Tutorial on General Equilibrium Analysis Ricardian Trade Model

Tutorial on General Equilibrium Analysis: Ricardian Trade Model The Microeconomics of International Trade ECN 230 Roberto J. Garcia School of Economics and Business, NMBU

General equilibrium trade analysis I Ricardian trade model Model specification Two countries: North and South Two goods: bread (B) and wine (W) One factor: labor (L) all else if fixed, e. g. (land) Base situation – example 1 Countries are initially closed to trade (autarky) Given information Production Possibilities North South Bread (B) 100 20 Wine (W) 50 100 • North has an absolute advantage in bread production • South has an absolute advantage in wine production 1

General equilibrium trade analysis I Representation of North’s economy Step 1. Production in North pre-trade • Production possibilities curve (PPC) North B s Technology permits North to produce 100 units of B W or 50 units of W or any linear combination of both s Constant production trade-off of 1 B for ½W or 1 W for 2 B s Slope of PPC is ΔB/ΔW = 2 • Linear PPC implies constant marginal cost (MC) 100 50 2

General equilibrium trade analysis I Step 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 100 B = 50 W which implies a MC of s 1 B = ½W s 1 W = 2 B • Constant MC implies horizontal supply until the max production level is reached and then becomes vertical (kinked supply curve) North’s supply of bread North’s supply of wine 3

General equilibrium trade analysis I Step 2. Consumption in North pre-trade • • Consumption information not given Closed economy: consumption must equal production Consumption possibilities are same as production possibilities Suppose demand for the goods is given as shown below s Bread market: quantity supplied = quantity demanded, [QSo]B = [QDo]B = 60 s Wine market: quantity supplied = quantity demanded, [QSo]W = [QDo]W = 20 North’s market for bread North’s market for wine 4

General equilibrium trade analysis I General equilibrium in North, pre-trade • For each good, quantity supplied = quantity demanded s Bread market: 60 units produced = units consumed, [Q 0]B = [C 0]B s Wine market: 20 units produced = units consumed, [Q 0]W = [C 0]W s Markets clear at 1 B = ½W and 1 W = 2 B North PPC Q 0 C 0 B 100 [Q 0]B 60 [C 0]B 60 W 20 [Q 0]W 20 [C 0]W 20 • Consumption possibilities curve (CPC) is the budget line s Slope of PPC = slope of CPC = ΔB/ΔW = 2/1 s Social welfare (SW) maximization: tangency to the budget line 5

General equilibrium trade analysis I Representation of South’s economy Step 1. Production in South pre-trade • Production possibilities curve (PPC) South B s Technology permits South to produce 20 units of B or W 100 units of W or any linear combination of both s Constant production trade-off of 1 B for 5 W or 1 W for 1/5 B s Slope of PPC is ΔB/ΔW = 1/5 20 100 • Linear PPC implies constant marginal cost (MC) 6

General equilibrium trade analysis I Step 1. Production in South pre-trade, continued • Trade-off in production is 20 B = 100 W s 1 B = 1/5 W s 1 W = 5 B • Constant MC implies horizontal supply until max production level is reached and then becomes vertical (kinked supply curve) South’s market for bread South’s market for wine 7

General equilibrium trade analysis I Step 2. Consumption in South pre-trade • Closed economy: consumption must equal production • Suppose demand for the goods is given as shown below South’s market for bread South’s market for wine 8

General equilibrium trade analysis I General equilibrium in South, pre-trade • For each good, quantity supplied = quantity demanded s Bread market: 10 units supplied and demanded, [Q 0]B = [C 0]B s Wine market: 50 units supplied and demanded, [Q 0]W = [C 0]W • Markets clear at 1 B = 5 W and 1 W = 1/5 B • Social welfare (SW) maximization: tangency to the budget line • Slope of PPC = slope of CPC = ΔB/ΔW = 1/5 South PPC Q 0 C 0 B 20 [Q 0]B 10 [C 0]B 10 W 100 [Q 0]W 50 [C 0]W 50 9

General equilibrium trade analysis I Step 3. Pre-trade prices • North s 100 B = 50 W s 1 B = ½W s 1 W = 2 B • South s 20 B = 100 W s 1 B = 5 W s 1 W = 1/5 B • North has a lower price of bread: [PB]S > [PB]N s s 1 B costs 5 W in South which is higher than ½ W in North has a comparative advantage in bread production PB > ½ W implies North has an incentive to produce B for export PW < 2 B implies consumers in North are better off importing W • South has a lower price of wine: [PW]N > [PW]S s s 1 W costs 2 B in North which is higher than 1/5 B in South has a comparative advantage in wine production PB < 5 W implies consumers in South better off importing B PW > 1/5 B implies South has an incentive to produce W for export • Price differential gives an incentive to trade s Pre-trade, P = MC s With trade, in sectors where ↑ P → P > MC country becomes exporter 10 s With trade, in sectors where ↓ P → P < MC, country becomes importer

General equilibrium trade analysis 1 Step 4. World prices: terms of trade (TOT) • TOT is defined by price and quantities traded s International price of bread in terms of wine (or wine in terms of bread) s 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 s World supply is the aggregation of supply in North and South s World demand can also be aggregated, but demand was not given s Consider the following world demand for each good such that there is equilibrium on the world market at 1 B = 1 W or 1 W = 1 B World wine market World bread market 11

General equilibrium trade analysis 1 Step 5. Change in price (ΔP) and economic adjustments • TOT was assumed to be 1 B = 1 W s ΔP in North: ↑PB from ½W to 1 W and ↓PW from 2 B to 1 B s ΔP in South: ↑PW from 1/5 B to 1 B and ↓PB from 5 W to 1 W • Adjustment in production s North: ↑ PB → ↑ QB and ↓ PW → ↓ QW until complete specialization at [Q 1]N s South: ↑ PW → ↑ QW and ↓ PB → ↓ QB until complete specialization at [Q 1]S • Adjustment in consumption depends on income and sub effects North South 12

General equilibrium trade analysis 1 Step 6. Trade and welfare implications • Quantity traded [QT] s North: [QT]N is 30 units of B exported in exchange for 30 units of W imported s South: [QT]S is 30 units of B imported in exchange for 30 units of W exported Production World [Q 1]N Consumption [Q 1]S [C 1]N [C 1]S Trade [QT]N [QT]S B 100 0 70 30 30 -30 W 100 0 100 30 70 -30 30 North South • There is only one TOT at which all markets are in equilibrium • Conditions: no government intervention, identical goods, competitive markets and no transactions/transport costs. 13

General equilibrium trade analysis 1 Step 6. Welfare implications • The 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 s s Efficiency in resource allocation Efficiency in production Efficiency in consumption Efficiency in exchange 14

General equilibrium trade analysis 1 Concluding comments General lessons from the results • Price differentials create an incentive for trade • A 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 situation • Specialization and trade result in gains that represent efficiency in resource use, production, consumption and exchange • The optimal amount traded is determined by the TOT bringing all markets into equilibrium Limitations and weaknesses of the model • Underlying 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 possible 15 • Model predicts no losers, only winners