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

5-2 Consumer Behavior Theory  How do consumers decide how much of each good to consume?

5-3 Consumer 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.

5-4 Consumer Indifference Curves Y X S1S1 S2S2 S3S3 Utility on S 3 > Utility on S 2 > Utility on S 1

5-5 Consumer Indifference Curves  are downward sloping because the goods are substitutes.  Slope is marginal rate of substitution (MRS): MU x /MU y.  are convex because of the principle of diminishing MRS.  represent the welfare of an entire country, not an individual.

5-6 Consumer Budget Constraint Y X 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 –P x /P y.

5-7 Consumer Equilibrium  Given relative prices (P X /P Y ) 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 (MU X /MU Y ) = (P X /P Y ).

5-8 Consumer Equilibrium Y X S1S1 S2S2 S3S3 Budget constraint E

5-9 Production Theory  How do producers choose the mix of inputs to use?  What determines production efficiency within the firm?

5-10 Isoquants Capital (K) Labor (L) A B 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). Isoquants shows the combinations of K and L that produce the same level of output.

5-11 Isoquants K L Q 1 = 75 units of output Q 2 =100 units of output Q 3 = 125 units of output Output on Q 3 > Output on Q 2 > Output on Q 1

5-12 Isoquants  are downward sloping because K and L are substitutes.  Slope is marginal rate of technical substitution (MRTS): MPP L /MPP K.  MRTS declines as more L and less K are used.  We’ll assume that production exhibits constant returns to scale.

5-13 Isocost Lines K L 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 –P L /P K or –w/r.

5-14 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 (MPP L /MPP K ) = (w/r).

5-15 Producer Equilibrium K L Q1Q1 Q2Q2 Q3Q3 isocost line E

5-16 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.

5-17 Edgeworth Box

5-18 Production Possibilities Frontier  Most PPFs are bowed out, not straight lines.  This is because resources are not equally suited to all kinds of production.

5-19 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.

5-20 The PPF with Increasing Opportunity Costs Y X PPF