International Economics

1. International Economics International Trade Theory The Standard Model of Trade March 1-8, 2007

2. 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 iso-value 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

3. Exercises • 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. • 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. • 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?

4. What combo of goods will Hungary consume? VV • 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 = DC×PC+DF×PF = V  the combo of goods produced and consumed lie on the same iso-value line • The consumption is also determined by the consumer preferences, showed by the indifference curves • The point of consumption is the one where an indifference curve is just tangent to the iso-value straight QF D IC4 IC3 IC2 IC1 Q QC QC-DC cloth exports

5. Exercises • Let the PP curve of two countries be I.: y = 100-x2/50, and II.: y = 100-x2/25 respectively. Both countries consume the goods in a 1x:2y combination. • 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? • 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. • 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)!

6. The welfare effect of trade QF CC – consumer preferences • 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 D2 D1 Q1 VV1 Q2 VV2 QC

7. Exercise • 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. • 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?

8. 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

9. 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 Q2 Q1 PP1 PP2 QC QC

10. Change in Terms of Trade • Hungary experiences a Type 1 biased growth – the output of 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)2<(PC/PF)1 – the terms of trade of Hungary worsen • 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 PC/PF RS1 RS2 (PC/PF)1 (PC/PF)2 RD (QC+QC*)/(QF+QF*)

11. 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 • 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. • What are the quatities produced at the beginning, and at the end of period from product y? • Is the economic growth biased?

12. 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. • How many y is imported to the country? • 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? • Is there a bias in the economic growth of the country?