Neoclassical Trade Theory: Tools to Be Employed

1
Neoclassical Trade Theory Tools to Be Employed

• Appleyard Field ( Cobb) Chapters 57

2
Basic Concepts for the Consumer Theory

• Bundle combination of goods (that are being
  consumed)
• If a consumer gets the same amount of utility
  from bundle A as from bundle B, she is
  indifferent between A and B
• Indifference curve is a set of all bundles that
  yield the same utility
• Slope of the indifference curve marginal rate
  of substitution (MRS) the increase of one good
  needed to compensate the loss of another good
• diminishing MRS ? declining marginal utility ?
  convex indifference curve ? concave utility
  function

3
Indifference Curve (two goods)
Good Y
Higher utility
12
Indifference curve 2
4
Indifference curve 1
10
3
Good X
4
Budget Constraint and the Equilibrium

• Budget constraint (budget line) maximum
  combinations of goods that can be bought with a
  fixed level of income (given the prices)
• Consumer maximizes her utility given her income
  and prices ? consumer chooses the highest
  indifference curve available
• In equilibrium MRS MUY/MUX PX/PY

5
The Consumer Equilibrium
Good Y

• Budget Constraint PXXPYY income
• Yincome/PY PX/PYX
• That is, slope of the budget constraint PX/PY

• Indifference Curve MUXXMUYYinitial utility
• Y (initial utility)/MUY-MUX/MUYX
• That is, slope of the indifference curve
  -MUX/MUY

Equilibrium PX/PYMUX/MUYMRS
y
x
Good X
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Marginal Utility Product

• Marginal utility the additional utility from
  consuming an additional (very small) unit of a
  good.
• Typically we assume that this is decreasing as
  consumption of a good increases, e.g. increasing
  the consumption of water from zero to one litre a
  day increases utility more than a change of
  consumption from 1000 to 1001 litre a day.
• Marginal product additional output from using
  an additional (very small) unit of factor of
  production.
• Typically we assume that if you keep the other
  factors of production constant, the marginal
  product is decreasing, e.g. you have 10 shovels
  (capital), then increasing the number of workers
  from 9 to 10 increases output more than
  increasing the workers from 10 to 11.

7
Production Capital and Labour
Low K/L ratio
High K/L ratio
Capital (K)
Capital (K)
Labour (L)
Labour (L)
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Basic Concepts for the Production Theory

• Isoquant combinations of inputs that produce
  the same level of output
• Slope of the isoquant Marginal rate of
  technical substitution (MRTS) the increase of
  an input needed to maintain the level of output
  after a decrease of another input
• Isocost combination of factors that can be
  bought for given input costs

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Producer Equilibrium

• Isocost PKKPLLcost of production
• K(cost of production)/PK PL/PKL

Capital

• Isoquant MPPKKMPPLLoutput
• K (output)/MPPK-MPPL/MPPKK

Equilibrium MRTSMPPL/MPPKPL/PK (Firm chooses
inputs to minimize the cost for given output)
K
Isoquant
Isocost
Labour
L
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Generalizing for the Whole Economy

• Community Indifference Curve
• If a give amount of good X is taken away from the
  economy how much of good Y is needed to put all
  consumers back to their initial utility level?
• Production Possibilities Frontier
• What can be produced given the resources of the
  economy ( budget constraint of the country)
• Instead of thinking about individuals, we now use
  the same ideas to think about whole countries.
  Note, however, that while this gives us the great
  gain of being able to use the powerful framework
  of the decision theory, one should be cautious of
  thinking about countries as if they were
  individuals. This point will be discussed in more
  detail later in the course.

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Production Possibilities Frontier (PPF) Constant
Opportunity Cost
Good Y
40
20
Good X
10
20
12
PPF Increasing Opportunity Cost
Good Y

• Why?
• Rising marginal cost
• Specific factors
• Different factor intensities

40
15
5
10
20
22
Good X
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Autarky Equilibrium
Good Y
Equilibrium MRT PX/PY MRS
Y
Community Indifference Curve slope -MUY/MUX
-MRS
Production Possibilities
Slope -PX/PY
Slope -Marginal Rate of Transformation (MRT)
X
Good X
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Gains from Trade

• Assuming
• Costless factor mobility
• Full employment of factors of production
• The indifference curve can show welfare changes
• For more discussion, see Appleyard and Field
  around page 93-95.

