Topic 05- Exchange and Comparative Advantage

Question 1

What are the 2 ways to look at exchange and what are they?

Answer 1

1) Trade- where 2 agents meet, negotiate and come up with an agreement at the end
2) Redistribution- no interaction between agents and change is imposed onto economic agents

Question 2

Define endowment

Answer 2

What resources economic agents have to begin with before trade/redistribution etc has taken place

Question 3

What is MRS?

Answer 3

Marginal rate of Substitution

Question 4

What is the marginal rate of substitution?

Answer 4

The amount of a good that a consumer is willing to consume compared to another good, as long as the new good is equally satisfying

Question 5

Is the marginal rate or substitution different to the marginal rate of technical substitution?

Answer 5

Yes
MRS relates to 2 goods
MRTS relates to 2 inputs (typically capital and labour) and how they can substituted for each other

Question 6

What are the MRS curves called?

Answer 6

Indifference curves

Question 7

Based on the preference of 2 goods, how do you know if the MRS indifference curve will be flat or steep?

Answer 7

Think about it in terms how much of a good the agent is willing to give up
So the agent would be willing to give up less of the good they want and more of the good they don’t want
… the curve will be steeper along the axis of the good they don’t want and flatter along the axis of the good they do want

Question 8

What do MRS indifference curves look like?

Answer 8

They look like isoquants- SEE IMAGE ON WORD DOC- example with apples and bananas (Friday and Robinson)

Question 9

What is autarky?

Answer 9

Where an agent/country etc does not trade with other agents/countries and is self reliant for resources- self sufficiency

Question 10

How can you tell if trade is a improvement or loss for the agent?

Answer 10

If you move to a quantity above the indifference curve then it is a benefit for the agent as they’re getting rid of a resource they do not need/like and gaining a resource they do need/like

Question 11

What is an edgeworth box and how do you construct it?

Answer 11

Graphical tool- rectangle
Flip one agents indifference curve graph and move it onto the other agents curve so that they are on top of each other
It is the total endowment in the economy to begin with so its dimensions are the total number of resource/good A as one of the axis and the total number of resource/good B as the other axis

Question 12

How can you use the edgeworth box in practice?

Answer 12

It can be used to see how both agents can benefit from trade
KEY thing to remember is that an agent benefits when from trade when they move above their indifference curve
… one benefits from moving above their indifference curve and the other agent (because one graph/curve is flipped) benefits from moving beneath their indifference curve
… the common area between the 2 agents where they both benefit is the area in which trade can take place so that it is beneficial for both parties

Question 13

What is one condition for the edgeworth box rule to hold which states that both agents can benefit from trade and why does it work?

Answer 13

The MRS curves for both agents must NOT be the same

If they are the same then there is no common area where both agents benefit and … there is NO mutual benefit from trade

Question 14

Describe what an edgeworth box actually looks like?

Answer 14

SEE KEY IMAGES WORD DOC

Question 15

What essentially does the edgeworth box rule say?

Answer 15

That both agents/parties/countries can benefit from trade with each other

Question 16

What is the technical name given to a point which allows for both agents to benefit from trade (when the MRS curves for each agent are different)?

Answer 16

Pareto improvement

Question 17

What is the technical name given to a point which doesn’t allow both agents to benefit from trade where one agent can only benefit at the cost of the other agent (when the MRS curves for each agent are equal)?

Answer 17

Pareto efficient- here no further trade is possible

Question 18

What is a contract curve?

Answer 18

The set of all Pareto efficient allocations in the edgeworth box so … all the points where the MRS curves of both agents are the same
… the curve connects all Pareto efficient points where the indifference curves are equal and are tangents to each other

Question 19

What is the core?

Answer 19

The core is part of the contract curve but it encompasses the area where both agents are better off than the initial endowment (distribution of resources/goods)- basically shows the outer edge of the area where trade could’ve been improved- better explained on diagram so SEE WORD DOC
It is basically where the agents will end up when no more trade can take place to benefit either agent- … when trade has been exhausted

Question 20

What is interesting about the core?

