Brief notes on Gains from Trade under Increasing Cost Conditions

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While under constant cost conditions, there is com­plete specialisation of a country in the production of a commodity, under increasing cost conditions, complete specialisation is not possible.

In Figure-2 PiPi is the production possibility curve of India and is the production possibility curve of England. The production possibility curve represents the maximum amount of one good that the country can produce for given amount of other good.

Under the increasing cost conditions, the production possibility curve is concave to the origin which indicates that in order to produce more of one good, increasing amount of other good are to be given up.

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From the different shapes of PiPi and PePe curves, it is clear that in India, conditions favour the production of wheat rather than cloth, while, in England; the conditions favour the production of cloth rather than wheat.

Point A is the autarky point for India and point B is the autarky point for England. In other words, in the absence of trade, India is producing and consuming at point A (i.e., OWi of wheat and OC of cloth) and England is producing and consuming at point B (i.e., OW of wheat and OCe of cloth).

The slopes of lines II and EE represent the domestic exchange ratios in India and England respectively. These exchange ratios show that wheat is cheaper in terms of cloth in India and cloth is cheaper in terms of wheat in England.

Under such conditions, both the countries will gain by entering into trade. India has the comparative advantage in the production and export of wheat and England in the production and export of cloth.

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India will gain by producing more of wheat and less of cloth, while England will gain a producing more of cloth and less of wheat. Trade between the two countries will continue until the opportunity cost (as represented by the slope of production possibility curve) in each country is equal to the international exchange ratio.

In this case, the international exchange ratio is given by line TT which is tangent to the two production possibility curves (PP. and PePe) at points A’ and B’. Thus, A’ and B’ are the points of specialisation for India and England respectively.

After trade, India will expand the production of wheat from OWi to OWi‘ and contract the production of cloth from OC to OC’. Similarly, England will expand the production of cloth from OCe to OC’e and contract the production of wheat from OWe to OWe‘. The results of trade are summarised below:

Gains from international trade are clear from the fact that India now obtains more cloth for every unit of wheat surrendered than before trade; the slope of TT is greater than II.

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Similarly, England now obtains more wheat for every unit of cloth surrendered than before trade; the slope of TT is less than EE.

As long as each country is able to consume along the line of international exchange ratio (TT) rather than its own line of domestic exchange ratio (II for India and EE for England), both the countries will gain in welfare.

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