CHAPTER 2

Exploring Further
2.1
Comparative Advantage in Money Terms
To illustrate comparative advantage in money
terms, refer to the comparative-advantage example
of Table 2.3 (pp. 35 of International Economics,
13th edition) that assumes that labor is the only
input and is homogeneous. Recall that (1) the
United States has an absolute advantage in the
production of both cloth and wine; and (2) the
United States has a comparative advantage in
cloth production, while the United Kingdom has
a comparative advantage in wine production. This
information is restated in Table EF 2.1. As we shall
see, even though the United Kingdom is absolutely
less efficient in producing both goods, it will
export wine (the product of its comparative advan-
tage) when its money wages are so much lower
than those of the United States that it is cheaper
to make wine in the United Kingdom. Lets see
how this works.
Suppose the wage rate is $20 per hour in the
United States, as indicated in Table 1. If U.S. work-
ers can produce 40 yards of cloth in an hour, the
average cost of producing a yard of cloth is $0.50
($20/40 yards $0.50 per yard); similarly, the aver-
age cost of producing a bottle of wine in the United
States is $0.50. Because Ricardian theory assumes
that markets are perfectly competitive, in the long
term a products price equals its average cost of
production. The prices of cloth and wine produced
in the United States are shown in the table.
Suppose now that the wage rate is 5 per hour
in the United Kingdom. Thus, the average cost
(price) of producing a yard of cloth in the United
Kingdom is 0.50 (5/10 yards 0.50 per yard),
and the average cost (price) of producing a bottle
of wine is 0.25. These prices are also shown in
Table EF 2.1.
Is cloth less expensive in the United States or
the United Kingdom? In which nation is wine less
expensive? When U.S. prices are expressed in dol-
lars and UK prices are expressed in pounds, we
cannot answer this question. We must therefore
express all prices in terms of one currencysay,
the U.S. dollar. To do this, we must know the pre-
vailing exchange rate at which the pound and the
dollar trade for each other.
Suppose the dollar/pound exchange rate is
$1.60 1. In Table EF 2.1, we see that the UK
hourly wage rate (5) is equivalent to $8 at this
exchange rate (5 $1.60 $8). The average dol-
lar cost of producing a yard of cloth in the United
Kingdom is $0.80 ($8/10 yards $0.80 per yard),
and the average dollar cost of producing a bottle
of wine is $0.40 ($8/20 bottles $0.40 per bottle).
Compared to the costs of producing these products
in the United States, we see that the United King-
dom has lower costs in wine production but higher
costs in cloth production. The United Kingdom
thus has a comparative advantage in wine.
TABLE EF 2.1
RICARDOS COMPARATIVE-ADVANTAGE PRINCIPLE EXPRESSED IN MONEY PRICES
CLOTH (YARDS) WINE (BOTTLES)
Nation Labor Input Hourly Wage Rate Quantity Price Quantity Price
United States 1 hour $20 40 $0.50 40 $0.50
United Kingdom 1 hour 5 10 0.50 20 0.25
United Kingdom* 1 hour $8 10 $0.80 20 $0.40
*Dollar prices of cloth and wine, when the prevailing exchange rate is $1.60 1. This exchange rate was chosen for this example because at other
exchange rates it would not be possible to have balanced trade and balance in the foreign-exchange market.
Chapter 2 2-1

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We conclude that even though the United
Kingdom is not as efficient as the United States
in the production of wine (or cloth), its lower wage
rate in terms of dollars more than compensates for
its inefficiency. At this wage rate, the UKaverage cost
in dollars of producing wine is less than the U.S.
average cost. With perfectly competitive markets,
the UK selling price is lower than the U.S. selling
price, and the United Kingdom exports wine to the
United States.
2-2 Foundations of Modern Trade Theory: Comparative Advantage

