General Equilibrium Model: Analyzing Production, Consumption, and Trade in Two Countries, Exercises of International Finance and Trade

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General Equilibrium Model Rehim Kılı¸c, Department of Economics, Marshall Hall, Michigan State University, East Lansing, MI, 48824 e-mail: kilicreh@msu.edu This version: April, May, and June 2002

1 The Model

general equilibrium refers to the equilibrium in which production, consumption, prices, and interna- tional trade are determined simultaneously for all goods produced and consumed in the economy.

1.1 Assumptions

• A1. Economic agents, consumers, and producers- firms- exhibit rational behavior in the sense that given all the available information, consumers maximize utility from consumption, and firms try to maximize profits.
• A2. Two countries in the world, A, and B. Two goods, C, and W. Some of each good is consumed in each country.

Under assumptions A1-A4 we can illustrate the supply conditions of a country by PPF. Draw PPF to illustrate the supply conditions in each country.

PPF: We can assume that either the economy is subject to increasing OCs or the constant OCs.

• A5. Perfect competition prevails in each indus- tries in each country. There are no externalities. We know that under perfect competition firms will maximize their profits when P = M C. Then market prices reflect the true social (opportu- nity) costs of production. Illustrate this graph- ically by drawing PPF and price line together.

2 Solution of the model

2.1 Autarky Solution

Autarky means self-sufficiency. The country is closed in the sense that she does not trade with the rest of the world. The autarky solution is the solution for a closed economy. Under the assumption of constant OCs we can illustrate the solution graphically as fol- lows.

The solution with Increasing OCs:

The national supply and demand curves can be obtained graphically as follows:

Bringing national supply and demand curves to- gether we can characterized the autarky general equi- librium in an alternative fashion as follows: