Page 26 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes Figure 2.5 explains the gains from international trade. AB is the transformation curve representing
the supply side and IC is the community indifference curve representing the demand side of an
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economy. The closed economy (no trade) equilibrium is shown by point E where the AB and IC curves
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are tangent to each other and both equal the domestic terms of trade or commodity price ratio (line) PP.
With the introduction of international (or free) trade the international price ratio (terms of trade) will
be different from the domestic price ratio (terms of trade). It is shown as P and is steeper than the
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domestic price ratio P. It means that the price of commodity X has increased in relation to commodity
Y in the world market. At the international price line P , the consumers move to point C on a higher
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community indifference curve CI, from point E on the IC curve. This movement from E to C measures
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the gan from exchange or consumption gain wth no change in production.
Since the price of X has increased in the world marker, producers increase its production and decrease
that of Y. This lead to movement along the transformation curve from point E to E where the
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international price line P is tangent equals the international price ratio. The new world terms of
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trade ratio P is the same as P because it is parallel to P . At E the country exports E Z of X in
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1
1
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exchange for ZC imports of Y.
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As a result of increased specialization in the production of X, there is shift in consumption from point
C on the IC curve to point C' on the IC curve, where consumers consume larger quantities of both X
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and Y. This movement from C to C' measures the gain from specialization in production or production
gain. At C', the marginal rate of substitution and the international price ratio are equal. Hence the
gains from international trade are maximized at points E and C' because the marginal rate of
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transformation in production and the marginal rate of substitution in consumption are equal to the
international price ratio P . The total gain from free tradeis the sum of the consumption are equal to
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the international price ratio P . The total gain from free trade is the sum of the consumption and
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production gains and is shown as improvement in welfare from IC to IC .
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2.4 An Application to Fair Allocation
Once we have a measure of the gains from trade in an economy, how can we distribute them fairly?
An “allocation rule” recommends for each economy a set of feasible allocations. We look for allocations
rules that distribute gains from trade fairly. First, we propose a method to determine the contribution
of each agent to the gains from trade. Then, we declare an allocation “fair” if each agent obtains her
contribution to the gains from trade. Finally, we propose an allocation rule which assigns to each
agent her contribution to the gains from trade. This rule is not efficient, but we show that a recursive
procedure distributes gains from trade fairly at each step and defines an efficient rule.
2.4.1 Contributions to Gains from Trade
In order to determine each agent’s contribution to the gains from trade, we propose to use the solution
concept of the theory of cooperative games known as the Shapley-value, using its interpretation as
rewarding agents as a function of their “marginal contributions” to all subgroups. We measure each
agent’s contribution to the gains from trade as the “marginal gains” in each subpopulation.
First, we generalize the definition of the weighted-gains family to allow for variable populations. For
each subpopulation N' ⊂ N and each economy (R,ω ) ε∈ , the α -weighted-gains metric measures gains

(
from trade of the subeconomy R N' ,ω N' ) by the largest vector z GR ,ω∈ ( N' N' ) proportional to α .
Self -Assessment
1. Choose the correct option:
(i) Mercantilism advocated that a country
(a) prohibit all exports because it viewed trade as zero sum, believing that one nation's gain
was another nation's loss.
(b) Should pursue Free trade because it viewed trade as zero sum, and therefore, that trade
would always be balanced.

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