Fall 2010

Copyright 2010

ECONOMICS 121
PROFESSOR MCDEVITT
SET #1
September 27, 2010

International trade (ECON 121)

 Sources and patters of trade.

 Distributional impacts of trade. (Is free trade “Bad” for poor countries?)
- Return of labor.
- Return of capital.
- Return of other resources.
 Trade barriers – tariffs and quotas.
 Immigration.
 Trade and long run econ growth.

Background information

1. S & D, consumer & producer surplus.

2. Consumer theory: U. function, indifference curve, MRS, Budget constraints.
3. Perfect competition. (P = MC)
[If define P > MC → can increase profit by Q ↑.]
4. Production theory: Isoquants, Isocosts, Edgeworth Box diagram.
5. Monopoly model.

Ricardian Trade Model & Comparative Advantage – Linear PPF

Assumptions:
1. 2 countries – A & B.
2. 2 goods – X & Y.
3. 1 input – Labor.
4. Constant Returns to Scale. (If double all input, double output.)
5. Perfect competition.

1
 
This document is authorized for use by Song Liu, from 9/27/2010 to 12/10/2010, in the course:
ECON 121: International Trade Theory (Fall 2010), University of California, Los Angeles.
Any unauthorized use or reproduction of this document is strictly prohibited.
Production Functions for country A:

X = 1/6 Lx (Lx = Labor used in the x industry.)

Y = 1/2 Ly (Ly = Labor used in the y industry.)
L = total amount of labor = 30
L = Lx + Ly (Labor constrain.)

Production Functions for country B:

X* = Lx*
Y* = Ly*
L* = 20
L* = Lx* + Ly*

For country A:

MPLx = dx/dLx = 1/6 X per labor hr.
MPLy = dy/dLy = 1/2 Y per labor hr.
aLx = 1/MPLx = 6 hrs. / X
aLy = 1/MPLy = 2 hrs. / Y
(Produce 1/6 of an X with 1 hr.)
(Takes 6 hrs. to produce 1 X.)
(aLy = “Labor requirement coefficient.”
number of labor hrs required to produce 1 unit of Y.)

For country B:

MPLx* = dx*/dLx* = 1 X per labor hr.

MPLy* = dy*/dLy* = 1 Y per labor hr.
aLx* = 1/MPLx* = 1 hr per X
aLy* = 1/MPLy* = 1 hr per Y

2
 
This document is authorized for use by Song Liu, from 9/27/2010 to 12/10/2010, in the course:
ECON 121: International Trade Theory (Fall 2010), University of California, Los Angeles.
Any unauthorized use or reproduction of this document is strictly prohibited.
Derivation of Production Possibility Frontier (PPF)

For country A need: For country B need:

1. Production function 1. Production function
X = 1/6 Lx → Lx = 6X X* = Lx*
Y = 1/2 Ly → Ly = 2Y Y* = Ly*
2. L = 30 2. L* = 20
3. L = Lx + Ly 3. L* = Lx* + Ly*
30 = 6X + 2Y → PPF 20 = X + Y → PPF

A’s PPF B’s PPF

18 L/ aLy  25
15 20
12
15
Y 9 Y
L/ aLx 10
6
3 5
0 0
0 1 2 3 4 5 6 0 5 10 15 20 25
X X

Generally, PPF: L = aLx · X + aLy · Y (L, aLx, and aLy will be given.)

3
 
This document is authorized for use by Song Liu, from 9/27/2010 to 12/10/2010, in the course:
ECON 121: International Trade Theory (Fall 2010), University of California, Los Angeles.
Any unauthorized use or reproduction of this document is strictly prohibited.
Slope of PPF?

(Marginal rate of transformation – MRT.)

= Opportunity cost of producing X in terms of forgone Y.
= MCx / MCy (Marginal cost of X / Marginal cost of Y)
Example: MCx = $30/X MCx/MCy
MCy = $10/Y = ($30/x) / ($10/Y) = 3Y/X
= aLx / aLy
Example: aLx = 6 hrs./X aLx / aLy
aLy = 2 hrs./Y = (6 hrs./X) / (2 hrs./Y) = 3Y/X
= (1/MPLx) / (1/MPLy) = MPLy / MPLx
Example: MPLy = 1/2 Y/hr MPLy / MPLx
MPLx = 1/6 X/hr = (1/2 Y/hr) / (1/6 X/hr) = 3Y/X

Calculate of the following

Opportunity Cost of X in terms of Y Opportunity Cost of Y in terms of X

(6 hrs./X)
A = 3Y per X 1/3 X per Y
(2 hrs./Y)
(1 hr/X)
B = Y per X 1X per Y
(1 hr/Y)

Absolute advantage: (hint comparing hrs.)

A country is said to have an absolute advantage in a good if it has higher MPL.

(i.e. Lower aLx or aLy)

Comparative advantage: (hint comparing goods.)

A country has comparative advantage in a good if it can produce goods at a lower

opportunity cost.

