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International Trade, 31E00500Lecture 1: Introduction
Saara Tamminen1
1VATT Institute of Economic Research, Finland
Winter 2016
Tamminen (VATT) Lecture 1 5.1.2016 1 / 57
Table of contents
1 Intro and Practicalities
2 Facts to be explained1: Interindustry specialization2: Intra-industry trade3: Multinationals, services trade and labor markets4: Firm Heterogeneity, trade and income inequality
3 Foundations of the classical theories of international tradeConstant returns to scaleProduction possibility frontierProduction in the competitive economyPreferences, demand and welfare
Tamminen (VATT) Lecture 1 5.1.2016 2 / 57
Intro and Practicalities
Practicalities 1/2
Textbook:Charles van Marrewijk (CvM), 2012:International economics, theory, application andpolicy,2nd edition, Oxford university press
Charles van Marrewijk is Dutch and a Professor of
International Economics (since 2008) at Utrecht
University School of Economics and a Professor of
Economics (since 2014) at the International Business
School Suzhou (IBSS) of Xi'an Jiaotong - Liverpool
University (XJTLU) in Suzhou, China.
Tamminen (VATT) Lecture 1 5.1.2016 3 / 57
Intro and Practicalities
Practicalities 2/2
Passing the course:
1 Exam 50 % (compulsory to pass the course),
2 Term paper 35 % (compulsory to pass the course),
3 Exercises 15 %.
Lectures:
Tue 10-12(Arkadia E-124)
Thurs 12-14 (Arkadia E-124)
some Fridays 10-12 (Arkadia E-124), see:https://mycourses.aalto.�/course/view.php?id=3611
Tamminen (VATT) Lecture 1 5.1.2016 4 / 57
Intro and Practicalities
Course schedule
11 "normal" lectures (3 di�erent lecturers)
Last (12th) lecture for the presentation of student's draft termpapers (11.2.2016)
3 exercise packages and 3 exercise lectures (the correct answers areonly provided during the exercise lessons)
Exercise lectures by the course's teaching assistant: AnnaliinaKotilainen, Aalto (annaliina.kotilainen@aalto.�)
Tamminen (VATT) Lecture 1 5.1.2016 5 / 57
Intro and Practicalities
Important notes
1 You are expected to read all chapters and articles allocated to eachlecture before the lectures. See the syllabus.
2 Lecture notes will be published online after the lectures.
3 Active classroom participation is very much appreciated.
Tamminen (VATT) Lecture 1 5.1.2016 6 / 57
Intro and Practicalities
Term paper 1/3
Important dates:
Deadline for sending the main research question and name of people inyour research team to Saara (saara.tamminen@vatt.�): Friday22.01.2016 at 23.59
Presentation of draft term papers Thursday 11.2.2016, 12-14
Deadline for sending the full Term Papers to Saara: Sunday28.02.2016 at 23.59
Tamminen (VATT) Lecture 1 5.1.2016 7 / 57
Intro and Practicalities
Term paper 2/3
Other instructions:
Create a team of 2-3 persons
Think of a research question, not research topic
Choose research methodology and present draft results 11.2.2016
15 mins per presentation + time for comments
Consider the feedback and �nalise your term paper
Detailed instruction on how to write the term paper in MyCourses
Tamminen (VATT) Lecture 1 5.1.2016 8 / 57
Intro and Practicalities
Term paper 3/3
Examples of past research questions:
How trade policies have a�ected the imports of cars to Finland?
Determinants of Foreign Direct Investments to sub-Saharan Africa?
Impact of EU membership on the new members' trade?
How trade has a�ected the incomes of the poorer versus the richer indeveloped countries?
New ideas and suggestions in MyCourse:
E.g. How a 5% decrease in labor costs is expected to a�ect Finland'sglobal trade �ows?
