LESSON #02A

TOOLS OF ANALYSIS FOR INTERNATIONAL

TRADE MODELS
ECON103 INTERNATIONAL ECONOMICS A
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 Lesson Outline

Modelling International Trade

Preliminary Assumptions
Tools of Analysis
General Equilibrium In A Closed Economy (Autarky)
Word Puzzle
MCQ Review

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 Modelling International Trade

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 Modelling International Trade
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.
Positive vs. Normative Analysis
Positive analysis: 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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 Modelling International Trade
General equilibrium model: in this model,
production, consumption, prices, and international
trade are all determined simultaneously for all
goods.
Seven preliminary model assumptions
Three tools of analysis: price line, production
possibilities frontier, and indifference curves
Equilibrium solution in autarky
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 Preliminary Assumptions

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 Preliminary Assumptions
1. Rational Economic Behaviour
2. Two-country, Two-good World
3. No Money Illusion
4. Fixed Resources and Technology
5. Perfect Competition in Both Industries in Both
Countries
6. Resources Perfectly Mobile Between Industries,
But Not Between Countries
7. Community Indifference Curves
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 Preliminary Assumptions
1. Rational Economic Behaviour
Economic agents are goal-oriented:
Consumers maximize satisfaction or utility, subject to
preferences and budget constraints. (c.f. Review Lessons
#01 and #02)
Firms maximize profit or minimize cost, subject to technology
constraints and quantity produced. (c.f. Review Lesson #03)
2. Two-country, Two-good World
2 countries, say A and B, producing and consuming 2 goods, say
automobiles (A) and wheat (W)
The 2 goods are identical in both countries.
Some of both goods are always consumed in both countries, i.e.
no corner-solutions.
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 Preliminary Assumptions
3. No Money Illusion
Economic agents make decisions based on changes in all
prices.
E.g. if the prices of the 2 goods increase by 10%, their
relative prices remain unchanged and, hence, will not lead to
any change in economic behaviour
4. Fixed Resources and Technology
Each country has fixed factor endowments, i.e. fixed
amount of capital and labour, and a constant level of
technology.

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 Preliminary Assumptions
5. Perfect Competition
This ensures that market prices reflect the true social
(opportunity) costs of production
No labour union or other market rigidities
6. Resources Perfectly Mobile Between Industries
This ensures that resources, i.e. capital and labour, earn
the same payments in both industries within a country.
7. Community Indifference Curves (CIC)
CIC represent the consumption preferences of the
community and, hence, maximizing the communitys utility
is the same as maximizing national economic welfare.
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 Tools of Analysis

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 Tool of Analysis #1: Price Line
Consider 2 goods: Automobiles (A) and Wheat (W)
Let PA be the price of autos and PW the price of wheat
If PA/PW = k, then:
1 unit of auto (A) = k units of wheat (W) (in value)
1 unit of wheat (W) = 1/k units of auto (A) (in value)
Nominal price: a price expressed in terms of money, e.g. PA
= $5,000 per auto, and PW = $2,000 per bushel
Relative price: a ratio of two product prices, e.g. PA/PW =
2.5, or 1 unit of auto = 2.5 bushels of wheat
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 Tool of Analysis #1: Price Line
Price Line (PL)shows
combinations of two goods M = PA x A + PW x W
that can be purchased with a W
= .
fixed amount of budget or

money, M.

Money (M) = PA x A + PW x W
Slope of PL = relative price
|Slope| = PA/PW
(PA/PW)
Note:
The equation of a straight line is given by:
Y = a + b.X,
where:
a = the intercept on the Y-axix
b = gradient or slope of the straight line.
A
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 Tool of Analysis #1: Price Line
Shift of PLcaused by a When M , or both PA and PW by
change in income or a same extent:
W
similar change in both
product prices.

A
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 Tool of Analysis #1: Price Line
Shift of PLcaused by a When M , or both PA and PW by
change in income or a same extent:
W
similar change in both
product prices.

A
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 Tool of Analysis #1: Price Line
Shift of PLcaused by a When only PA :
change in income or a
W
similar change in both
product prices.

Rotation of PLcaused

by a change in one
product price, other things
constant.

A
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 Tool of Analysis #1: Price Line
Shift of PLcaused by a When only PW :
change in income or a
W
similar change in both
product prices.

Rotation of PLcaused

by a change in one
product price, other things
constant.

A
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 Tool of Analysis #1: Price Line
2 Key Points About PL:
1. Price ratio (PA/PW) is the
W
rate of exchange between
2 goods A and W:
E.g. if PA=$2000 and
PW=$500, then PA/PW=4
implies that 1 auto = 4 wheat
|Slope| = PA/PW
(bushels)
2. All points on the PL have
equal values.

