1. Gains from Trade in Neoclassical Theory
Chapter 6
Gains from Trade in Neoclassical Theory
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Learning Objectives
Describe economic equilibrium in a country that has no trade.
Discover the welfare enhancing impact of opening a country to trade.
Demonstrate that either supply differences or demand differences between countries are sufficient to generate a basis for trade.
Distinguish the implications of key assumptions in the neoclassical trade model.

3. Problems With Classical Theory
Labor theory of value is unrealistic.
Assumption of constant opportunity costs is too restrictive.
Demand is largely ignored.

4. Autarky Equilibrium In the absence of trade
producers will seek to maximize profits.
consumers will seek to maximize utility.

5. Production Equilibrium In Autarky
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 MCX/MCY = PX/PY.

6. Producer Equilibrium in Autarky
At point E, MCX/MCY = PX/PY. E
Autarky Price Line
PPF X

7. Consumer Equilibrium in Autarky
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).

8. Consumer Equilibrium Y
Budget constraint E
CI4
CI3
CI2
CI1 X

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

10. Autarky Equilibrium Y Community indifference curve E Y1 Price line PPFX1 X

11. The Introduction of International Trade
Trade will cause relative prices to change.
Producers will respond to this by altering relative production of goods X and Y.
Consumers will respond to this by altering relative consumption of goods X and Y.

12. 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).

13. Production in Trade Y Steeper int’l price line
means PX/PY has increased. E Y1 E'
Autarky Price Line Y2
Int’l Price Line X1 X2 X

14. Trade Equilibrium Country A exports X3X2 (the
distance FE’), and imports
Y3Y2 (the distance FC’). Y C' Y3
imports F E' Y2
exports X3 X2 X

15. Movement From Autarky to Trade
Movement to trade causes relative price of good X to rise.
Higher relative price means 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.

16. Production and Consumption Gains from Trade
There are two distinct sources of trade gains
Consumption gain: even if producers don’t change production levels, welfare is enhanced.
Production gain: specialization in the comparative advantage product leads to higher welfare.

17. Consumption Gains Even if producers don’t change Y
production levels in response
to a change to (Px/Py)2, the new
consumer equilibrium at C is
on a higher indifference curve. Y C' C E E'
(Px/Py)2 X

18. Production Gains Eventually producers adjust Y
production levels to E’. This
permits additional gains to C’. Y C' C E E'
(Px/Py)2 X

19. 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 (PX/PY)A < (PX/PY)B.

20. Exports, Imports in A and B
Country B Y
Country A Y e' Y5 C' Y3
Exp. E e Y1 Y4 c'
Imp. Y6 E' Y2
Imp.
Exp. X3 X1 X2 X X5 X4 X6 X
6-20

21. 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.

22. 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.

23. Identical Demand Conditions
(PX/PY)T Y
CI1 Y5 f
C’, c’
CI2 Y2 Y3 F
(PX/PY)T X5 X2 X3 X
6-23

24. 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.

25. 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?

26. Identical Supply Conditions
PPF for both countries X
6-26

27. Identical Supply Conditions
(CI1)A E Y1
(PX/PY)A e Y4
(PX/PY)B
(CI1)B X1 X4 X
6-27

28. Identical Supply Conditions
E’, e'
(PX/PY)T e Y4 X1 X3 X4 X
6-28

29. Identical Supply Conditions
E’, e' e Y4 c' Y5 X2 X1 X3 X4 X5 X
6-29

30. 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.