Tamminen (VATT) Lecture 1 5.1.2016 9 / 57
Intro and Practicalities
Lecturers 1/3: Saara Tamminen
PhD International macroeconomics, Utrecht University (the Netherlands)
MSc International Economics, Erasmus University (the Netherlands)
BSc Economics, Helsinki School of Economics
Senior Researcher, Government Institute of Economic Research, Finland(VATT), 2011 →Economist, Ecorys Nederland, 2006-2011, research e.g. for EC, DG Trade
Research interests:
Firm heterogeneity, Services exports, Income inequality, Trade policies(e.g. NTMs in EU-US trade; Services exports and labor marketstructures in Finland)Computable General Equilibrium modelling, Ex-ante policy analyses(e.g. Trade Sustainability Impact Assessments)
Contact details: saara.tamminen@vatt.� / 040-3045537 / Economicum 1st�oor (make an appointment)
Tamminen (VATT) Lecture 1 5.1.2016 10 / 57
Intro and Practicalities
Lecturers 2/3: Yao Pan
PhD Economics, George Washington University(US)
B.A in economics, Renmin University of China
Assistant Professor of Economics, AaltoUniversity, 2013 →Research interests: Development and laboreconomics (e.g. Migration issues; Worker levelconsequences of import shocks)
Contact details: yao.pan@aalto.� /050-3824818 / Economicum A208
Tamminen (VATT) Lecture 1 5.1.2016 11 / 57
Intro and Practicalities
Lecturers 3/3: Katariina Nilsson-Hakkala
Associate Professor (Docent), Aalto university, Helsinki(since 2009)
PhD Economics, Stockholm School of Economics
Senior Researcher, VATT Institute of EconomicResearch, 2010 →Research interests: Labor and international economics(e.g. Multinational Firms and Job Tasks; Cross-BorderAcquisitions, Multinationals and Wage Elasticities)
Contact details: katariina.nilsson-hakkala@vatt.� /0295-519434 / Economicum
Tamminen (VATT) Lecture 1 5.1.2016 12 / 57
Facts to be explained 1: Interindustry specialization
Facts to be explained 1: Outline 1
What do we want to explain?
Real analysis vs. monetary analysis
Real analysis:
Why trade takes place?Implications of commodity and factor price changes on real variablessuch as labour and capital?Bene�ts from international trade?E�ects of trade restrictions and trade agreements on economies?
Focus on equilibrium determination and change in real trade �owsand welfare
Tamminen (VATT) Lecture 1 5.1.2016 13 / 57
Facts to be explained 1: Interindustry specialization
Facts to be explained 1: Outline 2
Issues:
Debate on the structures of world markets and their impact oneconomic development.
Integration of world trade. North-South trade, North-North trade andSouth-South trade
Inter-industry trade, intra-industry trade and value added fromtrade.
E�ects of trade policies and regional trade agreements.
Multinationals, o�-shoring (outsourcing abroad) and labor markets.
Firm heterogeneity and income inequality.
Tamminen (VATT) Lecture 1 5.1.2016 14 / 57
Facts to be explained 1: Interindustry specialization
Most countries are specialized in their production
Figure: Net exports of Finland 2013 (milj euro)
Tamminen (VATT) Lecture 1 5.1.2016 15 / 57
Facts to be explained 1: Interindustry specialization
Facts to be explained 1: Inter-industry specialization 1
Competitive general equilibrium theory, the backbone of the (classical)trade theories
We'll use mostly the simplest two-industry versions of the theory.
Production possibility frontier = possible combinations of output withfull capacity
Shape of the production possibility frontier a�ected by the availabilityof resources in the economy, technological knowledge (e�ectivelyused) and inter-sectoral di�erences in technologies.
These can di�er across countries and lead to the comparativeadvantage of nations.
Tamminen (VATT) Lecture 1 5.1.2016 16 / 57
Facts to be explained 1: Interindustry specialization
Facts to be explained 1: Inter-industry specialization 2
Classical trade theories focus on the supply side determinants ofinter-industry trade patters, e.g. factor endowments.
Two countries: Country A has more capital and country B morelabour.→ country A will export capital-intensive products and importlabour-intensive product from country B.
