model building in this chapter we are going to lean some tools for analyzing the following...

Model Building

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

Model Building


• What goods will a country import?

Model Building



• What goods will a country exports?

Model Building




• What will be the trade volume? how much trade ?

Model Building





• What will be the price at which they trade?

Model Building





• 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



- firms are profit maximizers



- firms are profit maximizers

- consumers are utility maximizers


2-- there are 2 countries; A (America) and B (Britain)


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 consumed all the time in both countries both goods are identical in both countries


3-- there is no money illusion.


4-- In each country factor endowment is fixed


4-- In each country factor endowment is fixed technology is constant


5-- Perfect competition in product market and


5-- Perfect competition in product market and input market


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




• level of satisfactions (total utility)




• level of satisfactions (total utility)

• only ordinal and not cardinal preferences.


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





iii-- MU >0

iv-- no nuisance commodity


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






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 )

Ps S + Pt T I

Model Building:

Budget Constraint

Ps S + Pt T I

Since I/ Ps is the total amount of S that one could buy with an income level I

Model Building:

Budget Constraint Ps S + Pt T I

Since I/ Ps is the total amount of S that one could buy with an

income level I and I/ Pt is the total amount of T that one could buy with a given amount of I, then the ratio of the I/ Pt to I/ Ps represents:

• slope of the price line (the budget line ).

- (I/Pt)/(I/Ps) = - (Ps/Pt)

Budget Constraint

Example


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.



Order of individuals

Preferences Janice Parisa Zach

1 apples oranges bananas

2 oranges bananas apples

3 bananas apples oranges



Order of

individuals

Preferences Janice Parisa Zach

1 apples oranges bananas

2 oranges bananas apples

3 bananas apples oranges


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.




• 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.


There are three possibilities to have a consistent preference ordering:

1-- Robinson Crusoe economy


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.




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:


Given the assumptions of:i-- Consumer and producers' rationality

ii-- Perfect competition in

-- factor market

-- product market

Model Building:




-- factor market

-- product market

iii-- Fixed

-- technology

-- endowment

Model Building:




-- factor market

-- product market

iii-- Fixed

-- technology

-- endowment

iv-- Increasing cost PPC

Model Building:


The economy will find an optimal solution on the PPC.

Model Building:


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:


T

S

Model Building:


T

S

PPC

Model Building:


T

S Price line/budget constraint

Model Building:


T

S

A

Indifference Curve

Model Building:


T

S

AS1

Indifference Curve

Model Building:


T

S

AS1

T1

Model Building:


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

MRSst = slope of the budget line = (-Ps/Pt)

Model Building:Adjustment to the equilibrium point

Let's assume that the economy produces at a point like B.

S

T

AT1

S1S2

T2

IC0

IC1B

Model Building: Adjustment to the equilibrium point

There will be a surplus of S and a shortage of T at the prevailing relative prices (Py/Px).


There will be a surplus of S and a shortage of T at the prevailing relative

prices (Py/Px).

• Surplus of S leads to a decrease in the production of S and employment of factors of production in that industry.


There will be a surplus of S and a shortage of T at the prevailing relative prices

(Py/Px). • 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.


There will be a surplus of S and a shortage of T at the prevailing relative

prices (Py/Px). • 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 SupplyUsing 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:


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:


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

Pt

S

T

A

S1

A’

S

Pt

S

T

A

S1

A’

S2

B

B’

S

Pt

S

T

A

S1

A’

S2

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 (MRSst). 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 (MRSst). 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

Ps/Pt

A

S1

A’

S

T

S

Ps/Pt

A

S1

A’

B

S2

B’

S

T

S

Ps/Pt

A

S1

A’

B

S2

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

Ps/Pt

ND

NS

E

Model Building:

International Comparison

S

Ps/Pt

ND

NS

E

S

A B

C D

E’

ND

NS

Britain

Great Britain United States

model building in this chapter we are going to lean some tools for analyzing the following...

Documents

process of model building

rational slide

fixed slide

constant slide

b britain slide

country import

country exports

goods s soybeans