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FACULTY OF ECONOMICS, UNIVERSITY OF

PORTO

1EC305: INTERNATIONAL TRADE

Chapter 2 International trade theory

The neoclassical theory

Introduction
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In what concerns international trade, the neoclassical analysis

emerged as a reaction to the Ricardian model

2 approaches:
Demand - Stuart Mill, Marshall;
Supply - Heckscher, Ohlin, Samuelson.

In spite of the different focus of each approach, there are

several important similarities between them:
They share the same general theoretical framework
namely, the idea of a general economic equilibrium
They share a set of assumptions
 The assumptions
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1. Production factors:
i. Scarce;
ii. Homogeneity
iii. Full employment;
iv. Perfectly mobile within the country, but immobile
between countries;
v. Decreasing returns.
2. Markets:
1. Perfect competition in all markets;
2. Equilibrium is the rule.

The assumptions
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3. International markets:
i. No obstacles to international trade of goods;

4. Supply:
i. Constant returns to scale;
ii. Increasing opportunity costs (reasons: product-
specific factors; decreasing marginal
productivities).
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The Production Possibilities Curve (PPC)

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o Increasing opportunity costs PPC is concave

o The opportunity cost of X is also know as the
marginal rate of transformation (MRTY/X) of Y
U by X
o In any point along the PPC:
MRTY/X=MCX/MCY (MC = marginal cost)
o In equilibrium (profit maximization):
MRTY/X=PX/PY.

V
0 X

The neoclassical demand approach

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The neoclassical demand approach uses some microeconomic

elements as main instruments for the analysis:
Indifference curves (IC): set of combinations of two goods (X
and Y) that allow the same level of utility for a consumer;
Production possibilities curves;

Departs from the analysis of Stuart Mill:

Who tried to solve a major lacuna in the Ricardian analysis:
the determination of the exact value of the ITT.
 Representing the demand side
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(Social) indifference curves (IC) they correspond to the sum of all

individual preferences and they have the same properties of the
individual IC:
Negatively sloped;

Never share the same point (never intersect);

The farther from the origin is the curve the higher is the level of
utility;
Convex (relative to the origin): decreasing marginal rate of
substitution (MRSY/X), implying that the substitution of good Y by
good X is progressively more difficult.

Representing the demand side

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Social indifference map

Y
M Equilibrium point:
MRSY/1X=PX/PY

X
MN budget constraint
 Representing the demand side
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The MRS is equal to the absolute slope of the IC in a specific

point of consumption:
MRSY/1X=|Y/X|=dY/dX=MUX/MUY

The MRSY/1X represents the number of units of good Y that

the consumer is willing to sacrifice in order to consume an
additional unit of good X, keeping the same level of utility.
In equilibrium, for any consumer:
MRSY/1X=PX/PY

This means that, in equilibrium, the budget constraint is

tangent to the highest attainable IC.

Equilibrium in autarky
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In autarky, for each good, production = consumption

Supply restraint for any good is given by the PPC:
In autarky, this curve also is the restraint for demand
This means that the PPF works like the budget constraint for a
particular consumer;
The PPF is also the PCF (possibilities consumption frontier).
Given the PPC and the (social) indifference map, the
equilibrium occurs in the point where the PPC is
tangent to the highest attainable IC (P0):
At this point, consumers are maximizing their utility (MRSY/1X=PX/PY)
and firms are maximizing their profit (MRTY/1X=PX/PY), thus:
MRTY/X =MRSY/1X=PX/PY
 Equilibrium in autarky
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Slope of MN = PX/PY :
equilibrium relative price
of X, i.e., ATTY/X;
Note that the opportunity
cost of X varies along the
M PPC (in the classical
Y model, the OCX was
constant) => i.e. the terms
U of trade vary along the
P0 PPF

a Equilibrium point: P0
N MRTY/1X=MRSY/1X=PX/PY

V X

Free trade equilibrium

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Suppose that, in autarky, (PX/PY)A < (PX/PY)B, i.e., ATTAY/1X <

ATTBY/1X
Different relative prices in autarky => incentive to trade

Country B will specialize in good Y (and export that

good)
With trade, relative prices become equal in the two
countries: (PX/PY)B decreases (increases in A) to (PX/PY)I =
ITTY/1X (slope of ST)
This changes the equilibrium points for producers and
consumers.
 Free trade equilibrium (country B)
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Country Bs production still

restrained by the PPC, but the
M equilibrium point for
Y producers change, as relative
S
prices varied
U
P1 P1, where MRTY/X =
C1 (PX/PY)I
Consumption possibilities are
T enlarged, as individuals may
now consume goods
N produced in each country:
The equilibrium point for
consumers becomes C1,
V X where MRSY/X = (PX/PY)I

Free trade equilibrium

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Free trade leads to the separation of the decisions of production

and consumption (in the two countries)
Relative prices change: (PX/PY)B => (PX/PY)I

Equilibrium in production changes: producers move to P1, where

MRTY/X = (PX/PY)I
Equilibrium in consumption changes: consumers move to C1,
where MRSY/X = (PX/PY)I, reaching an higher social indifference
curve.
The level of social utility increases => gains from trade,
resulting from the enlargement of the CPC.
 Gains from trade
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Correspond to attaining a superior level of satisfaction than that of

autarky (higher social IC)
Result from an expansion of the CPF
The total gains from trade may be divided into:
Production (or specialization) gains
Consumption (or international trade) gains
Concerning production, gains occur because the real value of
production increases:
As terms of trade change, firms may increase their value of
production and income by modifying factors mix and production
mix.
Concerning consumption, gains occur because relative prices changes
and the initial restriction (CPC = PPC) no longer holds:
Consumers never get worse than in autarky and a change in
relative prices can improve their situation.

Gains from trade (country B)

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M
Y S
Consumption gains:
U
P1 C0C0
C1 Production gains:
C0 C0 C1
C0' T Total gains from trade =
Consumption gains +
N
Production gains

V X

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 The role of demand in international
trade
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The role of demand in international trade

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 The role of demand in international trade
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The role of demand in international trade

=> Equilibrium (international trade)
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 The role of demand in international trade
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The role of demand in international trade

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 The International Terms of Trade (ITT)
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The theory of reciprocal demand, introduced by

Stuart Mill and later sistematized by Marshal,
answers the question of what is the value for the ITT.

The International Terms of Trade (ITT)

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Considering 2 goods and 2 countries, for each

relative price / terms of trade (Px/Py), it is possile to
determine the desired value of exports and imports
for each country:
This way, one can get the reciprocal demand curve
for each country
In our case, these curves would represent, for each
terms of trade:
For country B, the quantity of good Y that the
country would like to export and the quantity of
good X that the country would like to import
For country A, the quantity of good X that the
country would like to export and the quantity of
good Y that the country would like to import
 The International Terms of Trade (ITT)
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The reciprocal demand curve (country B)

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Bs production and consumption Bs exports and imports

p=7
Y p=3 Exp Y
p=5
P2 p=5
P1 p=3
X2
X1
C0 C2
C1
X2
X1

X Imp X
M1 M1

M2 M2
 The reciprocal demand curve (country B)
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International equilibrium
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International equilibrium occurs where the two reciprocal demand curves

intersect
This means one only value for the ITT
It occurs only when, for each good, the desired exports by one country equal the
desired imports by the other country

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