International Economics –Two-good marketsJhuato.sfc@gmail.com

GoalDevelop the tools to analyze trade in a 2-good economy:PPF (and budget constraint, a.k.a.

budget line)Preferences (collective and

individual)Choice (how the PPF and

preferences interact)

PPF

PPF: Increasing costs• The slope of the PPF is

the opportunity cost of one unit of good 1 in terms of good 2, a.k.a. the marginal rate of transformation of good 1 for good 2

• MRT_1,2 = MC_1/MC_2• With a concave PPF, the

MRT_1,2 is increasing as more of good 1 is produced

PPF: constant cost

Indifference curves

An indifference curve is a set of combinations of good 1 and good 2 that yield the same level of welfare to society

We assume society figures out a way to aggregate its individual preferences into a set of collective preferences

We make the following assumptions regarding the collective preferences of society More is better than less: A is preferred to B if it has more of

at least one of the goods Averages are better than extreme combinations: C is

preferred to A and B, if C is a combination that averages A and B

Preferences are consistent: if society prefers A to B and B to C, then society also prefers A to C.

By the 2nd assumption above, we draw the indifference curves as convex curves.

More is better

Averages are better

Preferences are consistent

Marginal rate of substitution

Output choice The output bundle (the amounts of good 1 and good

2 produced) will be determined by the interaction between the production possibilities of the economy captured by its PPF and the collective preferences over the two goods captured by its indifference curves.

Our focus is on the mechanics of choice. Once we define an equilibrium (or “optimal output choice”), we’ll want to shock the model to see what happens to this optimal bundle if the economic environment changes.

Again, if this economy does not trade, the output bundle chosen is also necessarily the consumption bundle.

Output choice: optimal output bundle

Output choice: optimal output bundle

Output choice: optimal output bundle 2