Advanced Microeconomics: Small Open Economy

Advanced Microeconomics
Small open economy
Jan Hagemejer
December 18, 2011
Jan Hagemejer Advanced Microeconomics

A small open economy
Consider an economy with:
J rms, each producing a consumer good qj from primary

inputs/factorszj = (z1j , . . . , zLj ) ≥ 0.
Production function fj (zj ).
Total endowment of inputs z̄1 , . . . , z̄L 0.
Endowments are initially owned by consumers and consumers

cannot consume them.
Suppose that the prices of the J produced commodities are

xed at p = (p1 , . . . , pJ ) - EXOGENEOUS world prices.
Factors can move freely between sectors. Immobile

internationally.

The rms' problem.
The rm solves the following problem:
Max j j (p f z ) − w · zj .
zj ≥0
Denote optimal input demands: z (p , w ) (vector).
Factor supply: (z̄1 , . . . , z̄L ) at positive input prices.

Factor market equilibrium
Denition
A equilibrium in the factor market for this economy given the

output prices p consists of an input price vector
w∗ = (w1∗ , . . . , wL∗ ) 0 and a factor allocation
(z1∗ , . . . , zJ∗ ) = ((z11

∗
, . . . , zL∗1 ), . . . , (z1∗J , . . . , zLJ
∗
)),
such that rms receive their desired factor demands under prices
(p , w ∗ ) and all the factor markets clear, that is:
zj∗ = zj (p , w ) for all j = 1, . . . , J and
z`∗j = z̄` ` = 1, . . . , L.
X
for all
j

Factor market equilibrium
Given concavity of rms' production function variables

w ∗ = (w1∗ , . . . , wL∗ ) and (z1∗ , . . . , zJ∗ ) constitute an equilibrium if the
following hold:
∂ fj (zj∗ )
pj = w`∗ for all ` = 1, . . . , L and j = 1, . . . , J and
∂ z`j
z`∗j = z̄` ` = 1, . . . , L.
X
for
j
Given the equilibrium in the factor market, the equilibrium output

levels are qj∗ = fj (zj∗ ) for every j.

Output market equilibrium
Alternative equilibrium specication:
Denition
Output levels (q1∗ , . . . , qJ∗ ) 0 and factor prices w ∗ 0 constitute

an equilibrium if and only if the following conditions hold:
∂ cj (w ∗ , qj∗ )
pj = for j = 1, . . . , J ,
∂ qj
(price equals marginal cost)
X ∂ cj (w ∗ , qj∗ )
= z̄` for ` = 1, . . . , L.
∂ w`
j
(sum of factor demands for each factor by all rms equals demand
for that factor).

The social planner solution
Social planner wanting to maximize the country's revenue:
pf z zj = z¯.
X
Max j j ( j ) s.t.
zj ≥0
j
compare it to the joint prot maximization by j rms subject to
j zj = z̄
∗
P
(market clearing):
(pj fj (zj ) − w ∗ · zj ).
X
Max
zj ≥0
j
which in fact gives:
pj fj (z ) zj = z¯.
X X
Max s.t.
zj ≥0
j j
So the two solutions generate same results.

The aggregate solution properties
The aggregate factor demands must then solve:
Max( f (z ) − w · z ),
z >0
where f (z ) is the aggregate production function for dollars

f (z ) = Max j pj fj (zj ) subject to j zj = z
P P
z1 ,...,zJ
The FOCs are:
∂ f (z )
w` = for every `.
∂ z`
The equilibrium factor price must be:
∂ f (z̄ )
w` = for every `.
∂ z`
The price of factor ` must be equal to its aggregate marginal
productivity (in terms of total country revenue).

The model closure
Note that we did not talk about the consumer.
Consumers (in the same fashion as producers) take the world

prices as given.
Consumers maximize utility given the world prices.
However, we can solve the two completely independently: why

- prices are exogenous (determined somewhere else in the
world).
If we did have consumers in our model, we would have some

budget constraints:
Balance of payments: the value of imports=value of exports

Equivalent to: value of sales of all produced goods = value of
purchases of all consumed goods.
Equivalent to: rms prots + factor earnings = value of all
consumed goods.