Answer 20

The agents can end up anywhere along the core therefore the location will determine which agent benefited more from trade
The agent which ends up with more of both resources benefits more from the trade
SEE DIAGRAM ON WORD DOC FOR CLARITY

Question 21

What are the 2 main reason why agents/countries may not like the initial endowment/allocation of resources?

Answer 21

1) There is unnecessary waste- by trading both agents can get more of what they want/need and … be better off
2) One agent may be envious (key word) of the other as one may have more of both goods/resources than the other

Question 22

What are the 2 main issues when allocating resources effectively?

Answer 22

1) Resource allocation should not be wasteful (each agent gets what they want and need)
2) Resource allocation should be fair (initial endowment should be more fair)

Question 23

What was the main issue with the initial solution we found using the edgeworth box and contract curve?

Answer 23

Although it solved issue of waste as trade was able to take place until no more could, it didn’t really solve the fairness of initial resource allocation as the endowment was unchanged and … they was inequality in terms of opportunity

Question 24

What is the solution to waste of resources and inequality in endowment?

Answer 24

2 principles:

1) Equality of opportunities- all agents given same starting point- maybe by redistributing the initial endowment- … same amount of each resource- also MUST guarantee same rates of exchange/prices (or access to same markets)
2) Liberalism- agents can act in their own interest- can pursue heterogenous (different) interests

Question 25

What does the second diagram on page 3 of topic 5 key images on word doc show?

Answer 25

Point A- initial endowment/allocation- point is not envy free nor is it Pareto efficient- point A isn’t envy free as an agent is likely not want more resources like the other agent
Point B- shows 1st rule of equal opportunity in action whereby redistribution of initial resources occurs and both agents are given equal amounts of each resource- … point B is in fact envy free as now each agent has the same starting point and opportunity- same number of each resource- hence why point B is in the middle of the edgeworth box
Point C- shows both rules applied- second rule of liberalism applied whereby agents are able to freely trade with whoever they want in the same market at the same exchange rate/price- trade is exhausted to the point where no more trade is possible hence why point C is on the core of the contract curve for point B … suggests that point C is both envy free and Pareto efficient

Question 26

How do you know for sure that point C is both envy free and Pareto efficient?

Answer 26

There is no waste as all trade opportunities are exhausted- leads us to core … Pareto efficiency is achieved
Point B was definitely envy free but the question is whether each agent is envious of one another at point C
BUT Point C is envy free despite the fact that each agent has different number of each resource as it is guaranteed under liberalism that each agent will have complete control over who they trade with, how much they trade, the price/exchange rate is same for all, the market is the same
As each agent has equal opportunity and complete choice/control over the trades which took place and led them to the core of the contract curve (point C), point C must be envy free as they chose to exchange each resource for the other based on their needs/wants
Each agent could’ve ended up with the same number of each resource but they didn’t so they don’t envy each other

Question 27

What does this so called optimum/ideal point where both equality and liberalism is achieved actually look like in practice?

Answer 27

See word doc topic 05 page 3

Question 28

What is the real life application of the idea that equality of opportunity combined with liberalism to do what you please is the optimum/ideal situation?

Answer 28

In links to the idea of intervention in economies
More specifically the type of economies we see in the western world (specifically the U.K) today- welfare state based capitalism- market economy
The U.K economy allows for liberalism as it allows people to freely choose their career path/business etc and therefore gives them complete control to pursue their heterogeneous (different interests)- capitalism
At the same time the U.K economy also has a welfare state which aims to provide equal opportunity for everyone so that everyone’s starting point is the same (whether it is successful is down to question but the aim is equality)
The welfare state aims to ensure that the same opportunities are available to all etc

Question 29

What are the criticisms of applying this model to reality?

Answer 29

The idea of endowment redistribution may be difficult to achieve in practice as it is unlikely that someone who is wealthy will give half their wealth to someone who is not wealthy so that they now have the same amount of wealth
In western economies like the U.K, if you are the son/daughter of a rich person you are likely to be rich and aren’t likely to have the same starting point as someone who is the son/daughter of someone who is not wealthy e.g. via inheritances etc
BUT also very difficult to control the varying talents of children- some children are better at football, running, education, music etc than others naturally and therefore do not have the same starting point
Also in some cases rates of exchange/prices aren’t the same for all which gives against what the model assumes