Econ452 Learning Unit 10
- 1. Learning Unit 10 Introduction to Standard Trade Model ECON452 International Economics
- 2. Objectives 1. Understand the components of the standard trade model, production possibilities frontiers, isovalue lines, and indifference curves. 2. Determine an optimal combination production and consumption under autarky on the standard trade model.
- 3. Introduction • Standard trade model is a general model that includes Ricardian, specific factors, and Heckscher-Ohlin models as special cases. – Two goods: food (F) and cloth (C) – Two countries: Home (H) and Foreign (F) • Two key relationships in the standard trade model – Relationship between the production possibility frontier and the optimal production choice – Relationship between the preference and the optimal consumption choice
- 4. Optimal Production Choice • What a country produces depends on the relative price of cloth to food PC /PF. • An economy chooses its production of cloth QC and food QF to maximize the value of its output V = PCQC + PF QF, given the prices of cloth and food. – The slope of an isovalue line equals –(PC /PF). – Produce at point where PPF is tangent to isovalue line. • At Q, an opportunity cost of cloth is equal to the relative price of shoe (MRT = PC/PF). – IF MRT < PC/PF then, it can increase profits (value) by producing more cloth. – IF MRT > PC/PF then, it can increase profits (value) by producing less cloth. Slope = - PC/PF
- 5. Relative Price and Production Choice • When a relative price of cloth is low at (PC /PF)1, a country will produce less cloth and more food at Q1. • When a relative price of cloth is high at (PC /PF)2, a country will produce more cloth and less food at Q2.
- 6. Consumption Choice • Trade will allow country to exchange goods and to choose any points along the isovalue line. • Given the preference of consumers, there are one combination of two goods along the isovalue line which gives the highest utility (satisfaction) to consumers. • Country’s preference is represented by indifference curves. – Community indifference curves: Assume that the country’s consumption decisions may be represented as if they were based on the tastes of a single representative consumer.
- 7. Indifference Curves • Indifference curve: shows the various combinations of two goods that yield equal utility (satisfaction) to the country. – Example: All three combinations of Cloth and Food (A, B, C) bring the same utility (satisfaction). • One indifference curve for each level of utility. Higher (right=upper) the indifference curve, greater the utility (satisfaction). – Example: Indifference curve2 gives higher utility (satisfaction) than Indifference curve1. Cloth Consumption (QC) Food Consumption (QF) Indifference curve1 A B C Indifference curve210 10 207 5 15
- 8. Marginal Rate of Substitution • Marginal rate of substitution (MRSXY) of X (cloth) for Y (food): the amount of Y (food) that a country could give up for one extra unit of X (cloth) and still remain on the same indifference curve (same utility). • MRS is a slope of indifference curve. MRS = ΔQF/ΔQC – Example: At B, MRS = 1 Food Consumption (QF) B 10 Indifference Curve1 Cloth Consumption (QC)10 5 15
- 9. Slope of Indifference Curve • MRS is a ratio of marginal utilities. MRS = MUC/MUF = (ΔTU/ΔQC)/(ΔTU/ΔQF) = ΔQF/ΔQC where MUC is marginal utility of consuming one more unit of cloth and TU is total utility of consuming QC and QF. • Indifference curve becomes steeper as it consumes less cloth (moving toward upper left) and flatter as it consumes more cloth (moving toward lower right). – As consumption of cloth increases, MUC decreases due to diminishing marginal utility, so MRS decreases. Cloth Consumption (QC) Food Consumption (QF) Indifference Curve1 A B C 10 10
- 10. Optimal Consumption Choice • There are many combinations of two goods that a country can choose to consume along the isovalue line. • There is one combination of two goods which brings the highest utility (satisfaction) to a country. – Example: Both Point A and B are on the isovalue line, but Point B on Indifference curve 1 gives higher utility (satisfaction) than Point A on Indifference curve 0. – Point C will bring higher utility (satisfaction) than Point B, but it cannot be reached by the given isovalue line. Food Consumption (QF) B Indifference Curve1 Cloth Consumption (QC) Indifference Curve2 Indifference Curve0 C A Isovalue Line
