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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

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Neoclassical Theory

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  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 • The PPF is bowed out, not a straight line • 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 < 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 > 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 A B X

  18. Community Indifference Curves Y Consumers are indifferent between pt. A and pt. B, and all other pts. on the CI A B X

  19. 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

  20. Community Indifference Curves Y CI4 CI3 CI2 CI1 X

  21. 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

  22. Consumer Equilibrium Y Price line E CI4 CI3 CI2 CI1 X

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

  24. Autarky Equilibrium Y Community Indifference Curve E Y1 PPF X1 X

  25. 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)

  26. Production in Trade Y E Y1 Autarky Price Line E' Y2 Int’l Price Line X1 X2 X

  27. Production in Trade Y Steeper int’l price line means PX/PY has increased E Y1 Autarky Price Line E' Y2 Int’l Price Line X1 X2 X

  28. Trade Equilibrium Y C' Y3 F E' Y2 X3 X2 X

  29. Trade Equilibrium Country A exports X3X2, and imports Y3Y2 Y C' Y3 imports F E' Y2 exports X3 X2 X

  30. 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

  31. 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

  32. Autarky in Countries A and B Country B Y Country A Y (PX/PY)A E e Y1 Y4 (PX/PY)B X1 X X4 X

  33. Autarky to Trade in A and B Country B Y Country A Y (PX/PY)T E e Y1 Y4 X1 X X4 X

  34. Production in Trade in A and B Country B Y Country A Y (PX/PY)T e' Y5 E e Y1 Y4 E' Y2 X1 X2 X X5 X4 X

  35. Consumption in Trade in A, B Country B Y Country A Y e' Y5 C' E e Y1 Y4 c' E' Y2 X1 X2 X X5 X4 X

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

  37. 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

  38. 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

  39. Identical Demand Conditions Y Country B’s PPF Country A’s PPF X

  40. Identical Demand Conditions Y (PX/PY)B CI1 e Y4 E Y1 (PX/PY)A X4 X1 X

  41. Identical Demand Conditions (PX/PY)T Y CI1 Y5 f e Y4 E Y1 Y3 F (PX/PY)T X5 X4 X1 X3 X

  42. Identical Demand Conditions (PX/PY)T Y CI1 Y5 f C’,c' Y2 CI2 Y3 F (PX/PY)T X5 X2 X3 X

  43. 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

  44. 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?

  45. Identical Supply Conditions Y PPF for both countries X

  46. Identical Supply Conditions Y (CI1)A E Y1 (PX/PY)A e Y4 (PX/PY)B (CI1)B X1 X4 X

  47. Identical Supply Conditions Y E Y1 Y3 E’, e' (PX/PY)T e Y4 X1 X3 X4 X

  48. Identical Supply Conditions Y2 Y C' E Y1 Y3 E’, e' e Y4 c' Y5 X2 X1 X3 X4 X5 X

  49. Identical Supply Conditions Y2 Y C' A’s imp. Y3 E’, e' F A’s exp. B’s exp. c' Y5 f B’s imp. X2 X3 X5 X

  50. 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

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