Lars Bergman

February, 2002

A General Equilibrium Model of a Small Open Economy

As an introduction to general equilibrium theory we construct a general equilibrium model of a

small open economy, where there is perfect competition on all goods and factor markets. As
this is a small open economy, the prices of internationally traded goods are determined on the
world market. We assume that there are two production factors, capital and labor, and that the
supply of these factors is totally inelastic. There are two sectors, each producing a certain type
of goods.
Constructing a general equilibrium model means deriving demand and supply functions for the
two goods markets and the two factor markets. Since the supply of production factors is given,
what remain to be determined are demand functions for the factor markets and supply and
demand functions for the goods markets. As this is an open economy, we must also consider
foreign trade when determining the equilibrium conditions for the goods markets and the
budget constraint of the economy as a whole.
We assume that the relations between input and output in the two lines of business can be
described by linearly homogeneous production functions of Cobb-Douglas type, i.e.,

xj = Ajnjj k1-j , j = 1,2

(1)

where x is production volume, n input of labor and k input of capitaL while A and are
constants. It can be shown that the latter constant, , equals the share of labor costs in total
production costs. The fact that the so-called output elasticity of labor and capital, i.e. the
parameters and 1- , adds up to one, means that the underlying technology exhibits constant
1

returns to scale (CRS). Another way of describing this condition is that the production function
is linearly homogeneous (homogeneous of degree one).
Starting from the production .functions of the different sectors and the assumption that
producers maximize their profit, we can derive demand functions for labor and capital as well
as expressions for the marginal production cost in sector. Formally this is done in two steps.
First we try to find the input of labor and capital that minimizes the cost of a given production
function volume. Then we try to find the production volume that maximizes profit. As is well
known, a necessary condition for profit maximization under perfect competition is that the
price of a product is equal to the marginal production cost of that product.

Demand for Production Factors

The first step is to define the cost functions of the producing sectors. Thus for sector the
following cost minimization problem is solved.

j w, r , x j min wn j rk j

1 a j

s.t. A j n j j k j

nj ,k j

xj ;

(2)
In other words, the cost function is defined as the solution of an optimization problem. This
means that it belongs to a class of functions called "optimum value functions". The
optimization problem (2) is a constrained minimization problem, but it can be transformed into
an unconstrained minimization problem by substituting the constraint into the objective
function. The "new" minimization problem can then be written:
1
1a j
j

j w, r , x j min wn j rA
nj

a j
1a j
j

1
1a j
j

(3)

The first order condition for minimum is that the derivative of (3) with respect to n j is equal to
zero, i.e. that
1

aj
1 a
1 a
1 a
w
rA j j n j j x j j 0 ;
1 aj

(4)
2

which can be written

1
1a j
j

1 a w A

1
1 a j
j

a jr

1
1 a j
j

(5)

and finally

nj A
1
j

1 a j

a jr

1 a w
j

x j n j w, r , x j

(6)

Thus we have an explicit expression for the demand for labor as a function of wages (w), the
cost of capital (r) and the production volume (xj). Similarly, the demand for capital is given by
the expression:

kj A
1
j

a j

a jr

1 a w
j

x j k j w, r , x j ;

(7)

These are the factor demand functions that we are looking for, and we could go on to derive the
product supply and demand functions. However, the factor demand functions discussed so far
alternatively can be derived from the cost functions of the production sectors. In order to show
this we make the following observation.
Since the demand functions (6) and (7) define the inputs of labor and capital, respectively, that
give the lowest cost for the given production volume, the cost function (2) can alternatively be
defined as
j w, r , x j wn j w, r , x j rk j w, r.x j ;

(8)
Substitution of (6) and (7) into (8) gives

a jr

j w, r , x j wA

1 a j w
1
j

1 a j

x j rA
1
j

a jr

a j

1 a w
j

xj

(9)

which can be written

j w, r , x j Aj 1a j

a j

1 a
j

a j 1

w jr

1a j

xj

(10)

Like the production function the cost function can be seen as a description of the technological
constraints of the production sectors. In many situations it is actually practical to start with the
cost function, i.e., postulating a certain shape for the cost function rather than deriving it from
assumptions about the production function. One reason for starting with the cost function is that
the derivation of demand functions (6) and (7) will be much simpler. According to
Shephards Lemma, these demand functions coincide with the partial derivatives of the cost
function with respect to the factor prices. In other words,
j w, r , x j
w

n j w, r , x j A

a jr

a jr

1
j

1a j

xj

1 a w
j

(11)
j w, r , x j
r

k j w, r , x j

A
1
j

a j

xj

1 a w
j

(12)

