II-B 1 II. General equilibrium approaches—theory

II-B 2 Geometric models 1.Standard model of resource allocation, production, trade and welfare 2.An open economy with pollution 3.Measuring pollution and economic welfare

II-B 3 A simple GE model Assume: –Two goods produced and consumed –Each good is produced using two factors Constant returns to scale –One factor (labor) is intersectorally mobile; the others are “specific” to sectors –Markets are complete and competitive Prices are set in world markets

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5 Spot test! 1.Use the diagram to show the value of total income. 2.For a given set of consumer preferences, show the pattern of trade. 3.Demonstrate that (a, b) is an equilibrium (hint: Walras’ Law).

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8 Spot test! What happens to factor returns when relative output prices change? 1.Returns to specific factors rise (fall) as sectoral output rises (falls) 2.Wage change depends on labor- intensity of expanding sector

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10 Spot test! 1.What happens to the structure of output as specific factor endowments increase? 2.What is the effect of technical progress in a sector? 1.The sector using that factor expands--and the other contracts 2.That sector’s output expands, and the other’s output contracts

II-B 11 An open economy with pollution The Antweiler, Copeland, Taylor (2001) diagram –‘Clean’ and ‘dirty’ goods –Comparative advantage in dirty good –Tariff on imports of clean good Effects of trade liberalization: –scale –composition –technique

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II-B 13 Factor endowment growth Scale and composition effects

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II-B 15 Environment and economic welfare ACT model tells us what happens to pollution. But consumer utility: u = u(c, -z) –Price or endowment changes affect c as well as z: what is the change in net welfare? –example: trade liberalization

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II-B 17 Spot test! Q. In the previous example, what is the optimal tariff, and how is it calculated? A.Where absolute values of slopes of R and C are equal (marginal environmental benefit=marginal cost in terms of consumption) B.Q. What is the optimal tariff on imports of a dirty good? C.A. t = 0.

II-B 18 Summary and conclusions Assumptions about optimizing behavior Assumptions about markets and technology Assumptions about trade Models must make assumptions explicit and be demonstrably consistent Complications can be introduced, but at a cost Target of analysis is important. Is it the environment only? Or a broader concept of welfare?

II-B 19 For next sessions Review duality and basic concepts, if necessary –Buffie, or equivalent. Look at OEE Ch. 2 models, and/or Ulph (1999).