Question

Compare and contrast the assumptions and outcomes of the competing formal models of international trade between countries, which are the constant-cost model and the increasing-cost model.

Answer 1

The main cause of production specialization in international trade is the difference in costs of production. Due to the relative differences in costs of production countries determine the products to be produced. Every country prefers certain products & services which are best suited for production. A country tends to produce those goods for which it has comparative advantage. It will select those goods in which the comparative costs or lower or in which it enjoys relative advantage. Comparative advantage states that aggregate output is maximized when countries specialize in the production of goods for which they have the lowest opportunity cost producer, and then trade for other goods. There are two models to explain this approach as discussed below.

Constant cost model: In this model marginal rate of transformation (MKT) plays an important role. It is the amount of one good which must be given up to release resources necessary for production of an additional unit of another good. The opportunity cost of one good is the amount of another good which a country must give up to produce an additional unit of another good. Opportunity cost measures the ratio of marginal costs of the two commodities. It also reflects comparative advantage of a country in producing a good. In constant cost model it implies that all resources are of equal quality and that they are all equally suited to the production of both commodities. In this model it is assumed that opportunity cost for production of a good in a country remains constant. In case of constant opportunity costs, there is complete specialisation, that is, of the two goods a country produces only one commodity.

Increasing cost model: As in a realistic world all resources do not produce equal amounts of two goods. When resources are not equally efficient in the production of the two goods we have the situation of increasing costs. This indicates a shift in resources from the production of one good to another good due to which marginal opportunity cost of one good goes on increasing. In this model the production possibility curve is not identi­cal with a price curve. Here specialization of production is not likely to be complete because of the occurrence of dimin­ishing returns or increasing costs as the production of one good is increased at the expense of the other good.