Model Building In this chapter we are going to lean some tools for analyzing the following questions:

Model Building In this chapter we are going to lean some tools for analyzing the following questions: What goods will a country import?

Model Building In this chapter we are going to lean some tools for analyzing the following questions: What goods will a country import? What goods will a country exports?

Model Building In this chapter we are going to lean some tools for analyzing the following questions: What goods will a country import? What goods will a country exports? What will be the trade volume? how much trade ?

Model Building In this chapter we are going to lean some tools for analyzing the following questions: What goods will a country import? What goods will a country exports? What will be the trade volume? how much trade ? What will be the price at which they trade?

Model Building In this chapter we are going to lean some tools for analyzing the following questions: What goods will a country import? What goods will a country exports? What will be the trade volume? how much trade ? What will be the price at which they trade? What is the effect of trade on the price of factors of production?

Model Building In the process of model building, one should make sure to avoid the normative aspects of the question under analysis.

Model Building In the process of model building, one should make sure to avoid the normative aspects of the question under analysis. That is, try to avoid making any "ought to be" statements which are in the realm of normative rather that positive economics. In Positive economics we always try to stay with the positive aspect of the analysis, i.e., we need to explain what is.

Model Building: ASSUMPTIONS: SUPPLY SIDE 1-- all economic agents are rational

Model Building: ASSUMPTIONS: SUPPLY SIDE 1-- all economic agents are rational - firms are profit maximizers

Model Building: ASSUMPTIONS: SUPPLY SIDE 1-- all economic agents are rational - firms are profit maximizers - consumers are utility maximizers

Model Building: ASSUMPTIONS: SUPPLY SIDE 2-- there are  2 countries; A (America) and B (Britain)

Model Building: ASSUMPTIONS: SUPPLY SIDE 2-- there are  2 countries; A (America) and B (Britain)  2 goods S (Soybeans) and T (Textiles)

Model Building: ASSUMPTIONS: SUPPLY SIDE 2-- there are  2 countries; A (America) and B (Britain)  2 goods S (Soybeans) and T (Textiles)  both goods are consumed all the time in both countries

Model Building: ASSUMPTIONS: SUPPLY SIDE 2-- there are  2 countries; A (America) and B (Britain)  2 goods S (Soybeans) and T (Textiles)  both goods are consumed all the time in both countries  both goods are identical in both countries

Model Building: ASSUMPTIONS: SUPPLY SIDE 3-- there is no money illusion.

Model Building: ASSUMPTIONS: SUPPLY SIDE 4-- In each country  factor endowment is fixed

Model Building: ASSUMPTIONS: SUPPLY SIDE 4-- In each country  factor endowment is fixed  technology is constant

Model Building: ASSUMPTIONS: SUPPLY SIDE 5-- Perfect competition in  product market and

Model Building: ASSUMPTIONS: SUPPLY SIDE 5-- Perfect competition in  product market and  input market

Model Building: ASSUMPTIONS: SUPPLY SIDE 6-- Factors of production are mobile within each country and industry.

Model Building: ASSUMPTIONS: DEMAND SIDE Each Indifference curve shows trade off between two commodities

Model Building: ASSUMPTIONS: DEMAND SIDE Each Indifference curve shows trade off between two commodities level of satisfactions (total utility)

Model Building: ASSUMPTIONS: DEMAND SIDE Each Indifference curve shows trade off between two commodities level of satisfactions (total utility) only ordinal and not cardinal preferences.

Model Building: ASSUMPTIONS: DEMAND SIDE Indifference curves analysis is based on the following assumptions: i-- Commodity units are divisible to a very small size,

Model Building: ASSUMPTIONS: DEMAND SIDE Indifference curves analysis is based on the following assumptions: i-- Commodity units are divisible to a very small size, ii-- consumers tastes are well defined,

Model Building: ASSUMPTIONS: DEMAND SIDE Indifference curves analysis is based on the following assumptions: i-- Commodity units are divisible to a very small size, ii-- consumers tastes are well defined, iii-- MU >0

Model Building: ASSUMPTIONS: DEMAND SIDE Indifference curves analysis is based on the following assumptions: i-- Commodity units are divisible to a very small size, ii-- consumers tastes are well defined, iii-- MU >0 iv-- no nuisance commodity

Model Building: ASSUMPTIONS: DEMAND SIDE Characteristics of ICs i-- ICs are non-intersecting.

Model Building: ASSUMPTIONS: DEMAND SIDE Characteristics of ICs i-- ICs are non-intersecting. ii-- ICs are continuous

Model Building: ASSUMPTIONS: DEMAND SIDE Characteristics of ICs i-- ICs are non-intersecting. ii-- ICs are continuous iii-- ICs are everywhere dense and go through every point in the XY map.

