1. The Theory of Trade Phillip J. Bryson Marriott School

2. Production and Transformation ► Production Possibilities Curve, or Transformation Curve ► Resource scarcity and social choice. ► Ricardian vs. Modern PPCs ► Law of increasing opportunity costs Unattainable combinations. Attainable (but Inefficient) combination. Line of attainable Combinations.. Def Goods C Goods

3. Increasing opportunity costs transformation ► More and more resources must be transferred from defense to consumer must be transferred from defense to consumer goods, to provide increases of equal increments in consumer goods. goods, to provide increases of equal increments in consumer goods. ∆C1 ∆C2 ∆C3 ∆C4 ∆D1 ∆D2 ∆D3 ∆D4 Some resources are Poorly suited to produce D goods, others to produce C goods.

4. Increasing opportunity costs transformation ► Increasing amounts must be sacrificed from defense goods to produce additional, constant increments of C goods. ∆C1 ∆C2 ∆C3 ∆C4 ∆D1 ∆D2 ∆D3 ∆D4 The slope of the Trans Curve shows the rate at which one commodity can be traded for the other in production

5. Modern vs. Ricardian Transformation Note that Ricardo’s linear transformation curve has constant opportunity costs of transformation. Inputs are perfect substitutes. Specialization can be complete. After specialization 20 bushels (40 hours) ---- 20 --- 40 yards (40 hours) 40

6. Trading (Not $) Prices in Commodity Space Remember how we calculated costs with Ricardo? Costs were based on pre-trade labor costs US ROW US ROW 1 bushel of wheat 2 hours <2.5 hours I yard of cloth 4 hours >1 hour In the U.S. how much wheat will one give for a yard of cloth? How much cloth with the ROW give for a bushel of wheat? How much cloth with the ROW give for a bushel of wheat? United States ROW United States ROW Price of wheat 0.5 yard/bushel 2.5 yards/bush Price of wheat 0.5 yard/bushel 2.5 yards/bush (=2/4) (=2.5/1) (=2/4) (=2.5/1) The price of wheat is how many yards of cloth we have to give up to get one more bushel.

7. The price of a bushel of wheat in terms of yards of cloth ► The price in commodity space can be seen as the slope of a line showing how much X you give up to get more Y. Wheat Cloth 20 yards 10 bushels.5 1

8. The price of a bushel of wheat in terms of yards of cloth ► Starting at any point (combination of wheat and cloth), and trade from that point along the line (at the rate of 2 bushels for 1 yard). point (combination of wheat and cloth), and trade from that point along the line (at the rate of 2 bushels for 1 yard). Wheat Cloth.....

9. Attaining the Unattainable ► Through trade, we can move from a point on the PPC to points outside it, points that were previously unattainable. W Cl. Starting at some point where our nation is producing and consuming, we discover we could trade a bushel of wheat for more than 2 yards of cloth in foreign markets. 0 We could actually gain more by specializing in wheat before trading for cloth..

10. Attaining the Unattainable ► Through trade, we can move from a point on the PPC to points outside it, points that were previously unattainable. W Cl. Starting at some point where our nation is producing and consuming, we discover we could trade a bushel of wheat for more than 2 yards of cloth in foreign markets. 0 We could actually gain more by specializing in wheat before trading for cloth. With a modern PPC, we will not specialize completely..

11. Attaining the Unattainable Different countries will face different prices (line slope) as they look for ways to trade beyond their PPC. W Cl 0. W 0 An important question is: where will we choose to produce, trade, and consume outside the PPC? At point A?.. A A At point B?. B B. At point C?. C. C.

12. Choosing A, B, or C ► The specific point of consumption, which a nation produces and trades to achieve, will be a matter of social choice. ► A “community indifference curve” reflects community choice and determines the point. ► An indifference curve shows a huge number of points of equal value to a consumer.

13. Indifference Curves ► Pres. Bush will be “indifferent” to certain combinations of HGs and Pretzels. As points move from left to right, the president has more pretzels, but fewer hand grenades. Some combinations of hand grenades and pretzels will be found of equal value by President George W. Bush.. Pretzels HGs

14. Indifference Curves ► Such points, and an infinite number of others can be joined together as an indifference curve. Some combinations of hand grenades and pretzels would not be found of equal value by President Bush.. Pretzels HGs.

15. Assumptions behind Indifference Curves ► Consumers are permitted to make choices in favor of goods and services they prefer. ► Their choices are consistent (transitive) ► More is preferred to less. ► Consumers have full knowledge of goods available and act rationally to optimize their consumption. ► Implicitly, goods are scarce, so rational consumption requires making choices.

16. Characteristics of Indifference Curves ► A movement to the North-East is an improvement. X Y Clear improvement: more of one good, no less of the other, or more of both. Clear loss: less of one good, no more The other, or less of both. Ambiguous: more of one, but less of the other. We don’t know if it’s an improvement until we know how each good is valued.

17. Characteristics of Indifference Curves ► Diminishing slope (“Marginal Rate of substitution of x for y,” or MRSxy) along the indifference curve. The MRSxy is the amount of y the consumer is just willing to give up to get one more unit of x. The consumer is willing to give up less of y as his supply declines and his stock of x is continually increasing. ∆X1 ∆X2 ∆X3 ∆Y1 ∆Y2 ∆Y3

18. Characteristics of Indifference Curves ► Transitivity, or consistent tastes. ► If A>B and B>C, A>C (“If A is preferred to B and B is preferred to C, A is preferred to C.”) ► For groups, or society as a whole, this may not work. Assume we have three individuals vote for their preferences. Will we get social transitivity? 1) A>B>CCounting the votes for 2) B>C>A1 and 3 we see A>B. 3) C>A>BCounting for 1 and 2 B>C. May we infer then, without further counting, that A>C.

19. The CIC and constraints ► We recognize that social transitivity cannot be taken for granted, but we can still gain a basic understanding of social choice using them. ► We want the indifference curve where we are ultimately located to be as far to the Northeast as possible. If Alpha Centauri is not possible, or even the moon, how about just atop Mount Timpanogas? ► What constrains how far to the northeast we can be situated? ► Of course! How far out we get depends on how well we produce, then trade.

20. Back to the social choice of A, B, and C W Cl 0. W 0 We asked earlier where we will choose to produce, trade, and consume once we are outside the PPC? At point A?.. A A At point B?. B B. At point C?. C. C.

21. We will choose the point that is located on the indifference curve furthest to the Northeast! W Cl 0. W 0.. A A. B B.. C. C. The tangency of the indifference curve to the terms of trade line will determine the optimal point of consumption, given production and trade possibilities. T T’ CIC T T’

22. Let’s look at that one more time! ► With the new prices that develop after trade opens, specialization is greater. England South Africa....

23. Trade Theory bottom line: one more time! ► With the new prices that develop after trade opens, specialization is greater. England South Africa.... Old production points New production: G 2, O 2 O2O2 O2O2 G2G2 G2G2 T T’ T Now, trading along TT’, the UK and SA can consume outside their PPC.

24. Trade Theory bottom line: one more time! ► ► Trading along TT’, the UK and SA can consume outside their PPC. EnglandSouth Africa.... T T’ T.C.C.C.C. D Social choice (the CIC) will determine whether the UK and SA will consume at C or D. CIC