The 2x2 case
Assumptions:
J=L=2
f z z f z
production function 1 ( 11 , 21 ) and 2 ( 12 , 22 ) are z
CRS/homothetic/homogeneous of degree 1.
factor 1 - labor, factor 2 - capital.
for every vector of factor prices w = (w1 , w2 ),

cj (w ) is the minimum cost of producing one unit of good j.
(unit cost)
aj (w ) = (a1j (w ), a2j (w )) the (unique) input combination at
which the min cost is reached.
aj (w ) are sometimes called: unit factor

requirements/demands

Factor intensity
Denition
The production of good 1 is relatively more intensive in factor 1

than is the production of good 2 if:
a11 (w ) a12 (w )
> ,
a21 (w ) a22 (w )
at all factor prices w = (w1 , w2 ).
NOW: ASSUME the above.

Pareto eciency

Important
Factor intensity (use of factor 1 relative to factor 2 in

production) of one rm exceeds the one of the other along all
points of the Pareto set (except on diagonal).
The Pareto set lies all above or all below the diagonal. If it
cuts the diagonal, it has to lie completely on the diagonal
(CRS).
Any ray from the origin cuts the Pareto set at most once. The
factor intensities move monotonically along the Pareto set.

Solution to the problem (1): factor demands
Factor demands are obtained through Shephard's lemma.
The total cost of production is:
Cj (w1 , w2 , q ) = cj (w1 , w2 )qj
Therefore:
∂ cj (w1 , w2 )qj
z`j (w1 , w2 , qj ) =
∂ w`
or:
∂ cj (w1 , w2 )
a` j (w ) =
∂ w`

Solution to the problem (2): factor wages
In equilibrium:
c1 (w1 , w2 ) = p1 and c2 (w1 , w2 ) = p2 .
Goods prices have two equal to the unit costs production of goods:
with CRS: MC = AC =unit cost and this follows from prot

maximization.

Equilibrium conditions - factor prices
Lerner-Pearce diagram (or how too graphically determine wages):
We can think of required production levels of good 1 and 2

that give us the same unit (i.e. 1 dollar) revenue
we can draw unit isoquants for both goods - the unit isovalue
lines:
1 = p1 f1 (z11 , z21 ) and 1 = p2 f2 (z12 , z22 )
We also can nd all the input combinations that cost exactly 1
dollar
the so called unit isocost line
z1 w1 + z2 w2 = 1
The isocost that that is tangent to both isoquants pins down

the factor wages.

Equilibrium conditions - factor prices
z2
q2=1/p2
1/w2
q1=1/p1
1/w1 z1

Solution to the problem (3): factor allocation
Once the factor wages are known, the

factor demands satisfy the following:
z11
∗ a11 (w ∗ ) z12
∗ a12 (w ∗ )
= and = .
z21
∗ a21 (w ∗ ) z22
∗ a22 (w ∗ )
The above expression, together with
the resource constraint
z̄` = z`∗1 + z`∗2 , ` = 1, 2.

gives us the equilibrium factor uses
and outputs.

Factor price equalization
Theorem
The equilibrium factor prices depend only on the technologies of

the two rms and on the output prices p .
NOTE: NOT on the factor endowments (but only in the small

open economy, i.e. with EXOGENEOUS prices of nal good).

Comparative statics
How does a change in the price of one of the outputs (eg. p1 )
aect the equilibrium factor prices and factor allocations?
p1 goes up. We need to produce less q1 to get one dollar of output.
w1 goes up and w2 goes down.
z2
q2=1/p2
1/w'2
1/w2
q1=1/p1
1/w'1 1/w1 z1
Comparative statics
p1 goes up. The green line shows proportional change in w1 .
Therefore w1 goes up more proportionately than p1 .
z2
q2=1/p2
1/w'2
1/w2
q1=1/p1
1/w'1 1/w1 z1
Comparative statics
p1 goes up. As factor 1 becomes more expensive, both rms start
using more of factor 2.
z2
q2=1/p2
1/w'2
1/w2
q1=1/p1
1/w'1 1/w1 z1
Stolper-Samuelson Theorem
Theorem
In the 2x2 production model with the factor intensity assumption, if

pj increases, then the equilibrium price of the factor more
intensively used in the production of good j increases, while the
price of the other factor decreases (assuming interior equilibria both
before and after the price change).

Rybczynski Theorem
Theorem
In the 2x2 production model with the factor intensity assumption, if

the endowment of a factor increases, then the production of the
good that uses this factor relatively more intensively increases and
the production of the other good decreases (assuming interior
equilibria, both before and after the change of endowment).

