Chapter 2 Study Questions

1. Identify the basic questions with which modern trade theory is concerned.
Explanation:
The modern theory of trade is concerned with following three basic questions:

 Basis for trade- modern trade theory tries to identify what is the basis of trade. It seeks to answer
why countries export certain products and import other products.
 Terms of Trade- Modern trade theory is also concerned about the terms at which trade takes place
between two countries. Terms of trade considers the relative price of exports in terms of imports. It is
interpreted as the ratio of export prices to import prices.
 Gains from International Trade- Modern trade theory tries to identify what are the gains in terms of
production and consumption due to international trade.

Answer:
Modern trade theory is concerned with questions related to what constitutes the basis of trade, at what terms
of trade do exports and imports occur and what are the gains from international trade, in terms of production
and consumption.

2. How did Smith’s views on international trade differ from those of the mercantilists?
Answer:
Mercantilists believed that one nation could gain only at the expense of other nations, considering fixed
wealth of the world while as per Economist S's belief, all nations could gain from trade if resources are
employed efficiently.

Economist S was thus a supporter of free trade, with minimum government intervention, while mercantilists
believed in active government intervention to ensure profitable trade.

3. Develop an arithmetic example that illustrates how a nation could have an absolute disadvantage in the
production of two goods and still have a comparative advantage in the production of one of them.
Answer:

Country A produces 4 units of Good X in an hour or 6 units of Good Y in an hour, whereas Country B
produces 2 units of Good X in an hour or 1 units of Good Y in an hour.

Country B has an absolute disadvantage in the production of both the goods since it produces fewer units of
both goods with same labor hours as Country A. However, the opportunity cost of Country A in the
production of Good X is lower than the opportunity cost of Country B in the same good. Thus, Country A
has the comparative advantage in the production of Good X.

On the other hand, the opportunity of production of Good Y is lower for Country B than that of Country A.
Thus, Country B has the comparative advantage in the production of Good Y.

4. Both Smith and Ricardo contended that the pattern of world trade is determined solely by supply
conditions. Explain.
Answer:
Both Individual S and Individual R claimed that a country's competitive position is determined by cost
conditions that influence the supply side of the market. For Individual S the basis of trade was absolute
advantage while for individual R the basis of trade is comparative advantage. Hence, the pattern of trade is
determined by the supply conditions.

5. How does the comparative-cost concept relate to a nation’s production possibilities frontier? Illustrate
how differently shaped production possibilities frontiers give rise to different opportunity costs.
Answer:
A production possibility frontier depicts the concept of opportunity cost of producing a good. The slope of
the curve illustrates the amount of one good that a country must sacrifice in order to produce an additional
unit of another good, provided that all resources are being utilized. The slope of the curve represents the
marginal rate of transformation, which is the rate of sacrifice or the opportunity cost. The opportunity cost of
producing a product determines the comparative advantage.

The slope of a production possibility frontier reflects the rate of sacrifice of one good that has to be done to
produce the other good. A straight line PPF indicates the country is producing under constant cost, while
production under situations of increasing cost leads to a concave PPF.

6. What is meant by constant opportunity costs and increasing opportunity costs? Under what conditions will
a country experience constant or increasing costs?
Answer:
Constant opportunity cost implies that the amount of production of a good that has to be foregone to increase
the production of the other good remains fixed, corresponding to increasing output. Increasing opportunity
cost implies that as output increases, the amount of one good that has to be foregone to increase the
production of the other good, keeps on increasing.

Constant opportunity costs occur when resources are of the same quality,can perfectly substitute each other,
and are equally adaptable for the production of both the goods.

Increasing opportunity cost occurs when resources are not completely adaptable to all uses and the quality of
the factors vary, so more and more of one good has to be given up to produce one unit of the other good.

7. Why is it that the pre-trade production points have a bearing on comparative costs under increasing cost
conditions but not under constant-cost conditions?
Answer:
Comparative advantage refers to the ability of a nation to produce at lower opportunity costs than its trading
partners. It measures the production of one good that has to be foregone to increase the production of the
other good by one unit.

In case of increasing cost conditions, the marginal rate of transformation keeps on changing from one point
to another. Thus, the point where the nation is producing or the autarky production determines the marginal
rate of transformation and comparative advantage for the country. This determines the direction of trade.

On the contrary, for constant cost the marginal rate of transformation remains the same at all production
points. Thus, a country's comparative advantage does not change depending on the current point of
production. Therefore, the initial point of production or the autarky production does not matter in case of
constant cost.

8. What factors underlie whether specialization in production will be partial or complete on an international
basis?
Answer:
The nature of opportunity costs primarily determines whether the specialization would be partial or complete
in the international trade. Under constant cost structure, specialization is complete in nature. Under
increasing cost conditions, trade only leads to partial specialization.

Partial specialization also occurs because all goods are not tradeable. Differences in tastes and preferences is
another reason for partial specialization.

9. The gains from specialization and trade are discussed in terms of production gains and consumption gains.
What do these terms mean?
Answer:
With specialization and division of labor, the quantity produced rises in the goods the country has comp
advantage in. These gains in production are called production gains.

