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Global Economy and Trade Policies Lecture 1 The standard trade model The Production Possibilities Frontier (PPF) Assume firms in Khon Kaen province only have resources to produce 2 things: noodles and ice tea.

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global economy and trade policies

Global Economy and Trade Policies

Lecture 1

The standard trade model

the production possibilities frontier ppf
The Production Possibilities Frontier (PPF)

Assume firms in Khon Kaen province only have resources to produce 2 things: noodles and ice tea.

Further assume that if firms only produce noodles the maximum output is 1000 packages of noodles per day, if firms only produce ice tea the maximum output is 2000 bottles of ice tea per day

the ppf
The PPF

bottles of ice tea

Point g is beyond the frontier: impossible

g

2000

Point h is possible, but not efficient

1000

h

0 500 1000 p. of noodles

the ppf4
The PPF

The PPF represents every point whereby the allocation of resources to produce noodles and ice tea are fully maximized.

the shape of the ppf
The shape of the PPF

The shape of the PPF is often bowed outward as a result of differences in marginal costs of resource allocation.

the shape of the ppf6
The shape of the PPF

When Khon Kaen’s firms use their resources to produce for example 1800 bottles of ice tea and 300 packages of noodles, some resources are probably badly allocated such as persons that are very good in producing noodles or equipment better suited for noodles…..

the ppf7
The PPF

bottles of ice tea

i

2000

1800

1000

0 300 500 1000 p. of noodles

slide8
….Therefore, it is easy to give up a few bottles of ice tea (for example -10) tea for many packages of noodles (+ 50) and the PPF is flat. Below an example:

i

1800

1790

300

350

isovalue lines
Isovalue lines

bottles of ice tea

On an isovalue each combination of ice and noodles generates the same total output. For instance, 1000+400=1400 and 800+600=1400

2000

1000

800

0 400 600 1000 p. of noodles

isovalue line
Isovalue line

On each point on an isovalue, the opportunity cost remains the same. Figure 5.2: relative price of cloth is exactly the same as the opportunity cost of cloth. In Q1 the opportunity cost of producing cloths is low, in Q2 high. So in general, the steeper the isovalue line, the higher the opportunity cost of the product or service on the “x” axis.

indifference curve
Indifference curve

bottles of ice tea

Combinations of total consumption of ice tea and noodles that satisfy the demand of customers

2000

0 1000 p. of noodles

indifference curves
Indifference curves

Clarification of page 88 top: each curve is bowed inward because the more bottles of ice tea consumers give up, the more valuable each remaining bottle becomes and the more compensation in terms of packages of noodles is requested.

the standard model
The standard model

bottles of ice tea

With this relative price (around 2) suppliers wish to produce 1300 b. of ice tea and 600 p. of noodles and consumers wish to buy 1700 b. of ice tea and 300 p. of noodles.

1700

1300

0 300 600 p. of noodles

the standard model14
The standard model

bottles of ice tea

Therefore, the Khon Kaen economy imports ice tea and exports noodles.

1700

1300

0 300 600 p. of noodles

the standard model15
The standard model

Why is this model useful: because the interaction of the PPF, the isovalue and the indifference curve allows us to analyze the allocation of resources, opportunity costs, supply and demand and export and import, all at the same time.

absolute price and quantity
Absolute price and quantity

p (TB)

Demand = p = -2q + 4 and

Supply = p = 3q -3

3q -3 = -2q +4

5q -3 = 4

5q = 7

q = 1.4

p = 3t1.4 - 3 = 1.2 and

p = -2t1.4 + 4 = 1.2

4

3

2

1

0

1

2

3

4

q (1000kg.

per day)

relative price and quantity
Relative price and quantity

Price ice tea/

price noodles

The higher the relative price of ice tea (in terms of noodles), the higher the relative supply of ice tea and the lower the relative demand for ice tea (in terms of noodles)

4

3

2

1

0

1

2

3

4

Quantity ice tea/

quantity noodles

export biased growth
Export biased growth

Price ice tea/

price noodles

A shift of the relative supply to the right leads to a decrease in the relative price: the terms of trade gets worse

4

3

2

1

0

1

2

3

4

Quantity ice tea/

quantity noodles

import biased growth
Import biased growth

Price ice tea/

price noodles

A shift of the relative supply to the left leads to an increase in the relative price: the terms of trade gets better

4

3

2

1

0

1

2

3

4

Quantity ice tea/

quantity noodles

immiserizing growth
Immiserizing growth

Export biased growth leading to a huge worsening of the terms of trade resulting in fewer revenues for poor countries compared to the situation before this growth. Of course, this depends on the price sensitivities of supply and demand.

changes in the relative curves
Changes in the relative curves

P it/n

rp = 3 q - 3

4

Suppliers becoming more sensitive for price: supply curve becomes flatter (“a” goes down), if less sensitive steeper (“a” goes up).

3

2

1

0

1

2

3

4

Q it/n

rp = q - 3

if the relative supply curve is steep
If the relative supply curve is steep….

…a worsening of the terms of trade will result in a small increase of the relative supply. In other words: the effect of the relative price decrease is larger than the effect of the volume increase, for instance:

Old export value: rp = 4, rq = 1000, thus export = 4000

New export value: rp = 3, rq = 1300, thus export now only = 3900

homework
Homework

Make problems 1, 2, 5, 6, 8 on pages 104 and pages 105