International Business Economics

V

production, .

I want to max GDP given the constraints I have the



GDP of this country = V (value of production).

An ISOVALUE line is a line representing a constant

value of production, V:

V = Pc * Qc + Pf * Qf

Qf = V/Pf – Pc/Pf * Qc

where Pc and Pf are the prices of cloth and food, V/pf is vertical intercept, and - Pc/Pf

 minus

(including the sign) is the slope of the isovalue line.

- I assume prices are given and values are given the slope is given.

 Q

- Given the relative price of cloth, the economy produces at the point , the tangency

point between (that touches) the highest possible isovalue lines.

At that point, the relative price of cloth equals the slope of the PPF, which equals the

opportunity cost of producing cloth =>

The trade-off in production equals the

trade-off according to market prices.

- General Equilibrium Model => how we

built the construction of economy,

represented in this graph.

- The points of intersection with the x- and y-axis are Qf* and Qc*.

The Production Possibility Frontier with Factor Substitution

3 possible production points:



(5) QA: outside production possibility line non-feasible:



since it is outside the line the line is the production



possibility frontier, which is generated by 3 constraints

(amount of capital, labor – can’t produce more of what

I already have - + technology).

(6) QB: on the production possibility line feasible and



efficient,

(7) QC: inside production possibility line feasible, but



not efficient.

I need to know the market prices of the products



and base my production on those.

I want to maximize my GDP given the constraints I have. The GDP in this economy is equal to

the value of production of the country:

=Pc∗Qc+ ∗Qf

v Pf

v Pc

= − ∗Qc

Qf Pf Pf

v/Pf = vertical intercept; Pc/Pf = slope of the line.



Prices and Production

We assume that prices are given, and we want to maximize

our level of production => want to stay on the line of

possibility frontier and on one of these curves: the Isovalue

lines:

The economy produces at the point that maximizes the

value of production given the prices it faces; this is

the point on the highest possible isovalue line. At that PC

point, the opportunity cost of cloth in terms of food is equal to the relative price of cloth, >

PF. The further out I go on the isovalue lines, the more value (V) has increased.

 C Is the point I should reach (the tangency point) on

 

PP and on further away isovalue line It also shows the



equilibrium point of the quantity of 2 products that needs

to be produced to be efficiently.

Only points on the line of production possibility frontier



(PPF) are efficient.

For international trade, since prices change

 overtime, also the wanted point on the graph and

on the different isovalue lines can change.

Assuming prices are given :

I want to maximize V by choosing the right quantities to stay also on the PP (so must

How am I going to maximize this product? How much

say on 1 of the parallel curves).

capital and how much labor do I need in order to produce Qf* and Qc*? We use

FACTOR PRICES: WAGE (cost of labor) and RENTAL RATE (cost of capital).

Choosing the Mix of Inputs

- Producers may choose different amounts of factors of production used to make

cloth or food. w r

- Their choice depends on the WAGE, , paid to labor and the RENTAL RATE, , paid when

renting capital.

w increases r, less more

- As the wage relative to the rental rate producers use labor and

capital in the production of both food and cloth.

Input Possibilities in Food Production less

A farmer can produce a calorie of food with capital if he or she

more inverse

uses labor, and vice versa => L and K have an

relationship.

A certain curve is representing a certain amount of food: e.g.,



50, 100, 200.

The ISOQUANT is telling me that I can produce 50 amounts of food in a certain way:

 In point A: lot of capital and small amount of labor,

o In point B: vice versa.

o

The curve is smooth I can substitute capital and labor “smoothly” – in a proportional way.



How do I decide if I produce at point A or B? I need to have PRICES capital

 

and labor (we already know that from previous graph) => Now I need to figure out in

which proportion/ quantities.

minimization.

Problem of cost

 This graph shows the optimal combination in order to produce the wanted quantity by

 minimizing costs.

=W ∗Lf +

TCf r∗Kf TCf W

= − ∗Lf

Kf ISOCOST curve.



r r

Vertical intercept + negative slope of the curve.



K L

I have (capital) on y-axis and (labor) on x-axis, and assume I want to produce 50.

I assume also in this case that factor prices are given, and I don’t know the total costs.

 I have different parallel equations with different intercepts they differ simply on TC.

 

I want to minimize costs to produce 50 of food => stay on the black line.

 I have a number of notable points between the curve and the parallel lines (point A, B,

 C, D, and E). (less

Lower points on the curve allow me to produce 50 by spending less costs)

 => C allows me to produce with less than B, and so than A, …

Tangency point is the solution not able to produce in a point where the curve and

 

the parallel lines do not meet each other.

