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Baby Economics
Some Tools and Terms…
C1-1
OVERVIEW
 Refresh some of the topics learned in
introductory economics courses
 Identify Specific tools required to
examine Issues in International
Economics (specifically trade)
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2.1) Important Terms and Tools
•Economic Model
•Demand
Supply
•Relativeand
(Real)
and Nominal Prices
•Autarky
(“Normative
No Trade”)
•Positive and
Analysis
•Production Possibilities Frontier (Curve)
•Indifference Curve (IC)
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2.1) Important Terms and Tools
•Consumer and Producer Surplus
•Welfare
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WELFARE

International Economics affects the
wellbeing of residents of any country.
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WELFARE
 Cross border exchange of goods and
service, and financial assets are welfare
improving because

Provide access to goods and services that
can’t be produced at home

Provide access to factors that are not
available at home

Serve as a forum for transfer of technology
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WELFARE

when a country involves in international
trade, there are always some losers and
some winners within a country.
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WELFARE
 Because
International trade may affect the producers’
benefits (Producers’ Surplus) and consumers’
benefits (Consumers’ Surplus) differently ….
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WELFARE
For Instance,

While consumers may gain from reduced
prices, access to new products/services and
quality, some producers may lose their
profits and even driven out of markets…loss
of jobs

Producers may also benefit from expanded
opportunities (access to resources, transfer
of a technology, ….)
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IMPROVING
WELFARE
Changes in
Consumer
Surplus
+
Changes in
Producer
Surplus
Gains (+ Changes) > Losses (- Changes)
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Demand, Supply and Autarky Price
Price
P
If a country engages in no international
trade
Supply
….Autarky price
Equilibrium Price
Equilibrium
Quantity
Demand
Quantity
Q
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Copyright©2003 Southwestern/Thomson Learning
Autarky: Why?
 The nation is closed to international trade
(Political reasons….)
 The country is self sufficient…

Net changes in its welfare when it involves
in international trade is ZERO

Thus decides to produce all what it
consumes/ consumes all what it produces..
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EXPORT
Price
Supply
Surplus
P1
P0
Demand
0
Qd
Qs
Quantity
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Copyright©2003 Southwestern/Thomson Learning
IMPORT
Price
Supply
P0
P1
Shortage
Demand
Quantity
0
Quantity
supplied
Quantity
demanded
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Copyright©2003 Southwestern/Thomson Learning
Production Possibilities Frontier
 A graph that shows alternative
combination of two products that
can be produced from the available
resources and technology
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The Production Possibilities Frontier
(PPF)
Beer
70
A
B
C
40
Wine
Usually PPF has a Bowed Out shape
Beer
70
A
B
0
C
40
Wine
Production Possibilities Frontier
 Illustrates Several Concepts
Attainable/Unattainable Production
levels
 Efficient and Slack Production Levels
 Tradeoffs/Opportunity Cost
 Economic Growth

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The Constant-Opportunity Cost Production Possibilities
Frontier (PPF)
Beer
Output levels outside PPF
are unattainable given the
current technology and
resources
70
55
A
D
40
B
C
25
E
0
10
20
30
40
Wine
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Fig.1.3. The Production Possibilities Frontier (PPF)
Beer
Output levels within PPF indicate
the presence of unused
(unemployed/slack) resources
and thus are inefficient
70
55
40
A
E
B
C
25
E
0
10
20
30
40
Wine
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Fig.1.3. The Production Possibilities Frontier (PPF)
Beer
A movement from A to B on PPF
shows the opportunity Cost of
producing 10 more units Wine=
15 units of Beer
70
55
A
40
B
C
25
E
0
10
20
30
40
Wine
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Economic Growth
Beer
An Outward shift in PPF
indicates Economic Growth
3,000
A
0
1,000
2000 Wine
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2.2. Basic Assumptions …
1. Economic Agents Exhibit Rational
Behavior

Are goal oriented
 Choose to use the available resources
in such a way that it gives them the
maximum possible satisfaction.
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2.2. Basic Assumptions …
2. There is No Money Illusion

Production and consumption decisions
are not based on changes only in some
prices…
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2.2. Basic Assumptions …
2. There is No Money Illusion

Production and consumption decisions
are based on changes in Real (relative)
NOT Nominal prices.
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2.2. Basic Assumptions …
3. Often times there are only 2
countries, 2 commodities, and 2
factors (2X2X2)

Convenience (2 dimensional graphs,
such as PPF, IC…)
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2.2. Basic Assumptions …
4. Factor endowments & technologies
are fixed.

