Global Economy and Trade Policies Lecture 1 The standard trade model
The Production Possibilities Frontier (PPF) Assume firms in Khon Kaen province only have resources to produce 2 things: noodles and ice tea. Further assume that if firms only produce noodles the maximum output is 1000 packages of noodles per day, if firms only produce ice tea the maximum output is 2000 bottles of ice tea per day
The PPF bottles of ice tea Point g is beyond the frontier: impossible g 2000 Point h is possible, but not efficient 1000 h 0 500 1000 p. of noodles
The PPF The PPF represents every point whereby the allocation of resources to produce noodles and ice tea are fully maximized.
The shape of the PPF The shape of the PPF is often bowed outward as a result of differences in marginal costs of resource allocation.
The shape of the PPF When Khon Kaen’s firms use their resources to produce for example 1800 bottles of ice tea and 300 packages of noodles, some resources are probably badly allocated such as persons that are very good in producing noodles or equipment better suited for noodles…..
The PPF bottles of ice tea i 2000 1800 1000 0 300 500 1000 p. of noodles
….Therefore, it is easy to give up a few bottles of ice tea (for example -10) tea for many packages of noodles (+ 50) and the PPF is flat. Below an example: i 1800 1790 300 350
Isovalue lines bottles of ice tea On an isovalue each combination of ice and noodles generates the same total output. For instance, 1000+400=1400 and 800+600=1400 2000 1000 800 0 400 600 1000 p. of noodles
Isovalue line On each point on an isovalue, the opportunity cost remains the same. Figure 5.2: relative price of cloth is exactly the same as the opportunity cost of cloth. In Q1 the opportunity cost of producing cloths is low, in Q2 high. So in general, the steeper the isovalue line, the higher the opportunity cost of the product or service on the “x” axis.
Indifference curve bottles of ice tea Combinations of total consumption of ice tea and noodles that satisfy the demand of customers 2000 0 1000 p. of noodles
Indifference curves Clarification of page 88 top: each curve is bowed inward because the more bottles of ice tea consumers give up, the more valuable each remaining bottle becomes and the more compensation in terms of packages of noodles is requested.
The standard model bottles of ice tea With this relative price (around 2) suppliers wish to produce 1300 b. of ice tea and 600 p. of noodles and consumers wish to buy 1700 b. of ice tea and 300 p. of noodles. 1700 1300 0 300 600 p. of noodles
The standard model bottles of ice tea Therefore, the Khon Kaen economy imports ice tea and exports noodles. 1700 1300 0 300 600 p. of noodles
The standard model Why is this model useful: because the interaction of the PPF, the isovalue and the indifference curve allows us to analyze the allocation of resources, opportunity costs, supply and demand and export and import, all at the same time.
Absolute price and quantity p (TB) Demand = p = -2q + 4 and Supply = p = 3q -3 3q -3 = -2q +4 5q -3 = 4 5q = 7 q = 1.4 p = 3t1.4 - 3 = 1.2 and p = -2t1.4 + 4 = 1.2 4 3 2 1 0 1 2 3 4 q (1000kg. per day)
Relative price and quantity Price ice tea/ price noodles The higher the relative price of ice tea (in terms of noodles), the higher the relative supply of ice tea and the lower the relative demand for ice tea (in terms of noodles) 4 3 2 1 0 1 2 3 4 Quantity ice tea/ quantity noodles
Export biased growth Price ice tea/ price noodles A shift of the relative supply to the right leads to a decrease in the relative price: the terms of trade gets worse 4 3 2 1 0 1 2 3 4 Quantity ice tea/ quantity noodles
Import biased growth Price ice tea/ price noodles A shift of the relative supply to the left leads to an increase in the relative price: the terms of trade gets better 4 3 2 1 0 1 2 3 4 Quantity ice tea/ quantity noodles
Immiserizing growth Export biased growth leading to a huge worsening of the terms of trade resulting in fewer revenues for poor countries compared to the situation before this growth. Of course, this depends on the price sensitivities of supply and demand.
Changes in the relative curves P it/n rp = 3 q - 3 4 Suppliers becoming more sensitive for price: supply curve becomes flatter (“a” goes down), if less sensitive steeper (“a” goes up). 3 2 1 0 1 2 3 4 Q it/n rp = q - 3
If the relative supply curve is steep…. …a worsening of the terms of trade will result in a small increase of the relative supply. In other words: the effect of the relative price decrease is larger than the effect of the volume increase, for instance: Old export value: rp = 4, rq = 1000, thus export = 4000 New export value: rp = 3, rq = 1300, thus export now only = 3900
Homework Make problems 1, 2, 5, 6, 8 on pages 104 and pages 105