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Chapter 2
Tools of Analysis
for International
Trade Models
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
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
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• 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?
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• 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
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• 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
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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.
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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.
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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
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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 ( P / P )
S
T
• 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.
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FIGURE 2.1 Example of a Price
Line
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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.
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Characteristics of a Production
Possibility Frontier
• 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)
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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 )
• 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
• 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
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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), previous slide).
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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
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TABLE 2.1 Illustration of
Condorcet’s Voting Paradox
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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
• Equilibrium—tangency point of the PPF
and CIC
• Consumption point before trade
• Production point before trade
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FIGURE 2.5 General Equilibrium for a
Closed Economy: Constant Opportunity Costs
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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
• Increases in real GDP may imply increases
in national welfare.
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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.
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FIGURE 2.8 Alternative Derivation
of the Autarky Price Ratio
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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.
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FIGURE 2.9 International
Differences in Autarky Prices
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Equation 2.1
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