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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
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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?
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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
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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.
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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
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Assumption 1: Rational Behavior
• Economic agents are goal-oriented.
• Consumers maximize satisfaction (subject
to constraints).
• Firms maximize profit (subject to
constraints).
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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.
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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.
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Relative Price Rule
•
If Ps / PT  k ,
then 1 unit of S  k units of T (in value)
or
1 unit of T  1/ k units of S (in value)
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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) = Ps  S  PT  T
• 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.
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FIGURE 2.1 Example of a Price Line
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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.
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Characteristics of a Production
Possibility Frontier
• Assumes full and efficient employment of
resources
• Slope of PPF
= opportunity (social) cost
=
T / S
• Shape of PPF: constant cost (linear PPF)
vs. increasing cost (bowed out PPF)
• See Figure 2.2
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FIGURE 2.2 Examples of Production Possibility
Frontiers: (a) Increasing Opportunity Costs; (b)
Constant Opportunity Costs
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Assumption 5: Perfect Competition in
Both Industries in Both Countries
• Price equals marginal cost or
slope of PPF (T / S) = slope of PL (PS / PT )
• Assumption 5 guarantees that market price
reflects the true social (opportunity) cost of
production. See Figure 2.3.
• Labor unions are not present.
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FIGURE 2.3 Relationship Between
Price Line and Production Point
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Assumption 6: Resources Perfectly
Mobile Between Industries
• This assumption guarantees that resources
earn the same payments in both industries
within a country.
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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.
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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.
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FIGURE 2.4 Indifference Curves
and Individual Utility Maximization
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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)).
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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.
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TABLE 2.1 Illustration of
Condorcet’s Voting Paradox
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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.
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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.
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FIGURE 2.5 General Equilibrium for a
Closed Economy: Constant Opportunity
Costs
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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.
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FIGURE 2.6 General Equilibrium for a
Closed Increasing Opportunity Costs
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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.
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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.
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FIGURE 2.7 Determination of Real
GDP Level
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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.
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FIGURE 2.8 Alternative Derivation
of the Autarky Price
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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.
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FIGURE 2.9 International
Differences in Autarky Prices
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