Chapter 2

Tools of Analysis
for International
Trade Models
 Topics to be Covered

The Basic Model Assumptions

The Basic Model Solutions
Measuring National Welfare

2013 Pearson Education, Inc. All rights reserved. 2-2

 Important Trade Questions

Why does international trade occur?

What are the benefits gained, and cost
incurred from trade?
What goods will a country export/import?
What will be the volume of trade?
What will be the prices at which trade
occurs?
What is the effect of trade on payments to
factors of production?

2013 Pearson Education, Inc. All rights reserved. 2-3

 Economic Methodology

An Economic model is a theoretical

description of the pattern of economic
behavior

Model uses assumptions about

environment and behavior of economic
agents to make predictions

2013 Pearson Education, Inc. All rights reserved. 2-4

 Positive vs. Normative Analysis

Positive analysisthe analysis of

economic behavior without making
recommendations about what is or ought to
be.

Normative analysiseconomic analysis

that makes value judgments about what is
or should be.

2013 Pearson Education, Inc. All rights reserved. 2-5

 The Basic Model

General equilibrium modelin this

model, production, consumption, prices,
and international trade are all determined
simultaneously for all goods.

2013 Pearson Education, Inc. All rights reserved. 2-6

 Assumption 1: Rational Behavior

Economic agents are goal-oriented.

Consumers maximize satisfaction (utility)

subject to constraints (budget).
Firms maximize profit subject to constraints
(costs).

2013 Pearson Education, Inc. All rights reserved. 2-7

 Assumption 2:
Two-country, Two-good World

Two countries: America (A) and Britain (B)

Two goods: Soybeans (S) and Textiles (T)
Goods are identical in both countries.
Some of both goods are always consumed
in both countries.

2013 Pearson Education, Inc. All rights reserved. 2-8

 Assumption 3: No Money Illusion

No money illusion means that economic

agents make decisions based on changes
in all prices.
Nominal pricea price expressed in
terms of money.
Relative pricea ratio of two product
prices.

2013 Pearson Education, Inc. All rights reserved. 2-9

 Assumption 3: No Money Illusion

2013 Pearson Education, Inc. All rights reserved. 2-10

 Relative Price Rule

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)

2013 Pearson Education, Inc. All rights reserved. 2-11

 Global Insights 2.1

Oil and gas prices rose significantly from

2007-2008, while prices of others goods did
not

Relative price change impacted consumer

and producer behavior

2013 Pearson Education, Inc. All rights reserved. 2-12

 Tool of Analysis: Price Line

Price Line (PL)shows combinations of

two goods that can be purchased with a
fixed amount of money.

Money (M) = Ps S PT T

2013 Pearson Education, Inc. All rights reserved. 2-13

 FIGURE 2.1 Example of a Price Line

PTT + PSS = M

Solving for T:
T = M/PT - (PS/PT)S

2013 Pearson Education, Inc. All rights reserved. 2-14

 Tool of Analysis: Price Line

Slope of PL = relative price (PS/PT)

Shift of PLcaused by a change in income
or a change in both product prices.
Rotation of PLcaused by a change in one
product price, other things constant.

2013 Pearson Education, Inc. All rights reserved. 2-15

 FIGURE 2.1 Example of a Price Line

Suppose that PS/PT rises from 2 to 3. What does

this imply?

a) The same amount of T now trades for 3

units of soybeans
b) T has become relatively more expensive
c) S has become relatively cheaper
d) S has become relatively more expensive

2013 Pearson Education, Inc. All rights reserved. 2-16

 Assumption 4:
Fixed Resources and Technology

Each country has fixed factor endowments

and constant level of technology.
Tool of analysis: Production Possibility
Frontier (PPF)
PPFshows maximum amount of one good
that can be produced given the countrys
fixed resources and technology and the
level of output of the other good.

2013 Pearson Education, Inc. All rights reserved. 2-17

 Characteristics of a Production
Possibility Frontier

Points on the PPF curve make full use of

resources
Slope of PPF = opportunity (social) cost
= T / S
Shape of PPF: constant cost (linear PPF)
vs. increasing cost (bowed out PPF)

2013 Pearson Education, Inc. All rights reserved. 2-18

 FIGURE 2.2 Examples of Production Possibility
Frontiers: (a) Increasing Opportunity Costs; (b)
Constant Opportunity Costs

Opportunity Costs The amount of production of one type

of good that must be sacrificed to produce one more unit of
another good

2013 Pearson Education, Inc. All rights reserved. 2-19

 FIGURE 2.2 Examples of Production Possibility
Frontiers: (a) Increasing Opportunity Costs; (b)
Constant Opportunity Costs

2013 Pearson Education, Inc. All rights reserved. 2-20

 In Class Exercise

In a simple economy 1000 workers are

available to produce houses and grain

Each worker can produce 1 house or 3 tons

of grain, with constant opportunity costs

Draw the PPF with houses on the horizontal

axis. Is slope constant? Why?

