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

2. 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 Q C ×P C +Q F ×P F =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 QCQC QFQF VV 4 VV 3 VV 1 VV 2 PP Q VV 4 =-P C /P F +C

3. 3 Exercises 1.The equation of the production possibility curve in Hungary is y = 35 - 1/4x 2. In autarky Hungarians trade off 5 units of y in order to get one extra unit of x. a)What combination of goods is produced and consumed in Hungary? b)At what international relative prices will Hungary export x, and y products? 2.The PP curve of country I. is y = 36 – 1/4x 2, while for country II. y = 25 – 1/8x 2. In autarky country I produces 20 units of y, while II. 7 units. a)At what international relative prices will the countries export y, or x products? b)At what international relative price will both countries export y? c)In case of b), which country has a greater comparative advantage in the production of y?

4. 4 What combo of goods will Hungary consume? 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: Q C ×P C +Q F ×P F = D C ×P C +D F ×P F = 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 QCQC QFQF IC 1 IC 2 IC 3 IC 4 VV Q D Q C -D C  cloth exports

5. 5 Exercises 1.Let the PP curve of two countries be I.: y = 100-x 2 /50, and II.: y = 100- x 2 /25 respectively. Both countries consume the goods in a 1x:2y combination. a)What are the quantities of goods produced and consumed in the two countries in autarky? b)What are the domestic prices (opportunity cost) in autarky? c)What are those international relative prices that provide mutually benefitial trade, and which products will the two countries specialise in? d)Give the quantities exported, and imported by the two countries if the international relative price P i = P x /P y = 1! e)Would the above situation fit into a two-country trading model? 2.Let the PP curve of two countries be I.: y = 60-2x; II.: y = 54-√x 3. 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 P x /P y = 4,5. a)What are the quantities of goods produced and consumed in the two countries in autarky? b)Is there a possibility for mutually benefitial trade for the two countries? If yes, which product should the countries specialise in? 3.See question b) of exercise II/1 (slide nr. 16)!

6. 6 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 QFQF VV 1 VV 2 QCQC Q2Q2 Q1Q1 D1D1 D2D2 CC – consumer preferences

7. 7 Exercise 1.The production possibility curve of a country engaged in international trade is: y = 72-x 2 /8. The international relative price is P i = P x /P y = 2. The consumers of the country purchase the products in a 2y:1x combination. a)What quantities of x, and y are produced in the country? b)What is the national income of the country measured in product x? c)How much x, and y will be consumed, and what are the quantities exported/imported?

8. 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. 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 QFQF QFQF QCQC QCQC PP 2 PP 1 PP 2 PP 1 Q2Q2 Q2Q2 Q1Q1 Q1Q1 Type 1 Type 2

10. 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 (P C /P F ) 2 <(P C /P F ) 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 P C /P F (Q C +Q C * )/(Q F +Q F * ) RS 1 RS 2 RD (P C /P F ) 1 (P C /P F ) 2

11. 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 1.The national income of a country measured in product y is: y 0 = 3000 billion units. During the given period the country experiences an economic growth that takes the income to y 1 = 3600 billion units. The international relative prices stay unchanged at P i = P x /P y = 2. The production of x (export product) has grown from Q x0 =2000 to Q x1 =2200. a)What are the quatities produced at the beginning, and at the end of period from product y? b)Is the economic growth biased?

12. 12 2.The national income of a country engaged in international trade is Y 0 = 1800 billion $. The price of its x (export) good is 2$, and y (import) good is 4$. The production of x is Q x0 =300 billion units, and the domestic demand for product y is D y0 =400 billion units. a)How many y is imported to the country? b)Thanks to economic growth the national income has increased to Y 1 =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?