14.

54 International Economics
Handout 1
Guido Lorenzoni
Fall 2005

1 An Exchange Economy
Consider two countries, Home and Foreign. Consumers in each country are
endowed with different amounts of two goods, Apples and Bananas.
The two countries are characterized by the following preferences. Home
consumers’ utility function is:

U (xA , xB ) ,

while Foreign consumers’ utility function is:

U ∗ (x∗A , x∗B ) .

Consumers’ endowments are the following: a home consumer has eA Apples

and eB Bananas while a foreign consumer has e∗A Apples and eB
∗
Bananas. There
are a continuum of measure 1 of home consumers and of foreign consumers.
Let’s start by looking at what happens if the two countries are in autarky.
Then we will analyze what happens if the two countries open to international
trade.

1.1 Demand function

The demand function can be derived from:

max U (xA , xB )
pA xA + pB xB ≤ pA eA + pB eB

∂U
= λpA
∂xA
∂U
= λpB
∂xB

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 ∂U

∂xA pA
∂U
= (1)

∂xB
pB
pA xA + pB xB = pA eA + pB eB (2)

These two equations define, implicitly, the marshallian demand function for
good A of the Home consumer XA (., .):
µ ¶
pA pA

xA = XA , eA + eB ,

pB pB

that depends on the relative prices and on real income. Notice that the con
sumers real income ppB
A
eA + eB is determined once we know the relative prices.
So, for given eA and eB we have a function that depends only on the relative
price ppB
A
and we can write:
µ ¶
pA
xA = fA .
pB

Home consumers will buy or sell good A depending on whether we have

xA > eA or xA < eA .

• Why marshallian demand function depends only on the relative price and
not on pA and pB separately?
• What do we know about XA (., .)? (review substitution effect, income
effect)
• Review graphical representation with indifference curves and budget con
straint.

Similar derivations and we get the demand for the foreign consumer
µ ¶
pA
x∗A = fA∗ .
pB

1.2 Autarky
Suppose the home country is closed to international trade.
Competitive equilibrium: find the relative price ppB
A
that solve:
µ ¶
pA
fA = eA .
pB

Market clearing condition.

Why not look at the other good?

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 −→If the budget constraint is satisfied and xA = eA then it has to be true

that xB = eB , because:
pA
xB − eB = (xA − eA )
pB
So one equilibrium condition is enough. In general with n goods there are n − 1
market clearing conditions that are independent (this is called Walras Law).

Claim 1 At autarky competitive equilibrium the relative prices are equal to the
MRS computed at the endowment:
¯
∂U ¯
∂xA ¯ pA,a
∂U ¯¯

∂x xA =eA pB,a
B
xB =eB

where the a stands for autarky prices.

To check that this is an equilibrium just check that conditions (1) and (2)
are satisfied.

eB

eA

The MRS represents the rate at which consumers are willing to trade apples
for bananas, i.e. how many bananas are they willing to give away in exchange
for one apple.

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 1.3 Trade
Suppose the two countries are in autarky and

pA,a p∗A,a
> ∗
pB,a pB,a

Edgeworth box. When they consume (eA , eB ) and (e∗A , e∗B ) the home consumer
assigns a higher "price" to apples than the foreign consumer, i.e. his MRS is
higher, i.e. the blue line tangent to the home consumer’s indifference curve
is steeper than the orange line tangent to the foreign consumer’s indifference
curve. The home consumer is willing to part with 3 bananas to obtain one extra
apple, the foreign consumer is willing to accept 1/4 of a banana in exchange for
one apple. There is room for a Pareto improvement. The home consumer gives
bananas to the foreign consumer in exchange for apples. Everybody is better
off.

eA*

eB eB*

eA

Suppose we open trade between the two countries. Now equilibrium inter
national prices are prices such that:
µ ¶ µ ¶
pA ∗ pA
f +f = eA + e∗A
pB pB
Or µ ¶ µ ¶
pA ∗ ∗ pA
f − eA = eA −f
pB pB

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 what home consumers buy is equal to what foreign consumers sell.

Again, enough to look only at equilibrium in one market (Walras Law

again...)
Why? From budget constraints we know that
pA
eB − xB = (xA − eA )
pB
pA ∗
x∗B − e∗B = (e − x∗A )
pB A

(the value of their sales must correspond to the value of their purchases). But,
the two right hand sides are equal, so the two left hand sides are equal too!

eB − xB = x∗B − e∗B .

eA*

eB eB*

eA

Now the green line represent the equilibrium relative price. Home consumers
are buying apples and selling bananas. The equilibrium relative prices of the
exports in terms of the imports is called the terms of trade for the home country
(here is ppB
A
). Here we have that:

pA,a pA p∗A,a
< < ∗ .
pB,a pB pB,a

Both countries gain from trading with the other country, home country buys
apples cheaper and country foreign buys banana cheaper.

Cite as: Guido Lorenzoni, course materials for 14.54 International Trade, Fall 2006.

MIT OpenCourseWare (http://ocw.mit.edu/), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].

 Claim 2 There is positive trade in equilibrium as long as

pA,a p∗A,a
6= ∗ .
pB,a pB,a

Claim 3 Both home and foreign consumers gain from trade.

Proof. Suppose (pA , pB ) are equilibrium with international trade. Then

home consumers utility is equal to

U T = max U (xA , xB )
pA xA + pB xB ≤ pA eA + pB eB

Notice that (eA , eB ) is feasible so it must be

U T ≥ U (eA , eB ) .

The same is true for the foreign consumer. But utility in autarky is clearly given
by
U A = U (eA , eB ) .
So we have
U T ≥ U A , U T ∗ ≥ U A∗ .

Cite as: Guido Lorenzoni, course materials for 14.54 International Trade, Fall 2006.

MIT OpenCourseWare (http://ocw.mit.edu/), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].