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Chapter5 - Chapter 5 Standard Model of a Trading Economy...

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Chapter 5: Standard Model of a Trading Economy Standard trade model is built on 4 key relationships: (1) relationship between production possibility frontier and the supply curve (2) relationship between relative prices and relative demand (3) determination of world equilibrium by world relative supply and world relative demand (4) effect of the terms of on a nations welfare Note: Terms of trade = price of a country’s exports price of imports Production possibilities and relative supply Assumptions: (1) each country produces 2 goods; Food (F) and Cloth (C) (2) Each country has a smooth curve for their PPF Point on the PPF that an economy actually produces depends on the price of cloth relative to food, P c /P F
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Market value of output is indicated by drawing a number of isovalue lines iso-value: lines along which the value of output is constant Each of these lines is defined by the equation: P C Q C + P F Q F = V Slope of the isovalue line = minus the relative price of cloth Economy will produce the highest value of output it can, which is achieved at point Q If P F Q F rises, the isovalue line would be steeper than before Therefore, an increase in relative price of cloth leads economy to produce more cloth and less food Relative supply of cloth increases when relative price of cloth rises Relative Prices and Demand value of an economy’s consumption equals the value of its production: P C Q C + P F Q F = P C D C + P F D F = V equation above says that the production and consumption must lie on the same line economy’s choice of a point on the isovalue line depends on the tastes of its consumers taste of an individual can be represented graphically by a series of indifference curves indifference curve: traces a set of combinations of cloth and food consumption that leave the individual equally well off Indifference curves have 3 properties: (1) they are downward sloping (if an individual is given less food, then to be made equally happy they must be offered more cloth) (2) the farther up and to the right the IC lies, the higher the level of welfare to which it corresponds (individual will prefer more of both goods to less) (3) each IC gets flatter as we move to the right (the more C and the less F an individual consumes, the more valuable a unit of F is at the margin compared with a unit of C, so more C will have to be provided to compensate any further reduction in F) the economy will choose to consume at the point on the isovalue line that yields the highest possible welfare this occurs when the isovalue line is tangent to the highest reachable indifference curve When P C /P F is increased: economy produces more C and less, which causes all the curves to shift (i.e the IC and isovalue line) The move of the indifference curve reflects two effects of the rise in P C /P F : (1) economy has moved to a higher IC, therefore it is better off This is b/c this economy is an exporter of cloth
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