Tools of Analysis for International Trade Models Chapter 2 Tools of Analysis for International Trade Models

Topics to be Covered Some Methodological Preliminaries The Basic Model Assumptions The Basic Model Solutions Measuring National Welfare National Supply and Demand

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?

Economic Methodology Model—an abstraction of reality; uses assumptions about environment and behavior of economic agents The test of the validity and usefulness of a model is how well its predictions match with experiences. Geometric model vs. algebraic model

Positive vs. Normative Analysis Positive analysis—the analysis of economic behavior without making recommendations about what is or ought to be. Normative analysis—economic analysis that makes value judgments about what is or should be.

The Basic Model General equilibrium model—in this model, production, consumption, prices, and international trade are all determined simultaneously for all goods. Beginning seven assumptions Three tools of analysis – price line, production possibilities frontier, and indifference curves Equilibrium solution

Assumption 1: Rational Behavior Economic agents are goal-oriented. Consumers maximize satisfaction (subject to constraints). Firms maximize profit (subject to constraints).

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.

Assumption 3: No Money Illusion No money illusion means that economic agents make decisions based on changes in all prices. Nominal price—a price expressed in terms of money. Relative price—a ratio of two product prices.

Relative Price Rule

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) = Slope of PL = relative price (PS/PT) Shift of PL—caused by a change in income or a change in both product prices. Rotation of PL—caused by a change in one product price, other things constant.

FIGURE 2.1 Example of a Price Line

Assumption 4: Fixed Resources and Technology Each country has fixed factor endowments and constant level of technology. Tool of analysis: Production Possibility Frontier (PPF) PPF—shows maximum amount of one good that can be produced given the country’s fixed resources and technology and the level of output of the other good.

Characteristics of a Production Possibility Frontier Assumes full and efficient employment of resources Slope of PPF = opportunity (social) cost = Shape of PPF: constant cost (linear PPF) vs. increasing cost (bowed out PPF) See Figure 2.2

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

Assumption 5: Perfect Competition in Both Industries in Both Countries Price equals marginal cost or Assumption 5 guarantees that market price reflects the true social (opportunity) cost of production. See Figure 2.3. Labor unions are not present.

FIGURE 2.3 Relationship Between Price Line and Production Point

Assumption 6: Resources Perfectly Mobile Between Industries This assumption guarantees that resources earn the same payments in both industries within a country.

Tool of Analysis: Indifference Curve Represents demand side of the economy Indifference Curve—shows combinations of two goods that yield the same level of satisfaction to a consumer.

Properties of Indifference Curves Individual-specific Downward-sloping Convex to the origin Higher curves indicate higher levels of satisfaction Non-intersecting See Figure 2.4.

FIGURE 2.4 Indifference Curves and Individual Utility Maximization

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 (refer to Figure 2.4(d)).

Assumption 7: Community Indifference Curves Community Indifference Curves (CIC) represent the consumption preferences of the community. Problem: group preferences may not be consistent. See Table 2.1 for example.

TABLE 2.1 Illustration of Condorcet’s Voting Paradox

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. The trade model here assumes this latter situation is true.

General Equilibrium Model for a Closed Economy (Autarky) Autarky—self-sufficient country before trade. Constant opportunity cost case vs. increasing opportunity cost Refer to Figure 2.5 Equilibrium—tangency point of the PPF and CIC (at point Z). The equilibrium point is also the closed economy’s optimal production and consumption points. Under constant opportunity costs, demand plays no role in determining relative prices.

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

Closed Economy Equilibrium under Increasing Costs Refer to Figure 2.6 Optimal production and consumption points are determined by the tangency of PPF and a CIC (point X). Changes in production conditions (such as improvement in technology) or changes in tastes would affect equilibrium.

FIGURE 2.6 General Equilibrium for a Closed Increasing Opportunity Costs

Measures of National Welfare Community Indifference Curve Gross Domestic Product (GDP) Nominal GDP can change due to a change in output and/or a change in prices.

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. See Figure 2.7. Another measure of national welfare is real per capita GDP.

FIGURE 2.7 Determination of Real GDP Level

Another Way of Showing General Equilibrium for an Economy 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 of a good at various relative prices Equilibrium autarky price— at the intersection of National Demand curve and National Supply curve. See Figure 2.8.

FIGURE 2.8 Alternative Derivation of the Autarky Price

Trade Based on Differences in Autarky Prices Refer to Figure 2.9 If country A has a lower autarky relative price of S, then it has a comparative advantage in S and a comparative disadvantage in T. International trade can occur based on comparative advantage. How do countries achieve comparative advantage? Answer lies with international differences in demand and supply.

FIGURE 2.9 International Differences in Autarky Prices