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Model Building

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Price line/budget constraint. Model Building: ... So, if we draw a tangent (relative price line) the relevant IC curve we can find ... – PowerPoint PPT presentation

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Title: Model Building

1
Model Building

In this chapter we are going to lean some tools
for analyzing the following questions

2
Model Building

In this chapter we are going to lean some tools
for analyzing the following questions
What goods will a country import?

3
Model Building

In this chapter we are going to lean some tools
for analyzing the following questions
What goods will a country import?
What goods will a country exports?

4
Model Building

In this chapter we are going to lean some tools
for analyzing the following questions
What goods will a country import?
What goods will a country exports?
What will be the trade volume? how much trade ?

5
Model Building

In this chapter we are going to lean some tools
for analyzing the following questions
What goods will a country import?
What goods will a country exports?
What will be the trade volume? how much trade ?
What will be the price at which they trade?

6
Model Building

In this chapter we are going to lean some tools
for analyzing the following questions
What goods will a country import?
What goods will a country exports?
What will be the trade volume? how much trade ?
What will be the price at which they trade?
What is the effect of trade on the price of
factors of production?

7
Model Building

In the process of model building, one should
make sure to avoid the normative aspects of the
question under analysis.

8
Model Building

In the process of model building, one should
make sure to avoid the normative aspects of the
question under analysis. That is, try to avoid
making any "ought to be" statements which are in
the realm of normative rather that positive
economics. In Positive economics we always try
to stay with the positive aspect of the analysis,
i.e., we need to explain what is.

9
Model Building ASSUMPTIONS SUPPLY SIDE

1-- all economic agents are rational

10
Model Building ASSUMPTIONS SUPPLY SIDE

1-- all economic agents are rational
- firms are profit maximizers

11
Model Building ASSUMPTIONS SUPPLY SIDE

1-- all economic agents are rational
- firms are profit maximizers
- consumers are utility maximizers

12
Model Building ASSUMPTIONS SUPPLY SIDE

2-- there are
2 countries A (America) and B (Britain)

13
Model Building ASSUMPTIONS SUPPLY SIDE

2-- there are
2 countries A (America) and B (Britain)
2 goods S (Soybeans) and T (Textiles)

14
Model Building ASSUMPTIONS SUPPLY SIDE

2-- there are
2 countries A (America) and B (Britain)
2 goods S (Soybeans) and T (Textiles)
both goods are consumed all the time in both
countries

15
Model Building ASSUMPTIONS SUPPLY SIDE

2-- there are
2 countries A (America) and B (Britain)
2 goods S (Soybeans) and T (Textiles)
both goods are consumed all the time in both
countries
both goods are identical in both countries

16
Model Building ASSUMPTIONS SUPPLY SIDE

3-- there is no money illusion.

17
Model Building ASSUMPTIONS SUPPLY SIDE

4-- In each country
factor endowment is fixed

18
Model Building ASSUMPTIONS SUPPLY SIDE

4-- In each country
factor endowment is fixed
technology is constant

19
Model Building ASSUMPTIONS SUPPLY SIDE

5-- Perfect competition in
product market and

20
Model Building ASSUMPTIONS SUPPLY SIDE

5-- Perfect competition in
product market and
input market

21
Model Building ASSUMPTIONS SUPPLY SIDE

6-- Factors of production are mobile within each
country and industry.

22
Model Building ASSUMPTIONS DEMAND SIDE

Each Indifference curve shows
trade off between two commodities

23
Model Building ASSUMPTIONS DEMAND SIDE

Each Indifference curve shows
trade off between two commodities
level of satisfactions (total utility)

24
Model Building ASSUMPTIONS DEMAND SIDE

Each Indifference curve shows
trade off between two commodities
level of satisfactions (total utility)
only ordinal and not cardinal preferences.

25
Model Building ASSUMPTIONS DEMAND SIDE

Indifference curves analysis is based on the
following assumptions
i-- Commodity units are divisible to a very
small size,

26
Model Building ASSUMPTIONS DEMAND SIDE

Indifference curves analysis is based on the
following assumptions
i-- Commodity units are divisible to a very
small size,
ii-- consumers tastes are well defined,

27
Model Building ASSUMPTIONS DEMAND SIDE

Indifference curves analysis is based on the
following assumptions
i-- Commodity units are divisible to a very
small size,
ii-- consumers tastes are well defined,
iii-- MU 0

28
Model Building ASSUMPTIONS DEMAND SIDE

Indifference curves analysis is based on the
following assumptions
i-- Commodity units are divisible to a very
small size,
ii-- consumers tastes are well defined,
iii-- MU 0
iv-- no nuisance commodity

29
Model Building ASSUMPTIONS DEMAND SIDE

Characteristics of ICs
i-- ICs are non-intersecting.