General equilibrium theory needed when one wants to discuss thedetermination of poverty, aggregate income and its distribution tofactors and people, and especially how trade a�ects these.
Classical trade theories also emphasize the structural changes impliedby e.g. reductions of trade barriers and international transport costs.
Tamminen (VATT) Lecture 1 5.1.2016 17 / 57
Facts to be explained 1: Interindustry specialization
Trade policies
Old fashioned trade policy: tari�s, quantitative restrictions or importquotas, tari�-quota systems and anti-dumping policies (e.g. EUimport restrictions for sugar)
New trade policy: non-tari� measures (NTMs) and non-tari� barriers(NTBs)
NTMs: all non-price and non-quantity restrictions on trade in goods,services and investment (e.g. technical standards and testing, licencerequirements, IPR rules, di�erences in regulations from one state toanother)NTBs: NTMs that can be considered protectionists restrictions andcan be disputed in WTO (e.g. excessive custom delays, �rm subsidies,embargoes)
Trade disputes and WTO: Bananas, Steel, Shrimps, Meat (hormones),lately mostly NTB disputes (e.g. subsidies to Boeing and Airbus)
Tamminen (VATT) Lecture 1 5.1.2016 18 / 57
Facts to be explained 1: Interindustry specialization
The classical trade theories to explain inter-industryspecialization
Lecture 2: Ricardian theory of Comparative advantage (from year1817)
Lecture 3: Factor intensity and the Heckscher-Ohlin model (from year1933) + Stolper-Samuelson proposition and Rybczynski proposition
Lecture 4: Trade policy: tari�s, quotas and NTMs (with perfectcompetition models)
Tamminen (VATT) Lecture 1 5.1.2016 19 / 57
Facts to be explained 2: Intra-industry trade
Facts to be explained 2: Intra-industry trade and 'new tradetheory'
Despite obvious inter-industry specialization various goods andservices are both exported and imported.
Exports of Nokia phones, import of iPhones
A growing share of world trade is intra-�rm trade. About 60 percentof US imports from EU were trade within multinationals in 2009.(Lanz & Miroudot, 2011)
Tamminen (VATT) Lecture 1 5.1.2016 20 / 57
Facts to be explained 2: Intra-industry trade
Figure: Finland, exports and imports of some product categories 2013 (millioneuro)
Tamminen (VATT) Lecture 1 5.1.2016 21 / 57
Facts to be explained 2: Intra-industry trade
Flows of sugar trade
Tamminen (VATT) Lecture 1 5.1.2016 22 / 57
Facts to be explained 2: Intra-industry trade
Facts to be explained 2: Intra-industry trade 2
Several ways to understand intra-industry trade:1 Product di�erentiation and consumer's love-of-variety:
Competitive theory for a �xed number of goods: Eaton and Kortummodel.Number of goods not �xed: Need for a theory of productdi�erentiation.
2 Theory of monopolistic competition and increasing returns to scale.
3 Strategic behavior of large oligopolistic �rms: incentive to enter eachothers' markets even if they produce identical goods.
4 Global fragmentation of production processes
Tamminen (VATT) Lecture 1 5.1.2016 23 / 57
Facts to be explained 2: Intra-industry trade
The 'new trade theories' and applied models to explainintra-industry trade
Lecture 5: Increasing returns to scale and imperfect competition(theories from year 1977 onwards)
Lecture 6: Intra-industry trade (theories from 1970's and 1980's) andGravity modelling (theories from 2002 & 2003 )
Lecture 7: Strategic (theories from 1980's) & applied trade policy,including applied partial and general equilibrium models' basics(developed especially after 1990's)
Tamminen (VATT) Lecture 1 5.1.2016 24 / 57
Facts to be explained 3: Multinationals, services trade and labor markets
Boeing 787 is produced in USA?
Tamminen (VATT) Lecture 1 5.1.2016 25 / 57
Facts to be explained 3: Multinationals, services trade and labor markets
Facts to be explained 3: O�-shoring (outsourcing abroad) 1
Lot of research in the last 15 years on analysing the fragmentation ofproduction processes (outsourcing of some stages of production toother �rms located possibly in foreign countries).
