INTERNATIONAL ECONOMICS Lecture 3 | Carlos Cuerpo | Why do countries trade? Some later answers

NEOCLASSICAL THEORY Haberler's Contributions: – Laid the conceptual foundation of modern trade theory – Opportunity Cost conception of CA: value of X in terms of foregone units of Y rather than in labour units. More systematic analysis of potential gains from trade. Neclassical Set-up: – Rational agents, perfect competition. – Examine Demand Conditions and Consumer Preferences. – Look at an economy's production capabilities. – Trade Pattern still determined by Comparative Advantage, but expand the reasoning behind relative price differences: Differences in Technology (labor productivity as well as capital productivity). Heterogeneity in preferences.

NEOCLASSICAL THEORY:PREFERENCES Consumer preferences: – Indifference curve: Definition: combination of goods that give an individual the same level of utility or satisfaction. Derived from the Utility function, as well as its properties. Curvature: Diminishing Marginal rate of substitution (ratio of Mg Utilities). Good Y Good X A B C ΔYΔY ΔXΔX MRS x,y = ΔY/ ΔX = MU x /MU y

NEOCLASSICAL THEORY Consumer preferences: – Edgeworth Box: Definition: represents the preferences of 2 individuals and the allocation of goods between them. Derived from the Utility function, as well as its properties. Curvature: Diminishing Marginal rate of substitution (ratio of Mg Utilities). Good Y Good X B A E Oa Ob A’ B’ Two sources of trade: Preferences Endowments or production capabilities Homothetic Preferences [diagonal] Representative consumer [aggregation] Individuals have the same preferences and spend their income in the same proportion in the two goods

NEOCLASSICAL THEORY Production Capabilities: – Assumptions: Perfect Competition in commodity and factor markets: flexible prices, factors fully employed. Fixed quantitites of inputs. Perfect mobility of L,K within a country bet immobile internationally. Zero transport costs and no barriers to trade: international price is unique. Balanced Trade: M=X. Homothetic tastes. – Opportunity Cost: [Haberler 1936 gets rid of the labor theory of value] Definition: In a two-good world (X and Y), the opportunity cost (OC) of X is the amount of Y which is given up for a unit of X. Redefine CA: A country has a CA in commodity X if it can produce an extra unit at a lower OC in terms of foregone Y than any other country.

NEOCLASSICAL THEORY Production Capabilities: – Production Possibility Frontier: Definition: highest attainable combinations of goods that can be produced with a fixed available supply of inputs (labour). Slope: Ratio at which good X can be transformed into good Y. Marginal rate of Transformation (ratio of Mg Costs): rate at which good X can be transformed into good Y. Good Y Good X A B ΔYΔY ΔXΔX MRT x,y = ΔY/ ΔX = MC x /MC y Country A’s PPCurve with constant costs [single input or homogenous use] J K ΔY*MC y = -ΔX*MC x

NEOCLASSICAL THEORY Production Capabilities: – Production Possibility Frontier: Increasing Costs: As resources are shifted from good X to good Y, the opportunity cost of each additional unit of X increases. Intuition: Profit maximization leads to an efficient use of resources. Marginal rate of Transformation (ie the slope of tangent RR) will become steeper as the opportunity cost increases [concavity]. Good Y Good X P MRT x,y = ΔY/ ΔX = MC x /MC y R R

NEOCLASSICAL THEORY Equilibrium in a closed economy: Individual firms, motivated by price signals are taken the necessary actions in order to reach the higher possible welfare. Intuition: The economy is operating at maximum efficiency. The rate at which the production of one good can be transformed into the production of the other commodity equals the rate at wich the consumer is indifferent and determines the barter ratio. Good Y Good X P MRT x,y = MRS x,y = p x /p y R R

NEOCLASSICAL THEORY International Trade: 2 countries-2 Goods – Pre-Trade Equilibrium: Search of a Comparative Advantage Good Y Good X P R R D D P* U U* Good X Good Y

NEOCLASSICAL THEORY International Trade: 2 countries-2 Goods – Post-Trade Equilibrium: Shift resources until equilibrium price ratio Good Y Good X P R R D D P* U U* Good X Good Y Q T T T T U’ V S U*’ V* Q* S* Country ACountry B

NEOCLASSICAL THEORY Trade Results: – Reallocation of resources due to CA. Complete specialization will usually not occur due to increasing costs. – Equalization of relative prices Different prices provided the incentive for trade – Increase in economic welfare in both countries: Division of Gains

CLASSICAL THEORY: J.STUART MILL Trade Results: – Reallocation of resources due to CA. Complete specialization will usually not occur due to increasing costs. – Equalization of relative prices Different prices provided the incentive for trade – Increase in economic welfare in both c: Division of Gains [elasticities] Country A World Trade Country B SSx,a S P* DeDm.b D Po C* C* C* Po Mb Xa

NEOCLASSICAL THEORY Assignements: – Group exercises: 3 and 4 page 31 [Eicher and Mutti] – Individual exercises: 1,3,5 and 6 pages 61, 62 [Eicher and Mutti] – Extra assignement: Offer curves pages 55 to 58.