30
Model Building ASSUMPTIONS DEMAND SIDE

Characteristics of ICs
i-- ICs are non-intersecting.
ii-- ICs are continuous

31
Model Building ASSUMPTIONS DEMAND SIDE

Characteristics of ICs
i-- ICs are non-intersecting.
ii-- ICs are continuous
iii-- ICs are everywhere dense and go through
every point in the XY map.

32
Model Building ASSUMPTIONS DEMAND SIDE

Characteristics of ICs
i-- ICs are non-intersecting.
ii-- ICs are continuous
iii-- ICs are everywhere dense and go through
every point in the XY map.
iv-- ICs have a negative slope

33
Model Building ASSUMPTIONS DEMAND SIDE

Characteristics of ICs
i-- ICs are non-intersecting.
ii-- ICs are continuous
iii-- ICs are everywhere dense and go through
every point in the XY map.
iv-- ICs have a negative slope
v-- ICs are Convex to the origin.

34
Model Building Budget Constraint

Indifference Curves show the desire of the
individual and the community. In other words,
their willingness.

35
Model Building Budget Constraint

Indifference Curves show the desire of the
individual and the community. In other words,
their willingness. But there is another
requirement, ability to purchase a commodity. (a
demand curve shows the ability and willingness )

36
Model Building Budget Constraint

Indifference Curves show the desire of the
individual and the community. In other words,
their willingness. But there is another
requirement, ability to purchase a commodity. (a
demand curve shows the ability and willingness )
Ps S Pt T ? I

37
Model Building Budget Constraint

Ps S Pt T ? I
Since I/ Ps is the total amount of S that one
could buy with an income level I

38
Model Building Budget Constraint

Ps S Pt T ? I
Since I/ Ps is the total amount of S that one
could buy with an income level I and I/ Pt is the
total amount of T that one could buy with a
given amount of I, then the ratio of the I/ Pt
to I/ Ps represents
slope of the price line (the budget line ).
- (I/Pt)/(I/Ps) - (Ps/Pt)

39
Budget Constraint

Example

40
Model Building ASSUMPTIONS DEMAND SIDE

7-- A consistent community's preferences can be
presented.
This is a tricky business. It is impossible
(Arrow's Impossibility Theorem) to generate a set
of ordering that is internally consistent for
individuals as well as for the community as a
whole.

41
Model Building ASSUMPTIONS DEMAND SIDE

7-- A consistent community's preferences can be
presented.
Order of individuals
Preferences Janice Parisa Zach
1 apples oranges bananas
2 oranges bananas
apples
3 bananas apples
oranges

42
Model Building ASSUMPTIONS DEMAND SIDE

7-- A consistent community's preferences can be
presented.
Order of
individuals
Preferences Janice Parisa Zach
1 apples oranges bananas
2 oranges bananas
apples
3 bananas apples
oranges

43
Model Building ASSUMPTIONS DEMAND SIDE

If the group were to rank these fruits, we would
have
apples are preferred to oranges by Janice and Zach

44
Model Building ASSUMPTIONS DEMAND SIDE

If the group were to rank these fruits, we would
have
apples are preferred to oranges by Janice and
Zach
Oranges are preferred to Bananas by Janice and
Parisa.

45
Model Building ASSUMPTIONS DEMAND SIDE

If the group were to rank these fruits, we would
have
apples are preferred to oranges by Janice and
Zach
Oranges are preferred to Bananas by Janice and
Parisa.
But yet, even though apples are preferred to
oranges and oranges are preferred to bananas,
apples are not preferred to bananas by the group.

46
Model Building ASSUMPTIONS DEMAND SIDE

There are three possibilities to have a
consistent preference ordering
1-- Robinson Crusoe economy

47
Model Building ASSUMPTIONS DEMAND SIDE

There are three possibilities to have a
consistent preference ordering
1-- Robinson Crusoe economy
2-- A dictatorial economy where one person
decides for all,

48
Model Building ASSUMPTIONS DEMAND SIDE

There are three possibilities to have a
consistent preference ordering
1-- Robinson Crusoe economy
2-- A dictatorial economy where one person
decides for all,
3-- all individuals have a same preference
ordering.

49
Model Building ASSUMPTIONS DEMAND SIDE

There are three possibilities to have a
consistent preference ordering
1-- Robinson Crusoe economy
2-- A dictatorial economy where one person
decides for all,
3-- all individuals have a same preference
ordering.
We assume all individuals have a same preference
ordering.

50
Model Building General Equilibrium Solution of
the Model Autarky Solution

Given the assumptions of
i-- Consumer and producers' rationality

51
Model Building General Equilibrium Solution of
the Model Autarky Solution

Given the assumptions of
i-- Consumer and producers' rationality
ii-- Perfect competition in
-- factor market
-- product market

52
Model Building General Equilibrium Solution of
the Model Autarky Solution

Given the assumptions of
i-- Consumer and producers' rationality
ii-- Perfect competition in
-- factor market
-- product market
iii-- Fixed
-- technology
-- endowment

53
Model Building General Equilibrium Solution of
the Model Autarky Solution

Given the assumptions of
i-- Consumer and producers' rationality
ii-- Perfect competition in
-- factor market
-- product market
iii-- Fixed
-- technology
-- endowment
iv-- Increasing cost PPC

54
Model Building General Equilibrium Solution of
the Model Autarky Solution

The economy will find an optimal solution on the
PPC.