One measure of international outsourcing is the share of importedintermediates in production.
An increase in the share may be an indication of o�-shoring
Factories of Nokia and Kone abroad increased imported intermediateinput use
Tamminen (VATT) Lecture 1 5.1.2016 26 / 57
Facts to be explained 3: Multinationals, services trade and labor markets
Facts to be explained 3: O�-shoring 2
Especially small countries such as Denmark, Finland, Netherlands andSweden have a high share of imported intermediates.
The increases have been highest in Denmark, Finland, Germany andSweden (largest percent increase in Japan).
What explains the increasing fragmentation and o�-shoring ofproduction?
Liberalisation of world trade, communication technologies, integrationof Eastern Europe and China in the world economy, increasinginternational competition.
The other side: increasing exports of services.
Tamminen (VATT) Lecture 1 5.1.2016 27 / 57
Facts to be explained 3: Multinationals, services trade and labor markets
Facts to be explained 3: Services exports
Services exports, di�erent modes:
Mode 1: Cross-border supply;
Mode 2: Consumption abroad;
Mode 3: Commercial presence; and
Mode 4: Presence of natural persons.
(Mode 5: Domestic indirect services value added embodied in goodstrade, Cernat 2014)
Note: Services exports vs. service sectors' exports
Tamminen (VATT) Lecture 1 5.1.2016 28 / 57
Facts to be explained 3: Multinationals, services trade and labor markets
Figure: Examples of services trade
Tamminen (VATT) Lecture 1 5.1.2016 29 / 57
Facts to be explained 3: Multinationals, services trade and labor markets
Figure: Extent of services trade and recent trends
Tamminen (VATT) Lecture 1 5.1.2016 30 / 57
Facts to be explained 3: Multinationals, services trade and labor markets
Trade and labor markets
How does trade a�ect our job markets?
Does o�-shoring shift our jobs to China?
Global fragmentation of production processes and 'trade in tasks'
What statistics should be look when we want to analyse the e�ects oftrade on labor markets? Gross exports vs. domestic value added ofexports?
Does general decrease in salary costs help Finnish exports'competitiveness and increase our employment?
Tamminen (VATT) Lecture 1 5.1.2016 31 / 57
Facts to be explained 3: Multinationals, services trade and labor markets
Figure: Gross value of exports vs. their domestic value added (VA), Finland(OECD, TiVA indicators)
Tamminen (VATT) Lecture 1 5.1.2016 32 / 57
Facts to be explained 3: Multinationals, services trade and labor markets
Figure: The Great Structural change in Finnish exports (OECD, TiVA indicators)
Tamminen (VATT) Lecture 1 5.1.2016 33 / 57
Facts to be explained 3: Multinationals, services trade and labor markets
Share of exports' value added from services
Figure: Share of export's domestic value added originating from service sectors(OECD, TiVA indicators)
Tamminen (VATT) Lecture 1 5.1.2016 34 / 57
Facts to be explained 3: Multinationals, services trade and labor markets
Models on multinationals and trade in tasks to explain thesephenomena
Lecture 8: Multinational Firms and Fragmentation of Production(theories from 2004 onwards)
Lecture 9: O�shoring and labor markets (theories developed duringthe last 10 years)
Tamminen (VATT) Lecture 1 5.1.2016 35 / 57
Facts to be explained 4: Firm Heterogeneity, trade and income inequality
Figure: The long term view on trade developments, (Source: ourworldindata.org)
Tamminen (VATT) Lecture 1 5.1.2016 36 / 57
Facts to be explained 4: Firm Heterogeneity, trade and income inequality
Trade & Income inequality
Income inequality has decreased between many country pairs, but has
increased within-countries in the majority of countries during last 30 years
(Anand & Segal, 2008)(Galbraith & Kum, 2005)
Helsingin Sanomat, 20.1.2014: �85 richest persons own as much wealth as
the the poorest half of the world's population in total. �
