commodities.
• Balance of payments and adjustments in the balance of payment represent
macroeconomic aspects of international economics because balance of payment
deals with total receipts and total payments with the rest of the world, and
adjustment in the balance of payment deals with adjustment mechanism and other
economic policies that affect the level of national income and the general price of
the nation as a whole respectively.
• According to Adam Smith trade between two nations is based on absolute
advantage. The absolute advantage means the greater efficiency the one nation
may have over another in the production of a commodity. This was the basis for
trade between two nations for Adam Smith. Smith argued that with free trade one
nation could specialize in the production of that commodity in which it is more
efficient (or has an absolute advantage) than the other nation.
• Law of comparative advantage, developed by David Ricardo, postulates that even
if one nation is less efficient than (absolute disadvantage) the other nation in
production of both commodities, there is still a basis for mutually beneficial trade,
unless the absolute disadvantage is in the same proportion.

Questions for Review

1. What is the basis for trade and what are the gains from trade?
2. Explain labour theory of value.
3. Explain Haberler’s opportunity cost theory with example.
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