Major Questions

Two parts of International Economics

(i) Real Analysis (trade theory)
(ii) Monetary Analysis (international finance).

Themes in Real Analysis:

(i) Pattern of trade

Why doesn't Kenya export supercomputers to the United States?

Why doesn't the United States export coffee to Colombia?
Why does India export garments to the US ?
Why does the United States export cars to Germany and Germany
also export cars to the United States?
Why does India trade more with US than with Japan ?
Why do some countries not trade with each other at all?

Major Questions
(ii) Relative prices (terms of trade)
If India exports a bushel of wheat, what determines how much coffee
can be had in exchange for it?

(iii) Welfare and commercial policy

If countries trade, do they benefit from this trade or are they harmed by
it?
Do some countries gain at the expense of others?
Will they be best off with free trade or by implementing taxes and other
restrictions on trade?
Will the market, left alone, lead to the best solution, or are there market
failures?
If there are market failures, are there measures the government can (or
will) take to reach such an optimum?
How do we decide which measure is appropriate?

Approach to the Study of Trade Theory

A single model will not illuminate every aspect of

international trade: variety of simplified models
A theory of international trade could be developed from two
different bases.

(i) Start with specified aggregate behavioral relationships (e.g.,

Keynesian open economy models) and then deduce the results of a
world with two (or more) such economies.
(ii) Start with a description of individual agents in the economy,
their objectives, choices and constraints, and then aggregate to
derive the interactions of two (or more) such economies.

Many possible specifications within this broad division.

We follow the second approach (real analysis)

Approach to the Study of Trade Theory

Simplified models of general equilibrium barter exchange
Numeraire good: any good whose price is fixed at 1 so all
other prices are in terms of the numeraire good.
if good X is the numeraire, prices are normalized by Xs price; only
relative prices are relevant

Ignores macro economic disequilibrium by assuming the

existence of full employment and aggregate trade balance.
First step: how the economies look in the absence of
international trade (autarky)?

Approach to the Study of Trade Theory

Specify the characteristics of an economy.
The agents in the economy (individuals as consumers and
supplier of factors and firms)
The objective of each agent
The choices that each agent must make
The constraints that each agent acts under
(i) Individuals
Objective: maximize utility (consumption of final good / variety, do not
specify all of the determinants of utility).
Choices: levels of final goods/ no of varieties that they consume
(assumption: all factors are supplied inelastically i.e. in fixed amounts).
Constraints: earnings on inelastically supplied labour and holding of
capital (if any)

Approach to the Study of Trade Theory

(ii) Firms
Objective: maximize profit (indeterminate level of output under
perfect competition and constant returns to scale).
Firms are cost minimizers subject to achieving a certain level of output

Choices: (a) level of output of each good produced (say goods X

and Y); (b) combination of factors (say K, L) with which to
produce that output
Constraints: production function which represents all of the
technical possibilities for production
under perfect competition, prices of both goods and factors are taken as
given by individual firm)
under constant returns to scale, we can represent the entire productive
sector as a single firm following the behavioral assumptions.

Approach to the Study of Trade Theory

(iii) Government
Objective:
(i) nave assumption: solely concerned with maximizing national
welfare, appropriately defined
(ii) "Political Economy" assumption: number of plausible theories of
trade policy objectives (e.g.., in representative democracies,
governments act so as to maximize the votes received by the ruling
party in subsequent elections).

Choices:

whether there will be any international trade at all

Taxes/subsidies on production/consumption of one good or the other
Taxes/subsidies on the use of one factor or another
Impose tariffs, voluntary export restraints, quotas, and other measures.

Constraints: simply the constraints of individuals and firms

(nave assumption) or its own constraints for producing votes
(political economy assumption)

Consumer equilibrium
2 2 economy: 2 goods (X and Y) and 2 factors (K and L)
Combine the indifference curve map with the budget
constraint utility is maximized when the budget line is
tangent to the highest IC
Budget constraint: I = pxX +pyY
Y = (I / py) (px /py)X
px
MRS
py

Equilibrium:

MRS

U
Y

U
X

Producer equilibrium
X = Fx (Kx, Lx)
Y = Fy (Ky, Ly)

(homogenous of the first degree)

Fixed total supply of capital and labor

K Kx Ky
L Lx Ly

(full employment condition)

Competitive equilibrium
If industries are competitive, production is efficient and will
occur on the production possibility frontier.
Where on the PPF? Consider the value-of-marginal product
conditions
pxMPLX = w
pxMPKX = r
pyMPLY = w

pyMPKY= r

pxMPLX = pyMPLY

pxMPKX = pyMPKY

px MPLY MPKY

p y MPLX MPKX

Competitive Equilibrium
px y Ly y K y

p y x Lx x K x

Factors are in fixed total supply, which means that

Lx Ly
Thus

K x K y

px
y
MRT
py
x

MRT (marginal rate of transformation) slope of the PPF

Y and X must have opposite signs, so the MRT is positive

Competitive Equilibrium
The value of a country's output is also its income, so the price
line (which is tangent to the PPF) is also the budget line of
consumers in the aggregate.
Price line can be considered as a National budget line
all points on the line have the same value of consumption

General equilibrium
Combine the demand and supply sides to arrive at the general
equilibrium
Producers and consumers are assumed to be competitive; first,
consider the closed (autarky) economy.
(1) Producers pick output such that, at given commodity
prices, the MRT is equal to the producer price ratio
(2) Consumers pick commodities such that, at given
commodity prices, their MRS in consumption is equal to the
consumer price ratio
(3) The supply and demand for each commodity must be equal

General Equilibrium
Assuming that consumer and producer prices are the same, we
have

px
MRT
py
px
MRS
py
Xc X

(producer optimization)

(consumer optimization)

Yc Y p

(market clearing)

p denotes production, and c consumption

General Equilibrium in the Open Economy

The economy can engage in trade at the fixed world price
ratio, p* p*x p*y
The first two optimization conditions remain unchanged, but
world prices will generally be different from the autarky prices
p* MRTproducer optimization
optimization
p* consumer
MRS
Trade balance condition (instead of market clearing condition)
The value of what a country exports should be equal to what it
imports

General Equilibrium in the Open Economy

Domestic output evaluated at world prices is the income of the
country
National budget line can be obtained by placing a line with
the slope of the world price ratio p* through the production
point on the PPF
Consumers can choose any point on the national budget line,
because the value of consumption will be equal to the value of
production at any point on the line