International Economics
International Trade Theory
The Standard Model of Trade
March 1-8, 2007
The Standard Model of Trade
• What combination of goods
will Hungary produce?
• The country will attempt to
maximise its wealth  will
try to get to the highest isovalue straight possible
• QC×PC+QF×PF=V (output
value) V  max!
• The highest value of output
is showed by the production
possibility curve
• The country will produce the
combo of goods where one
of the iso-value straights is
just tangent to the PP curve
QF
VV4=-PC/PF+C
PP
VV2
Q
VV4
VV1
VV3
QC
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Exercises
1.
The equation of the production possibility curve in Hungary is y =
35 - 1/4x2. In autarky Hungarians trade off 5 units of y in order to
get one extra unit of x.
a)
b)
2.
What combination of goods is produced and consumed in Hungary?
At what international relative prices will Hungary export x, and y
products?
The PP curve of country I. is y = 36 – 1/4x2, while for country II. y
= 25 – 1/8x2. In autarky country I produces 20 units of y, while II. 7
units.
a)
b)
c)
At what international relative prices will the countries export y, or x
products?
At what international relative price will both countries export y?
In case of b), which country has a greater comparative advantage in
the production of y?
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What combo of goods will Hungary
consume?
VV
QF
D
IC1
• In an open economy a country can
consume and produce a different
combination of goods – the amount
of goods purchased are situated to
the right of the PP curve, and not on
it
• But: the value of Hungary’s
consumption must equal its
production: QC×PC+QF×PF =
IC4
DC×PC+DF×PF = V  the combo of
goods produced and consumed lie on
IC3
the same iso-value line
IC2
• The consumption is also determined
by the consumer preferences,
showed by the indifference curves
Q
• The point of consumption is the one
where an indifference curve is just
tangent to the iso-value straight
QC
QC-DC  cloth exports
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Exercises
1.
Let the PP curve of two countries be I.: y = 100-x2/50, and II.: y = 100x2/25 respectively. Both countries consume the goods in a 1x:2y
combination.
a)
b)
c)
d)
e)
2.
Let the PP curve of two countries be I.: y = 60-2x; II.: y = 54-√x3. It is also
known that in autarky country I. consumes twice as much y products as
x, and that the domestic relative price in country II. is Px/Py = 4,5.
a)
b)
3.
What are the quantities of goods produced and consumed in the two countries
in autarky?
What are the domestic prices (opportunity cost) in autarky?
What are those international relative prices that provide mutually benefitial
trade, and which products will the two countries specialise in?
Give the quantities exported, and imported by the two countries if the
international relative price Pi = Px/Py = 1!
Would the above situation fit into a two-country trading model?
What are the quantities of goods produced and consumed in the two countries
in autarky?
Is there a possibility for mutually benefitial trade for the two countries? If yes,
which product should the countries specialise in?
See question b) of exercise II/1 (slide nr. 16)!
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The welfare effect of trade
• The welfare effect is
determined by the terms
of trade
• Terms of trade: the price
of good the country
initially exported divided
by the price of good it
initially imported
• The rise in terms of trade
increases a country’s
welfare, while the decline
reduces it
QF
D2
CC – consumer
preferences
D1
Q1
Q2
VV1
VV2
QC
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Exercise
1.
The production possibility curve of a country engaged
in international trade is: y = 72-x2/8. The international
relative price is Pi = Px/Py = 2. The consumers of the
country purchase the products in a 2y:1x combination.
a)
b)
c)
What quantities of x, and y are produced in the country?
What is the national income of the country measured in
product x?
How much x, and y will be consumed, and what are the
quantities exported/imported?
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Economic Growth and International Trade
• Two issues:
– Is growth in other countries good or bad?
• Bigger market for exports
• Bigger competition for local producers
– Is domestic growth good or bad?
• Opportunity to export more
• Export prices decline  domestic growth favours foreigners
• Economic growth represents an outward shift of
the country’s production possibility curve. Could
be caused by:
– Increase in resources
– Improvement in efficiency
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• Growth usually is biased: the PP shifts out more to one
direction than to the other: for any given relative price a
rise in the output of one product is experienced, relative
to that of the other product
• Assumption: terms of trade remain unchanged
QF
QF
Type 1
Type 2
Q2
PP2
PP1
Q1
Q1
Q2
PP1
QC
PP2
QC
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Change in Terms of Trade
• Hungary experiences a Type 1
biased growth – the output of
PC/PF
cloth rises, the food production
declines.
• In a two-country modell that
means that the relative supply of
cloth will rise at any world
relative price – RS shifts to the
right
(PC/PF)1
• (PC/PF)2<(PC/PF)1 – the terms of
trade of Hungary worsen
(PC/PF)2
• Export biased grwoth: growth
that disproportionately expands
a country’s production
possibilities in the direction of the
good it exports  the country’s
terms of trade worsen
RS1
RS2
RD
(QC+QC*)/(QF+QF*)
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Will Growth Hurt Hungary?
•
•
If growth is export-biased, or the partner country’s growth is
import-biased, Hungary’s terms of trade drop
If however the growth is import-biased, or the other country’s
growth is export-biased, Hungary’s terms of trade get better
Exercise
1.
The national income of a country measured in product y is: y0 =
3000 billion units. During the given period the country experiences
an economic growth that takes the income to y1 = 3600 billion
units. The international relative prices stay unchanged at Pi =
Px/Py = 2. The production of x (export product) has grown from
Qx0=2000 to Qx1=2200.
a)
b)
What are the quatities produced at the beginning, and at the end of
period from product y?
Is the economic growth biased?
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2. The national income of a country engaged in
international trade is Y0 = 1800 billion $. The
price of its x (export) good is 2$, and y (import)
good is 4$. The production of x is Qx0=300
billion units, and the domestic demand for
product y is Dy0=400 billion units.
a) How many y is imported to the country?
b) Thanks to economic growth the national income has
increased to Y1=2250 billion $. In the same time the
output of the sector producing y has grown to
Sy1=360 billion units, and the domestic demand for
it to Dy1=500 billion units. What changes took place
in the imports of the country?
c) Is there a bias in the economic growth of the
country?
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