Model Building: ASSUMPTIONS: DEMAND SIDE Characteristics of ICs i-- ICs are non-intersecting. ii-- ICs are continuous iii-- ICs are everywhere dense and go through every point in the XY map. iv-- ICs have a negative slope

Model Building: ASSUMPTIONS: DEMAND SIDE Characteristics of ICs i-- ICs are non-intersecting. ii-- ICs are continuous iii-- ICs are everywhere dense and go through every point in the XY map. iv-- ICs have a negative slope v-- ICs are Convex to the origin.

Model Building: Budget Constraint Indifference Curves show the desire of the individual and the community. In other words, their willingness.

Model Building: Budget Constraint Indifference Curves show the desire of the individual and the community. In other words, their willingness. But there is another requirement, ability to purchase a commodity. (a demand curve shows the ability and willingness )

Model Building: Budget Constraint Indifference Curves show the desire of the individual and the community. In other words, their willingness. But there is another requirement, ability to purchase a commodity. (a demand curve shows the ability and willingness ) P s S + P t T  I

Model Building: Budget Constraint P s S + P t T  I Since I/ P s is the total amount of S that one could buy with an income level I

Model Building: Budget Constraint P s S + P t T  I Since I/ P s is the total amount of S that one could buy with an income level I and I/ P t is the total amount of T that one could buy with a given amount of I, then the ratio of the I/ P t to I/ P s represents: slope of the price line ( the budget line ). - (I/P t )/(I/P s ) = - (P s /P t )

Budget Constraint Example

Model Building: ASSUMPTIONS: DEMAND SIDE 7-- A consistent community's preferences can be presented. This is a tricky business. It is impossible (Arrow's Impossibility Theorem) to generate a set of ordering that is internally consistent for individuals as well as for the community as a whole.

Model Building: ASSUMPTIONS: DEMAND SIDE 7-- A consistent community's preferences can be presented. Order of individuals PreferencesJaniceParisaZach 1apples oranges bananas 2 oranges bananas apples 3 bananas apples oranges

Model Building: ASSUMPTIONS: DEMAND SIDE 7-- A consistent community's preferences can be presented. Order of individuals PreferencesJaniceParisaZach 1apples oranges bananas 2 oranges bananas apples 3 bananas apples oranges

Model Building: ASSUMPTIONS: DEMAND SIDE If the group were to rank these fruits, we would have: apples are preferred to oranges by Janice and Zach

Model Building: ASSUMPTIONS: DEMAND SIDE If the group were to rank these fruits, we would have: apples are preferred to oranges by Janice and Zach Oranges are preferred to Bananas by Janice and Parisa.

Model Building: ASSUMPTIONS: DEMAND SIDE If the group were to rank these fruits, we would have: apples are preferred to oranges by Janice and Zach Oranges are preferred to Bananas by Janice and Parisa. But yet, even though apples are preferred to oranges and oranges are preferred to bananas, apples are not preferred to bananas by the group.

Model Building: ASSUMPTIONS: DEMAND SIDE There are three possibilities to have a consistent preference ordering: 1-- Robinson Crusoe economy

Model Building: ASSUMPTIONS: DEMAND SIDE There are three possibilities to have a consistent preference ordering: 1-- Robinson Crusoe economy 2-- A dictatorial economy where one person decides for all,

Model Building: ASSUMPTIONS: DEMAND SIDE There are three possibilities to have a consistent preference ordering: 1-- Robinson Crusoe economy 2-- A dictatorial economy where one person decides for all, 3-- all individuals have a same preference ordering.

Model Building: ASSUMPTIONS: DEMAND SIDE There are three possibilities to have a consistent preference ordering: 1-- Robinson Crusoe economy 2-- A dictatorial economy where one person decides for all, 3-- all individuals have a same preference ordering. We assume all individuals have a same preference ordering.

Model Building: General Equilibrium Solution of the Model: Autarky Solution Given the assumptions of: i-- Consumer and producers' rationality

Model Building: General Equilibrium Solution of the Model: Autarky Solution Given the assumptions of: i-- Consumer and producers' rationality ii-- Perfect competition in -- factor market -- product market

Model Building: General Equilibrium Solution of the Model: Autarky Solution Given the assumptions of: i-- Consumer and producers' rationality ii-- Perfect competition in -- factor market -- product market iii-- Fixed -- technology -- endowment

Model Building: General Equilibrium Solution of the Model: Autarky Solution Given the assumptions of: i-- Consumer and producers' rationality ii-- Perfect competition in -- factor market -- product market iii-- Fixed -- technology -- endowment iv-- Increasing cost PPC

Model Building: General Equilibrium Solution of the Model: Autarky Solution The economy will find an optimal solution on the PPC.