The supply of factors and technology
in each country is fixed
 Allows us to draw PPF and trace the
growth path of a nation
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PPF (Production)
Beer
PPF
Wine
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PPF
Beer
6
A bowed out shape of the PPF
shows an increasing Opportunity
Cost
A
B
ΔB=1
C
5
ΔB=2
3
D
ΔB=3
0
1
2
3
4
E
Wine
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PPF
Beer
12
Result from a neutral
technical progress
6
C
5
3
0
1
2
3
4
8
Wine
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PPF
Beer
12
A non-neutral
technical progress
6
C
5
3
0
1
2
3
4
Wine
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PPF
Beer
A non-neutral
technical progress
6
5
C
3
0
1
2
3
4
8
Wine
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2.2. Basic Assumptions …
5. Markets are Perfectly Competitive

Market prices reflect the true social
(opportunity) costs of production.

…P=MC; No Intervention; trade
unions have no impact on wages…
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2.2. Basic Assumptions …
6. Factors are perfectly mobile within
industries

Guarantees that resources earn the
same payments in every production
sector…
 Can move to sectors where returns are
higher…price equalization..
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2.2. Basic Assumptions …
6. Preferences can be represented by
indifference curves (IC)
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Definition and Properties of ICs
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Definition
 Indifference curves are graphs that
reflect the consumption preferences of
individuals
 Locus of bundles of goods that yield
the same level of satisfaction
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IC (Consumption)
Beer
Different combination of two goods that give a
consumer the same (equal) level of
satisfaction
24
A
14
C
E
4
2
6
10
Wine
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IC (Consumption)
Beer
Bundles of Beer and Wine ( A, C, or E) gives a
consumer equal (the same) level of
satisfaction (utility)
24
A
C
14
E
4
2
6
10
Wine
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IC (Consumption)
Beer
Budget Line (Price Line): A line that shows the
different combination of two goods that a
consumer can buy given his budget
24
A
B
4
10
Wine
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IC (Consumption)
Beer
The Tangency between IC and budget line
shows utility max point
24
A
B
4
10
Wine
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Properties
1. Are Down ward slopping
(Trade-offs)
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Properties
Are Down ward slopping
Indicate that both goods are
(Trade-offs)
If one bundle
(E) has
lesstoofthe
oneconsumer….
good (Beer),
“truly”
goods
Beer
1.
it must have more of another good (A) to be
equally pleasing as the other bundle (E).
24
A
14
C
E
4
2
6
10
Wine
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Properties
2. Convex to the Origin (Bowed In)
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2. Convex to the Origin…(Variety)
Beer
Indicate that consumers are willing to give up
less and less quantities of one good (Beer) for
increased consumption of another good (Wine)
24
A
14
C
E
4
2
6
10
Wine
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Properties
3.Infinitely many ICs…
(Ranking)
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3. Infinitely many ICs…
Beer
Consumers can describe their feelings regarding any
conceivable
consumption
bundles…
An indifference
curve on
the upper and right hand side
of another indifference curve shows higher level of
satisfaction..
24
A
14
C
E
4
2
6
10
Wine
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IC (Consumption)
Beer
Higher utility with the same budget
24
A
C
B
4
10
Wine
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Properties
4. Two Indifference curves never Intersect
(Consistency)
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4. Two ICs never intersect…
Beer
Violates the rationality Assumption
24
A
14
C
4
E
2
6
Wine
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Why PPF and IC?
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Production and Consumption
(Using PPF and IC)
Beer
D
A
C
IC(2)
B
IC(1)
PPF
Wine
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