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Exploring Further 2.2
Indifference Curves and Trade
In this section, we introduce indifference curves to
show the role of each countrys tastes and prefer-
ences in determining the autarky points and how
gains from trade are distributed.
The role of tastes and preferences can be illus-
trated graphically by a consumers indifference
curve. An indifference curve depicts the various
combinations of two commodities that are equally
preferred in the eyes of the consumer; that is, yield
the same level of satisfaction (utility). The term
indifference curve stems from the idea that the
consumer is indifferent about the many possible
commodity combinations that provide identical
amounts of satisfaction.
Figure EF 2.1 illustrates a consumers indiffer-
ence map, which consists of a set of indifference
curves. Referring to indifference curve I, a con-
sumer is just as happy consuming, say, six bushels
of wheat and one auto at point A as consuming
three bushels of wheat and two autos at point B.
All combination points along an indifference curve
are equally desirable because they yield the same
level of satisfaction. Besides this fundamental char-
acteristic, indifference curves have several other
features:
Indifference curves pass through every point in
the figure;
Indifference curves slope downward to the
right;
Indifference curves are bowed in (convex) to
the diagrams origin;
Indifference curves never intersect each other;
Indifference curves lying farther from the ori-
gin (higher curves) represent greater levels of
satisfaction.
Having developed an indifference curve for
one individual, can we assume that the preferences
of all consumers in the entire nation could be
added up and summarized by a community indif-
ference curve? Strictly speaking, the answer is no,
because it is impossible to make interpersonal com-
parisons of satisfaction. For example, person A may
prefer a lot of coffee and little sugar, but person B
prefers the opposite. The dissimilar nature of indi-
viduals indifference curves results in their being
noncomparable. Despite these theoretical pro-
blems, a community indifference curve can be
used as a pedagogical device that depicts the role
of consumer preferences in international trade.
Using indifference curves, let us now develop a
trade example to restate the basis-for-trade and the
gains-from-trade issues. Figure EF 2.2 depicts the
trading position of the United States. The United
States in the absence of trade will maximize
FIGURE EF 2.1
A CONSUMERS INDIFFERENCE MAP
5 4 3 2 1
0
6
5
4
3
2
1
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B
C
D
E
l
Autos
II
III
An indifference map is a graph that illustrates an entire
set of indifference curves. Each higher indifference
curve represents a greater level of satisfaction for the
consumer. A community indifference curve denotes
various combinations of two goods that yield equal
amounts of satisfaction to the nation as a whole.
Chapter 2 2-3

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satisfaction if it can reach the highest attainable
indifference curve, given the production constraint
of its production possibilities schedule. This will
occur when the U.S. production possibilities sched-
ule is just tangent to indifference curve I, at point
A. At this point, the U.S. relative price ratio is
denoted by line t
U.S.
, which equals the absolute
slope of the production possibilities curve at that
point.
Suppose that the United States has a compara-
tive advantage vis--vis Canada in the production
of autos. The United States will find it advantageous
to specialize in auto production until the two coun-
tries relative prices of autos equalize. Suppose
this occurs at production point B, where the U.S.
price rises to Canadas price, depicted by line tt.
Also suppose that tt becomes the international
terms-of-trade line. Starting at production point B,
the United States will export autos and import
wheat, trading along line tt. The immediate problem
the United States faces is to determine the level of
trade that will maximize its satisfaction.
Suppose that the United States exchanges 6
autos for 50 bushels of wheat at terms of trade tt.
FIGURE EF 2.2
INDIFFERENCE CURVES AND TRADE
E
C
A
D
B
II
I
United States
tt
t
U.S.
24
Autos
18 14 9 2
0
240
290
323
365
423
W
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a
t
A nation benefits from international trade if it can achieve a higher level of satisfaction (indifference curve) than it can
attain in the absence of trade. Maximum gains from trade occur at the point where the international terms-of-trade line
is tangent to a community indifference curve.
2-4 Foundations of Modern Trade Theory: Comparative Advantage