A
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 Tool of Analysis #1: Price Line
Illustration of 2 Key Points:
Given initial endowment at
point P with AP and WP W
quantities of A and W
respectively
With no market for exchange,
Q
one can only consume the WQ
bundle (AP,WP) at P P |Slope| = PA/PW
With a market for exchange at WP
price ratio PA/PW, one can now
exchange the bundle P for any
R
bundle on the PL, such as at WR
points Q(AQ,WQ) and R(AR,WR). AQ AP AR
A
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 Tool of Analysis #1: Price Line
Illustration of 2 Key Points:
The values of the bundles P,
W
Q and R on the same PL
are the same, viz.:
VP = PA.AP + PW.WP
Q
VQ = PA.AQ + PW.WQ WQ

VR = PA.AR + PW.WR P
WP
And VP = VQ = VR

WR R

AQ AP AR
A
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 Tool of Analysis #1: Price Line
Illustration of 2 Key Points:
On a higher PL with the
W
same relative prices PA/PW,
the value of any bundle on
it is greater, i.e. VS > VP
Q S
Likewise, on a lower PL with

the same PA/PW, the value P

of any bundle on it is
greater, i.e. VT < VP T
R

A
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 Tool of Analysis #2: PPF
Each country has fixed factor endowments and
constant level of technology.
Production Possibility Frontier (PPF):
Various alternative combinations of two goods a
nation can produce when all factors of production
are used to the maximum efficiency
Maximum output possibilities of a nation given the
resource constraints, level of technology.

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 Tool of Analysis #2: PPF
Shape of PPF:
a) increasing cost (bowed out PPF)
b) constant cost (linear PPF)

(a) Increasing Opportunity Costs (b) Constant Opportunity Costs

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 PPF and Opportunity Cost
PPF is the boundary that separates feasible production from
unattainable production.
Points A, B, C are efficient; Point F is unattainable; and Point D is
inefficient.

A F

D C

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 PPF and Opportunity Cost
On the PPF, e.g. point A, we have full and efficient employment of
resources. If we want 1 more auto, we have to give up some wheat,
by moving some factor inputs, e.g. labour, from the wheat farm to
automobile factory.

D C

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 PPF and Opportunity Cost
Opportunity cost is the cost associated with opportunities that
are forgone by not putting the firm's resources to their best
alternative use.

D C

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 PPF and Opportunity Cost
Hence, the opportunity cost of auto production at point A is given by
the slope of the PPF at A. This is also called the marginal rate of
transformation (MRT) of autos for wheat. MRT measures how much
wheat must be given up to produce one additional unit of auto.

=

W
A MRTA
A
B
=

D C

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 PPF and Opportunity Cost
At point D, the opportunity cost of either auto or wheat is ZERO,
because there are idle labour or capital resources which can be
deployed to produce more of one good without sacrificing the other
good.

A MRTA

D C

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 PPF and Marginal Costs
On the PPF, the MRT of autos for wheat increases with
increasing level of auto production.
This is due to increasing marginal cost (MC) of production.

=

A MRTA

MRTB
MRTC > MRTB > MRTA

MRTC

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 PPF and Price Line
With assumption of perfect competition in all markets, price equals
marginal cost Pauto = MCauto and Pwheat = MCwheat
Hence, the optimum production point is at B where the price line is
tangent to the PPF

= =

A

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 PPF and Price Line
At price ratio of Pauto/Pwheat, production at any other point on the
PPF would not be optimum. For example, at point A:

MRT shows that A autos could be obtained

by giving up W wheat
PL through point A shows that W wheat is
valued at A autos at the market rate of
A exchange
As A > A, => move
B resources from wheat to
W
auto production until
point B is reached
C
A
A

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 PPF and Price Line
Similarly, at point C:
A reached
W B
MRT shows that W wheat could be
obtained by giving up A autos
PL through point C shows that A autos
are valued at W wheat at the market
rate of exchange
As W > W, => move resources from
auto to wheat production until point B is

W
C

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 Tool of Analysis #3: 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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 Tool of Analysis #3: Indifference Curve
W
Properties of
W

Indifference Curves:
W0

Individual-specific
W1

Downward-sloping

Convex to the origin A0 A1 A A

Higher curves indicate W W PA/PW

higher levels of
satisfaction
Non-intersecting

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 Tool of Analysis #3: Indifference Curve

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.