Model Building: General Equilibrium Solution of the Model: Autarky Solution The economy will find an optimal solution on the PPC. This optimal point will be the tangency point of the budget line, indifference curve, and the Production Possibility Curve, say point A.

Model Building: General Equilibrium Solution of the Model: Autarky Solution T S

T S PPC

Model Building: General Equilibrium Solution of the Model: Autarky Solution T S Price line/budget constraint

Model Building: General Equilibrium Solution of the Model: Autarky Solution T S A Indifference Curve

Model Building: General Equilibrium Solution of the Model: Autarky Solution T S A S1S1 Indifference Curve

Model Building: General Equilibrium Solution of the Model: Autarky Solution T S A S1S1 T1T1

At this point, A, where all three components of the system converge, the Marginal Rate of Substitution between S and T, and slopes of the budget line and the PPC Curve are equal MRS st = slope of the budget line = (-P s /P t )

Model Building: Adjustment to the equilibrium point Let's assume that the economy produces at a point like B. S T A T1T1 S1S1 S2S2 T2T2  IC 0 IC 1 B

Model Building: Adjustment to the equilibrium point Let's assume that the economy produces at a point like B. S T A T1T1 S1S1 S2S2 T2T2   IC 0 IC 1 B

Model Building: Adjustment to the equilibrium point There will be a surplus of S and a shortage of T at the prevailing relative prices (P y /P x ).

Model Building: Adjustment to the equilibrium point There will be a surplus of S and a shortage of T at the prevailing relative prices (P y /P x ). Surplus of S leads to a decrease in the production of S and employment of factors of production in that industry.

Model Building: Adjustment to the equilibrium point There will be a surplus of S and a shortage of T at the prevailing relative prices (P y /P x ). Surplus of S leads to a decrease in the production of S and employment of factors of production in that industry. Shortage of T leads to an increase in production of T and therefore those resources that are released from industry S are absorbed in the T industry.

Model Building: Adjustment to the equilibrium point There will be a surplus of S and a shortage of T at the prevailing relative prices (P y /P x ). Surplus of S leads to a decrease in the production of S and employment of factors of production in that industry. Shortage of T leads to an increase in production of T and therefore those resources that are released from industry S are absorbed in the T industry. As a result the output mix will be changed from B to A.

Model Building: National Demand and Supply Using the information provided in the PPC and ICs, we can derive the national demand and supply.

Model Building: National Supply Using the information provided in the PPC and ICs, we can derive the national demand and supply. We know the slope of the PPC gives the technical rate of transformation of one commodity into another.

Model Building: National Supply Using the information provided in the PPC and ICs, we can derive the national demand and supply. We know the slope of the PPC gives the technical rate of transformation of one commodity into another. So if we draw a tangent (representing the relative price of S in terms of T) to the PPC at every point we can derive the national supply for the two commodities.

Model Building: National Supply Using the information provided in the PPC and ICs, we can derive the national demand and supply. We know the slope of the PPC gives the technical rate of transformation of one commodity into another. So if we draw a tangent (representing the relative price of S in terms of T) to the PPC at every point we can derive the national supply for the two commodities. We can see how many units of S is produced at every relative price.

S PtPt S T  A S1S1  A’

S PtPt S T  A S1S1  

S PtPt S T  A S1S1    S2S2 B B’

S PtPt S T  A S1S1  A’   S2S2 NS B’ B

Model Building: National Demand We also know that the slope of the IC gives the Marginal Rate of Substitution between Textiles and Soybeans (MRS st ). That is, the rate at which a consumer is willing to exchange one commodity for another.

Model Building: National Demand We also know that the slope of the IC gives the Marginal Rate of Substitution between Textiles and Soybeans (MRS st ). That is, the rate at which a consumer is willing to exchange one commodity for another. So, if we draw a tangent (relative price line) the relevant IC curve we can find the amount of the commodity (S) that will be demanded at that relative price.

S T S P s /P t  A S1S1  A’

S T S P s /P t  A S1S1  A’  B S2S2  B’

S T S P s /P t  A S1S1  A’  B S2S2  B’ ND

Model Building: General equilibrium If we put both the national demand and the supply we can find the equilibrium price and the quantity of all commodities

Model Building: General equilibrium: Autarky S P s /P t ND NS E

Model Building: International Comparison S P s /P t ND NS E S   AB CD E’ ND NS Britain Great Britain United States