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This exchange would shift the United States from
production point B to post-trade consumption
point D. But the United States would be no better
off with trade than it was in the absence of trade.
This is because in both cases the consumption
points are located along indifference curve I.
Trade volume of 6 autos and 50 bushels of wheat
thus represents the minimum acceptable volume of
trade for the United States. Any smaller volume
would force the United States to locate on a lower
indifference curve.
Suppose instead that the United States trades
22 autos for 183 bushels of wheat. The United
States would move from production point B to
post-trade consumption point E. With trade, the
United States would again locate on indifference
curve I, resulting in no gains from trade. From the
U.S. viewpoint, trade volume of 22 autos and 183
bushels of wheat therefore represents the maxi-
mum acceptable volume of trade. Any greater vol-
ume would find the United States moving to a
lower indifference curve.
Trading along terms-of-trade line tt, the
United States can achieve maximum satisfaction if
it exports 15 autos and imports 125 bushels of
wheat. The U.S. post-trade consumption location
would be at point C along indifference curve II,
the highest attainable level of satisfaction. Compar-
ing point A and point C reveals that with trade
the United States consumes more wheat, but fewer
autos, than it does in the absence of trade. Yet point
C is clearly a preferable consumption location. This
is because under indifference-curve analysis, the
gains from trade are measured in terms of total
satisfaction rather than in terms of the number of
goods consumed.
Chapter 2 2-5

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2.3 Exploring Further
Offer Curves and the Equilibrium Terms of Trade
John Stuart Mills theory of reciprocal demand
considered the significance of demands influence
on the terms of trade. But his theory was somewhat
vague and generalized. It was Alfred Marshall who
formally demonstrated the usefulness of offer
curves as a graphic method of illustrating how the
interaction of supply and demand determines the
equilibrium terms of trade.
1
Nature of an Offer Curve
An offer curve depicts the various amounts of
two products that a country wishes to trade, given
different price ratios. For each price ratio, the offer
curve shows how much of one product a country
is willing to trade for certain amounts of another
product. Therefore, an offer curve can be thought
of as both a supply curve and a demand curve.
An offer curve is a supply curve in the sense that
it shows the amounts of an export product that
will be offered for sale at various terms of trade.
Reflecting domestic supply factors, such as technol-
ogy and resource endowments, an offer curve shows
that more of an export product will be supplied
on the market as its relative price increases. This is
especially plausible if it assumes that the country
produces under increasing cost conditions.
In Figure EF 2.3, as the U.S. terms of trade
improve (the terms-of-trade line rotates upward),
the United States finds that a given amount of
its autos trades for larger quantities of the import
good, wheat. This results in the United States being
1
Marshall, Alfred, The Pure Theory of Foreign Trade, London: London School of Economics and Political Science, 1930.
FIGURE EF 2.3
OFFER CURVE: DEMAND AND SUPPLY INTERPRETATIONS
W
2
W
1
W
0
A
B
C
A
1
A
0
A
2
tt
2
tt
1
tt
0
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Autos (U.S. Export)
U.S.
tt
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tt
1
tt
2
B9
A9
C9
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1
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0
A
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A
2
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Autos (Canada Import)
Canada
2-6 Foundations of Modern Trade Theory: Comparative Advantage