Helsingin Sanomat, 25.1.2014: �World Economic Forum in Davos warned
about the political instabilities caused by income inequality. In the streets of
Bangkok, in the barricades of Kiova and even in the war in Syria this threat
is already a reality. �
The Washington Post, 24.1.2014: �Income inequality hurts economic growth,
researchers say. �
Tamminen (VATT) Lecture 1 5.1.2016 37 / 57
Facts to be explained 4: Firm Heterogeneity, trade and income inequality
Trade & Income inequality
Income inequality has decreased between many country pairs, but has
increased within-countries in the majority of countries during last 30 years
(Anand & Segal, 2008)(Galbraith & Kum, 2005)
Helsingin Sanomat, 20.1.2014: �85 richest persons own as much wealth as
the the poorest half of the world's population in total. �
Helsingin Sanomat, 25.1.2014: �World Economic Forum in Davos warned
about the political instabilities caused by income inequality. In the streets of
Bangkok, in the barricades of Kiova and even in the war in Syria this threat
is already a reality. �
The Washington Post, 24.1.2014: �Income inequality hurts economic growth,
researchers say. �
Tamminen (VATT) Lecture 1 5.1.2016 37 / 57
Facts to be explained 4: Firm Heterogeneity, trade and income inequality
Trade & Income inequality
Income inequality has decreased between many country pairs, but has
increased within-countries in the majority of countries during last 30 years
(Anand & Segal, 2008)(Galbraith & Kum, 2005)
Helsingin Sanomat, 20.1.2014: �85 richest persons own as much wealth as
the the poorest half of the world's population in total. �
Helsingin Sanomat, 25.1.2014: �World Economic Forum in Davos warned
about the political instabilities caused by income inequality. In the streets of
Bangkok, in the barricades of Kiova and even in the war in Syria this threat
is already a reality. �
The Washington Post, 24.1.2014: �Income inequality hurts economic growth,
researchers say. �
Tamminen (VATT) Lecture 1 5.1.2016 37 / 57
Facts to be explained 4: Firm Heterogeneity, trade and income inequality
Trade & Income inequality
Income inequality has decreased between many country pairs, but has
increased within-countries in the majority of countries during last 30 years
(Anand & Segal, 2008)(Galbraith & Kum, 2005)
Helsingin Sanomat, 20.1.2014: �85 richest persons own as much wealth as
the the poorest half of the world's population in total. �
Helsingin Sanomat, 25.1.2014: �World Economic Forum in Davos warned
about the political instabilities caused by income inequality. In the streets of
Bangkok, in the barricades of Kiova and even in the war in Syria this threat
is already a reality. �
The Washington Post, 24.1.2014: �Income inequality hurts economic growth,
researchers say. �
Tamminen (VATT) Lecture 1 5.1.2016 37 / 57
Facts to be explained 4: Firm Heterogeneity, trade and income inequality
Only a fraction of �rms export
Finland has around 200 000 �rms (excluding self-employed)
Around 10% of all �rms are exporting in Finland
But around 21% of �rms in "export sectors" are exporting
Among medium and large �rms these share are signi�cantly higher,but vary from sector to sector
Tamminen (VATT) Lecture 1 5.1.2016 38 / 57
Facts to be explained 4: Firm Heterogeneity, trade and income inequality
Figure: Exporting �rms vs. export value by number of products and destinations(Marrewijk, 2012, �gure 17.3)
Comparison: 18 �rms created 50% of Finland's gross exports in 2010. 2.3% of
export �rms (0.35% of all �rms) accounted for 89% of Finland's gross exports in
2010.Tamminen (VATT) Lecture 1 5.1.2016 39 / 57
Facts to be explained 4: Firm Heterogeneity, trade and income inequality
Facts to be explained 4: Firm Heterogeneity and 'new newtrade theory'
Exporting �rms are more productive,larger, pay better wages and do moreR&D than domestically oriented �rms inthe same sector. (Figure 4: Mayer &Ottaviano, 2008)
Learning-by-exporting or self-selection?
