Tutorial on General Equilibrium Analysis: Ricardian Trade Model - PowerPoint Presentation

1. Tutorial on General Equilibrium Analysis: Ricardian Trade ModelThe Microeconomics of International TradeECN230Roberto J. GarciaSchool of Economics and Business, NMBU

2. General equilibrium trade analysis IRicardian trade modelModel specificationTwo countries: North and SouthTwo goods: bread (B) and wine (W)One factor: labor (L) all else if fixed, e.g. (land)Base situation – example 1Countries are initially closed to trade (autarky)Given informationNorth has an absolute advantage in bread productionSouth has an absolute advantage in wine productionProduction PossibilitiesNorthSouthBread (B)100 20Wine (W) 501001

3. General equilibrium trade analysis IRepresentation of North’s economyStep 1. Production in North pre-tradeProduction possibilities curve (PPC)Technology permits North to produce 100 units of B or 50 units of W or any linear combination of bothConstant production trade-off of 1B for ½W or 1W for 2BSlope of PPC is ΔB/ΔW = 2NorthB100W 502Linear PPC implies constant marginal cost (MC)

4. General equilibrium trade analysis IStep 1. Production in North pre-trade, continued A linear PPC implies constant marginal rate of product transformation (constant MC of switching production from B to W).Trade-off in production is 100B = 50W which implies a MC of1B = ½W1W = 2BConstant MC implies horizontal supply until the max production level is reached and then becomes vertical (kinked supply curve)North’s supply of bread3North’s supply of wine

5. General equilibrium trade analysis IStep 2. Consumption in North pre-tradeConsumption information not givenClosed economy: consumption must equal productionConsumption possibilities are same as production possibilitiesSuppose demand for the goods is given as shown below4North’s market for breadNorth’s market for wineBread market: quantity supplied = quantity demanded, [QSo]B = [QDo]B = 60Wine market: quantity supplied = quantity demanded, [QSo]W = [QDo]W = 20

6. General equilibrium trade analysis IConsumption possibilities curve (CPC) is the budget lineSlope of PPC = slope of CPC = ΔB/ΔW = 2/1Social welfare (SW) maximization: tangency to the budget line5General equilibrium in North, pre-tradeFor each good, quantity supplied = quantity demandedBread market: 60 units produced = units consumed, [Q0]B = [C0]B Wine market: 20 units produced = units consumed, [Q0]W = [C0]W Markets clear at 1B = ½W and 1W = 2BNorthPPCQ0C0B 100[Q0]B60[C0]B60W 20[Q0]W20[C0]W20

7. General equilibrium trade analysis IRepresentation of South’s economyStep 1. Production in South pre-tradeProduction possibilities curve (PPC)Technology permits South to produce 20 units of B or 100 units of W or any linear combination of bothConstant production trade-off of 1B for 5W or 1W for 1/5BSlope of PPC is ΔB/ΔW = 1/5Linear PPC implies constant marginal cost (MC)SouthB 20W1006

8. General equilibrium trade analysis IStep 1. Production in South pre-trade, continued Trade-off in production is 20B = 100W 1B = 1/5 W1W = 5BConstant MC implies horizontal supply until max production level is reached and then becomes vertical (kinked supply curve)South’s market for bread7South’s market for wine

9. General equilibrium trade analysis IStep 2. Consumption in South pre-tradeClosed economy: consumption must equal productionSuppose demand for the goods is given as shown below 8South’s market for breadSouth’s market for wine

10. General equilibrium trade analysis IGeneral equilibrium in South, pre-tradeFor each good, quantity supplied = quantity demanded Bread market: 10 units supplied and demanded, [Q0]B = [C0]B Wine market: 50 units supplied and demanded, [Q0]W = [C0]W Markets clear at 1B = 5 W and 1W = 1/5BSocial welfare (SW) maximization: tangency to the budget lineSlope of PPC = slope of CPC = ΔB/ΔW = 1/5SouthPPCQ0C0B 20[Q0]B10[C0]B10W100[Q0]W50[C0]W509

11. 10General equilibrium trade analysis INorth has a lower price of bread: [PB]S > [PB]N 1B costs 5W in South which is higher than ½ W in North North has a comparative advantage in bread productionPB > ½ W implies North has an incentive to produce B for exportPW < 2B implies consumers in North are better off importing WSouth has a lower price of wine: [PW]N > [PW]S 1W costs 2B in North which is higher than 1/5 B in SouthSouth has a comparative advantage in wine productionPB < 5W implies consumers in South better off importing BPW > 1/5 B implies South has an incentive to produce W for exportPrice differential gives an incentive to tradePre-trade, P = MCWith trade, in sectors where ↑ P → P > MC country becomes exporterWith trade, in sectors where ↓ P → P < MC, country becomes importerSouth20B = 100W 1B = 5W1W = 1/5BNorth100B = 50W 1B = ½W 1W = 2B Step 3. Pre-trade prices

12. 11General equilibrium trade analysis 1Step 4. World prices: terms of trade (TOT)TOT is defined by price and quantities tradedInternational price of bread in terms of wine (or wine in terms of bread)Amount of bread that must be traded to receive a unit of wine (and the reciprocal of wine for bread)TOT: market clearance of world supply and demand World supply is the aggregation of supply in North and South World demand can also be aggregated, but demand was not givenConsider the following world demand for each good such that there is equilibrium on the world market at 1B = 1W or 1W = 1BWorld bread marketWorld wine market

13. General equilibrium trade analysis 1Step 5. Change in price (ΔP) and economic adjustmentsTOT was assumed to be 1B = 1W ΔP in North: ↑PB from ½W to 1W and ↓PW from 2B to 1BΔP in South: ↑PW from 1/5 B to 1B and ↓PB from 5W to 1WAdjustment in production North: ↑ PB → ↑ QB and ↓ PW → ↓ QW until complete specialization at [Q1]NSouth: ↑ PW → ↑ QW and ↓ PB → ↓ QB until complete specialization at [Q1]SAdjustment in consumption depends on income and sub effectsSouthNorth12

14. General equilibrium trade analysis 1Step 6. Trade and welfare implicationsQuantity traded [QT] North: [QT]N is 30 units of B exported in exchange for 30 units of W importedSouth: [QT]S is 30 units of B imported in exchange for 30 units of W exportedThere is only one TOT at which all markets are in equilibrium Conditions: no government intervention, identical goods, competitive markets and no transactions/transport costs. SouthNorthProductionConsumptionTradeWorld[Q1]N[Q1]S[C1]N[C1]S[QT]N[QT]SB100100 07030 30-30W100 01003070-30 3013

15. General equilibrium trade analysis 1Step 6. Welfare implicationsThe change in prices from pre-trade to the terms of trade increases purchasing power in both countries (outward shift in CPC or budget line) and raises utility (SW)The gains from trade results from the process of specialization and trade that improves efficiency and welfare Efficiency in resource allocationEfficiency in productionEfficiency in consumptionEfficiency in exchange14

16. General equilibrium trade analysis 1Concluding commentsGeneral lessons from the resultsPrice differentials create an incentive for tradeA cost-competitive country has a comparative advantage and will be a net exporting country in a free trade situation A high-cost country has a comparative disadvantage and will be a net importing country in a free trade situationSpecialization and trade result in gains that represent efficiency in resource use, production, consumption and exchangeThe optimal amount traded is determined by the TOT bringing all markets into equilibriumLimitations and weaknesses of the modelUnderlying technology assumes constant MC rather than increasing costs Linear PPC means shifting resources between sectors comes at no additional cost and that complete specialization is possibleModel predicts no losers, only winners15