4
 
This document is authorized for use by Song Liu, from 9/27/2010 to 12/10/2010, in the course:
ECON 121: International Trade Theory (Fall 2010), University of California, Los Angeles.
Any unauthorized use or reproduction of this document is strictly prohibited.
Q: Who has absolute advantage For good X?
Country B. Because aLx* < aLx (1hr < 6hrs)

Who has absolute advantage For good Y?

Country B. Because aLy*< aLy (1hr < 2 hrs)

Q: Who has comparative advantage in good X?

Country B. Since 1Y/X < 3Y/X.

Who has comparative advantage in good Y?

Country A. Since 1/3X/Y < 1X/Y.

No trade scenario (benchmark)

Preliminary point.
(Px/ Py) = relative price of X = price of X in terms of foregone Y.

Example:
Px/Py = ($2/X) / ($1/Y) = 2Y/X

Iso-Revenue Curve (seller’s point of view)

Revenue = Px · X + Py · Y
100 = 20 · X + 10 · Y (What combination of X&Y generates revenue of $100)

X Y
0 10 12 ISO‐Rev. Curve (Rev.= 100) 
10
1 8 8

2 6 Y 6
4
3 4 2
4 2 0
0 1 2 3 4 5 6
5 0 X

5
 
This document is authorized for use by Song Liu, from 9/27/2010 to 12/10/2010, in the course:
ECON 121: International Trade Theory (Fall 2010), University of California, Los Angeles.
Any unauthorized use or reproduction of this document is strictly prohibited.
 200 = 20 · X + 10 · Y (What combination of X&Y generates revenue of $200)

X Y 22 ISO‐Rev. Curve (Rev.= 200) 
20
0 20 18
16 ISO‐Rev. Curve (Rev.= 100) 
1 18 14
Y 12
10
2 16 8
6
4
2
0
0 1 2 3 4 5 6 7 8 9 10 11

10 0 X

Notice: Higher Iso-Rev. Curve corresponds to higher revenues.

Slope of Iso-Rev. Curve = Px / Py

Budget constraint (Consumer’s point of view)

I = Px · X + Py · Y

PPF 

NO TRADE
IC1  Equilibrium

Demonstrate that
Px / Py = slope of Iso-Rev. = MCx / MCy = slope of PPF
(No corner solution)

6
 
This document is authorized for use by Song Liu, from 9/27/2010 to 12/10/2010, in the course:
ECON 121: International Trade Theory (Fall 2010), University of California, Los Angeles.
Any unauthorized use or reproduction of this document is strictly prohibited.
Suppose initially that
Px / Py > MCx / MCy
(slope of Iso-Rev. > slope of PPF)

Iso‐Rev. curve 

YD 

IC

PPF

0=YS  XD  XS 

 XS > XD (Surplus of X) => Px ↓

YS = 0 < YD (Shortage of Y) => Py ↑
 Px / Py ↓ (Slope of Iso-Rev. gets flatter)

** Do the case that Px / Py < MCx / MCy

Px / Py = MCx / MCy (Leads to equilibrium in all markets.)

Px/ Py = Opportunity cost of X = MCx / MCy = aLx / aLy = MPLy / MPLx

END OF LECTURE*************************************************

7
 
This document is authorized for use by Song Liu, from 9/27/2010 to 12/10/2010, in the course:
ECON 121: International Trade Theory (Fall 2010), University of California, Los Angeles.
Any unauthorized use or reproduction of this document is strictly prohibited.
September 29, 2010

From last time “given”

Country A Country B Derived Results

MPLx = 1/6 X/hr MPLx* = 1 X/hr. PPF A: 30 = 6X + 2Y

(aLx = 6 hrs./X) (aLx* = 1 hr /X) PPF B: 20 = X + Y

MPLy = 1/2 Y/hr MPLy* = 1 Y/hr. A: Opp. Cost of X = 3Y/X

(aLy = 2 hrs./Y) (aLy* = 1 hr /Y) B: Opp. Cost of X = Y/X

L = 30 hrs. L* = 20 hrs.
Slope of PPF (MRT) = Opp. cost of X = MCx / MCy = aLx / aLy = MPLy / MPLx

In equilibrium, (Px / Py) = (MCx / MCy)

slope of Iso-Rev. = slope of PPF

Assume the following

Country A Country B

18 24
15 20
12 16
Y 9 Y
6 8
ICB
3 ICA
0 0
0 1 2 3 4 5 6 0 3 6 9 12 15 18
20 21

X X

Given Given
(3X) (3Y/X) = 9Y
Cost of producing X in terms of Y

8
 
This document is authorized for use by Song Liu, from 9/27/2010 to 12/10/2010, in the course:
ECON 121: International Trade Theory (Fall 2010), University of California, Los Angeles.
Any unauthorized use or reproduction of this document is strictly prohibited.
Both production and consumption numbers:

X Y
A 3 6
B 12 8
World 15 14

With Specialization and trade

2 issues:

