Topic&2:&The&Standard&Model&

&

THE!STANDARD!TRADE!MODEL!

Juan!A.!Mañez!
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!Juan!A.!Mañez! Topic&2 & & & & & &1/40&

Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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!! 1.&Introduc:on.&Basic&concepts&

1. Production choice: isovalue lines and production possibilities frontier

(PPF)

2. Consumption choice: budget constraint and indifference curves

3. Market equilibrium

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !2/40 !!

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!! 1.1&Produc:on&Choice:&isovalue&lines&

• Two countries: Home (H) and Foreign (F)

• Each country produces two goods: food (f) and cloth (c)

• If a country produce efficiently, given the market prices Pf and Pc, it will choose a
quantity of f and c that maximizes the level of production, V.
• Isovalue lines: they represent the value of production:

V = PfQf + PcQc [given Pf and Pc]

• Lines with combinations of (Qf and Qc) such that the production value is constant
• Reordering we obtain

V pc
Qf = − Q
pf pf c

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !3/40 !!

Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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!! 1.1&Produc:on&Choice:&PPF&

! The PPF shows the combination of maximum quantities of goods that an economy
can produces given an endowment of production factors (L, K) and a technology "
production capacity of an economy

! The slope of the PPF shows the opportunity costs of producing a larger quantity of
one of the goods (ΔQc"δQf)
• The opportunity costs of producing cloth in terms of food is given by the number of
units of food I have to give up to produce one additional unit of cloth
• The opportunity cost is increasing: δQc"ΔQf " δδQc"ΔQf
"the production possibilities frontier is concave (wrt to the origin)

! An increase in the endowment of resources and/or an improvement of the available

technology" shift outwards of the PPF

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !4/40 !!

 Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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!! 1.1&Produc:on&Choice:&PPF&
Food
Technical efficiency: maximum combinations of quantities of f and c
that an economy can produce given a factor endowment (K and L) and a
technology

Not accessible
Qf0
Qf1

Qf2

Inefficient

• pppQ Qc1 Cloth

c0 Qc2
Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !5/40 !!

Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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!! 1.1&Produc:on&Choice:&PPF&

! For a set of given relative prices (Pc/Pf), an economy with this PPF will produce in E
(if it is compatible with the demand conditions): tangency between the PPF and the
highest isovalue function that is possible to reach
Food
• The higher V, the farther from the origin is
the isovalue line (V3 > V2> V1 >V0)
• The slope of the isovalue line (|tg α|= Pc/Pf
gives us the relative prices

Cloth
Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !6/40 !!
 Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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!! 1.1&Produc:on&Choice:&PPF&

! An increase in (Pc/ Pf), increases the slope of the isovalue line. The
economy produces more cloth and less food. The equilibrium
production changes from E1 a E2 increase of the relative supply of
cloth
p2c p1c q2c q1c
f
> f→ f > f
FPP p p1 q2 q1
E ! 2
q! 1f 1
|tg!a|!!=!(Pv!/!Pa)1!<!(Pv!/!Pa)2!=!|tg!β!|!

E2
q! 2f α

β!
V2

c
!q1 q! 2c
Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !7/40 !!

Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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!! 1.2&Consump:on&choice:&budget&constraint&

The!budget&constraint&includes&all!the!combina8ons!of!goods!that!a!
consumer!can!access!given!her!income!(Y0)!and!(market)!prices!of!the!
(Pf,Pc)!
& & & &! Y ≥ p f q f +pc qc
!0
Assuming!the!the!budget!constraints!is!binding!we!can!draw!the!budget!
constraint!line!as:!
Y0 Pc
! Y 0
=p q
f f
+p q
c c
→ Q f
= * Q
Pf Pf c
!
Maximum!Qf!=!Y0&/&Pf&&
Maximum!Qc!!=!Y0&/&Pc&&
La!slope&!of!the!budget!constraint!line!(in!absolute!value)!represents!
the!rela8ve!price!of!the!two!goods!(Pc/Pf)

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !8/40 !!

 Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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!! 1.2&Consump:on&choice:&budget&constraint&

Food
Given&Y0,Pc,Pf:&& Y0 = Q f ⋅Pf + Qc ⋅Pc
⎛Y ⎞ ⎛ P ⎞
Q f = ⎜ 0 ⎟ − ⎜ c ⎟ ⋅Qc
⎝ Pf ⎠ ⎝ Pf ⎠
P
y0 tg!α = c
pf Pf
! !
The!rela8ve!price!to!cloth!wrt!
E food!is!the!absolute!value!of!the!
F
slope!of!the!budget!constraint!
line!
α y0
Cloth
O
C ! pc
Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !9/40 !!

Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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!! 1.2&Consump:on&choice:&budget&constraint&

Food The slope of the budget constarint line indicates the quantity of
a good (food) that one has to give up to get an additional unit
of other good (cloth) given income and prices.

Analysis of an increase in the price of f (f

y p becomes relatively more expensive)
!0 f pf " p‘f (p’f > pf )
y p' H
!0 f
F To obtain an additional unit of food, one has to
give up to a larger quantity of C (GG’’ frente a
E
F GG’)

α y0
Cloth
O
G G G ! pc
Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !10/40!!
 Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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!! 1.2&Consump:on&choice:&Indifference&Curves&
Indifference curves: Combinations of goods (food and cloth) that provide tth same level
of satisfaction (utility or income).
Properties of the indifference curves:
- negative and decreasing slope

U0!<!U1!<!U2!!

Δ&u:lidad&

U2
U1
U0 C
Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !11/40!!

Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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!! 1.2&Consump:on&choice:&tangency&solu:on&

! Budget constraint" consumptions possibilities

• Combinations of food and cloth that could be consumed (given the income
and the price of the goods)
" It does not show us which is the actual combination demanded

! Indifference curve" individual preferences

! The economy will choose the point on the budget constraint line that provides
maximum possible welfare/income (highest indifference curve)
"Tangency between the budget constraint line and an indifference
curve.

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !12/40!!

 Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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!! 1.2&Consump:on&choice:&tangency&solu:on&

Qf

Qf1 E U3
U2
U1
U0
Qc
Qc1
Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !13/40!!

Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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2!!Market Equilibrium: Autarky
! In general in this kind of models:
• Value of production= Value of consumption
Budget constraint line " pf Qf + pc Qc = Y
Isovalue line " pf Df + pc Dc = V

Given that the value of production = income " budget constraint line=
isovalue line

• In autarky: production in units = consumption in units" choice of

production and consumption must be the same

QF = DF
QC = DC

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !14/40!!

 Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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2.!! Market Equilibrium: Autarky
! Market equilibrium in autarky:
• Tangency between the PPF (supply) and the indifference curve farther from
the origin (demand) that is possible to reach
• Equilibrium relative prices (Pc/Pf) " slope of the tangency line between the
PPF and the indifference curve
• These relative prices determine the slope the isovalue line (budget constraint
line)

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !15/40!!

Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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2!!Market Equilibrium: Autarky
# Production possibilities Consumption possibilities
1. Analysis of the production decision: The economy produces in E where the
isovalue farther from the origin is tangent to the PPF " maximization of the value
of production
Qf

QfE E
U1 Slope
|tg α | = / !
α! U0
QcE Qc

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !16/40!!

 Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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2!!Market Equilibrium: Autarky
# Production possibilities Consumption possibilities
2. Analysis of the consumption decision: The economy consumes in E, this is the
tangency point between the isovalue line (budget constraint line) and the highest
indifference curve" maximization of welfare (income)
Qf

QfE E
U1 Slope
|tg α | = / !
α! U0
QcE Qc

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !17/40!!

Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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3.!! Gains from trade: a Standard Model of a Trading Economy
! Common&characteris:cs&of&the&models&of&trade:!

1. The!produc8ve!capacity!of!an!economy!is!represented!by!its!produc8on!
possibili8es!fron8er!(PPF)!
"!Difference!between!PPF!result!in!trade!

2. A!country’s!produc8on!possibili8es!determine!its!rela8ve!supply&
func:on&

3. The!world&equilibrium&is!determined!by!the!the!world!rela8ve!demand!
func8on!and!the!world!rela8ve!supply!func8on!(that!is!located!between!
the!na8onal!rela8ve!supplies)!

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !18/40!!

 Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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2.!! Gains from trade: a Standard Model of a Trading Economy

Basic&proposi:on:&

If in absence of trade the relative prices of two goods differ between

two countries, both countries will gain trading the goods at any
intermediate price relationship.

If the PPF are different between two countries" different relative prices
in autarky (given the demand consditions)

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !19/40!!

Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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2.!! Gains from trade
Sources of gains from International Trade:
2.1. Gains derived from the exchange trading (short run): without changes in
the allocation of the resources
2.2. Gains derived from specialization (medium run)
[Changes in the production and reallocation of the resources stimulated by the new
possibilities offered by trade]
Trade incentives make each country to concentrate productive efforts into theses activities
which carries out relatively well (comparative advantage principle)
$ Reallocation of productive resources, given the initial PPF
2.3 The international trade may incentive producer to reorganize their productive
activities (dynamic gains" long run)
$ Advantages stemming from increase of production, more intense competition"
potential production expansion

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !20/40!!

 Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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2.1 Gains
!! from trade: sources of comparative advantage" countries differ: diferent PPFs

Qf Let us consider 2 countries (H, F) which produce two

goods (f,c), y with different production structures
(≠PPF) :
FPPF
- Due to different technologies (T.3-Ricardo)
(Q )
*
0 - Due to different allocation of resources (T.4-H-O)
! f

(The two countries have the same preferences)

(Q )
*
1

! f

Q0f
! 1
Q FPPH Opportunity cost (c/f)
! f higher for F (lower for H)"
H has comparative advantage in the
production of c
Qc0 Qc1 Qc
! !
Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !21/40!!

Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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2.2 Gains
!! from trade: sources of comparative advantage" countries differ: diferent PPFs

Qf
(Pc/Pf)2 1)!≠!PPF!"!≠!RS!![RSc`f=f(Pc/Pf)]!
(Pc/Pf)2
(Q1f )* ⎛ Q1 ⎞
*
! pc1 Qc1
PPFF → 1 > ⎜ c1 ⎟
pc2 pc1 p 1
Qf ⎝ Qf ⎠
> ! f
(Q2f )* p2f p1f *
! ! pc2 Qc2 ⎛ Qc2 ⎞
(Pc/Pf)1 → 2 >⎜ 2⎟
p2f Qf ⎝ Qf ⎠
!

At any relative price (Pc/Pf), H

produces a combination c/f such
Q1f PPFH that [Qc/Qf]> [Qc/Qf]*
! 2
Q (Pc/Pf)1
! f RS (c/f) is larger for H
1 2
c *
(Q ) (Q2c )* Q Q
! 1
! ! ! Qc
c c

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !22/40!!

 Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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2.3 Gains
!! from trade: sources of comparative advantage" countries differ: diferent PPFs

2) ≠ PPF " ≠ RS" ≠ relative prices in autarky

Qf
PPFF
With identical preferences, NP"!tg α = (Pc/Pf)!
the different PPF
give rise to RM"tg β = (Pc/Pf)*
E*
different relative
prices in autarky
*
⎛p ⎞ ⎛p ⎞
PPFH E ⎜ ⎟ >⎜ ⎟
c c

α p p
!⎝ f ⎠ ⎝ f ⎠
β
Qc

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !23/40!!

Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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2.4Gains
!! from trade: sources of comparative advantage" countries differ: diferent PPFs

≠PPF"!≠!RS!"!≠!Pc/Pf!(assuming!=!RD)!!
*
⎡P ⎤ F ⎡P ⎤ ⎡S ⎤ ⎡S ⎤ ⎡P ⎤ H
⎢ c⎥ ⎢ c⎥ ⎢ c⎥ ⎢ c⎥ ⎢ c⎥
* ⎢P ⎥ S S P ⎡S ⎤
!⎢⎣ f ⎥⎦ !⎢⎣ f ⎥⎦
P
!⎢⎣ f ⎥⎦ ⎡ S ⎤ !⎣ f ⎦ !⎢⎣ f ⎥⎦ ⎢ c⎥
⎢ c⎥ S
S !⎢⎣ f ⎥⎦
!⎢⎣ f ⎥⎦ A*

