General Equilibrium Analyses in Trade Model Lect.1 Basic Tools for General Equilibrium Analyses in Trade Model Dr. Nisit Panthmait

Diminishing marginal rate of substitution Basic Tools for General Equilibrium Analysis Demand Side: Community Indifference Curve (CIC) Shows various combinations of two goods with equivalent welfare Downward sloping And Convexity CI Since Y(MUy) = - X(MUx)  -Y/X = MUx/MUy Good X Good Y CI0 Y X Diminishing marginal rate of substitution MRS = - = Y X MUx MUy

Consumer demand is always satisfied with more goods Ordinal and Transitivity: Farther out from origin point Means higher welfare to consumer CI1 CI2 CI3 Good X Good Y CI0

Non-intersecting Community Indifference Curve CI0: B = A = C A = B = C = D CI1: A = D Good X Good Y CI0 B A C CI1 > CI0  D > C contradiction D CI1

These are the wrong Portions of CIC. Why? Good X Good Y C0

Consumer equilibrium: Maximize welfare subject to the income constraint (Budget constraint) Slope of budget line: Y/X = (0y)/(-0x) = (I1/Py)/(-I1)Px) = - Px/Py = MRS Good X Good Y CI0 y1 x1 x y A I1 I2 At point A: (Px)(0x1) + (Py)(0y1) = I1 y1 = (I1)/(Py) – (Px/Py)X1 Y = (I1)/(Py) – (Px/Py)X  Y/X = – Px/Py

Supply side: Production possibility frontier (PPF) Isoquent concept: Show various combinations of two inputs that produce same level output Downward sloping and Convexity for possible substitution Capital Labor Q1 K1 L1 K1’ L1’ P P’ K L Marginal rate of technical substitution (K)x(MPPK) = - (L)x(MPPL) K/L = - MPPL/MPPK K/L = MRTS

Q2 Q3 Q4 Non-intersecting Farther out from origin point Means greater quantities of outputs Capital Labor Q1 K1 L1 K1’ L1’ P P’ K L

Capital intensive output expansion path Constant return to scale: a given percentage increase in all inputs will lead the same percentage increase in output Capital intensive output expansion path 4K1 P’ L1 G’ Capital Labor Q1=10 K1 2L1 2K1 P Q2=20 4L1 Labor intensive output expansion path G

Producer Equilibrium:At the point the isoquant is tangent to the isocost. Firm maximizes output for the given cost (i.e., most efficient production), Or firm minimizes its factor cost for the given level of output. The slope of isocost (or the factor price line) K/L = 0K/-0L = - (B1/r)/(B1/w) = w/r where r is labor wage, w is capital rental rate = MPPL/MPPK = MRTS Capital Labor Q1 K1 L1 P K L K’ L’ B1 B2 P’ Q2 H At point P: B1 = rK + wL rK = B1 – wL K = (B1/r) – (w/r)L K/L = - w/r

S is capital-intensive (K/L)s > (K/L)c or (L/K)s < (L/K)c C is labor-intensive (L/K)s < (L/K)c or (K/L)s > (K/L)c S-Isoquant (K/L)s Ks Ls Oc Lc Kc Increasing K Increasing L L K C-Isoquant (K/L)c

Resources allocation in two goods within a country Os (K/L)s Ls Ks Increasing L Increasing K Oc Lc Kc Increasing K Increasing L (K/L)c L K Isoquant

The Edgeworth Box: L 0s K S1 S2 S3 S4 S5 K 0c L C1 C2 C3 C4 C5 V Not Pareto Efficiency Contract curve: production efficiency locus with increasing opportunity cost

The Edgeworth Box: L 0s K S1 S2 S3 S4 S5 K 0c L C1 C2 C3 C4 C5 Not Pareto Efficiency V Contract curve: production efficiency locus with constant opportunity cost

Country II: Capital abundant country Steel Clothes S3 S2 S1 S0 C3 C2 C1 C0 Country II: Capital abundant country K2 L2

Country I: Labor-abundant country Clothes Steel S3 S2 S1 S0 C3 C2 C1 C0 Country I: Labor-abundant country KI LI

Constant vs. Increasing Opportunity Cost on the PPF Good Y Good X PPF (or contract curve) with increasing opportunity cost Constant increase Increasing Opportunity Cost PPF (or contract curve) Decreasing increase

General equilibrium: domestic demand = domestic supply Production at point A0 is satisfied and consumed by consumers demand within a country with constant opportunity cost. (Classical case) Good Y Good X PPF & budget curve CI0 A0 (Px/Py) CI1 CI2

Classical Autarky Equilibrium CI0 CI1 CI2 B A PX PY E (autarky price) X -Cloth Y-Steel PPF Marginal rate of transformation (MRT) Of substitution (MRS)

General equilibrium: domestic demand = domestic supply Production at point A0 is satisfied and consumed by consumers demand within a country with increasing opportunity cost. (Neo-classical case) Good Y Good X PPF CI0 A0 (Px/Py) CI1 CI2 Budget curve

Community Indifferent curves Autarky Equilibrium CI0 CI1 CI2 Community Indifferent curves X -Cloth Y-Steel PPF B A PX PY E (autarky price) Marginal rate of transformation (MRT) Of substitution (MRS)

x ay ax a L Y - = - ax ay y a x L + = the slope is = - Px Py Given labor endowment is fixed with L y a x L + = LA aX Good X Good Y ay PX PY Country A Solving for x ay ax a L Y y - = the slope is - ax ay = - Px Py

Unit cost in producing X is ax or (w x ax) |w –wage in money term Total cost in producing X is axx Then x X a P MC = => In perfect competition: Similarly: Thus:

Trade Triangle Concept From the export country view of point: exports 10 units imports 10 units PT = 1 = terms of trade or relative price exports 10 units imports 5 units PT =1/2 =Terms of trade becomes worse

Trade Triangle Concept exports 10 units imports 15 units PT = 3/2 = Terms of trade better off for export country