1. What determinies world price of X?

(i.e. what determines (Px / Py) world) - answer later

2. What is the impact on each country as they move from no trade to trade?
* I will give you (Px / Py) world.

For trade to be mutually beneficial, (Px / Py) world must lie

1Y / X < (Px / Py) world < 3Y / X

Opp. Cost of X in country B Opp. Cost of X in country A

Example: Assume (Px / Py) world = 2Y/X

A’s Produce own X Costs 3 Y/X A wants to import X

point X Trade for X Costs 2 Y/X Cheaper (Implies A wants to export Y)
of Produce own Y Costs 1/3X/Y Cheaper A wants to produce
view Y Trade for Y Costs 1/2X/Y its own Y.

B’s Produce own X Costs 1 Y/X Cheaper B wants to produce

point X Trade for X Costs 2 Y/X its own X
of Produce own Y Costs 1 X/Y B wants to import Y
view Y Trade for Y Costs 1/2X/Y Cheaper (Implies B wants to export X)

9
 
This document is authorized for use by Song Liu, from 9/27/2010 to 12/10/2010, in the course:
ECON 121: International Trade Theory (Fall 2010), University of California, Los Angeles.
Any unauthorized use or reproduction of this document is strictly prohibited.
Assume each country completely specializes in good for which they have a
comparative advantage: Before trade (production consumption bundle)

X Y X Y
A 0 15 A 3 6
B 20 0 B 12 8
World 20 15 World 15 14
18 Slope of PPF = 3Y/X
15 But (Px / Py) world = 2Y/X
12
Y 9
6.5 ICA’ CPF (consumption
6
ICA
3 possibility frontier) –
0
shows bundles can
0 1 2 3 4 5 6
X
consume with trade
4.25
No trade

24 Slope of PPF = 1Y/X

20 But (Px / Py) world = 2Y/X
16
Y
8.5
8
ICB
ICB’
0
0 3 6 9 12 15 18
20 21

X 15.75
No trade

10
 
This document is authorized for use by Song Liu, from 9/27/2010 to 12/10/2010, in the course:
ECON 121: International Trade Theory (Fall 2010), University of California, Los Angeles.
Any unauthorized use or reproduction of this document is strictly prohibited.
Assume that (in equilibrium.)

A desires to buy (import) 4.25 units of X => A must give up (export) 8.5Y
(2Y/X) (4.25X) = 8.5Y

4.25 X

A B (Px / Py) world = 2Y/X

8.5 Y

After specialization and trade

X Y

A 0 + 4.25 = 4.25 15 – 8.5 = 6.5

Prod. + imp. = consumption Prod. – exp. = consumption
B 20 – 4.25 = 15.75 0 + 8.5 = 8.5
Prod. – exp. = consumption Prod. + imp. = consumption
World 20 (Better off) 15 (Better off)
When no trade

X Y
A 3 6
B 12 8
World 15 14

Wages

Preliminary points

1. π = Px · X - W · Lx W = nominal (money) wage rate.

Profit = Rev. - Costs

dπ/dLx = Px (dx/dLx) – W = 0
Px · MPLx – W = 0
Px · MPLx = W

11
 
This document is authorized for use by Song Liu, from 9/27/2010 to 12/10/2010, in the course:
ECON 121: International Trade Theory (Fall 2010), University of California, Los Angeles.
Any unauthorized use or reproduction of this document is strictly prohibited.
 Likewise, Py · MPLy = W

If Px · MPLx > W competition will drive untill Px · MPLx = W

2. Labor is free to move across sectors.

W is same in each industry.

3. Real wage rate MPLx = (W/Px)

Real wage rate: this refers to the number of units of a good a worker can
purchase with its money wage.

Ex. W = $2/hr, Px = $1/X

W/Px = ($2/hr) / ($1/X) = 2X/hr
W/Py = MPLy

Before trade After trade (at Px/Py = 2Y/X)

MPLx = 1/6 X/hr

MPLy = 1/2 Y/hr All workers in Y industory MPLy = 1/2 Y/hr

A Real wage in terms of X

= (MPLy)(Py/Px) = (1/2X/hr)(1/2Y/X) = 1/4X/hr > 1/6 X/hr (better off)

Before trade After trade (at Px/Py = 2Y/X)

MPLx* = 1 X/hr. All workers in X industory MPLx* = 1 X/hr.

MPLy* = 1 Y/hr.
B Real wage in terms of Y

= (MPLx*)(Px/Py) = (1X/hr)(2Y/X) = 2Y/hr > 1Y/hr (better off)

Conclusion: Within countries real wages ↑

END OF LECTURE AND END OF SET #1*****************************

12
 
This document is authorized for use by Song Liu, from 9/27/2010 to 12/10/2010, in the course:
ECON 121: International Trade Theory (Fall 2010), University of California, Los Angeles.
Any unauthorized use or reproduction of this document is strictly prohibited.