Neoclassical Theory

Neoclassical Theory

Problems With Classical Theory

• Labor Theory of Value unrealistic

• Assumption of constant opportunity costs too restrictive

• Demand is largely ignored

Increasing Opportunity Cost

• The PPF is bowed out, not a straight line

• This is because resources are not equally suited to all kinds of production

The PPF with Increasing Opportunity Costs

Y

X

PPF

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

– MCX/MCY

The PPF with Increasing Opportunity Costs

RomanceNovels

Econ. JournalArticles

A B

C

D

5 6 15 16

5350

30

15

The opportunity cost of the 16thjournal article is more than that ofthe 6th.

Therefore, the PPF must be bowed out.

The Relative Price Line

• The price of good X in terms of good Y is represented by the slope of a downward-sloping straight line

The Relative Price Line

Here X is relatively cheap (Px/Py is small)Y

X

Slope = Px/Py

The Relative Price Line

Here X is relatively expensive (Px/Py is big)Y

X

Slope = Px/Py

Producer Equilibrium

• 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

The PPF with Increasing Opportunity Costs

Y

X

PPF

Producer Equilibrium

Y

X

E

Autarky Price Line

PPF

At point E, MCX/MCY = PX/PY

Producer Equilibrium

Y

X

PPF

At point Q, MCX/MCY < PX/PY,so more X and less Y will beproduced

Q

PX/PY

MCX/MCY

Producer Equilibrium

Y

X

PPF

At point Z, MCX/MCY > PX/PY,so less X and more Y will beproduced

MCX/MCY

PX/PY

Z

Producer Equilibrium

• Neither Q nor Z can be equilibria

• Only when MCX/MCY = PX/PY will equilibrium be attained (that is, only at point E)

Preferences: Including the Demand-Side

• The aggregated preferences of a country can be represented by community indifference curves

Community Indifference Curves

Y

X

A

B

Community Indifference Curves

Y

X

A

B

Consumers are indifferent between pt. Aand pt. B, and all other pts. on the CI

Community Indifference Curves

Y

X

A

B

Consumers are indifferent between pt. Aand pt. B, and all other pts. on the CI

There are many, many CIs each representing higher or lower levels of consumer satisfaction

Community Indifference Curves

Y

X

CI1

CI2

CI3

CI4

Consumer Equilibrium

• Given relative prices (PX/PY), consumers will choose a combination of X and Y that puts them on the highest possible community indifference curve

Consumer Equilibrium

Y

X

CI1

CI2

CI3

CI4

Price line

E

Autarky Equilibrium

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

Autarky Equilibrium

Y

X

E

X1

Y1

Community IndifferenceCurve

PPF

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)

Production in Trade

Y

X

E

X1

Y1

E'

X2

Y2

Int’l Price Line

Autarky Price Line

Production in Trade

Y

X

E

X1

Y1

E'

X2

Y2

Int’l Price Line

Autarky Price Line

Steeper int’l price linemeans PX/PY has increased

Trade Equilibrium

Y

X

E'

X2

Y2

C'

X3

Y3

F

Trade Equilibrium

Y

X

E'

X2

Y2

C'

X3

Y3

F

Country A exports X3X2, and imports Y3Y2

exports

imports

Movement From Autarky to Trade (Country A’s Perspective)

• Movement to trade causes relative price of good X to rise

• Higher relative price of X triggers a shift in production: 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

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

Autarky in Countries A and B

Country A Country BY Y

X X

(PX/PY)A

(PX/PY)B

X1

Y1

X4

Y4

Ee

Autarky to Trade in A and B

Country A Country BY Y

X XX1

Y1

X4

Y4

Ee

(PX/PY)T

Production in Trade in A and B

Country A Country BY Y

X XX1

Y1

X4

Y4

E e

(PX/PY)T

X2

Y2

X5

Y5e'

E'

Consumption in Trade in A, B

Country A Country BY Y

X XX1

Y1

X4

Y4

E e

X2

Y2

X5

Y5e'

E'

C'

c'

Exports, Imports in A and B

Country A Country BY Y

X XX1

Y1

X4

Y4

E e

X2

Y2

X5

Y5e'

E'

C'

c'

X3

Y3

F

Imp.

Exp.

X6

Y6

Exp.

Imp.

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

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

Identical Demand ConditionsY

X

Country B’s PPF

Country A’s PPF

Identical Demand ConditionsY

X

(PX/PY)A

(PX/PY)B

CI1

e

E

X1

Y1

X4

Y4

Identical Demand ConditionsY

X

CI1

e

E

X1

Y1

X4

Y4

(PX/PY)T

(PX/PY)T

f

F

X3

Y3

X5

Y5

Identical Demand ConditionsY

X

CI1

(PX/PY)T

(PX/PY)T

f

F

X3

Y3

X5

Y5

CI2

C’,c'

X2

Y2

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

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?

Identical Supply ConditionsY

X

PPF for both countries

Identical Supply ConditionsY

X

(PX/PY)A

(CI1)A

(CI1)B

(PX/PY)B

E

e

Y1

Y4

X1 X4

Identical Supply ConditionsY

X

E

e

Y1

Y4

X1 X4

E’, e'

(PX/PY)T

X3

Y3

Identical Supply ConditionsY

X

E

e

Y1

Y4

X1 X4

E’, e'

X3

Y3

C'

c'

X5

Y5

X2

Y2

Identical Supply ConditionsY

X

E’, e'

X3

Y3

C'

c'

X5

Y5

X2

Y2

F

f

A’s imp.

A’s exp.

B’s exp.

B’s imp.

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