Due to trade, when a country can operate at a consumption point outside its domestic production possibility
frontier, this gain is termed as consumption gain.

10. What is meant by the term trade triangle?

Explanation:
A nation specializes in production of a good in which it has a comparative advantage. Thus, it exports that
good and imports the good in which it has a comparative disadvantage. After trade, the nation can move
higher on its PPC as its production as well as consumption rises. In the diagram of the nation's PPC, the
trade triangle illustrates the nation's exports along the horizontal axis, its imports along the vertical axis, and
terms of trade of a country represented by the slope.
The following figure illustrates the terms of the trade line along the production possibility frontier of the
trading line, which specializes in the production of the good Y. The following figure illustrates the terms of
the trade line along the production possibility frontier of the trading country, which specializes in the
production of the good Y.

The following figure illustrates the terms of the trade line along the production possibility frontier of the
trading country, which specializes in the production of good X.

Answer:
The trade triangle of a country is a triangle on the diagram showing a nation's production possibilities curve
that illustrates the nation's exports along the horizontal axis, its imports along the vertical axis, and terms of
trade of a country represented by the slope.

11. With a given level of world resources, international trade may bring about an increase in total world
output. Explain.
Answer:
Producing on the basis of comparative advantage means that the nation will produce those goods that it can
produce at lower opportunity cost. that is, the goods it has comparative advantage in. As a result, countries
produce and specialize in goods they are most efficient at, leading to higher production for all countries, and
the world as a whole.

12. The maximum amount of steel or aluminum that Canada and France can produce if they use all the
factors of production at their disposal with the best technology available to them is shown (hypothetically) in
Table 2.8.

Assume that production occurs under constant-cost conditions. On graph paper, draw the production
possibilities frontiers for Canada and France; locate aluminum on the horizontal axis and steel on the vertical
axis of each country’s graph. In the absence of trade, assume that Canada produces and consumes 600 tons
of aluminum and 300 tons of steel and that France produces and consumes 400 tons of aluminum and 600
tons of steel. Denote these autarky points on each nation’s production possibilities frontier.

a. Determine the MRT of steel into aluminum for each nation. According to the principle of
comparative advantage, should the two nations specialize? If so, which product should each country
produce? Will the extent of specialization be complete or partial? Denote each nation’s specialization
point on its production possibilities frontier. Compared to the output of steel and aluminum that occurs
in the absence of trade, does specialization yield increases in output? If so, by how much?
Explanation :
Compute marginal rate of transformation for Country C (MRTc):

Compute marginal rate of transformation for Country F (MRTF):

Calculate the MRT of steel in Country C:

Calculate the MRT of steel in Country F:

Calculate the steel production under no specialization and trade:
Output of Steel before Specialization and Trade
= teel Production in Country C + Steel Production in Country F
= 600 + 300
= 900

Compute gain in steel output:

Gain in Steel Output = Steel Production With Trade - Steel Production Without Trade
= 1200 tons - 900 tons
= 300 Tons

Calculate the aluminum production under no specialization and trade:

Output of Aluminum before Specialization and Trade
= Aluminum Production in Country C + Aluminum Production in Country F
= 600 + 400
= 1,000

Compute gain in aluminum output:

Gain in Aluminum Output
= Aluminum Production With Trade - Aluminum Production Without Trade
= 1,500 tons - 1,000 tons
= 500

Answer:
MRT of Country C in terms of steel production to aluminum production is 1/3.

MRT of Country F in terms of steel production to aluminum production is 3/2.

Based on the principle of comparative advantage, the two countries should specialize:

Country C should specialize in aluminum production while country F should specialize in steel
production.

Both the countries will undergo complete specialization.

Due to trade, aluminum production will increase by 500 units while steel production will increase by
300 units.

b. Within what limits will the terms of trade lie if specialization and trade occur? Suppose Canada and
France agree to a terms of trade ratio of 1:1 (1 ton of steel =1 ton of aluminum). Draw the terms of
trade line in the diagram of each nation. Assuming 500 tons of steel are traded for 500 tons of
aluminum, are Canadian consumers better off as the result of trade? If so, by how much? How about
French consumers?
Answer:

c. Describe the trade triangles for Canada and France.

Explanation:
Trade triangle for a country consists of a triangle made by the consumption points after trade occurs, in
relation to the terms of trade.

For country F, after the 1:1 ratio is imposed, 500 units of steel are exported and 500 units of aluminum
are imported. Thus the trade triangle consists of 500 units of steel, 500 units of aluminum and terms of
trade equal to 1 ton of steel per ton of aluminum.
 For country C, after the 1:1 ratio is imposed, 500 units of steel are imported and 500 units of aluminum
are exported. Thus the trade triangle consists of 500 units of steel, 500 units of aluminum and terms of
trade equal to 1 ton of steel per ton of aluminum.

Answer:
For country F, the trade triangle consists of 500 units of steel, 500 units of aluminum and terms of trade
equal to 1 ton of steel per ton of aluminum.