B*
B
*
* ⎡D ⎤ ⎡D ⎤ ⎡D ⎤
⎡D ⎤ A ⎢ c ⎥=⎢ c ⎥ ⎢ c⎥
⎢ c⎥ D D
D !⎢⎣ f ⎥⎦ ⎢⎣ f ⎥⎦ D
!⎢⎣ f ⎥⎦
!⎢⎣ f ⎥⎦
⎡Q ⎤ ⎡Q ⎤ ⎡Q ⎤
⎢ c⎥ ⎢ c⎥ ⎢ c⎥
Q Q Q
!⎢⎣ f ⎥⎦ !⎢⎣ f ⎥⎦ !⎢⎣ f ⎥⎦
Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !24/40!!
 Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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2.5 Gains
!! from the exchange trading (without reallocation of resources)

H& % Without trade (Autarky)

% Equilibrium: tangency between the PPF
and the highest indifference curve that is
Qf tangent (Yo)
% The tangency line between the PPF and
C (pc/pf)C the indifference curve (Yo) signals the
relative prices (pc/pf)
% These relative price determine the budget
Y1
constraint line (isovalue line) (A’B) of H
Y0
A F % Consumption: tangency between the
isovalue line A’B y and the
M
indifference curve (Yo)" point E
E % Production: tangency between the
G X isovalue line A’B and the PPF" point
(pc/pf)0
D B E
% Equilibrium: Consumption=Production
Qc
(both in money terms and in units)
Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !25/40!!

Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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2.5 Gains
!! from the exchange trading (without reallocation of resources)

%With international trade:

H& % New relative prices
(pc/pf)C "(pc/pf)*>(pc/pf)C>(pc/pf)
Qf o H: Relative increase of the price of cloth
with respect to food
pc/pf)C o (pv/pa)C >(pv/pa)" the slope of the new
C (
isovalue line (CD) is larger than the slope
of the isovalue line A’B
Y1
!Production: it is yet in E as there
Y0
A F are not resources reallocation
!Consumption: given the change in
M relative prices, the consumption point
E is given by the tangency between the
G X budget constraint line and the
(pc/pf)0
B
indifference curve Y1" F
D
Qc
Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !26/40!!
 Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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Gains
!! from the exchange trading (without reallocation of resources)

H& % Characteristics of the equilibrium with trade:

% Production: E
% Consumption: F
Qf
% Exports: X
% Imports: M
C (pc/pf)C
o Value of the X = Value of the M
% Income Y1> Y0" higher than in autarky"
Y1
gain from international trade
Y0
A F % Trade triangle: FGE

M The trade implies a (relative) decrease of the price

E the imported goods that results in increase of
G X income.
(pc/pf)0
D B

Qc
Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !27/40!!

Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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2.5 Gains
!! from the exchange trading (without reallocation of resources)

Exercise![Link]!using!a!figure!that!F!also!gains!with!
F& trade! !
a)!Gains!from!exchange!trading!without!resource!
!
realloca8on!

!
!

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !28/40!!

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2.6 Gains
!! from the exchange trading (without reallocation of resources)

Summarising:&
&
The&output&of&each&country&does&not&change,&but&the&income&increases&both&in&H&
and&F&as!they!can!exchange!goods!at!price!different!from!the!autarky!ones!
!
!
* C
& ⎛p ⎞ ⎛p ⎞ ⎛p ⎞
⎜ ⎟ >⎜ ⎟ >⎜ ⎟
c c c

⎝ pf ⎠ ⎝ pf ⎠ ⎝ pf ⎠
! * * * *
! !A' B > CD = C D > A'B

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !29/40!!

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2.6 Gains
!! derived from specialization (resources reallocation)

# Whereas when we analyse pure gains from exchange trading, resources

reallocation is not allowed, now we allow the specialization of H in the
production of c (the good for which H has comparative advantage)
# Each economy can use their resources in the activity that is more profitable
according to relative world prices.
# H will specialize in c (it has comparative advantage)
# F will specialize in f (it has comparative advantage)

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !30/40!!

 Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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2.6 Gains
!! derived from specialization (resources reallocation)

% We use as starting point a situation in which

H& we have taken into account pure exchange
trading gains:
o ! Production: E
Qf o Consumption: F
C (pc/pf)C o Relative prices with trade: (pc/pf)C
P !
Y2
Y1
B
Y0
A
F
M
E
S (pc/pf)0
XD A B
N Qc

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Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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2.6 Gains
!! derived from specialization (resources reallocation)

o Analysis of the decision of production and

H& consumption
o Production: as (pc/pf)C> (pc/pf), i.e.,, good c is
relatively more expensive abroad, international
!
Qf trade stimulates the reallocation of resources
from the production of food to the production of
C (pc/pf)C
cloth.
P
Y2 o The slope of the isovalue line that is relevant
Y1
B for producers is (pc/pf)C
Y0
A o Production: tangency between the PPF and
F
M the higher isovalue line with slope (pc/pf)C
that is possible to reach (PN)" point A
E
o As we allow resource reallocation, H
S (p /p )
X A B
c f 0 achieves a higher production value.
D Qc!
N

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2.6 Gains
!! derived from specialization (resources reallocation)

o Analysis of the decision of production and

H& consumption
o Consumption: tangency between the isovalue
line PN and the highest indifference curve that is
!
Qf tangent to it.
!
C (pc/pf)C
P
Y2
Y1
B
Y0
A
F
M
E
S (pc/pf)0
XD A B
N Qc

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !33/40!!

Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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2.6 Gains
!! derived from specialization (resources reallocation)

o The effects of productive specialization can be

H& summarized as follows:
o Change in consumption: from F to B
o Change
!
in production: from E to A
Qf
o Income increase: Y2>Y1
C (pc/pf)C o Imports: SB
P o Exports: SA
Y2
Y1
B o Trade triangle in H: BSA
Y0
A
F
M !

E
S (pc/pf)0
XD A B
N Qc

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !34/40!!

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2.1 Gains
!! from the specialization (reallocation of resources)

Exercise [Link] using a figure that F also gains with trade

F& b) Gains from !productive specialization
!

!
!

Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !35/40!!

Topic&2&:&The&Standard&Model& Interna8onal!Economics!
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2.7 Gains
!! from the economies of scale and improved efficiency

H& # Using as starting point a situation in which we

have taken into account both the gains from
pure exchange trading and the gains from
Qf product specialization of country H in c:
o Consumption: B
X o Production: A
(pc/pf)C C Y2 Y3
# We consider now the LR situation in which the
C specialization allows profiting from economies of
Y1 B
Y0 scale, and increasing efficiency in production
A what would shift the PPF outwards (from TT to
T F
T’T’).
T !
E
!
C
A B (pc/pf)0
D T
T Qc !
Y
Juan!A.!Mañez! Topic!2 ! ! ! ! ! ! !36/40!!
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2.7 Gains
!! from the economies of scale and improved efficiency

H& # Analysis of the decisions of production and

consumption
o Production: tangency between the new
Qf PPF (TT’) and the isovalor line with slope
(pv/pa)C that its tangent to it (XY)" point
X C’
(pc/pf)C C Y2 Y3 o Consumption: tangency between the
C isovalue line (XY) and the highest
Y1 B indifference curve that is possible to reach
Y0 (Y3)" C
A
T F

T
E !
C
A B (pc/pf)0 !
D
T T Qc
Y
!
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2.7 Gains
!! from the economies of scale and improved efficiency

H& # The effects derived from improved efficiency

and profiting from economies of scale may
be summarized as follows:
Qf o Change in consumption: from B a C
o Change in production: A a C
o Income increase: Y3>Y2
(pc/pf)C C Y2 Y3 o Exports: SC’
C
Y1 B o Imports: SC
Y0
A
T F

T !
E !
S C pc/pf)0
A (

D T !
T Qc
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2.7 Gains
!! from the specialization (reallocation of resources)

Exercise [Link] using a figure that F also gains with trade

F& c) Gains from !economies of scale and improved efficiency
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3. Sources
!! of the gains from international trade

If the relative prices of two goods differ between countries in

autarky, both countries can gain trading the goods at any
intermediate relative price

Why do relative prices differ between countries in autarky? &' why do productive
structures differ?
• Tema 3: Ricardo’s model " tecnology
• Tema 4: Heckscher-Ohlin model" factors’ endowment

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