- 11. Condition for Optimal Consumption Combination • At the optimal (maximum utility) consumption combination, the isovalue line is tangent to the indifference curve. • A slope of isovalue line is equal to a slope of indifference curve. PC/PF = MRS • At B, an additional utility from consuming an additional unit of cloth is equal to its relative price. Food Consumption (QF) B Indifference Curve1 Cloth Consumption (QC) Slope = -PC/PF
- 12. PPF and Indifference Curves • A country can choose any production combination along its PPF. • It can reach the highest utility (satisfaction) at Point A on Indifference curve 2. – Point B is possible, but gives less utility on Indifference Curve 1. – Point C is impossible because it is outside of PPF. Quantity of Food (QF) A Indifference Curve2 Quantity of Cloth (QC) Indifference Curve1 Indifference Curve3 B C PPF
- 13. Optimal Production and Consumption under Autarky • Autarky: absence of trade • In the absence of trade, each country produces and consumes at a point where the country’s production possibility frontier is tangent to the highest indifference curve. • Under autarky, a country produces what it consumes. Quantity of Food (QF) A Indifference Curve Quantity of Cloth (QC) PPF Slope = -PC/PF Isovalue Line
- 14. Optimal Production and Consumption Condition under Autarky • At the optimal point, the slope of PPF is equal to the slope of indifference curve. MRTCF = MRSCF • At optimal, an opportunity cost of cloth is its value. – If they are not equal, the country can increase its welfare by producing more of goods whose value is higher than cost. • At equilibrium (tangent point) MRTCF = MRSCF = PC/PF
- 15. Equilibrium Relative price • Equilibrium relative price (PC/PF): the slope of line tangent to the country’s production possibility frontier and indifference curve at the autarky point of production and consumption. – The forces of demand and supply in each country determine the equilibrium relative price. – Demand is represented by the country’s indifference curves. – Supply is represented by the country’s production possibility frontier.
- 16. Difference in PPFs and Equilibrium under Autarky • If each country has a PPF with different shape due differences in resources, even with the same preference across countries (identical indifference curves) each country chooses a different combination of goods to be produced and consumed under autarky. Quantity of Food (QF) AF Indifference Curve Quantity of Cloth (QC) PPFF Slope = -(PC/PF)F Quantity of Food (QF) AH Indifference Curve Quantity of Cloth (QC) PPFH Slope = -(PC/PF)H
- 17. Relative Prices across Countries under Autarky • Under autarky – Home has more resources to produce cloth, while Foreign has more recourses to produce food. – Relative price of cloth is lower in Home than Foreign. (PC/PF)H < (PC/PF)F • A difference in relative prices across countries under autarky provides comparative advantage in each country. – Home has a comparative advantage in production of cloth, while Foreign has a comparative advantage in production of food.
- 18. Difference in Preference and Equilibrium under Autarky • If each country has different preference, even with the same resources across countries (identical PPFs) each country chooses a different combination of goods to be produced and consumed under autarky. Quantity of Food (QF) AH Indifference Curve Quantity of Cloth (QC) PPFH Slope = -(PC/PF)H Quantity of Food (QF) AF Indifference Curve Quantity of Cloth (QC) PPFF Slope = -(PC/PF)F
- 19. Relative Prices across Countries under Autarky • Under autarky – Home prefer more food than cloth, while Foreign prefer more cloth than food. – Relative price of cloth is lower in Home than Foreign. (PC/PF)H < (PC/PF)F • A difference in relative prices across countries under autarky provides comparative advantage in each country. – Home has a comparative advantage in production of cloth, while Foreign has a comparative advantage in production of food.
- 20. Disclaimer Please do not copy, modify, or distribute this presentation without author’s consent. This presentation was created and owned by Dr. Ryoichi Sakano North Carolina A&T State University Disclaimer Please do not copy, modify, or distribute this presentation without author’s consent. This presentation was created and owned by Dr. Ryoichi Sakano North Carolina A&T State University