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willing to offer more autos for sale. Similarly,
improving terms of trade for Canada results in it
being willing to offer additional amounts of its
export product (wheat) for sale.
As a demand curve, an offer curve shows the
quantities of imports that will be demanded
at various terms of trade. Reflecting domestic
demand conditions, the offer curve shows that
more of the import product will be demanded as
its relative price falls. In Figure EF 2.3 [1], we see
that as the terms of trade improve for the United
States, the relative price of its import good falls;
that is, it requires fewer auto exports for the
United States to purchase a given quantity of
Canadian wheat. The United States thus moves
upward along its offer curve, demanding larger
amounts of wheat. The reverse holds equally true
for Canada.
Offer Curve Construction
The shape and location of a countrys offer curve
are based on its supply and demand conditions,
which are reflected in its production possibilities
curve and community indifference curve. These
tools can be used to build an offer curve.
Referring to Figure EF 2.4, suppose that its
upper part represents U.S. production possibilities
under increasing cost conditions. Assume that in
the absence of trade the United States achieves
the equilibrium point of production and consump-
tion at point R, at which community indifference
curve I is tangent to the production possibility
curve. At this point, the U.S. price ratio is indicated
by t
U.S.
. With international trade, suppose the
United States finds the international price ratio to
be given by line tt
S
. United States production thus
moves to point S, where community indifference
curve II is tangent to tt
S
. By exchanging AP
S
autos
for AS wheat, the United States can attain a post-
trade equilibrium at point S. Should the interna-
tional price ratio be at tt
T
, the United States could
produce at point T, exchanging BP
T
autos for BT
wheat.
To build the U.S. offer curve, first redraw the
price ratios (from the figures upper part) in the
lower part of the figure as positively sloped lines.
At international terms of trade tt
S
, the United States
can offer OA (equal to AP
S
) autos in exchange for
OC (equal to AS) wheat. This exchange results
in point S, one point along the U.S. offer curve. In
like manner, other points along the offer curve can
be established. The main point to be emphasized
in this example is that the construction of an offer
curve reflects both the supply and demand condi-
tions of a country.
The Equilibrium Terms of Trade
Offer curve analysis is intended to determine the
relative prices at which trade actually takes place
that is, the equilibrium terms of trade. By bringing
together the supply characteristics embodied in
a countrys production possibilities curve and the
demand preferences depicted in a community indif-
ference curve, offer curve analysis exhibits the con-
dition of a market equilibrium.
If the existing terms of trade are to be the equi-
librium terms of trade, the amount of a product
that a country wants to export must match the
amount demanded as imports by another country.
In Figure EF 2.5, point E represents the market
equilibrium of the United States and Canada. At
terms of trade tt
0
, the quantity of autos the United
States is willing to export (OA
0
) equals the quantity
of autos demanded by Canada (OA
0
). In like man-
ner, Canadas wheat exports (OW
0
) just match U.S.
wheat imports (OW
0
). However, what if market
equilibrium does not exist? Are there forces that
will restore market balance?
Figure EF 2.5 also illustrates a case of market
disequilibrium. At the terms of trade tt
1
, the number
of autos that the United States is willing to supply
(OA
1
) is less than the number of autos demanded
by Canada (OA
2
). A shortage of autos thus exists.
At terms of trade tt
1,
the amount of wheat that
Canada is willing to supply (OW
2
) exceeds the
amount demanded by the United States (OW
1
).
Chapter 2 2-7

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FIGURE EF 2.4
CONSTRUCTING AN OFFER CURVE
W
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(
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.
S
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I
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Autos (U.S. Export)
U.S. Production
Frontier
tt
S
P
S
P
T
t
U.S.
tt
T
A
B
R
S
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O
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II
III
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.

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U.S.
Autos (U.S. Export)
tt
S
tt
T
t
U.S.
D
C
O
A B
T
S
2-8 Foundations of Modern Trade Theory: Comparative Advantage