Rybczynski Theorem

Factor price equalization
It happens because:
c1 (w1 , w2 ) = p1 and c2 (w1 , w2 ) = p2 .
Or: p1 ∂ f (∂z11
z11
,z21 )
= w1 and p2 ∂ f (∂z12
z12
,z22 )
= w2 . So wages are
only dependent on the value of marginal productivities.
Therefore a change in endowment does not aect the level of

wages (because the ratios factor use stay constant).
However, the economy will specialize more in labour (capital)

intensive goods if it is more abundant in labour (capital).

2x2 production economy recap
Distinct consumer and producer problems given world prices

(we so far focus only on the producer problem).
Factor price equalization: factor prices are only a function of

technology and world prices. Not endowments. If all countries
have the same technology, the wages are the same everywhere.
Stolper-Samuelson - p1 up, w1 up, w2 down (good 1 more

intensive in factor 1).
Rybczynski theorem - ω1 up, y1 up, y2 down (good 1 more

intensive in factor 1).

Advanced Microeconomics: Small Open Economy

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Advanced Microeconomics

Small open economy

December 18, 2011

Jan Hagemejer Advanced Microeconomics

Consider an economy with:

J rms, each producing a consumer good qj from primary

Total endowment of inputs z̄1 , . . . , z̄L  0.

Endowments are initially owned by consumers and consumers

Suppose that the prices of the J produced commodities are

Factors can move freely between sectors. Immobile

Jan Hagemejer Advanced Microeconomics

The rm solves the following problem:

Denote optimal input demands: z (p , w ) (vector).

Factor supply: (z̄1 , . . . , z̄L ) at positive input prices.

Jan Hagemejer Advanced Microeconomics

A equilibrium in the factor market for this economy given the

(z1∗ , . . . , zJ∗ ) = ((z11

zj∗ = zj (p , w ) for all j = 1, . . . , J and

Jan Hagemejer Advanced Microeconomics

Given concavity of rms' production function variables

Given the equilibrium in the factor market, the equilibrium output

Jan Hagemejer Advanced Microeconomics

Alternative equilibrium specication:

Output levels (q1∗ , . . . , qJ∗ )  0 and factor prices w ∗  0 constitute

(price equals marginal cost)

Jan Hagemejer Advanced Microeconomics

Social planner wanting to maximize the country's revenue:

compare it to the joint prot maximization by j rms subject to

which in fact gives:

So the two solutions generate same results.

Jan Hagemejer Advanced Microeconomics

The aggregate factor demands must then solve:

where f (z ) is the aggregate production function for dollars

Jan Hagemejer Advanced Microeconomics

Note that we did not talk about the consumer.

Consumers (in the same fashion as producers) take the world

Consumers maximize utility given the world prices.

However, we can solve the two completely independently: why

If we did have consumers in our model, we would have some

Balance of payments: the value of imports=value of exports

Jan Hagemejer Advanced Microeconomics

factor 1 - labor, factor 2 - capital.

for every vector of factor prices w = (w1 , w2 ),

aj (w ) are sometimes called: unit factor

Jan Hagemejer Advanced Microeconomics

The production of good 1 is relatively more intensive in factor 1

Jan Hagemejer Advanced Microeconomics

Jan Hagemejer Advanced Microeconomics

Factor intensity (use of factor 1 relative to factor 2 in

Jan Hagemejer Advanced Microeconomics

Factor demands are obtained through Shephard's lemma.

The total cost of production is:

Cj (w1 , w2 , q ) = cj (w1 , w2 )qj

Jan Hagemejer Advanced Microeconomics

c1 (w1 , w2 ) = p1 and c2 (w1 , w2 ) = p2 .

with CRS: MC = AC =unit cost and this follows from prot

Jan Hagemejer Advanced Microeconomics

Lerner-Pearce diagram (or how too graphically determine wages):

We can think of required production levels of good 1 and 2

the so called unit isocost line

The isocost that that is tangent to both isoquants pins down

Jan Hagemejer Advanced Microeconomics

J rms, each producing a consumer good qj from primary

Total endowment of inputs z̄1 , . . . , z̄L 0.

The rm solves the following problem:

Given concavity of rms' production function variables

Alternative equilibrium specication:

Output levels (q1∗ , . . . , qJ∗ ) 0 and factor prices w ∗ 0 constitute

compare it to the joint prot maximization by j rms subject to

where f (z ) is the aggregate production function for dollars

with CRS: MC = AC =unit cost and this follows from prot

Therefore a change in endowment does not aect the level of