Page 41 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 3 : Free Trade Theory — Absolute Advantage, Comparative Advantage and Opportunity Cost

Figure 1 shows the UK (country A). The axis Oy represents units of wheat. The axis Ox represents Notes
units of cloth. If all resources available in the UK are devoted to producing cloth, On’ units of cloth
will be produced. If all the resources available in the UK are devoted to producing wheat, On units of
wheat will be produced. Any point on the curve nn’ represents a combination of wheat and cloth
production, nn’ is the production possibility frontier for country A. Assuming all resources are fully
employed, country A will be producing at some point on the production possibility curve where both
wheat and cloth are produced.
Where on the production possibility curve will country A be located ? To answer this question we
need information
• on the preferences of consumers in country A for wheat relative to cloth, and
• on the relative prices of wheat and cloth. Remember, at this stage we have not introduced the
possibility of foreign trade.
Information on relative prices is therefore represented by the domestic price schedule. Information on
preferences is represented by the community’s indifference curve.
The indifference curve ii’ in Figure 3.1 shows the two goods, wheat and cloth, and the combinations
of wheat and cloth that are equally acceptable to consumers in country A. The price schedule pp’
shows the relative prices of wheat and cloth, the rate at which they can be traded one for another in
country A. In effect, the slope of pp’ is the domestic opportunity cost.
The ‘no foreign trade’ or ‘autarky’ equilibrium is at e. Here the marginal rate of transformation in
production (the slope of nn’) is equal to the marginal rate of substitution in consumption (the slope of
ii’) and is equal to the domestic opportunity cost (the slope of pp’). At e, country A produces Ow of
wheat, and Oc of cloth. This equilibrium represents the most efficient use of resources for both
producers and consumers and yields the maximum level of real income in country A.

y
T I
n p I
e’
Wheat e
I’
I
’
Specialisation p’
e*
T’
O n’ Cloth x

Figure 3.1 : The gains from trade
Gains from trade

We now open up country A to foreign trade. To simplify matters, the analysis uses a partial equilibrium
approach, showing the effects of trade on country A only. If we were to introduce country B, as in a
general equilibrium approach, more sophisticated geometric tools would be needed.
We know that foreign trade is beneficial if the domestic opportunity cost is different from the
international opportunity cost of wheat and cloth. A line TT’ is constructed to represent the
international terms of trade, i.e. the rate at which wheat trades (exchanges) for cloth in the international
economy. Because it differs from the domestic opportunity cost it is constructed with a different
slope to pp’. TT’ also indicates how much cloth country A will produce when it is opened up to trade.
It must be tangential to nn’ because after trade, country A must still be somewhere on its production
possibility curve, producing both wheat and cloth. The location is indicated by the new post-trade

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