Classical Trade Models: simplified version
Basic Assumptions
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One period (static world)
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Trade in final goods
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Final goods produced with factors (no intermediates)
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No fiat money
o Relative prices are key
o One good chosen as numeraire (i.e. unit of account, its price by definition is one)
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Perfect competition, market clearing, full employment
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Identical profit maximizing firms
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Constant returns to scale technologies with the following properties:
o Linear expansion paths: isoquants have the same slope along rays starting at the origin
o Marginal products depend only on input factor ratios
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Identical utility maximizing agents with “nice” preferences (or “nice” community indifference curves) over final
goods
o “Nice” indifference curves are convex to the origin and have linear expansion paths
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Agents are endowed with factors (some mobile across sectors others not, model dependent) and own firms.
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Balanced trade: value of imports = value of exports
Country:
o
o
o
Factors
Technologies/Firms
Agents with preferences
Competitive Equilibrium (CE) in Autarky :
two goods (X, Y) and two mobile factors (L, K) example
Definition:
A CE in autarky is a price ratio (pX /pY ), factor prices (w, r after the numeraire is chosen) , a production bundle and a
consumption bundle such that:
1. agents maximize utility subject to their “relevant” budget constraint
2. firms maximize profits
3. output and input markets clear
Remarks:
1. implies that the utility maximizing bundle (i.e. consumption bundle ) can be found when the “relevant “ budget
constraint is tangent to the highest possible indifference curve.
2. implies that the profit maximizing bundle/s can be found when the PPF is tangent to highest possible isovalue
line (or touches the highest possible isovalue line if the PPF is linear, resulting in a non-unique bundle in some
cases). This highest isovalue line will be the “relevant budget constraint” (think about the case of a single agent
endowed with a fixed amount of L and of K).
3. total supply and total demand of X , Y, L and K are equal at the equilibrium prices. Notice that the supplies of L
and K are given (fixed/inelastic)
Competitive Equilibrium for a Small Open Economy (SOE) Trading Freely with ROW (rest of the world)
Small means the country takes world prices as given/fixed
Definition:
Given a world price ratio (pX /pY ), a CE for a SOE in Free Trade is a set of factor prices (w, r after the numeraire is
chosen) , a production bundle and a consumption bundle such that:
1.
2.
3.
4.
agents maximize utility subject to their “relevant” budget constraint
firms maximize profits
input markets clear
trade is balanced (i.e. value of exports=value of imports)
Remarks:
The last condition implies that the value of consumption equals the value of production.
International Free Trade Equilibrium: 2 countries
Definition:
Is a price ratio (pX /pY ) such that world markets in final goods clear and each country is in a SOE competitive equilibrium
under Free Trade.
Concepts/tools:
Relative Supply
Relative demand
Excess demand