Topic 4: Analysis of Equilibrium. Outline: 1. Main ideas. Partial equilibrium. General Equilibrium. Offer curves. Terms of trade. 2. Partial equilibrium analysis of trade. 3. General equilibrium analysis of trade. READ: Ch. 4.
Main ideas: Partial equilibrium analysis is the analysis of equilibrium from the point of view of a single consumer, single firm or a single market General equilibrium analysis is the analysis of equilibrium from the p.o.v. of all consumers, firms and markets. It is qualitatively distinct from partial equilibrium analysis. The analysis of equilibrium in a single market is based on the use of supply and demand curves. With only two markets and two traders, general equilibrium analysis can be carried out using offer curves. An offer curve maps the combinations of trades (sales of one good in exchange for purchases of the other) that a single trader desires to carry out at different price ratios between the two goods.
Applied to a country, a country s desired sales of one good are its desired exports. It s desired purchases of the other good are its desired imports. The price ratio between its exports and its imports are known as the country s terms of trade. A country s offer curve maps the combinations of international trades (desired exports of one good versus desired imports of the other) that it desires to engage in as its terms of trade change. Partial equilibrium analysis. On the PPF-CIC-IBC diagram, the production point represents supply decisions taken by perfectly competitive domestic firms. The consumption point represents demand decisions taken by domestic consumers. At the autarky equilibrium, domestic supply equals domestic demand.
If the world relative price of a good exceeds its domestic relative price under autarky, domestic supply exceeds domestic demand and the country exports the excess. A country s export supply curve is derived from the domestic supply and demand curves of its export good. It is defined only for relative prices above the autarky relative price of that good; measures the horizontal distance between domestic supply and demand at each such price; has a vertical intercept at the autarky relative price of the export good; increases in the relative price of the good. If the world relative price lies below the domestic relative price under autarky, domestic demand exceeds domestic supply and the country imports the difference.
A country s import demand curve is derived from the domestic supply and demand curves of its import good. It is defined only for relative prices which lie below the autarky relative price of that good; measures the horizontal distance between domestic demand and supply at each such price; has a vertical intercept at the autarky relative price of the export good; decreases in the relative price of the good. With two countries, so long as the relative price of the good under consideration lies between its autarky relative price in each country, one will export and the other will import the good. Equilibrium in the market under consideration will arise when one country s desired exports equal the other s desired imports at a given relative price.
General equilibrium analysis. A country s offer curve is derived from its PPF-CIC-IBC diagram by mapping out its desired imports and exports at different values of the slope of its IBC line. An offer curve (OC) has the following properties: Any point on the OC gives a combination of desired exports and desired imports that the country is willing to carry out at a given relative price. If a straight line is drawn from the origin to any point on the OC, the slope of the line gives the relative price at which that particular trade is desired. The OC must pass through the origin ( no exports = no imports ). It must pass through quadrant 1 and quadrant 3, not quadrants 2 and 4 (cannot import both goods and would not want to export both). The slope of the OC as it passes through the origin gives the autarky relative price of the horizontal axis good. Each OC bends towards the imports axis (as the relative price of imports falls, there is a positive income effect on domestic demand for the export good). With two countries and two goods, the equilibrium price ratio and the equilibrium volume of trade is determined by the intersection of the two OCs. Note that the relative price is the same in both countries. their trade plans are mutually consistent.
The OC diagram is useful for comparative static analysis: an increased desire by the citizens of one country to consume their own exportable good will cause its OC to shrink and raise the price of its exports. a parallel outward shift in a country s PPF will cause an outward shift in its OC and cause its export prices to fall. and so on.