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 Tool of Analysis #3: Indifference Curve

Community Indifference Curves (CIC) represent

the consumption preferences of the community.
Every person in the country has identical tastes and
incomes. The trade model here assumes this latter
situation is true.
That is, the representative consumer

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 Consumption and Price Line
On the demand side of the economy, the community indifference
curve (CIC) shows combinations of autos and wheat that yield the
same level of satisfaction. Higher CIC yields higher satisfaction for
every person in the economy.

CIC3
CIC2
CIC1
CIC0

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 Consumption and Marginal Utility
The slope at any point on an CIC is called the marginal rate of
substitution (MRS) of autos for wheat. It measures the communitys
willingness to pay for an additional unit of auto by consuming less
wheat.
MRSX
=

X
W

=
A
Y
Z
CIC0

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 Consumption and Marginal Utility
On the CIC, the MRS of autos for wheat declines with increasing
level of auto consumption.
This is due to diminishing marginal utility (MU) of consumption.
MRSX

X =
MRSY
Y
MRSX > MRSY > MRSZ
Z
CIC0
MRSZ

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 Consumption and Price Line
When output markets are perfectly competitive, all consumers
allocate their budgets so that their MRS between two goods are
equal to the price ratio.
Hence, the optimum consumption point is at Y, where:

X = =

Y

Z
CIC0

Slope =

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 Consumption and Price Line
At the price ratio Pauto/Pwheat , consumption at any other point on the
CIC would not be optimum. For example, at point X:
MRS shows that consumers
are willing to give up W
wheat to obtain A autos
X PL through point X shows
that W wheat could be
Y traded for A* auto at
market rate of exchange
A*
Z
W CIC
As0 A* > A, => rational
consumers
would substitute A
Slope =
for W (i.e. more A, less W)

A until point Y is reached

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 Consumption and Price Line
Similarly at point Z: MRS shows that consumers are willing to
give up A autos to obtain W wheat
PL through point Z shows that A autos
could be traded for W* wheat at
market rate of exchange
X As W* > W, => rational consumers
would substitute W for A (i.e. more W,
Y less A) until point Y is reached

Z
W*
CIC0

W Slope =

A
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 General Equilibrium In A Closed Economy (Autarky)

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 Closed Economy Equilibrium

Autarky self-sufficient country before trade.

Constant opportunity cost vs. increasing opportunity cost

Equilibrium tangency point of the PPF and CIC.

The equilibrium point is also the closed economys optimal

production and consumption points.

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Closed Economy Equilibrium: Constant Opportunity Costs

Under constant opportunity costs, demand plays no role in

determining relative prices.

=
=

CIC0

PPF

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Closed Economy Equilibrium: Increasing Opportunity Costs

In autarky, the economys production point B will coincide with

its consumption point Y at the domestic terms of trade given
by the price ratio where:

= =

Y
B
CIC0

PPF

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Closed Economy Equilibrium: Increasing Opportunity Costs

Changes in production conditions (such as improvement in

technology) or changes in tastes (or preferences) would affect
equilibrium.

= =

Y
B
CIC0

PPF

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Closed Economy Equilibrium: Increasing Opportunity Costs

Question#1: Given the forms the PPF and CIC take, can there
be another point of tangency between the 2 curves other than
point B (or Y)?

= =

Y
B
CIC0

PPF

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Closed Economy Equilibrium: Increasing Opportunity Costs

Question#2: Can the following be an equilibrium? What will

happen?

B Y
Y
B CIC1
CIC0



PPF

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Closed Economy Equilibrium: Increasing Opportunity Costs

Question#2: Can the following be an equilibrium? What will

happen?
There will an excess demand for autos and an excess supply
of wheat at this domestic price ratio.

Excess Supply of wheat

B
Y
CIC1

Excess demand for autos
PPF

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Closed Economy Equilibrium: Increasing Opportunity Costs

Question#2: Can the following be an equilibrium? What will

happen?

Hence, will rise until is restored.

B Y
Y
B CIC1
CIC0



PPF

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Closed Economy Equilibrium: Increasing Opportunity Costs

Gross domestic product (GDP) is a measure of economic

activity in a country. It is calculated by adding the total value
of a country's annual output of goods and services.

Y
B
CIC0

PPF

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Closed Economy Equilibrium: Increasing Opportunity Costs

Question #3: What is the GDP if A and W are the quantities

of autos and wheat produced in this closed economy
equilibrium?
Nominal GDP = Pauto.A + Pwheat.W

Y
w B
CIC0

PPF
A

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Closed Economy Equilibrium: Increasing Opportunity Costs

From this, real GDP can then be derived for this 2-good closed
economy as follows:
Nominal GDP = Pauto.A + Pwheat.W



Real GDP, = . +

(Note: Here, we have expressed real GDP in terms of wheat)

Y
w B
CIC0

PPF
A

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 End of Lesson

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