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Therefore, there is a surplus of wheat. The relative
price of autos will rise and wheats relative price
will fall until all surpluses and shortages are elimi-
nated. At equilibrium point E, the supply matches
the demand for both products. Conversely, a
shortage of wheat and a surplus of autos results
in the relative price of wheat rising and the relative
price of autos falling until market equilibrium is
restored at point E.
Shifting Offer Curves: Changes in the
Equilibrium Terms of Trade
Because an offer curve is derived from a countrys
production possibilities curve and community
indifference curve, changes in the supply and
demand conditions underlying these schedules
induce a shift in the offer curves location. This
shift in location results in a change in the equilib-
rium terms of trade and the volume of trade. Let us
consider two possibilities.
Referring to Figure EF 2.6, suppose the United
States and Canada are initially in equilibrium at
point E, trading at terms of trade tt
0
. Holding con-
stant the Canadian supply of resources and tech-
nology, suppose that Canadas demand shifts away
from autos, its import good, toward wheat, its
export good. Because Canada now desires autos
less intensely, it is willing to trade less wheat than
before for a given number of autos. Canadas offer
FIGURE EF 2.5
OFFER CURVES AND EQUILIBRIUM TERMS OF TRADE
W
2
tt
0
tt
1
S
E
R
W
0
W
1
A
1
A
0
A
2
O
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h
e
a
t

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a
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a
d
a

s

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x
p
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t
)
Autos (U.S. Export)
Canada
U.S.
Chapter 2 2-9

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curve thus shifts from Canada
0
to Canada
1
. At the
initial terms of trade, tt
0
, the market now is in
disequilibrium: There exists an excess demand for
wheat and an excess supply of autos. The relative
price of wheat rises until market equilibrium is
restored at point G. Both countries now trade at
terms of trade tt
1
. This trading situation affects
Canadas welfare in two ways. The reduction in
the volume of trade reduces its welfare, but the
improving terms of trade increases its welfare.
The actual effect that these opposing forces have
on Canadas welfare depends on their relative
strength. It is left to the reader to verify that if
Canadas demand shifts away from wheat to
autos, its terms of trade will worsen and its volume
of trade will increase.
Referring to Figure EF 2.7, again assume that
the United States and Canada are initially in equi-
librium at point E, trading at terms of trade tt
0
.
Holding constant U.S. demand for wheat and
autos, suppose that technological advances result
in the United States becoming more productive in
manufacturing autos, its exportable good. This pro-
ductivity causes a rightward shift in the U.S. offer
FIGURE EF 2.6
CHANGES IN THE TERMS OF TRADE: INCREASED DEMAND FOR EXPORT GOOD
tt
0
tt
1
W
2
W
1
W
0
U.S.
0
Canada
0
Canada
1
A
1
A
0
A
2
O
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e
a
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(
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a
n
a
d
a

s

E
x
p
o
r
t
)
Autos (U.S. Export)
F
E
G
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g
h
t
s

r
e
s
e
r
v
e
d
.

N
o

d
i
s
t
r
i
b
u
t
i
o
n

a
l
l
o
w
e
d

w
i
t
h
o
u
t

e
x
p
r
e
s
s

a
u
t
h
o
r
i
z
a
t
i
o
n
.
curve, from U.S.
0
to U.S.
1
. At point F on the initial
terms-of-trade line tt
0
, the United States is now will-
ing to sell a larger number of autos than Canada is
willing to purchase. Market equilibrium is restored
at point G, when the fall in the relative price of autos
is sufficient to clear the market of the surplus of
autos. Therefore, the terms of trade worsen for the
United States although its volume of trade increases.
FIGURE EF 2.7
CHANGES IN THE TERMS OF TRADE: INCREASED SUPPLY OF EXPORT PRODUCT
tt
0
tt
1
U.S.
0
U.S.
1
Canada
0
W
0
W
1
W
2
A
1
A
2
A
0
O
W
h
e
a
t

(
C
a
n
a
d
a

s

E
x
p
o
r
t
)
Autos (U.S. Export)
E G
F
Chapter 2 2-11

C
e
n
g
a
g
e

L
e
a
r
n
i
n
g
.

A
l
l

r
i
g
h
t
s

r
e
s
e
r
v
e
d
.

N
o

d
i
s
t
r
i
b
u
t
i
o
n

a
l
l
o
w
e
d

w
i
t
h
o
u
t

e
x
p
r
e
s
s

a
u
t
h
o
r
i
z
a
t
i
o
n
.