Neoclassical Theory

1
Neoclassical Theory
2
Problems With Classical Theory

• Labor theory of value unrealistic
• Assumption of constant opportunity costs too
  restrictive
• Demand is largely ignored

3
Increasing Opportunity Cost

• Most PPFs are bowed out, not straight lines
• This is because resources are not equally suited
  to all kinds of production

4
The PPF with Increasing Opportunity Costs
Y
PPF
X
5
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

6
The PPF with Increasing Opportunity Costs
Romance Novels
The opportunity cost of the 16th journal article
is more than that of the 6th.
A
B
53
50
Therefore, the PPF must be bowed out
C
30
D
15
5
6
16
Econ. Journal Articles
15
7
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

8
The Relative Price Line

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

Y
Slope Px/Py
X
9
The Relative Price Line

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

Y
Slope Px/Py
X
10
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

11
The PPF with Increasing Opportunity Costs
Y
PPF
X
12
Producer Equilibrium
Y
At point E, MCX/MCY PX/PY
E
Autarky Price Line
PPF
X
13
Producer Equilibrium
Y
At point Q, MCX/MCY lt PX/PY, so more X and less Y
will be produced
MCX/MCY
Q
PX/PY
PPF
X
14
Producer Equilibrium
At point Z, MCX/MCY gt PX/PY, so less X and more Y
will be produced
Y
MCX/MCY
Z
PX/PY
PPF
X
15
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)

16
Preferences Including the Demand-Side

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

17
Community Indifference Curves
Y
Consumers are indifferent between pt. A and pt.
B, and all other pts. on the CI
There are many, many CIs each representing
higher or lower levels of consumer satisfaction
A
B
X
18
Community Indifference Curves
Y
CI4
CI3
CI2
CI1
X
19
Consumer Equilibrium

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

20
Consumer Equilibrium
Y
Price line
CI4
E
CI3
CI2
CI1
X
21
Consumer Equilibrium
New price line
If PX/PY rises, more Y will get consumed, and
less X.
Y
F
E
CI4
CI3
CI2
CI1
X
22
Autarky Equilibrium

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

23
Autarky Equilibrium
Y
Community Indifference Curve
E
Y1
Price line
PPF
X
X1
24
Production in Trade

• Lets 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)

25
Production in Trade
Y
Steeper intl price line means PX/PY has increased
E
Y1
Autarky Price Line
E'
Y2
Intl Price Line
X
X1
X2
26
Trade Equilibrium
Country A exports X3X2 (the distance FE), and
imports Y3Y2 (the distance FC)
Y
C'
Y3
imports
F
E'
Y2
exports
X
X2
X3
27
Movement From Autarky to Trade (Country As
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

28
Countries A and B Together

• Lets 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 lt (PX/PY)B

29
Exports, Imports in A and B
Country B
Country A
Y
Y
e'
Y5
C'
Y3
Exp.
E
e
Y1
Y4
c'
Imp.
Y6
E'
Y2
F
Imp.
Exp.
X2
X1
X
X
X4
X5
X3
X6
30
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

31
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

32
Identical Demand Conditions
Y
Country Bs PPF
Country As PPF
X
33
Identical Demand Conditions
Y
(PX/PY)B
CI1
e
Y4
E
Y1
(PX/PY)A
X
X1
X4
34
Identical Demand Conditions
(PX/PY)T
Y
CI1
Y5
f
e
Y4
E
Y1
Y3
F
(PX/PY)T
X
X1
X4
X3
X5
35
Identical Demand Conditions
(PX/PY)T
Y
CI1
Y5
f
C, c
CI2
Y2
Y3
F
(PX/PY)T
X
X3
X5
X2
36
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

37
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?

38
Identical Supply Conditions
Y
PPF for both countries
X
39
Identical Supply Conditions
Y
(CI1)A
E
Y1
(PX/PY)A
e
Y4
(PX/PY)B
(CI1)B
X
X1
X4
40
Identical Supply Conditions
Y
E
Y1
Y3
E, e'
(PX/PY)T
e
Y4
X
X1
X4
X3
41
Identical Supply Conditions
Y2
Y
C'
E
Y1
Y3
E, e'
e
Y4
c'
Y5
X
X1
X4
X3
X5
X2
42
Identical Supply Conditions
Y2
Y
C'
As imp.
Y3
E, e'
F
As exp.
c'
Bs exp.
Y5
f
Bs imp.
X
X3
X5
X2
43
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