Neoclassical Theory

Problems With Classical Theory Labor Theory of Value unrealistic Assumption of constant opportunity costs too restrictive Demand is largely ignored

Increasing Opportunity Cost The PPF is bowed out, not a straight line This is because resources are not equally suited to all kinds of production

The PPF with Increasing Opportunity Costs Y X PPF

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 –MC X /MC Y

The PPF with Increasing Opportunity Costs Romance Novels Econ. Journal Articles A B C D The opportunity cost of the 16th journal article is more than that of the 6th. Therefore, the PPF must be bowed out.

The Relative Price Line The price of good X in terms of good Y is represented by the slope of a downward- sloping straight line

The Relative Price Line Here X is relatively cheap ( P x /P y is small) Y X Slope = P x /P y

The Relative Price Line Here X is relatively expensive ( P x /P y is big) Y X Slope = P x /P y

Producer Equilibrium Producers will choose to produce where the relative cost of producing one more unit of X is just equal to the relative price at which the producer can sell a unit of X That is, equilibrium occurs where MC X /MC Y = P X /P Y

The PPF with Increasing Opportunity Costs Y X PPF

Producer Equilibrium Y X E Autarky Price Line PPF At point E, MC X /MC Y = P X /P Y

Producer Equilibrium Y X PPF At point Q, MC X /MC Y < P X /P Y, so more X and less Y will be produced Q P X /P Y MC X /MC Y

Producer Equilibrium Y X PPF At point Z, MC X /MC Y > P X /P Y, so less X and more Y will be produced MC X /MC Y P X /P Y Z

Producer Equilibrium Neither Q nor Z can be equilibria Only when MC X /MC Y = P X /P Y will equilibrium be attained (that is, only at point E)

Preferences: Including the Demand-Side The aggregated preferences of a country can be represented by community indifference curves

Community Indifference Curves Y X A B

Y X A B Consumers are indifferent between pt. A and pt. B, and all other pts. on the CI

Community Indifference Curves Y X A B 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

Community Indifference Curves Y X CI 1 CI 2 CI 3 CI 4

Consumer Equilibrium Given relative prices (P X /P Y ), consumers will choose a combination of X and Y that puts them on the highest possible community indifference curve

Consumer Equilibrium Y X CI 1 CI 2 CI 3 CI 4 Price line E

Autarky Equilibrium In equilibrium, supply and demand jointly determine P X /P Y, and therefore how much X and Y is produced (and consumed)

Autarky Equilibrium Y X E X1X1 Y1Y1 Community Indifference Curve PPF

Production in Trade Let’s suppose that Country A has a comparative advantage in good X What will happen to the relative price of good X as Country A moves to trade? It will rise (otherwise, Country A would not wish to produce more of good X in order to export it)

Production in Trade Y X E X1X1 Y1Y1 E' X2X2 Y2Y2 Int’l Price Line Autarky Price Line

Production in Trade Y X E X1X1 Y1Y1 E' X2X2 Y2Y2 Int’l Price Line Autarky Price Line Steeper int’l price line means P X /P Y has increased

Trade Equilibrium Y X E' X2X2 Y2Y2 C' X3X3 Y3Y3 F

Trade Equilibrium Y X E' X2X2 Y2Y2 C' X3X3 Y3Y3 F Country A exports X 3 X 2, and imports Y 3 Y 2 exports imports

Movement From Autarky to Trade (Country A’s Perspective) Movement to trade causes relative price of good X to rise Higher relative price of X triggers a shift in production: more X will be produced, less Y Higher relative price of X lowers consumption of X, raises consumption of Y Extra X is exported, shortfall in Y is met by imports

Countries A and B Together Let’s continue to suppose that A has a comparative advantage in good X Therefore, B must have a comparative advantage in good Y It must also be true that (P X /P Y ) A < (P X /P Y ) B

Autarky in Countries A and B Country A Country B YY XX (P X /P Y ) A (P X /P Y ) B X1X1 Y1Y1 X4X4 Y4Y4 E e

Autarky to Trade in A and B Country A Country B YY XX X1X1 Y1Y1 X4X4 Y4Y4 E e (P X /P Y ) T

Production in Trade in A and B Country A Country B YY XX X1X1 Y1Y1 X4X4 Y4Y4 E e (P X /P Y ) T X2X2 Y2Y2 X5X5 Y5Y5 e' E'

Consumption in Trade in A, B Country A Country B YY XX X1X1 Y1Y1 X4X4 Y4Y4 E e X2X2 Y2Y2 X5X5 Y5Y5 e' E' C' c'

Exports, Imports in A and B Country A Country B YY XX X1X1 Y1Y1 X4X4 Y4Y4 E e X2X2 Y2Y2 X5X5 Y5Y5 e' E' C' c' X3X3 Y3Y3 F Imp. Exp. X6X6 Y6Y6 Imp.

Minimum Conditions for Trade Trade will be mutually advantageous as long as the two countries’ APRs differ This can occur because of: –differences on the supply side, or –differences on demand side, or –both

Identical Demand Conditions Suppose that the citizens of Country A have the exact same tastes and preferences as the citizens of Country B Then their community indifference curves would be identical Autarky prices will still differ between the countries as long as the countries differ on their supply sides

Identical Demand Conditions Y X Country B’s PPF Country A’s PPF

Identical Demand Conditions Y X (P X /P Y ) A (P X /P Y ) B CI 1 e E X1X1 Y1Y1 X4X4 Y4Y4

Identical Demand Conditions Y X CI 1 e E X1X1 Y1Y1 X4X4 Y4Y4 (P X /P Y ) T f F X3X3 Y3Y3 X5X5 Y5Y5

Identical Demand Conditions Y X CI 1 (P X /P Y ) T f F X3X3 Y3Y3 X5X5 Y5Y5 CI 2 C’,c' X2X2 Y2Y2

Identical Demand Conditions Even if demand conditions are the same, differences in supply conditions would cause differences in APRs across countries, and so: Trade could still be mutually advantageous Implicitly, this is what is going on in the Classical model

Identical Supply Conditions What if two countries have identical technologies and resource endowments? Then their PPFs would be identical The Classical model would predict no trade, but what does the Neoclassical model show?

Identical Supply Conditions Y X PPF for both countries

Identical Supply Conditions Y X (P X /P Y ) A (CI 1 ) A (CI 1 ) B (P X /P Y ) B E e Y1Y1 Y4Y4 X1X1 X4X4

Identical Supply Conditions Y X E e Y1Y1 Y4Y4 X1X1 X4X4 E’, e' (P X /P Y ) T X3X3 Y3Y3

Identical Supply Conditions Y X E e Y1Y1 Y4Y4 X1X1 X4X4 E’, e' X3X3 Y3Y3 C' c' X5X5 Y5Y5 X2X2 Y2Y2

Identical Supply Conditions Y X E’, e' X3X3 Y3Y3 C' c' X5X5 Y5Y5 X2X2 Y2Y2 F f A’s imp. A’s exp. B’s exp. B’s imp.

Identical Supply Conditions Even if supply conditions are the same, differences in demand conditions would cause differences in APRs across countries, and so: Trade could still be mutually advantageous This was not a possibility in the Classical model, because it assumed away demand