What is the optimum combination of inputs that allows me to produce food?

 Given by the tangency point between the lowest possible ISOCURVE and the

price curve (i.e., 50) e.g., point A, with points on x- and y-axis being Ka and La.

 increases

Suppose that W/r (the line changes and so also the

tangency) and the new tangency point becomes B (Kb and

less more

Lb) => The company will utilize capital and labor =>

increase

K/Lf will (go up).

Kf

=

akf

- Qf

Lf

=

alf

- Qf

Choosing the Mix of Inputs (cont.)

Assume that at any given factor prices, cloth production uses more labor relative to

capital than food production uses:

labor intensive,

- Production of cloth is relatively while production of food is relatively

capital intensive. CC FF.

- Relative factor demand curve for cloth lies outside that for food

L-intensive:

Suppose C is

 Lc Lf Kc Kf

> [ < ]

Kc Kf Lc Lf

Or

Lc Lf

Qc Qf alc alf

> =¿ >

Kc Kf akc akf

Qc Qf

Factor Prices and Input Choices

At any given wage-rental ratio, cloth

production uses a higher labor-

capital ratio; when this is the case,

we say that cloth production is

labor-intensive and that food

capital-intensive

production is .

Factor Prices and Goods

Prices

Is there a correlation between FACTOR PRICES and GOOD PRICES?

equal

In competitive markets, the PRICE of a good should its COST OF PRODUCTION,

which depends on the FACTOR PRICES. How changes in the wage and rent affect the

cost of producing a good depends on the mix of factors used.

increase more

An in the rental rate of capital should affect the price of food than the price of

capital-intensive

cloth since food is the industry.

- one-to-one relationship between the ratio of the wage



rate to the rental rate, w/r, and the ratio of the price of cloth to that of food, Pc/Pf.

increases decreases decreases more

r => W/r => Pc/Pf the food sector utilizes

 

capital (the capital-intensive sector is food) => price of food goes up more than price of

capital/ growth.

Changes of factor prices are linked in this model in this curve.

 

labor-intensive

Because cloth production is while food production is

capital-intensive, the higher the relative cost of labor, the higher

must be the relative price of the labor-intensive good.

Whatever happens in the labor or factor market will have an

 impact in factor prices.

Reach the key result.



Stolper-Samuelson theorem

- : If the relative price of a good increases, then the real

wage or rental rate of the factor used intensively in the production of that good increases,

while the real wage or rental rate of the other factor decreases income distribution.



- Any change in the relative price of goods alters the distribution of income.

Vs.

- Rybczinsky theorem economic growth.



- H-O (Heckscher-Ohlin) theorem international trade + gains from trade.



- Factor price equalization theorem.

From Goods Prices to Input Choices If the relative price of cloth rises,

the wage-rental ratio must rise.

This will cause the labor-capital

ratio used in the production of

both goods to drop.

- Suppose that price of cloth

increases relative to price of food

(Pc/Pf) => W/r increases, so that

workers will have a higher wage

rate, w/r (increasing it is higher

than increasing wage of capital).

What is the real wage and real

- rental rate (price of capital)?

We have nominal variables

here.

- Workers are better off and capital is lower => Workers gain more than capital W/r



increases it can be the result of W going up a lot, and r increasing just a bit, or W



increasing and r decreasing.

- So, this is the result of workers gaining more and capitalists losing *see article for



more in-depth analysis*

An increase in the relative price of cloth, Pc/Pf, is predicted to:

- raise income of workers relative to that of capital owners, w/r,

- raise the ratio of capital to labor services, K/L, used in both industries,

- raise the real income (purchasing power) of workers and lower the real income of

capital owners.

Resources and Output

Assume an economy’s labor force grows, which implies that its ratio of labor to capital,

L/K, increases.

- Expansion of production possibilities is biased toward cloth.

- At a given relative price of cloth, the ratio of labor to capital used in both sectors remains

constant.

- To employ the additional workers, the economy expands production of the relatively

labor-intensive good, cloth, and contracts production of the relatively capital-

intensive good, food.

Resources and Production Possibilities

Given that Pc/Pf increases => Qc/Qf also increases.

If companies observe price of product is increasing, they are

 willing to produce more product.

An increase in the supply of labor shifts the economy’s production

possibility frontier outward disproportionately in the direction of

cloth production.

At an unchanged relative price of cloth, food production declines.

An economy, generally, will tend to be relatively

 intensive

effective at producing goods that are in th