Introduction to Neoclassical Trade Theory

1
Chapter 5

• Introduction to Neoclassical Trade Theory
• (The Fun Stuff)

2
Tools

• Consumer preferences
• Consumer equilibrium maximize utility (in terms
  of goods and services consumed) subject to a
  budget constraint
• Tools
• Individual- indifference curves
• Aggregate- Community indifference curves

3
Tools

• Producers
• Individual firm
• choose combination of inputs that will minimize
  cost subject to the technology required to
  produce the chosen level of output
• minimize cost subject to isoquant constraint.
• Tools Isocost lines and Isoquant curves

4
Tools

• Producers
• Country
• choose the combination of outputs that will
  maximize profits
• firms make this choice subject to a technology
  constraint
• Tool
• the production possibility frontier

5
Individual Indifference Curves

• Recall Utility is ordinal - all we know is that
  a higher level of utility is better, we dont
  know how much better
• An indifference curve maps out the relationship
  between a number of consumption packages that
  maintain an individuals utility (sense of
  satisfaction) at a constant level
• A higher indifference curve denotes a higher
  level of utility U(s3)gtU(s2)gtU(s1)

6
Consumer Indifference Curves
7
Consumer Indifference Curves

• Indifference curves slope downward, because more
  is better
• Therefore, any point (like J) to the right and
  above another point (like G) must represent a
  higher level of utility.
• J must be on a higher indifference curve than G.

8
Consumer Indifference Curves

• NOTE diminishing marginal utility implies that
  indifference curves are convex to the origin.
• as a person tries to maintain the same level of
  utility by consuming more and more of one good
  and less of the other, the person requires larger
  quantities of the good being increased to
  compensate for the good being lost.

9
Impossible Intersecting Curves for An Individual
Consumer
Indifference curve S1 shows consumer is
indifferent between B and A. S2 shows that the
consumer is indifferent between A and C
10
Impossible Intersecting Curves for An Individual
Consumer
This implies that the consumer is indifferent
between A, B and C But point C has more of both
goods that point B, therefore the consumer must
prefer point C to point B
11
A Community Indifference Curve
A community indifference curve represents bundles
of X and Y that yield the same level of utility
for each individual in the country.
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A Community Indifference Curve

• Community indifference curves are NOT found by
  adding individual indifference curves.
• We ask the question
• If a certain amount of good X is taken away, so
  that each person loses the same proportion of it
  (example, they all lose 10 of X),
• Then how much Y must be given to each consumer
  to make him and her return to the same level of
  utility.
• Adding the amount of Y each consumer needs across
  all consumers tells us the point on the community
  indifference curve when X falls 10

13
A Community Indifference Curve

• Recap of main point
• Community indifference curves are NOT found by
  adding individual indifference curves.
• Community indifference curves are found by adding
  the amount of Y each consumer needs to compensate
  for a given loss of X distributed proportionately
  across consumers.

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A Community Indifference Curve

• The consequence
• How much X each consumer has before the change
  depends on the income distribution in the
  country!
• Every community indifference curve is drawn based
  on the distribution of income at the initial
  point of consumption.
• A change in price, etc.. that changes the income
  distribution will also change the shape of the
  indifference curve.

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Intersecting Community Indifference Curves
Community indifference curves CAN
intersect!!! CI1 and CI2 represent different
income distributions
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Intersecting Community Indifference Curves
Starting at A, a change that brings the country
to point B is a gain, given the income
distribution at A ( CI1 to CI1 )
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Intersecting Community Indifference Curves
Starting at B, a change that brings the country
BACK to point A is a gain, given the income
distribution at B ( CI1 to CI1 )
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How we deal with Intersecting Indifference curves
with trade

• While we develop the theory, we assume curves do
  not intersect, or, since the change is an
  improvement at old distribution, we measure
  welfare gain based on original income
  distribution.

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How Intersecting Indifference curves affect
analysis

• The main point to take from this is
• The distribution of income MATTERS
• Since the gain or loss in community utility
  depends on income distribution, we need to watch
  how income distribution changes for any policy,
  not only trade.

20
Consumer Budget Constraint
The consumer budget constraint is defined by
MPyYPxX. What is its slope?
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Consumer Equilibrium
Consumer equilibrium is found by MUx/Px MUy/Py
or MUx/MUyPx/Py What does it mean if
MUx/Px gtMUy/Py ?
22
Production Isoquants
Isoquants show the substitution between capital
and labour that is required to maintain a
particular level of output. The slope of an
isoquant is - MPPL/MPPK
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Homothetic Isoquants with Constant Returns to
Scale
An isoquant is homothetic if a change in the
output constraint, but not the relative prices of
capital and labour could be drawn as a ray from
the origin
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Homothetic Isoquants with Constant Returns to
Scale
An isoquant is homothetic if a change in the
output constraint, but not the relative prices of
capital and labour could be drawn as a ray from
the origin
25
Homothetic isoquants

• If a function is homothetic, but returns to scale
  are decreasing, how would you show this on an
  isoquant map?
• (answer on board)

26
Producer Equilibrium
Producers minimize cost subject to the output
constraint Q1, to reach equilibrium
27
Next class

• More producer theory
• We will define what it means for an industry to
  be
• capital intensive,
• labour intensive
• We will show how output of industries link to
  production possibility frontier
• therefore show how output for the country links
  to demands for capital and labour and
• affects wages and rental rates.