Supply of Goods
With perfect competition on all goods and factor markets profit-maximizing Producers are
willing to increase supply as long as the market price of the product exceeds the marginal
production cost. In equilibrium the market price therefore coincides with the marginal
production cost. The marginal production cost is equal to the partial derivative of cost function
(10) with regard to production volume. Thus a necessary condition for equilibrium is:

pj

c j w, r , x j
a
a 1 a 1a
Aj 1a j j 1 a j j w j r j
x j

(13)
It should be noted that in this case the marginal cost is independent of the production volume,
i.e., that the marginal cost curve is horizontal. This follows from the fact that the production
function is homogeneous of degree one, i.e., that the underlying technology exhibits constant

returns to scale. In other words there are no supply functions, and the level of output in
equilibrium is determined by the demand at a price equal to marginal cost.
Demand for Goods
The demand for goods is a consequence of the fact that households allocate their disposable
incomes among different commodities in order to maximize their well-being. Formally, this
means that each household maximizes a utility function under the constraint that expenditures
should be equal to disposable income. In the following, all households are aggregated into a
single household sector. As the households jointly own all disposable income of the aggregated
household, m, is equal to the national income. The disposable income consists of the national
income the net of transfers from the rest of the world. We denote the net transfer as vg where v
is the exchange rate between domestic and foreign currency. In other words,

m = wn + rk + vg ;

(14)

where n and k are the total supplies of labor and capital.

In order to simplify the derivation of the demand functions, we assume that the preferences of
the aggregated household can be represented by a utility function of Cobb-Douglas type, i.e.,
the same kind of function as the production function (1). As is well known, however, utility
cannot be measured in absolute terms in a meaningful way. This means that the utility function
only ranks different consumption alternatives1. This, in turn, means that all transformations of
the utility function that maintain the order of preference between the different combinations of
goods are equally good as descriptions of the underlying preferences. Taking logs is such a
transformation, which also facilitates the derivation of the demand functions we are looking for.
Against this background the decision problem of the household can be formulated in the
following way:

max b ln c1 1 b ln c2
c1c2

s.t. p1 c1 p2 c2 m ;

(15)

To solve this problem we can form a Lagrange function, i.e., the function
1

Thus, if the value of the utility function is 2 for consumption alternative A and 1 for consumption
alternative B, it means that the household prefers A to B, It does not however, mean that a is
conceived as twice as good as B.

L c1 , c 2 , b ln c1 1 b ln c 2 m p1c1 p 2 c 2 ;

(16)

and maximize it with respect to c1 and c2. This means that we should determine the partial
derivatives of the function with respect to c1 and c2 and set each one of them equal to zero. This
operation gives
b
p1 0 ;
c1

(17)

1 b p

c2

(18)

which, after elimination of , leads to

b p2 c2 = p1 c1 b p1 c1 ;

(19)

If we now utilize the budget constraint this can be written

b m = p1 c1 ;

(20)

which, together with (14), becomes the demand function for commodity 1, i.e.,

c1 p1 , p2 , w, r , v

b wn rk vg
p1

(21)

and in the corresponding way the demand function for commodity 2 becomes

c 2 p1 , p 2 , w, r , v

1 b wn rk vg
p2

(22)

As we deal with an open economy faced with given prices on internationally traded goods, the
domestic goods prices are equal to the world market prices expressed in domestic currency. In
other words,
p1 vp1w

(23)

p 2 vp 2w

(24)

with obvious notations. This means that in their final form the demand functions can be
written.

c1 p1 , p 2 , w, r , v
c 2 p1 , p 2 , w, r , v

b wn rk vg
vp1w

1 b wn rk vg
vp 2w

(25)

(26)

Current Account
In an open economy export can be seen as an activity "producing" foreign currency, thereby
facilitating the import of goods and services. All imports must be. financed by exports, loans or
gifts from the rest of the world. We disregard loans and let g denote gifts from the rest of tl!e
world. Accordingly the following conditions for the current account must be satisfied in
equilibrium :
p1w z1 p2w z2 g 0 ;
(27)

