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


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


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

X

Slope = Px/Py


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


Y

X

PPF


Y

X

E

Autarky Price Line

PPF

At point E, MCX/MCY = PX/PY


Y

X

PPF

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

Q

PX/PY

MCX/MCY


Y

X

PPF

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

MCX/MCY

PX/PY

Z


• 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


Y

X

A

B

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


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


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


X XX1

Y1

X4

Y4

Ee

(PX/PY)T

Production in Trade in A and B


X XX1

Y1

X4

Y4

E e

(PX/PY)T

X2

Y2

X5

Y5e'

E'

Consumption in Trade in A, B


X XX1

Y1

X4

Y4

E e

X2

Y2

X5

Y5e'

E'

C'

c'

Exports, Imports in A and B


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


X

(PX/PY)A

(PX/PY)B

CI1

e

E

X1

Y1

X4

Y4


X

CI1

e

E

X1

Y1

X4

Y4

(PX/PY)T

(PX/PY)T

f

F

X3

Y3

X5

Y5


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


X

(PX/PY)A

(CI1)A

(CI1)B

(PX/PY)B

E

e

Y1

Y4

X1 X4


X

E

e

Y1

Y4

X1 X4

E’, e'

(PX/PY)T

X3

Y3


X

E

e

Y1

Y4

X1 X4

E’, e'

X3

Y3

C'

c'

X5

Y5

X2

Y2


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

neoclassical theory

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