Chapter 2

Tools of Analysis
for International
Trade Models
 Topics to be Covered

• Some Methodological Preliminaries

• The Basic Model Assumptions and Solutions
• Measuring National Welfare
• National Supply and Demand

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 Important Trade Questions

• Why does international trade occur?

• What are the benefits gained, and cost
incurred from trade?
• What goods will a country export/import?
• What will be the volume of trade?
• What will be the prices at which trade
occurs?

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 Economic Methodology

• 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.
• Geometric model vs. algebraic model

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 Examples of the Geometric
and Algebraic Analysis

• Advantages of both framework

- Geometric framework: visualizes how
shifts in demand and supply curve affect
equilibrium price and quantity

- Algebraic framework: simplifies computing

the numerical values of equilibrium price
and quantity

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An Example of the Geometric
Framework for Demand and Supply

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 An Example of the Algebraic
Framework for Demand and Supply
• Equation of a straight-line demand curve:

P=a+bQd

P: price of the product

Qd: quantity demanded at that price
a: vertical intercept of the demand curve
b: slope of the demand curve

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 An Example of the Algebraic
Framework for Demand and Supply
• Equation of a straight-line supply curve

P=c+dQs

P: price of the product

Qs: quantity supplied at that price
c : vertical intercept of the supply curve
d : slope of the supply curve

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 Supply and Demand in the
Algebraic Framework

P = 16 – 2Qd (1)
P = 4 + 4Qs (2)

In equilibrium, Qs = Qd = Q*
4 + 4Q* = 16 – 2Q* (3)

Q* = 2 ⇒ Qs = Qd=2,

Substitute Q* back into

the eq’n to get P*=12

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 The Basic General
Equilibrium Model

• In this model, production, consumption,

prices, and international trade are all
determined simultaneously for all goods.
• Beginning seven assumptions
• Three tools of analysis – price line,
production possibilities frontier, and
indifference curves

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 Assumption 1: Rational Behavior

• Economic agents are rational and goal-

oriented.
• Consumers want to maximize satisfaction
(subject to budget constraints).
• Firms want to maximize profit (subject to
factor price 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.
• 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.
ü Money illusion: individuals make decisions based on
changes in some prices without considering changes in
others

• 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 (PS/PT)
• Shift of PL—caused by a change in income
or a change in both product 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

• Each country has fixed factor endowments

and constant level of 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

• Assumes full and efficient employment of

resources
• Slope of PPF = opportunity (social) cost
= DT / DS
• Shape of PPF: constant cost (linear PPF)
vs. increasing cost (bowed out PPF)
• See Figure 2.2

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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 (=relative price ratio) equals marginal cost

(=slope of the PPF) or

slope of PPF (DT / DS) = slope of PL (PS / PT )

• Remember that a firm in a competitive market
maximizes its profit when price (=MR) equals
marginal cost.

• Assumption 5 guarantees that market price reflects

the true social cost (=opportunity cost) of
production. See Figure 2.3.

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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

• This assumption guarantees that factors

earn the same payments in both industries
within a country.
• Factors will move freely to the industries
that pay more.

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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
ü To guarantee the consistency of group decisions, assume
: one-person economy (Robinson Crusoe type)
: identical tastes and identical incomes of every person
: strict one-person dictatorship

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 Tool of Analysis: Indifference
Curve

• Indifference Curve—shows combinations

of two goods that yield the same level of
satisfaction to a consumer.
ü Individual-specific
ü Downward-sloping
ü Diminishing MRS (convex to the origin) means that
consumers like variety
ü Higher curves indicate higher levels of satisfaction
ü 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)).

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 General Equilibrium Model
for a Closed Economy (Autarky)

• Autarky—self-sufficient country before trade.

• Equilibrium—tangency point of the PPF and CIC
(at point Z).
• The equilibrium point is also the closed economy’s
optimal production and consumption points.
• Under constant opportunity costs, demand plays
no role in determining relative prices but picking
out the precise quantity of the two goods.

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 FIGURE 2.5 General Equilibrium for a
Closed Economy: Constant Opportunity
Costs

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 Closed Economy Equilibrium
under Increasing Opportunity Costs

• Refer to Figure 2.6

• Optimal production and consumption points
are determined by the tangency of PPF and
a CIC (point X).
• At U, pressure from higher consumer
demand (since marginal benefit is greater
than marginal cost represented by the slope
of PPF) will tend to drive the relative price of
S up, encouraging producers to expand
output S.
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 FIGURE 2.6 General Equilibrium for a
Closed Increasing Opportunity Costs

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 Measures of National Welfare

• Nominal and Real Gross Domestic Product

• Nominal GDP

ü Nominal GDP can change due to a change in output and a

change in prices.

• Real GDP

ü (PS/PT)ⅹS denotes the value of S good measured in units

of T good.
ü A change in real GDP reflects real (output) change rather
than nominal (price) change → Real GDP implies the
standard of living
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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. See Figure 2.8.

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 FIGURE 2.8 Alternative Derivation
of the Autarky Price

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 Trade Based on Differences in
Autarky Prices

• Refer to Figure 2.9

• 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. How do countries
achieve comparative advantage? Answer
lies with international differences in demand
and supply.
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 FIGURE 2.9 International
Differences in Autarky Prices

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 Derivation of National Supply
Curve

• Refer to Figure A2.1

• The top diagram of panel a shows country A’s
production possibilities frontier and three different
price lines tangent to the PPF.
• The rightward movement of the tangency points
indicates that as the relative price of good S rises,
firms produce more S.
• This information is transferred to the lower diagram
where A’s national supply of S curve shows the
various output levels at corresponding prices.
• The national supply curve is upward-sloping
reflecting increasing opportunity costs.

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 FIGURE A2.1 Derivation of
National Supply and Demand Curves

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 Derivation of the National
Demand Curve
• See panel b of Figure A2.1
• The top diagram is similar to that in panel a but
with community indifference curves tangent with
the price lines.
• These tangency points show the desired
consumption levels at the different prices. As the
price rises, consumption falls.
• The lower diagram plots the various consumption
levels at each relative price resulting in country A’s
downward-sloping national demand curve.

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