Multiplication by the exchange rate, v, transforms the balance equation to a condition in

domestic currency, but naturally does not change its real economic signification. Substituting
(23) and (24) we can write the current account in foreign currency as
p1 z1 p2 z2 vg 0 ;

(28)
The Complete General Equilibrium Model
By means of the equations derived in the preceding sections it is now a possible to formulate a
complete general equilibrium model of our open economy. The relevant equations can be
divided into two groups, one concerning product markets and the other concerning factor
markets. We then get
Product Markets
a. Supply ( = production ) equal to demand ( = consumption plus net export )
7

X1
x2

b Wn Rk Vg
Z1
P1

1 b wn rk vg z
p2

(i)
;

(ii)

b. Price equal to marginal cost

p1 A11 a1 a1 1 a1

a1 1

w a1 r 1 a1

a2 1

w a2 r 1a2 ;

(iii)

p 2 A21 a 2a2 1 a 2

(iv)

c. Internationally determined product prices

p1 vp1w ;

(v)

p2 vp2w ;

(vi)

d. Equilibrium conditions for the current account

p1 z1 p2 z2 vg 0 ;

(vii)
Factor Markets
Supply (=given quantities) equal to demand

a1r

n A
1 a1 w
(viii)
1
1

a1 r

k A

1
1

1 a1

a2 r

x1 A
1 a2 w
1
2

a1

a2 r

x1 A

1
2

1 a2

x2

a2

x2

(ix)

In all, the model has nine so-called endogenous variables, i.e., variables determined within the
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the model. These variables are: x1, x2, z1, z2, p1, p2, w, r, v. However, the general price level
does not affect allocation of resources in this model; a proportional change of all product and
factor prices and the exchange rate does not affect the equilibrium conditions. In other words
the model can only determine relative prices.
This means that we have to normalize the price system of the model. The standard approach is
to set the sum of all prices equal to unity. However, if we are sure that all prices are positive in
equilibrium, which is the case in the model presented here, one can alternatively set a specific
price equal to unity. In this model we set the price of foreign currency equal to unity, i.e.
V

= 1;

(x)

With this addition the model has ten equations but only nine endogenous variables. .However,
according to Walras' Law, equilibrium on four of the five markets of the model economy (two
goods markets, two. factor markets and one market for foreign currency) leads to equilibrium
also on the fifth market. Thus one of the equilibrium conditions is superfluous. We.choose to
omit the constraint for the current account, which means that the model in its final form can be
written:
Product Markets
a. Supply ( = production ) equal to demand ( = consumption plus net export )

x1

x2

b wn rk vg
z1
p1

1 b wn rk vg z
p2

b. Price equal to marginal cost

p1 A11 a1 a1 1 a1

a1 1

w a1 r 1 a1

p 2 A21 a 2a2 1 a 2

a2 1

w a2 r 1a2 ;

c. Internationally determined product prices

p1 p1w ;
p2 vp2w ;

Factor Markets
Supply ( = given quantities ) equal to demand

a1r

n A
1 a1 w
1
1

1 a1

a1 r

k A
1 a1 w
1
1

a2 r

x1 A
1 a2 w
1
2

a1

a2 r

x1 A
1 a 2 w
1
2

1a2

x2 ;

a2

x2

Note that the model can. easily be converted to a model of a closed economy by deleting
section c (Internationally determined product prices) and the current account balance
constraint.
Model Variants
In the following, the above model will be used for numerical comparative static
experiments. Thus we will show how variations in exogenous variables such as world
market prices and domestic factor supply influence resource allocation and factor prices.
For these experiments, we specify two variants of the model. The first variant is identical
with the above "base model" and is denoted the H(eckscher)-O(hlin) model. The reason
for this is that, apart from the specific ftmction forms, the model builds on exactly the
same conditions as the theory for international trade usually associated with the Swedish
economists Eli Heckscher and Bertil Ohlin. The other variant is denoted the T-NT model
and is worked out to illustrate resource allocation between the tradables (T) and the NonTradables (NT) producing sectors in an open economy. The step from the H-O model to
10

the T-NT model is short. Assuming that sector 2 is the NT -sector, we only have to
eliminate the variable Z2 and the equation p2 = v p2w.

