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Increasing cost and PPF
International Trade Theory
International Equilibrium with
Increasing Cost
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Increasing cost and PPF
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{
{
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If the principle of increasing cost
prevails.
PPF is not a straight line but bowed
outwards
Because the slope of PPF is
opportunity cost, and it increases as
production of a good increases
The slope of PPF is also called
marginal rate of transformation
Community utility and
indifference curve
{
{
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Preference of the community
Indifference curve (IC)
The higher IC represents a higher
utility the community achieves
The Ricardian model assumes the
opportunity cost is constant even as
production expands
In the real world the principle of
increasing cost prevails.
Examples: marginal costs increases
as production increases
Productivity of inputs are not of
uniform quality
Increasing cost and PPF
clothing
0
food
Indifference curve
clothing
Indifference curve
0
food
1
Community utility and
indifference curve
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{
{
Indifference curve and the budget line
The objective of the society is
achieving as higher utility as
possible.
Or, to the farthest northeast IC it
can.
Note it is restricted by the budget
line. The income the society has.
clothing
0
The Income Line (IL) or the budget line
and Consumption Possibilities Curve
(CPC)
food
The budget line and consumption
possibility curve
Clothing (C)
Food versus clothing
Pf F + PcC = I
Pf F + PcC = I
Or,
Generally, good X and good Y
C=
I Pf
−
F
Pc Pc
Slope is
Px X + PyY = I
−
Pf
Pc
0
Consumption Possibility Curve
Clothing (C)
food (f)
Consumption Possibility Curve
Clothing (C)
−
Pf
Pc
possibilities to consume
various combinations
of food and clothing
IC
0
food (f)
0
food (f)
2
Autarky state of a country
{
Equilibrium of an autarky country
clothing
Autarky means a closed economy
that with no trade
Production and consumption choice
PPF
IC
0
Equilibrium of an autarky country
clothing
Small open economy
{
Domestic price Pf/Pc is the
slope of the tangent line
Production and consumption choice
food
{
A small country takes the world
price as given
It is too small to influence the world
price
PPF
IC
0
food
Small open economy
Small open economy
clothing
clothing
Consumption bundle
Income line
Slope of
the Income
line is the
World price
•Consumption possibility line
•Its slope is the terms of trade
•Which is how many units of food
can be exchanged for clothing
•It is also the price ratio of food
and clothing
IC
PPF
0
PPF
Production bundle
food
0
IC
food
3
What happens if the world clothing
price / food price is very high
Small open economy
clothing
clothing
Production bundle
Consumption bundle
Import of
clothing
Consumption bundle
IC
PPF
Production bundle
0
Export of
clothing
PPF
0
food
The Ricardian model has completed
specialization in production
Small open economy
{
{
With increasing cost, the export
country is not completely
specialized in its export
It still produces both goods, food
and clothing.
This is different from the case of the
straight PPF line in the Ricardian
model
food
Import of food
Export of food
{
IC
clothing
Consumption bundle
PPF
Import of
clothing
Production bundle
IC
0
food
Export of food
Terms of trade (TOT)
Improvement (deterioration) of TOT
TOT= price of exports / price of imports
Imports
Imports
•Slope of the consumption possibility line
TOT =
Pexp orts
Pimports
improves
Pexp orts
Pimports
PPF
0
TOT =
PPF
exports
0
IC
exports
4
Terms of trade (TOT)
Gain from trade
TOT= price of exports / price of imports
clothing
clothing
Consumption bundle with trade
•Slope of the consumption possibility line
TOT =
Pf
Pc
PPF
IC
PPF
IC with trade
IC without trade
0
0
food
food
Consumption gain vs.
production gain
What happens if TOT improves?
A to B: Consumption gain
clothing
clothing
B to C: Production gain
B
PPF
C
A
ICA
PPF
ICC
ICB
0
0
New IC
IC
food
food
5