Introduction to Neoclassical Trade Theory: Tools to Be Employed Chapter 5 Introduction to Neoclassical Trade Theory: Tools to Be Employed McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives Review the microeconomic principles of consumer and producer behavior. Explain the concepts and limitations of a community indifference curve. Examine the underlying basis for a production possibilities frontier with increasing opportunity costs.

Consumer Behavior Theory How do consumers decide how much of each good to consume?

Consumer Indifference Curves Y Consumers are indifferent between pt. A and pt. B, and all other pts. on the CI. There are many, many CIs each representing higher or lower levels of consumer satisfaction. A B X

Consumer Indifference Curves Y Utility on S3 > Utility on S2 > Utility on S1 S3 S2 S1 X

Consumer Indifference Curves are downward sloping because the goods are substitutes. Slope is marginal rate of substitution (MRS): MUx/MUy. are convex because of the principle of diminishing MRS. represent the welfare of an entire country, not an individual.

Consumer Budget Constraint Y Budget constraint shows combinations of X and Y that can be purchased with a given level of income at fixed prices. The slope of the budget constraint is –Px/Py. X

Consumer Equilibrium Given relative prices (PX/PY) and income, consumers will choose a combination of X and Y that puts them on the highest possible community indifference curve. Consumer equilibrium occurs where (MUX/MUY) = (PX/PY).

Consumer Equilibrium Y Budget constraint E S3 S2 S1 X

Production Theory How do producers choose the mix of inputs to use? What determines production efficiency within the firm?

Isoquants Capital (K) A B Labor (L) Isoquants shows the combinations of K and L that produce the same level of output. Producers can generate the same level of output using more K and less L (pt. A) or using less K and more L (pt. B). A B Labor (L)

Isoquants K Q3 = 125 units of output Q2 =100 units of output Output on Q3 > Output on Q2 > Output on Q1 Q3 = 125 units of output Q2 =100 units of output Q1 = 75 units of output L

Isoquants are downward sloping because K and L are substitutes. Slope is marginal rate of technical substitution (MRTS): MPPL/MPPK. MRTS declines as more L and less K are used. We’ll assume that production exhibits constant returns to scale.

Isocost Lines K Isocost line shows combinations of K and L that can be purchased with a given level of total cost at fixed factor prices. The slope of the budget constraint is –PL/PK or –w/r . L

Producer Equilibrium Given relative factor prices (w/r) and cost, producers will choose a combination of K and L that generates the maximum output. Producer equilibrium occurs where (MPPL/MPPK) = (w/r).

Producer Equilibrium K isocost line E Q3 Q2 Q1 L

The Edgeworth Box If we have two industries, it is instructive to combine isoquant-isocost diagrams for each into a single diagram. This construct is called an Edgeworth box.

Edgeworth Box

Production Possibilities Frontier Most PPFs are bowed out, not straight lines. This is because resources are not equally suited to all kinds of production.

Production Possibilities Frontier Slope of a tangent line at any point along the PPF is: the marginal rate of transformation, or the opportunity cost of the horizontal axis good, or MCX/MCY.

The PPF with Increasing Opportunity Costs X