topic 2.2

TOOLS OF ANALYSIS FOR INTERNATIONAL TRADE MODELS

Topic 2.2

The basic model

When measuring welfare gains the reference point is autarky.

Consider Figure 2.5

It represents a closed economy.

There are two goods:
· Soybeans (S)
· Textiles (T)

EF is the PPF

CIC0 ,CIC1 ,CIC2 are I.C.s

Producing at ‘Z’ allows the country to reach the highest I.C.

The point (Sz, Tz) is determined by the production opportunities and tastes.

Note that this model has no mechanism to explain how the economy gets to Z. There is no explicit market, no dynamics.

But we can say that if agents behave rationally and there is a competitive market we should reach Z eventually.

The key assumption is that if this is a competitive market [That is, agents take prices as given and do not try to strategize.] Then we think that this will be the solution. There is an enormous literature in microeconomics (general equilibrium) theorizing about when an economy will be at the competitive and welfare maximizing equilibrium solution. We are not getting into this theory. But we can do some experiments testing weather these solutions are at least plausible.

In the competitive equilibrium at Z we can say that certain conditions must hold.
One condition is that the relative price of the two goods must equal the ratio of marginal utilities at the tangency point on the indifference curve CIC1.

Equivalently, the MRS (marginal rate of substitution ) (along CIC1) at Z must equal the ratio of prices.

MRS=Ps/Pt

MUs /MUy=Ps /Pt

MUs /Ps= MUy / Pt

Where Ps, Pt =dollar prices of S, T
MU =marginal utility
(By the way we are ignoring all the negatives of these slopes)

The argument for which we expect to reach Z is a sort of proof by contradiction. We look at a point that is not Z and show that agents will move in the correct direction.

Consider point Y.

There is an argument that consumers will move in the ‘correct ‘direction. What is it?

Figure 2.6

Figure 2.6 represents a situation with increasing opportunity costs in production

If the economy is at a point like ‘U’ then producers will move in the correct direction. Why?