What is the e�ect of this �rmheterogeneity on economic structures?
Tamminen (VATT) Lecture 1 5.1.2016 40 / 57
Facts to be explained 4: Firm Heterogeneity, trade and income inequality
Trade policy: The Banana trade war
The Banana War in 1990's and the structure of banana trade
Who won and who lost in the deal?
Tamminen (VATT) Lecture 1 5.1.2016 41 / 57
Facts to be explained 4: Firm Heterogeneity, trade and income inequality
Melitz model and its extensions to explain the e�ects oftrade on economic structures
Lecture 10: Firm heterogeneity and the Melitz model (empirics from1995 onwards and Melitz model from 2003)
Lecture 11: Trade and income inequality (theoretical explanationsdeveloped from 2008 onwards)
Tamminen (VATT) Lecture 1 5.1.2016 42 / 57
Foundations of the classical theories of international trade
Quick review of microeconomic basics
Basics of supply in the general equilibrium of a perfectly competitiveeconomy:
Constant returns to scale (CRS), production possibility set, theprinciple of value maximization in a competitive economy.
Basics of demand:
From individual demand to aggregate demand, (quasi)-homotheticpreferences.
→ General equilibrium in a small open economy
Tamminen (VATT) Lecture 1 5.1.2016 43 / 57
Foundations of the classical theories of international trade Constant returns to scale
Constant returns to scale 1
Constant returns to scale (or perceived so at the �rm level), CRS, areintimately linked to perfect competition.
Increasing returns to scale: often in monopolistic competition.
Decreasing returns to scale: a "short run" phenomenon due to somefactor �xed in the short run.
Assume all �rms in any industry j have identical CRS technologies.Then the industry production can be presented by the same functionwith industry-level inputs as inputs in this production function.
Tamminen (VATT) Lecture 1 5.1.2016 44 / 57
Foundations of the classical theories of international trade Constant returns to scale
Constant returns to scale 2
The function is said to be homogeneous of degree 1 w.r.t. inputs if
Fj (λVj) = λFj (Vj) , λ > 0
where Vj = inputs (capital, labour, land etc.): if all inputs arechanged proportionately (λ), output will change in the sameproportion and production is characterised by CRS.
E.g: Cobb-Douglas
Fj (Kj , Lj) = Kαj L
1−αj , 0 ≤ α ≤ 1
E.g: LeontiefFj (Kj , Lj) = min {aKj , bLj}
, where a, b ≥ 0 are technology parameters
Tamminen (VATT) Lecture 1 5.1.2016 45 / 57
Foundations of the classical theories of international trade Production possibility frontier
Production possibility set
Assume now that in the given economy all sectors j have CRSproduction functions, identical within each sector but possibly di�eringbetween sectors.
Assume that the total factor supplies in the economy are V , e.g.(K , L).
Then the production possibilities are de�ned as the collection of allsectoral production levels Qj that are feasible: these production levelscan be obtained by some allocation of inputs between the sectors.
Thus (Q1,Q2, ...,QM) is in the production possibility set, ifQj ≤ Fj (Vj) in all sectors j and V1 + V2 + ...+ VM ≤ V (or∑M
j=1 Vj ≤ V ).
Tamminen (VATT) Lecture 1 5.1.2016 46 / 57
Foundations of the classical theories of international trade Production possibility frontier
Production possibility frontier 1
The production possibility frontier gives the maximum production levelof one good for any given level of production of other goods.
Production possibility frontier is the boundary of the productionpossibility set.
For a two sector economy for general production functions theproduction possibility set can have almost any "shape"
With CRS PPF is concave, with increasing returns to scale (IRS) it isconvex
With CRS the production possibility set is convex (with IRSnon-convex): If two allocations of factors of production and theimplied levels of production are feasible then any mixture of theseallocations is also feasible.