Parameter Values and Base Case

In order to solve the model numerical values for a number of parameters and exogenous
variables have to be determined. In the experiments shown in the following sections we
assume that there are 100 units of labor and 100 units of capital and that the net gift from
abroad is zero. The assumptions are chosen to make net export equal to zero and all goods
and factor prices equal to the 'base case". Consequently GDP is 200 .
The parameter b in the utility function of the household is assumed to be 0.50.
Furthermore, the following numerical values are used.

Sector/Commodity

aj

Aj

pwj

1 (T)

0.75 1.7548

1.00

2 (NT)

0.25 1.7548

1.00

The values chosen for parameters aj means that sector 1 (the T-sector) is labor-intensive
intensive, while sector 2 (the NT-sector) is capital-intensive. The following equilibrium
values for the endogenous variables (with the terms of the T-NT model in parenthesis)
apply in the base case:

X1
X2
Z1
Z2

p1
p2
w
r

Variable
(XT)
(XNT)
(ZT)
(-)
( pT )
( pNT )

Values in Base Case

100
100
0
0
1.00
1.00
1.00
1.00

11

Production and use of resources in the base case can also be described by means of the
following so-called SAM (Social Acconnting Matrix) where h is the aggregated domestic
household and row is the "rest of the world.

Social Accounting Matrix for Small Open Economy

( note : along the rows are shown incomes )

X1
X2
L
K
Hh
RoW
Total

X1

X2

75
25

25
75

0
100

0
100

100

100

Hh
100
100

RoW
0
0

Total
100
100
100
100

200
0

100

100

200

( note : down the columns are shown expenditures )

Experiments with the H-O Model

The next step is to to use the models for controlled experiments, i.e., variations of one
exogenous variable at a time. In. this section we show two experiments.The first
experiment is bult on the assumption that the world market price of commodity 1, i.e., the
labor-intensive commodity, rises by 10 per cent under otherwise unchanged conditions.
The experiment can be seen as an illustration of the so-called Stolper-Samuelson
Theorem. The other experiment assumes that the supply of labor increases by 10 per cent
under otherwise unchanged conditions and can be seen as an illustration of the so-called
Rybczynski Theorem. Please observe that the goods prices are set on the world market.
The results are summarized in the following table (please note that the consumption of each
commodity is equal to production mmus net export).

12

X1
X2
Z1
Z2

p1
p2
w
r

Values in Base Case

100
100
0
0
1.00
1.00
1.00
1.00

p1w

10% higher

114
85
18
-20
1.10
1.00
1.15
0.95

n 10% higher
115
95
10
-10
1.00
1.00
1.00
1.00

As will be seen by the table, a price increase for the labor-intensive commodity by 10 per cent
leads to an increase of wages (w) and a decrease of the capital remuneration (r). Please
observe that the wage-increase is larger than 10 percent, i.e., larger than the price increase for
labor-intensive products. This is the the key insight provided by the so-called StolperSamuelson Theorem.
The increased supply of labor leads to an increase in the production of the labor-intensive
commodity and a decrease in the production of the capital-intensive commodity at unchanged
factor intensity. The conclusion about factor intensities fol1ows from the fact that the relative
factor prices are not affected by the change in aggregated factor supply. This result is the key
insight provided by the so-called Rybczynski Theorem.

Experiments with the T-NT Model

13

The T-NT model can be used to illustrate how a "currency gift", for example the discovery of
natural gas that can be sold on the international market with essentially no input of domestic
resources, will influence the use of resources and factor prices. The issue was brought up in
connection with a phenomenon called the "Dutch Disease", which concerned the consequences
for the Dutch economy of the discovery of large amounts of natural gas in the Groningen field.
Similar issues have been brought up in Norway. In the experiment the "gift" is supposed to
correspond to 10 income units. Please observe that the price of the T-commodity is set on the
world market. The results are summarized in the following table (please note that the
consumption of each commodity is equal to production minus net export)

X1
X2
Z1

p1
p2
w
r

Values in Base Case

100
100
0
1.00
1.00
1.00
1.00

Currency Gift of 10
96
104
-10
1.00
1.03
0.99
1.04

As will is seen in the table, the "currency gift" leads to a restructuring of production in the
direction of the NT-sector, and this restructuring is "driven" by a relative price increase of the
NT-commodity.

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