(PX/PY)FT
Good Y
Equilibrium MRT (PX/PY)FT MRS
YC
Imports
YA
YP
(PX/PY)A
XC
XA
XP
Good X
Exports
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Consumption and Production Gains
(PX/PY)FT
Good Y
production gain
consumption gain
(PX/PY)A
Good X
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Mutual Gains
Country 1
Country 2
(PX/PY)FT
(PX/PY)FT
Good Y
Good Y
YP
YC
YA
Exports
YC
Imports
YA
YP
(PX/PY)A
(PX/PY)A
XA
XP
XC
XA
XP
XC
Good X
Good X
Exports
Imports
Note that the graphs are not drawn accurately. In
a two-country model, the amount of imports of
good Y from Country 1 must equal the amount of
exports of good Y to Country 2 (and similarly for
good X)
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Identical PPF, Different Preferences
(PX/PY)FT
Good Y
(PX/PY)A
(PX/PY)A
Good X
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Defining Central Concepts for Neoclassical Trade
Theory

• Terms of Trade PX/PM
• the world price of a country's exports relative
  to the world price of its imports
• PX/PY in the two-country-two-goods-model
• terms of trade improve when this index rises,
  i.e. for the same amount of exports the country
  will get a larger amount of imports
• Offer Curve reciprocal demand curve indicating
  countrys quantity of imports and exports at all
  terms of trade

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Other Concepts Called Terms of Trade

• Income Terms of Trade (PX/PM)QX
• Index of total export earnings PXQX divided by
  price of imports ? countrys ability to import
• Single Factoral TOT(PX/PM)OX
• Oproductivity index. Intuition the amount of
  imports available for unit of work effort
• Double Factoral TOT(PX/PM)(OX /OM)

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Deriving the Offer Curve
Note that there is a mistake in AF Figure 4 page
99 (in the 4th ed.)
Offer Curve
Good Y
YC
(PX/PY)1 TOT1
Imports1
YP
(PX/PY)2 TOT2
(PX/PY)1
XP
XC
Good X
Exports1
Potential price lines PXQXPYQY
? QY(PX/PY)QX i.e. given the prices, the value
of exports equals the value of imports
Good Y
YC
Imports1
Imports2
YP
Imports2
(PX/PY)2
Exports2
XP
XC
Good X
Exports1
Exports2
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Putting the Offer Curves to One Graph
Country 2
Country 1
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Trading EquilibriumThe determination of
international prices
(PX/PY)E TOTE
(PX/PY)
Country 2s offer curve
Good Y Imports to country 1 exports from
country 2
Country 1s offer curve
Good X Exports from country 1 Imports to
country 2
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Shift of Offer Curves (1)

• Assume that in Country 1 there is shift in
  preferences and the taste for imports (good Y)
  increases
• That is, for every terms of trade, country 1 is
  willing to trade more
• That is, the offer curve shifts rightwards

OC1
OC0
(PX/PY)1
(PX/PY)2
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Shift of Offer Curves (2)

• New equilibrium
• More trade
• New terms of trade new relative prices
• (PX/PY)E lt (PX/PY)E
• i.e. the relative price of good Y increase

(PX/PY)E TOTE
(PX/PY)E TOTE
Country 2s offer curve
Good Y Imports to country 1 exports from
country 2
Country 1s offer curves
Good X Exports from country 1 Imports to
country 2
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Improvement in Terms of TradeSubstitution,
Production and Income Effects

• Improvement in Terms of Trade ? relative price of
  the exported good X increases ? relative price of
  the imported good Y decreases
• Substitution effect consumers shift their
  purchases towards the imported goods
• Production effect producers start producing more
  exports
• Income effect (terms-of-trade effect) real
  income of the home country rises (more demand for
  both X and Y)