2013 Pearson Education, Inc. All rights reserved. 2-21

 In Class Exercise

Slope of PPF = opportunity cost of houses

(H) in terms of grain (G) = MCH /MCG.

One house uses three times the labor

needed to produce one ton of grain.

2013 Pearson Education, Inc. All rights reserved. 2-22

 Assumption 5: Perfect Competition in
Both Industries in Both Countries

Under perfect competition, price equals

marginal cost or

slope of PPF (T / S) = slope of PL (PS / PT )

Assumption 5 guarantees that market price

reflects the true social (opportunity) cost of
production.

2013 Pearson Education, Inc. All rights reserved. 2-23

 FIGURE 2.3 Relationship Between
Price Line and Production Point

2013 Pearson Education, Inc. All rights reserved. 2-24

 Assumption 6: Resources Perfectly
Mobile Between Industries

Factors of production will respond to

differences in factor payments

This assumption guarantees that resources

earn the same payments in both industries
within a country.

2013 Pearson Education, Inc. All rights reserved. 2-25

 The Basic Model: Recap of
the Assumptions
1. Economic agents exhibit rational behavior
2. Two countries, two goods
3. No money illusion
4. Factor endowments are fixed and
technology is constant
5. Perfect competition
6. Factors of production are perfectly mobile
Tools of Analysis: Price Line, PPF
2013 Pearson Education, Inc. All rights reserved. 2-26
 Tool of Analysis: Indifference
Curve

Represents demand side of the economy

Indifference Curveshows combinations

of two goods that yield the same level of
satisfaction to a consumer.

2013 Pearson Education, Inc. All rights reserved. 2-27

 Properties of Indifference
Curves

Individual-specific
Downward-sloping
Convex to the origin
Higher curves
indicate higher
levels of satisfaction
(utility)

2013 Pearson Education, Inc. All rights reserved. 2-28

 Properties of Indifference
Curves

Non-
intersecting

2013 Pearson Education, Inc. All rights reserved. 2-29

 Consumer Utility Maximization

2013 Pearson Education, Inc. All rights reserved. 2-30

 Consumer Utility Maximization

Consumer maximizes utility subject to an

income or budget constraint (price line)
Consumer equilibrium solution occurs
at the tangency point of an indifference
curve and the price line
At this point slope of I-curve equals slope of
price line = -PS / PT

2013 Pearson Education, Inc. All rights reserved. 2-31

 Assumption 7: Community
Indifference Curves

Community Indifference Curves (CIC)

represent the consumption preferences of
the community.

Assume there is a set of CICs that express

the preferences of the community over the
consumption of various bundles of goods

2013 Pearson Education, Inc. All rights reserved. 2-32

 TABLE 2.1 Illustration of
Condorcets Voting Paradox

2013 Pearson Education, Inc. All rights reserved. 2-33

 Situations When Group
Preferences Are Consistent

One-person, Robinson Crusoe-type economy

Strict one-person dictatorship
Every person in the country has identical
tastes and incomes.

2013 Pearson Education, Inc. All rights reserved. 2-34

 General Equilibrium Model
for a Closed Economy (Autarky)

AutarkyCountry does not take part in trade

Constant opportunity cost case vs. increasing
opportunity cost

Equilibriumtangency point of the PPF and CIC

Under constant opportunity costs, demand plays
no role in determining relative prices.

2013 Pearson Education, Inc. All rights reserved. 2-35

 FIGURE 2.5 General Equilibrium for a
Closed Economy: Constant Opportunity
Costs

2013 Pearson Education, Inc. All rights reserved. 2-36

 FIGURE 2.6 General Equilibrium for a
Closed Increasing Opportunity Costs

2013 Pearson Education, Inc. All rights reserved. 2-38

 FIGURE 2.6 If the economy is initially at
point U, describe the forces that move the
economy to X.

2013 Pearson Education, Inc. All rights reserved. 2-39

 Clicker Question

If a country is at a point on its PPF where the slope

of the PPF is flatter than the slope of the CIC
touching that same point, then the standard of living
would rise if outputs of the two goods would change
so as to move down the PPF curve.

a) True
b) False

Hint: Draw a diagram

2013 Pearson Education, Inc. All rights reserved. 2-40
 Clicker Question: Answer

This statement is
true. In this case,
society is willing to
pay more than it
would cost to
obtain one more
unit of the good on
the horizontal axis.

2013 Pearson Education, Inc. All rights reserved. 2-41

 Measures of National Welfare

Community Indifference Curve

Gross Domestic Product (GDP) level of
output of goods and services produced by
an economy
Nominal GDP can change due to a change in
output and/or a change in prices.

2013 Pearson Education, Inc. All rights reserved. 2-42

 Real GDP

A change in real GDP reflects real (output)

change rather than nominal (price) change.
Increases in real GDP may imply increases
in national welfare or standard of living.

2013 Pearson Education, Inc. All rights reserved. 2-43

 FIGURE 2.7 Determination of Real
GDP Level

2013 Pearson Education, Inc. All rights reserved. 2-44