LECTURE 5 Trade Indifference Curve: The social utility function is defined as U (C1, C2) 1

It is assumed that U (C1, C2) is increasing, differentiable and quasi concave. Using the social utility function, it is possible to define a direct trade utility function. Meade (1 !"# defined the direct trade utility function $TU# as% U (E, v) = max {u (C): C = X E, and &here ' (M ( ) '# * n)dimensional vector of e+ports (imports#, - * mdimensional vector of factor inputs, . * n)dimensional vector of outputs, / * 0ggregate consumption bundle 1 (., v# 2 3 is the production possibility curve The $TU is then defined as the ma+imum utility level of the economy by choosing optimal consumption and production bundles 4hen the e+port levels E are chosen e+ogenously. 5otice that no commodity prices or budget constraint appear in the definition of the $TU function. The $TU function is continuous and quasi)concave in E and v, increasing in v and decreasing in E. $efine a 6agrangian function U (E, v) = max $ {u (C) % &' (X(C E) )' ( (X, v)# * C, X (X, v) ! "# "

$ifferentiating $ by /i and .i respectively, i * 1..n, to give the first)order conditions% +$,+Ci = ui &i ! " +$,+Xi = &i ( )'
i

5
i

!" (7 87.i.

4here ui is the marginal utility of good i and

5o4, consider any goods i and 9 that are produced and consumed. &ith the inequalities being replaced by equalities, the above equations : ; ! can be combined together to give ui,u. = 5ote that
i i

is the marginal rate of transformation bet4een goods i and 9.

The partial derivative of the $TU function +U,+Ei = ( &i , i = 1''n +U,+v. = ( )' 4here
9 .

0 1

, . = 1''m

* 7 87v9.

5o4, consider any t4o goods i and 9, 4hich are consumed and produced domestically, then the above condition < ; =, 4e get +U,+Ei,+U,+E. = &i, &. Therefore, +U,+Ei,+U,+E. = ui,u. =
i

1"

The $TU function in this frame4or> can be represented by the trade indifference curve. The slope of a trade indifference curve for a t4o goods 4orld is equal to, d32,dE1 = ( dE2,dE1 = +U,+E1,+U,+E2 = u1,u2 = 4 11

56T: T&e Ricardian Ca7e 3aximi8e U (C1, C2) 7'9 C1 % 4C2 = X1 % 4X2 " : 4 :; Then, 4e can define trade indifference curve < in the follo4ing 4ay% E1 = (X1 C1) = L,CL1 ( C1 32 = (C2 X2) = C2 Then to achieve a given 4elfare level, 4e must have U (L,CL1 ( E1, 32) = = 0nd the corresponding terms of trade 4ill be 1

6 = E1, 32 &riting U (L, CL1 ( E1, 32) = < >E1, 32?, &e obtain trade indifference curve by setting @ = <. It can be verified that since U is monotonically increasing in /1 and /2 and is concave, < is also monotonically increasing in M2, decreasing in '1 and concave. Ma+imi?ing U sub9ect to C1 % 4C2 = X1 % 4X2 &ith .1 * 68 /61 and ." * 3 is equivalent to ma+imi?ing < sub9ect '1 * pM". $ = U (C1, C2) % A {L,CL1 ( C1 ( 4C2# +$,+C1 = +u,+C1 ( A = " +$,+C2 = +u,+C2 ( 4 A = " +u,+C2,+u,+C1 = 4 BimiCarCD, $E = < >E1, 32? %) (E1 ( 432# +$E,+E1= + <,+E1 % ) = " +$E,+32= + < ,+32 ) 4 = " ( + <,+32,+<,+E1 = 4 +<,+E1 dE1 % +<,+32 d32 = " Fr ( +<,+32,+<,+E1 = dE1,d32 T&erefGre,

dE1,d32 = 4 = +u,+C2,+u,+C1

T&e HeG( CCa77icaC T&eGrD Gf Trade: T&e IecJ7c&er F&Cin BamueC7Gn (IFB) 9&eGrD Gf 9rade: T&e a77um49iGn7: 1. @roduction functions are similar internationally. ". Aactor 'ndo4ments are the dissimilar internationally. 0nd factors are immobile bet4een countries. B. Tastes are similar in all countries. :. @roduction functions are neo classical and many factors are permitted. !. @erfect competition prevails every4here. C. 5o transportation costs. T&e T&eGrem: 0 country e+ports the commodity 4hich uses intensively its relatively abundant factor and imports the commodity 4hich is intensive in the use of its relatively scare factor. Kefini9iGn7 Gf reCa9ive fac9Gr aLundance Gr 7carci9D: 6rice defini9iGn: M& N Mf @&ere M i7 9&e OaPe: ren9aC ra9iG (@,r)' 1

6&D7icaC Kefini9iGn% J& N Jf @&ere J i7 9&e ca4i9aC : CaLGur ra9iG (Q,L)' HGO, Ce9 u7 9aJe 9&e 4rice defini9iGn % Dince 4e >no4 from our analysis of production that there is an one to one relationship bet4een factor price and commodity price in the absence of technical progress as given by% R(OS ( rS ) = (61S ( 62S) * 2

That is, if R is positive meaning >" E >1 then the M and 4 are inversely related. Fn the other hand, if R is negative meaning >" G >1 then the M and p are positively related. Thus, for R N ", a higher M implies a lo4er 4. Fr, in other 4ords a country 4here labour is relatively scarce (or capital is relatively abundant#, the relative price of the labour intensive good is also higher, that is lo4er 4. Therefore, a labour scarce or a capital abundant economy tends to e+ports the capital intensive good and vice versa. Thus J2 N J1, 9&en 4& N 4f Fr, if J2 : J1, 9&en 4& : 4f 5 -

Tac9Gr in9en7i9D rever7aC: If factor intensities are reversible, then if the autar>y 4age8rental ratios of the t4o countries lie on the same side of the factor)intensity reversal point, the HFD theorem continues to be valid, but if they lie on different sides, at least one of the countries violates the HFD dictum. T&e RGCe Gf Kemand: The HFD theorem is valid under price definition only under the assumption that the community indifference map is 4ell behaved. That is, the utility function for both the countries is defined to be homothetic so that the income elasticity of demand is unity. 6&D7icaC Kefini9iGn:

If 4e assume absence of technical progress then from the comparative static analyses 4e get (61S(62S)=(QS(LS),A(UK%UB)%VS (W1W2) ,(UK%UB) / 0gain, let us assume for the time being that the utility functions are homothetic. Then, the above relationship reduces to (61S(62S) = (QS(LS),A (UK%UB) 0

The equation < states that there is a unique relationship bet4een factor endo4ment proportions and the commodity prices. Thus, if J2 N J1 then A is positive and hence the relation bet4een > and p in both countries is given by the negatively inclined curve. Fn the other hand, if J2 : J1 the A is negative and therefore the relation bet4een > and p is given by the positively inclined curve. >

T&e RGCe Gf Kemand: /onsider the relation given by <. If demand patterns are dissimilar, that is W1 X W2, then the above unique relationship bet4een > and p may get reversed. T&e EYuiCiLrium in In9erna9iGnaC Trade:

' 1 * . 1 /1 ' " * /" ) . " Aactor @rice 'quali?ation