Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Ad Advanced dI International t ti lE Economics i

ECON 758
Professor Yamin Ahmad Lecture 2: Tools of Analysis for International Trade Models
Partial and General Equilibrium Production Possibility Frontiers Indifference C Curves r es

In This Lecture
Assumptions of the Basic Model Price Line Production Possibilities Frontier and MRT (marginal rate of transformation) Consumer Indifference Curves and MRS (marginal rate of substitution) s bstit tion) Closed Economy (Autarky) Equilibrium National Demand and Supply Curves

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Economic Methodology
Economic Modelan abstraction (simplification) of reality; use mathematics to represent real world ideas.
Geometric model: limited to 3 dimensions Algebraic model: not hampered by dimensionality limitations

Types of Economic Models

Partial equilibrium (PE) model output, output consumption, prices and trade are determined for a p particular market or g good, , one at a time.
Typically ignore resource constraint

P Positive iti analysis l i the th analysis l i of f economic i behavior without making recommendations about what is or ought g to be. Normative analysis economic analysis that makes value judgments about what is or should be.
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General equilibrium (GE) model output, consumption prices consumption, prices, and trade are all determined simultaneously for all goods.
Incorporates resource constraint
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

The Basic General Equilibrium Model

General Model Assumptions 1 Rational 1. R i lB Behavior h i 2. Two Country, Two Good World 3. No Money Illusion
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Assumption 1: Rational Behavior

Economic agents (producers and consumers) are goal-oriented. Consumers maximize satisfaction (utility), subject bj t t to constraints. t i t Firms maximize profit, subject to constraints.

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Note: These lecture notes are incomplete without having attended lectures

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Assumption 2: Two-country Two country, Two Two-good good World

Two countries: America (A) and Britain (B) Two T goods: d Soybeans S b (S) and dT Toys (T) Goods are identical in both countries. Some of both goods are always consumed in both countries.
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Assumption 3: No Money Illusion

No money illusion means that economic agents make decisions based on changes in all prices. Nominal p price a p price expressed p in terms of money. Relative price a ratio of two product prices.
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Relative Price Rule

A Very Simple Example Example

Suppose Ps = 10; PT = 5;

If Ps / PT = k , then 1 unit of S = k units of T (in value) or 1 unit of T = 1/ k units of S (in value)

Question: How many Ts would be of equal value to four Ss?

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Tool of Analysis: Price Line

Price Line (PL) shows combinations of two goods that can be purchased with a fixed amount of money money. Money (M) =

Example of a Price Line

T 20

Ps S + PT T
T=
12 10

slope =

T 2 = = 2 1 S

|Slope of PL| = relative price

( PS / PT )

Shift of PL caused by a change in income (money) (money). Rotation of PL caused by a change in one product price, other things constant.
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Hence slope = 2 = 2 =
S
4 5

PS PT

10
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S=
2-11
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Production/ Supply Side

Supply Side Assumptions 4 Fixed 4. Fi d R Resources and dT Technology h l 5. Perfect Competition 6. Perfect Mobility of Resources
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Assumption 4: Fixed Resources and Technology

Tool of analysis: Production Possibilities Frontier (PPF) PPF shows maximum amount of one good th t can be that b produced d d given i th the countrys t fi fixed d resources and technology and the level of output of the other good good.

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Note: These lecture notes are incomplete without having attended lectures

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Features of a Production Possibilities Frontier

Full and efficient employment of resources Slope of PPF = opportunity (social) cost =

Examples of PPFs
a) Increasing Opportunity Cost
T

b) Constant Opportunity Cost

T

T / S
(Marginal Rate of Transformation MRT)

F E

I J G

Shape of PPF:
constant cost (linear PPF) vs. increasing cost (bowed out/concave PPF)
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D
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S
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Production Possibilities Frontier (cont (cont.) )

Question: Which of the PPFs below represent greater production in the economy?
T

Assumption 5: Perfect Competition in Both Industries in Both Countries

Price equals marginal cost or

slope of PPF = slope of PL P T ie i.e. = S PT S PS MRT = PT

Labor unions are not present Hence the price ratio is determined by the slope of the PPF!
S

D C

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Relationship Between Price Line and Production Point

T

Assumption 6: Resources Perfectly Mobile Between Industries

Resources earn the same payments in both industries within a country country.
Factors of production will move between industries in response espo se to o any a y potential po e a differences d e e ces in factor ac o payments

slope =

PS PT

E F Production Point

G S

Factors (e.g. labor) earn the same factor payments (i.e. wages) in both industries within a country

Slope of PPF (MRT) = Slope of Price Line (PS / PT)

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Demand Side
Demand Side Assumptions 7. Social or National Indifference Curves Tool of Analysis: Indifference Curves Represents demand side of the economy (consumers) Indifference Curve shows combinations of two goods that yield the same level of satisfaction (utility) ( utility ) to a consumer.
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An Indifference Curve
T

Indifference Curves are: Individual Specific

0

Downward Sloping
1

T0 T1

Convex to the origin

U0

S0

S1

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Note: These lecture notes are incomplete without having attended lectures

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Marginal Rate of Substitution (MRS)

T

Indifference Curves (cont (cont.) )

T

Slope of IC = MRS = T / S
D

What is the MRS?