For country C, the trade triangle consists of 500 units of steel, 500 units of aluminum and terms of trade
equal to 1 ton of steel per ton of aluminum.

13. The hypothetical figures in Table 2.9 give five alternate combinations of steel and autos that Japan and
South Korea can produce if they fully use all factors of production at their disposal with the best technology
available to them. On graph paper, sketch the production possibilities frontiers of Japan and South Korea.
Locate steel on the vertical axis and autos on the horizontal axis of each nation’s graph.

a. The production possibilities frontiers of the two countries appear bowed out, from the origin. Why?
Answer:
The production possibility curve for Country J is as follows.
The production possibility curve for Country SK is as follows.

The PPF of both the countries would be bowed out because of increasing opportunity costs.

b. In autarky, Japan’s production and consumption points along its production possibilities frontier are
assumed to be 500 tons of steel and 600 autos. Draw a line tangent to Japan’s autarky point, and from
it, calculate Japan’s MRT of steel into autos. In autarky, South Korea’s production and consumption
points along its production possibilities frontier are assumed to be 200 tons of steel and 800 autos.
Draw a line tangent to South Korea’s autarky point, and from it, calculate South Korea’s MRT of steel
into autos.
Explanation:
Calculate Country J's MRT of steel into autos:
To calculate Country SK's MRT of steel into autos, calculate the slope of the tangent:

Answer:

Country J's MRT for auto is ⅙ tons of steel per auto.

c. Based on the MRT of each nation, should the two nations specialize according to the principle of
comparative advantage? If so, in which product should each nation specialize?
Answer:
Similarly, for country SK, the MRT of steel into autos is 6. Thus, the MRT of autos into steel is ⅙, for
Country SK.

The MRT of autos into steel is lower for Country SK than Country J. Therefore, Country SK should
specialize in the production of steel.

d. The process of specialization in the production of steel and autos continues in Japan and South Korea
until their relative product prices, or MRTs, become equal. With specialization, suppose the MRTs of
the two nations converge at MRT=1. Starting at Japan’s autarky point, slide along its production
possibilities frontier until the slope of the tangent line equals 1. This becomes Japan’s production point
under partial specialization. How many tons of steel and how many autos will Japan produce at this
point? In like manner, determine South Korea’s production point under partial specialization. How
many tons of steel and how many autos will South Korea produce? For the two countries, do their
combined production of steel and autos with partial specialization exceed their output in the absence of
specialization? If so, by how much?
Answer:

The production point for country J is marked, which corresponds to 200 tons of steel and 1300 units of
autos.
 The production point for Country SK is marked, which corresponds to 900 tons of steel and 400 units
of autos.

Yes, the partial specialization production of steel and auto for both the countries exceed the autarky
production. The production gains for the countries is 400 tons of steel and 300 autos.

e. With the relative product prices in each nation now in equilibrium at 1 ton of steel equal to 1 auto
(MRT=1), suppose 500 autos are exchanged at these terms of trade.
(1) Determine the point along the terms of trade line at which Japan will locate after trade occurs. What
are Japan’s consumption gains from trade?
Answer: X

(2) Determine the point along the terms of trade line at which South Korea will locate after trade
occurs. What are South Korea’s consumption gains from trade?
Answer: X

14. Table 2.10 gives hypothetical export price indexes and import price indexes (2000 = 100) for Japan,
Canada, and Ireland. Compute the commodity terms of trade for each country for the period 2000–2016.
Which country’s terms of trade improved, worsened, or showed no change?

Answer:
Calculate terms of trade for Country J in 2000:
Calculate terms of trade for Country J in 2016:

Calculate terms of trade for Country C in 2000:

Calculate terms of trade for Country C:

Calculate terms of trade for Country I in 2000:

Calculate terms of trade for Country I

Country J's commodity terms of trade improved to 107. Country C's commodity terms of trade remained
constant at 100. Country I's commodity terms of trade worsened to 88.

15. Why is it that the gains from trade could not be determined precisely under the Ricardian trade model?
Answer:
The gains a country enjoys from free trade depend on the equilibrium terms of trade, which is determined by
world supply and demand conditions. By recognizing only the role of supply, Individual R was unable to
determine the equilibrium terms of trade. Thus, gains from trade could not be determined from individual
R's model because it focuses only on the supply side, that is exports.

16. What is meant by the theory of reciprocal demand? How does it provide a meaningful explanation of the
international terms of trade?
Answer:
According to the reciprocal demand theory, the actual ratio at which the true countries trade the goods is
determined by the strength of each country's demand for the product of the other or the reciprocal demand.

The trading nations of the same size with similar intensity of demand for each other's products will benefit
equally from trade. In the case of unequal size of the nations, the domestic exchange ratio prevailing in the
market will be that of the larger nation.

17. How does the commodity terms of trade concept attempt to measure the direction of trade gains?
Answer:
The terms of trade (ToT) identify direction of trade gains by taking the ratio of exports and imports of the
country. The commodity terms of trade concept measures the gains from trade by considering the price of
exports and the price of imports in a country.