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Chapter 2. Tools of Analysis for International Trade Models. Topics to be Covered. Economic Methodology Assumptions of the Basic Model Price Line Production Possibility Frontier Community Indifference Curves Closed Economy (Autarky) Equilibrium Measures of National Welfare
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Chapter 2 Tools of Analysis for International Trade Models
Topics to be Covered Economic Methodology Assumptions of the Basic Model Price Line Production Possibility Frontier Community Indifference Curves Closed Economy (Autarky) Equilibrium Measures of National Welfare National Supply and Demand Curves
Why do countries trade with one another? • What specific benefits can countries obtain through international trade? • Which country produces which good(s)? • Why do countries export and import certain goods? • At what prices do countries exchange exports and imports? • How does international trade differ from interregional trade?
It makes little sense for a country or a region to produce what it can buy from another country or region at a lower cost • There is a concern that buying from foreign sources may lead to a loss of domestic jobs • All countries can benefit if each country specializes in production those goods it can produce best and satisfy their other wants and needs by trading for them
Trade occurs because a businessperson thinks they can make a larger profit by moving goods from where they are currently produced to someplace else where they can be sold at a higher price
Economic Methodology Model—Economist often build economic models to help them understand the pattern of economic behavior. An economic model is a theoretical description of the behavior. Verbal models are the most important of all. Geometric, which is the case with most of the models found in this book. Algebraic, used mainly in statistical evaluation of economic data.
Economic Methodolgy • 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—output, consumption, prices, and trade are all determined simultaneously for all goods. Beginning (7) assumptions Three tools of analysis 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.
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 Shift of PL—caused by a change in income or a change in both good prices. Rotation of PL—caused by a change in one product price, other things constant.
Assumption 4: Fixed Resources and 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 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)
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 Labor unions are not present
FIGURE 2.3 Relationship Between Price Line and Production Point
Assumption 6: Resources Perfectly Mobile Between Industries 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
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), previous slide).
Assumption 7: Community Indifference Curves Community Indifference Curves (CIC) represent the consumption preferences of the community. Problem: group preferences may not be consistent
General Equilibrium Model for a Closed Economy (Autarky) Autarky—self-sufficient country before trade. Constant opportunity cost case vs. increasing opportunity cost Equilibrium—tangency point of the PPF and CIC Consumption point before trade Production point before trade
FIGURE 2.5 General Equilibrium for a Closed Economy: Constant Opportunity Costs
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 Increases in real GDP may imply increases in national welfare.
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.
FIGURE 2.8 Alternative Derivation of the Autarky Price Ratio
Trade Based on Differences in Autarky Prices 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.