Tamminen (VATT) Lecture 1 5.1.2016 47 / 57
Foundations of the classical theories of international trade Production possibility frontier
Example of PPF with a funny shape
Tamminen (VATT) Lecture 1 5.1.2016 48 / 57
Foundations of the classical theories of international trade Production possibility frontier
The convexity of the production possibility set means thefollowing shape:
Tamminen (VATT) Lecture 1 5.1.2016 49 / 57
Foundations of the classical theories of international trade Production possibility frontier
Production possibility frontier 4
In addition to CRS we assume that the production functions have thefollowing properties:
Marginal product of each input is non-negative (in most relevant casesalways positive). This is equivalent to saying that the �rst derivativeof the production function with respect to each input is non-negative.
They are (quasi-) concave.
This assumption just generalizes the idea that the marginal product ofeach input is declining.
Tamminen (VATT) Lecture 1 5.1.2016 50 / 57
Foundations of the classical theories of international trade Production in the competitive economy
Production in the competitive economy 1
Why do we pay attention to the production possibility frontier?
The competitive economy is Pareto-e�cient: from that equilibriumnobody's welfare can be improved without reducing somebody else'swelfare.
This implies that at the equilibrium prices the aggregate income ismaximized.
Thus, if p is the competitive equilibrium price (vector) and Q theequilibrium output (vector) then
pQ ≡∑
pjQj ≥ pQ′
for any other output (vector) in the production possibility set.
This implies that the competitive equilibrium output is always in theproduction possibility frontier.
Tamminen (VATT) Lecture 1 5.1.2016 51 / 57
Foundations of the classical theories of international trade Production in the competitive economy
Production in the competitive economy 2
In the two sector economy we know that at the equilibrium incomep1Q1 + p2Q2 ≡ Y is maximized subject to the constraintQ2 ≤ P (Q1;V ), where P (Q1;V ) is the production possibility frontier,with ∂Q2
∂Q1= P ′ (Q1;V ) < 0,P” ≤ 0.
Graphically: Let Y be any level of income. Then the combinations ofoutputs that yield this level of income is
Q2 =Y
p2− p1
p2Q1
This can be called the iso-income line.
The output levels are chosen to maximize the income Y given theproduction possibility set.
Tamminen (VATT) Lecture 1 5.1.2016 52 / 57
Foundations of the classical theories of international trade Production in the competitive economy
The optimal choice, Y max, is described as:
Tamminen (VATT) Lecture 1 5.1.2016 53 / 57
Foundations of the classical theories of international trade Preferences, demand and welfare
From preferences to individual demand
Consumers maximize utility U = U(X1,X2, ...,Xi )
Utility function increasing in all commodities
Bundles that create the same level of utility belong to the sameindi�erence curve
Slope of the indi�erence curve = marginal rate of substitution (MRS)
Most functions induce diminishing MRS
Homothetic demand → indi�erence curves next to each other, nointersections
Tamminen (VATT) Lecture 1 5.1.2016 54 / 57
Foundations of the classical theories of international trade Preferences, demand and welfare
Demand and welfare
Max utility U = U(X1,X2, ...,Xi ), subject to budget constraintI = p1 ∗ X1 + p2 ∗ X2 + ...+ pi ∗ Xi
Utility maximised when MRS = p1p2
(prove this to yourselfmathematically)
Aggregate demand function, X = D(pi , I ) exists if preferences areidentical and homothetic
Higher utility indi�erence curve = higher aggregate welfare, but notnecessarily for all individuals
Tamminen (VATT) Lecture 1 5.1.2016 55 / 57
Foundations of the classical theories of international trade Preferences, demand and welfare
General equilibrium, autarky
Y
X
U(1)
U(0)
B
A
Budget constraint: 𝑌 =𝐼
𝑝𝑦−
𝑝𝑥
𝑝𝑦𝑋
𝐼
𝑝𝑦
𝐼
𝑝𝑥
PPF
Tamminen (VATT) Lecture 1 5.1.2016 56 / 57
Foundations of the classical theories of international trade Preferences, demand and welfare
Next lecture
Thursday 7.1, 12-14, on Comparative advantage with Yao Pan
Tamminen (VATT) Lecture 1 5.1.2016 57 / 57