The Theory of Trade

1
The Theory of Trade

• Phillip J. Bryson
• Marriott School

2
Production and Transformation
Unattainable combinations

• Production Possibilities Curve, or Transformation
  Curve
• Resource scarcity and social choice.
• Ricardian vs. Modern PPCs
• Law of increasing opportunity costs

. .
C Goods
Line of attainable Combinations
.
.
.
Attainable (but Inefficient) combination
Def Goods
3
Increasing opportunity costs transformation
Some resources are Poorly suited to produce D
goods, others to produce C goods.

• More and more resources
• must be transferred from defense to consumer
• goods, to provide increases of equal
  increments in consumer goods.

?D1 ?D2 ?D3 ?D4
?C1 ?C2 ?C3 ?C4
4
Increasing opportunity costs transformation
The slope of the Trans Curve shows the rate at
which one commodity can be traded for
the other in
production

• Increasing amounts must be sacrificed from
  defense goods to produce additional, constant
  increments of C goods.

?D1 ?D2 ?D3 ?D4
?C1 ?C2 ?C3 ?C4
5
Modern vs. Ricardian Transformation
Note that Ricardos 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
• 1 bushel of wheat 2 hours lt 2.5 hours
• I yard of cloth 4 hours gt 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?
  
• United
  States ROW
• Price of wheat 0.5 yard/bushel 2.5
  yards/bush
• (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 wheatin 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
.5
1
10 bushels
20 yards
Cloth
8
The price of a bushel of wheatin 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).

.
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.

We could actually gain more by specializing in
wheat before trading for cloth.
W
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
Cl
10
Attaining the Unattainable

• Through trade, we can move from a point on the
  PPC to points outside it, points that were
  previously unattainable.

We could actually gain more by specializing in
wheat before trading for cloth. With a modern
PPC, we will not specialize completely.
W
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
Cl
11
Attaining the Unattainable

• Different countries will face different prices
  (line slope) as
• they look for ways to trade beyond their PPC.

An important question is where will we choose to
produce, trade, and consume outside the PPC?
W
W
At point A?
At point B?
. C
. B
At point C?
.
B
.
.
A
.
A
.
C
.
0
0
Cl
Cl
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
Some combinations of hand grenades and pretzels
will be found of equal value by President George
W. Bush.

• 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.

HGs
. . .
Pretzels
14
Indifference Curves
Some combinations of hand grenades and pretzels
would not be found of equal value by President
Bush.

• Such points, and an infinite number of others can
  be joined together as an indifference curve.

HGs
. . .
. .
Pretzels
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.

Clear improvement more of one good, no less of
the other, or
Y
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
dont know if its an improvement until we
know how each good is valued.
X
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.

?Y1
?Y2
?Y3
?X1 ?X2 ?X3
18
Characteristics of Indifference Curves

• Transitivity, or consistent tastes.
• If AgtB and BgtC, AgtC
• (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) AgtBgtC Counting the votes for
• 2) BgtCgtA 1 and 3 we see AgtB.
• 3) CgtAgtB Counting for 1 and 2
• BgtC. May we infer then, without further
  counting, that AgtC.

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
We asked earlier where we will choose to
produce, trade, and consume once we are outside
the PPC?
W
W
At point A?
At point B?
. C
. B
At point C?
.
B
.
.
A
.
A
.
C
.
0
0
Cl
Cl
21
We will choose the point that is located on the
indifference curve furthest to the Northeast!
The tangency of the indifference curve to the
terms of trade line will determine the optimal
point of consumption, given production and trade
possibilities.
W
W
T
. C
CIC
. B
.
B
.
.
T
A
.
A
.
C
CIC
.
T
T
0
0
Cl
Cl
22
Lets 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
T
.
G2
Old production points
.
T
New production G2 , O2
.
Now, trading along TT, the UK and SA can
consume outside their PPC.
T
.
G2
T
O2
O2
24
Trade Theory bottom line one more time!

• Trading along TT, the UK and SA can
• consume outside their PPC.

Social choice (the CIC) will determine whether
the UK and SA will consume at C or D.
T
England
South Africa
.
.C
.
T
. D
. D
CIC
CIC
.
.C
T
.
T