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International Economics - International Equilibrium in Trade, International Economics

International Economics >> International Equilibrium in Trade

International Equilibrium in Trade: An Extension Of the Classical Trade Theory 

The gain of trade has been indicated in terms of increase in trade ignore the demand side consumption possibility. The trade theories discussed so far are based on only the supply side of international trade. The classical and new-classical theories of trade ignore the demand side. These theories assume implicitly the existence of demand-it is implicit in the commodity price ratios. The trade theories developed in this kind of framework do not reveal when the nations reach their equilibrium positions, i.e., the point where they optimize the levels of their specialization and trade and maximize the gains from trade. This issue of international trade will be answered in this chapter. We will discuss here how trading nations reach their respective equilibrium position with foreign trade. Specifically, we will show how the equilibrium levels of total production, exports and imports are determined.

The equilibrium level is one that optimizes the production and trade and maximizes e gains from trade. The international equilibrium in tread can e traced by analyzing their respective domestic supply and demand conditions. The supply conditions, i.e., the total production possibility and marginal rate 0 transforma­tion, are given by their production possibility curves. The production possibility curve has already been derived and discussed in Chapter 3. What we need now is to incorporate the demand conditions into the international trade theory to find the international trade equilibrium. The device b which demand conditions and com­modity preferences of the people of a country are expressed is called social indifference curve or community indifference curve, not discussed so far therefore before we proceed to trace the international trade equilibrium, let us first describe the concept of social indifference curve, its properties and limitations.  

The social indifference curve

The social indifference curve is analogous to the individual indifference curve Individual indifference curve are used to analyze consumer's equilibrium. Like-wise, economists use social indifferent curve to analyze society's equilibrium. In fact, the social indifference curve is the application of individual indifference curve at the society level under certain assumptions. The social indifference curve has all the properties of an individual indifference curve.

Equilibrium of a closed economy

 It will however be helpful to know a closed economy reaches its equilibrium with respect to production and consumption in the absence of trade. A closed economy is one that has no economic transactions with the rest of the world. A closed economy reaches its equilibrium when it reaches its highest possible social indifference curve given its production possibility frontiers. In other words, a closed economy reaches its equilibrium when its marginal rate of transformation (MRT) equals the social marginal rate of substitution (MRS)at the highest possible the price ratio of the two goods must be equal to MRT and MRS. The equilibrium example may be expressed more precisely as follows.

                                      MRTR, J = MRSR.J = P /PR


The general equilibrium with trade: a single country case

Having described tile production and consumption equilibrium of India and Bangladesh in the' absence of trade, we, now turn to analyze the production and consumption equilibrium of the two countries with trade. For convenience sake, we begin with a single country case. We will show how trade affects the relative prices of goods and how change in relative prices forces the producers of a country to specialize in a product which has a lower opportunity cost. 

The general equilibrium: two country case

We have described, in the preceding section, how trade alters the relative prices; how change in relative prices brings about specialization; and how nations can consume beyond their production frontiers. This is partial analysis confined to a single country-India or Bangladesh. It does not show how India and Bangladesh reach the state of general equilibrium. The two countries reach the state of general equilibrium when the following condition is fulfilled.


          (ii)     X1R = MBR, and

(iii)    XBJ = M IJ

where X and M are exports and imports respectively.

In simple words, the two countries reach the state of general equilibrium when

(i)      The marginal rate of transformation (MRT) in both the countries is the same,

(ii)     The marginal rate of substitution (MRS) in both the nations is the same,

(iii)    MRT= MRS in both the nations,

(iv)    The price ratios are the same in both the nations,

(v)     MRT = MRS = prices ratios in both the nations, and

(vi)    Export of one country equals the import of the other.

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