360-2-1 - Chapter 2 Tools of Analysis for International...

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Chapter 2 – Tools of Analysis for International Trade Models See p. 28 in textbook. We construct an economic model of int’l trade to answer the questions like: Which countries trade what to whom? Why does int'l. trade occur? What goods will a country import, and what will it export? What will be the volume of trade? What will be the prices for trade? How does trade affect wages? How does trade affect rates of return (ROI)? We start in this chapter by building an economic model of a self-sufficient country, in isolation, with NO int’l trade , or “autarky.” Then we can introduce int’l trade and compare no trade (autarky) vs. trade. Economic Models – theoretical, abstract descriptions of economic behavior. Models can be verbal, or mathematical (geometric or algebraic) based on logic, most common. We use mostly geometric models, graphs. Models are necessarily a) abstractions from reality and b) simpler than reality, and may not always be perfectly accurate. Friedman: “The test of a theory is its ability to predict reality,” even if assumptions are abstract and simple. Examples: Maps or sheet music. Hard sciences (physics, chemistry, biology, pharmacology, botany, medicine, etc.) vs. Social sciences: Controlled or laboratory experiments. Issue: Positive vs. Normative analysis. Positive: What effect will an increase in cigarette taxes have on quantity demanded? Normative: Should we increase taxes on cigarettes and by how much? Example: Trade protection. Positive vs. Normative analysis of tariffs. ASSUMPTIONS OF BASIC ECONOMIC MODEL (GE) : 1
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General Equilibrium (GE) Approach looks at all sectors/markets of the economy (labor, inputs, output, credit, foreign exchange, etc.). Advantage of GE : we can study/analyze effects of trade on all sectors, comprehensive approach. Disadvantage of GE : Complicated, requires simplifying assumptions. Assumption 1 : Economic agents (firms and consumers) act rationally. Firms maximize profits (or share price or shareholder wealth), consumers maximize “utility.” Without this assumption, behavior would be random and unpredictable and could not be modeled. Assumption 2 : Two country, two good world - America (A) and Britain (B) producing and consuming Soybeans (S) and Textiles (S). Goods are homogenous, tradable, and some of each is always consumed in both countries. Conclusions of a two-good, two-country world can usually be generalized to a many-country, many- good world. For convenience of geometric analysis (graphs), we limit to two variables. Assumption 3 : No money illusion, i.e. confusing nominal and real prices. Decisions should be based on real prices, real interest rates, real variables or relative prices, and not nominal prices (P S or P T ). Relative price ratio = P S / P T or $10 / $5 = 2 if 1 bushel of soybeans is $10 and 1 yard of textiles is $5. The relative price of soybeans in terms of textiles is 2, or 2x as expensive.
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