55
Model Building General Equilibrium Solution of
the Model Autarky Solution

The economy will find an optimal solution on the
PPC. This optimal point will be the tangency
point of the budget line, indifference curve, and
the Production Possibility Curve, say point A.

56
Model Building General Equilibrium Solution of
the Model Autarky Solution

S
T
57
Model Building General Equilibrium Solution of
the Model Autarky Solution

S
PPC
T
58
Model Building General Equilibrium Solution of
the Model Autarky Solution

Price line/budget constraint
S
T
59
Model Building General Equilibrium Solution of
the Model Autarky Solution

S
Indifference Curve
A
T
60
Model Building General Equilibrium Solution of
the Model Autarky Solution

S
Indifference Curve
A
S1
T
61
Model Building General Equilibrium Solution of
the Model Autarky Solution

S
A
S1
T
T1
62
Model Building General Equilibrium Solution of
the Model Autarky Solution

At this point, A, where all three components of
the system converge, the Marginal Rate of
Substitution between S and T, and slopes of the
budget line and the PPC Curve are equal
MRSst slope of the budget line (-Ps/Pt)

63
Model BuildingAdjustment to the equilibrium
point

Let's assume that the economy produces at a point
like B.

T
T2
IC1
B
A
T1
IC0
?
S
S1
S2
64
Model BuildingAdjustment to the equilibrium
point

Let's assume that the economy produces at a point
like B.

T
T2
IC1
B
A
T1
IC0
?
?
S
S1
S2
65
Model Building Adjustment to the equilibrium
point

There will be a surplus of S and a shortage of T
at the prevailing relative prices (Py/Px).

66
Model Building Adjustment to the equilibrium
point

There will be a surplus of S and a shortage of T
at the prevailing relative prices (Py/Px).
Surplus of S leads to a decrease in the
production of S and employment of factors of
production in that industry.

67
Model Building Adjustment to the equilibrium
point

There will be a surplus of S and a shortage of T
at the prevailing relative prices (Py/Px).
Surplus of S leads to a decrease in the
production of S and employment of factors of
production in that industry.
Shortage of T leads to an increase in production
of T and therefore those resources that are
released from industry S are absorbed in the T
industry.

68
Model Building Adjustment to the equilibrium
point

There will be a surplus of S and a shortage of T
at the prevailing relative prices (Py/Px).
Surplus of S leads to a decrease in the
production of S and employment of factors of
production in that industry.
Shortage of T leads to an increase in production
of T and therefore those resources that are
released from industry S are absorbed in the T
industry.
As a result the output mix will be changed from B
to A.

69
Model Building National Demand and Supply

Using the information provided in the PPC and
ICs, we can derive the national demand and
supply.

70
Model Building National Supply

Using the information provided in the PPC and
ICs, we can derive the national demand and
supply. We know the slope of the PPC gives the
technical rate of transformation of one commodity
into another.

71
Model Building National Supply

Using the information provided in the PPC and
ICs, we can derive the national demand and
supply. We know the slope of the PPC gives the
technical rate of transformation of one commodity
into another. So if we draw a tangent
(representing the relative price of S in terms of
T) to the PPC at every point we can derive the
national supply for the two commodities.

72
Model Building National Supply

Using the information provided in the PPC and
ICs, we can derive the national demand and
supply. We know the slope of the PPC gives the
technical rate of transformation of one commodity
into another. So if we draw a tangent
(representing the relative price of S in terms of
T) to the PPC at every point we can derive the
national supply for the two commodities. We can
see how many units of S is produced at every
relative price.

73
T
A
?
S
Pt
A
?
S
S1
74
T
A
?
?
S
Pt
A
?
S
S1
75
T
A
B
?
?
S
Pt
B
?
A
?
S
S1
S2
76
T
A
B
?
?
S
Pt
NS
B
?
A
?
S
S1
S2
77
Model Building National Demand

We also know that the slope of the IC gives the
Marginal Rate of Substitution between Textiles
and Soybeans (MRSst). That is, the rate at which
a consumer is willing to exchange one commodity
for another.

78
Model Building National Demand

We also know that the slope of the IC gives the
Marginal Rate of Substitution between Textiles
and Soybeans (MRSst). That is, the rate at which
a consumer is willing to exchange one commodity
for another. So, if we draw a tangent (relative
price line) the relevant IC curve we can find the
amount of the commodity (S) that will be demanded
at that relative price.