Higher g Indifference Curves represent higher levels of utility. y Why? U1 and U2 represent t combinations of T and S that are at l least t the th same (if not more) of either good (compared to U0). )
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T slope = S
F

It reflects the opportunity cost faced by consumers of gaining an additional unit of good S, but at the same level of utility.
U1 S

U2 U1 U0 S

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Some Things to Think About About

Question: Can indifference curves cross? Answer: Question: Are the indifference curves parallel? ll l? Answer:

Properties of Indifference Curves

To summarize, indifference curves are: Individual-specific Downward sloping Downward-sloping Convex to the origin Higher curves indicate higher levels of satisfaction Non-intersecting Non intersecting Slope of indifference curve is the marginal rate of substitution (MRS)

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Consumer Utility Maximization

Consumer maximizes utility subject to an income or budget constraint (price line) What does this mean?...
Given your budget (income), you try and pick combinations of S and T that lie within your budget whilst giving you the greatest utility!

Consumer Utility Maximization

T

slope =

PS PT

Consumer solution occurs at the tangency point of an indifference curve and the budget constraint.
U2 U1 U0 S

T*

S*
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Consumer Utility Maximization

T

Assumption p 7: Social Indifference Curves

Social or National Indifference Curves (SIC) represent the consumption preferences of the consumers in a country. Problem: group preferences may not be consistent.
S

Hence, at the consumers solution: MRS =

PS PT PS PT

T*

Slope of IC = MRS =

U1

Quick illustration: Condorcets Voting Paradox

S*
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

General Equilibrium q Model for a Closed Economy (Autarky)

Definitions: Autarky self-sufficient country before trade i trade, i.e. e it represents the level of production and consumption that would in a country in the absence of trade Equilibrium q tangency g yp point of the PPF and Social Indifference Curves
i.e. MRT = MRS
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3 bundles of goods: A, B and C vs B: A wins two votes to one A vs. B vs. C: B wins two votes to one Does that mean A is preferred to C?

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Note: These lecture notes are incomplete without having attended lectures

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

General Equilibrium q for a Closed Economy: y Constant Opportunity Costs

T

General Equilibrium q for a Closed Economy: y Increasing Opportunity Costs

T

Z is i th the only l equilibrium ilib i point i ti in this closed economy! Why?

G TU

Price Line

Equilibrium is at X! why?
PS PT

slope =
U X

Suppose we are at U.
Market price of S < Price consumers willing to pay for S (and vice versa for T) Hence Hence, production of S increases, and T decreases.
S
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Tz

Z SIC3 SIC2 SIC1 SIC0 S Sz E

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TX

SIC1 SIC0 SU SX H

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Note: These lecture notes are incomplete without having attended lectures

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Tricky Question #1:

T

Another Way y of Showing g General Equilibrium for an Economy

Suppose we are at an initial i i i l equilibrium ilib i at X. What would happen pp if p peoples p tastes changed and they preferred more S to T!
SIC0

PL0
G

slope =
X

PS PT

National Supply Curve shows the amounts of a good produced in a nation at various relative prices for that good. National Demand Curve shows the amounts of national consumption p of a g good at various relative prices.

TX

Show what happens graphically! Where is the new equilibrium point?

SX
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S
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Derivation of National Supply

T PS/PT=1 1 PS/PT=1/2 H PS/PT=2 K G 1/2 H Q3 Q1 Q2 S Q1 S 2 G 1 K PS/PT NSS T

Derivation of National Demand

I
PS/P T=1

PS/PT I 2

K G

G SIC2 1 SIC3 SIC1 1/2

PS/PT= 2

J NDS

H D2 D1

PS/PT=1/2

Q3

Q2

D3 S

D2

D1

D3

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Autarky Equilibrium

Alternative Derivation of Autarky Price Ratio

PS/PT NSS

E Equilibrium ilib i autarky k price i determined d i d at the intersection of National Demand curve and the National Supply curve. curve

1 NDS

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Trade Based on Differences in Autarky Prices

If country A has a lower autarky relative price of S, then it has a comparative advantage in S and a comparative p disadvantage g in T. I International t ti l trade t d can occur based b d on comparative advantage.
We W shall h ll see thi this next tl lecture t

International Differences in Autarky Prices

PS/PT PS/PT NSSA NSSB

2 1 NDSA NDSB

Country A
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Country B
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