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
PPF
X
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
Romance
Novels
53
50
A
The opportunity cost of the 16th
journal article is more than that of
the 6th.
B
Therefore, the PPF must be
bowed out.
C
30
D
15
5 6
15 16
Econ. Journal
Articles
The Relative Price Line
• The price of good X in terms of good Y is
represented by the slope of a downwardsloping straight line
The Relative Price Line
Here X is relatively cheap (Px/Py is small)
Y
Slope = Px/Py
X
The Relative Price Line
Here X is relatively expensive (Px/Py is big)
Y
Slope = Px/Py
X
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
PPF
X
Producer Equilibrium
Y
At point E, MCX/MCY = PX/PY
E
Autarky Price Line
PPF
X
Producer Equilibrium
Y
Q
MCX/MCY
At point Q, MCX/MCY < PX/PY,
so more X and less Y will be
produced
PX/PY
PPF
X
Producer Equilibrium
Y
At point Z, MCX/MCY > PX/PY,
so less X and more Y will be
produced
MCX/MCY
Z
PX/PY
PPF
X
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
A
B
X
Community Indifference Curves
Y
Consumers are indifferent between pt. A
and pt. B, and all other pts. on the CI
A
B
X
Community Indifference Curves
Y
Consumers are indifferent between pt. A
and pt. B, and all other pts. on the CI
A
There are many, many CIs each
representing higher or lower levels of
consumer satisfaction
B
X
Community Indifference Curves
Y
CI4
CI3
CI2
CI1
X
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
Price line
E
CI4
CI3
CI2
CI1
X
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
E
Y1
Community
Indifference
Curve
PPF
X1
X
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
E
Y1
E'
Y2
Autarky Price Line
Int’l Price Line
X1
X2
X
Production in Trade
Steeper int’l price line
means PX/PY has increased
Y
E
Y1
E'
Y2
Autarky Price Line
Int’l Price Line
X1
X2
X
Trade Equilibrium
Y
Y3
Y2
C'
F
X3
E'
X2
X
Trade Equilibrium
Y
Y3
Country A exports X3X2,
and imports Y3Y2
C'
imports
Y2
F
E'
exports
X3
X2
X
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
Y
Country A
Y
Country B
(PX/PY)A
E
Y1
e
Y4
(PX/PY)B
X1
X
X4
X
Autarky to Trade in A and B
Y
Country A
Y
Country B
(PX/PY)T
E
Y1
Y4
X1
X
e
X4
X
Production in Trade in A and B
Y
Country A
(PX/PY)T
Y5
Y1
Country B
Y
E
Y4
e'
e
E'
Y2
X1
X2
X
X5 X4
X
Consumption in Trade in A, B
Y
Country A
Y5
C'
Y1
Country B
Y
E
Y4
e'
e
c'
E'
Y2
X1
X2
X
X5 X4
X
Exports, Imports in A and B
Y
Country A
Y1
Y2
e'
Y5
C'
Y3
Country B
Y
Exp.
E
e
Y4
Y6
Imp.
c'
E'
F
Imp.
Exp.
X3 X1
X2
X
X5 X4
X6
X
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 Conditions
Y
Country B’s PPF
Country A’s PPF
X
Identical Demand Conditions
Y
(PX/PY)B
CI1
e
Y4
E
Y1
X4
X1
(PX/PY)A
X
Identical Demand Conditions
(PX/PY)T
Y
CI1
Y5
Y4
f
e
E
Y1
Y3
F
(PX/PY)T
X5 X4
X1 X3
X
Identical Demand Conditions
(PX/PY)T
Y
CI1
Y5
f
C’,c'
Y2
CI2
Y3
F
(PX/PY)T
X5
X2
X3
X
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 Conditions
Y
PPF for both countries
X
Identical Supply Conditions
Y
Y1
(CI1)A
E
(PX/PY)A
e
Y4
(PX/PY)B
(CI1)B
X1
X4
X
Identical Supply Conditions
Y
Y1
E
Y3
E’, e'
e
Y4
X1
X3
X4
(PX/PY)T
X
Identical Supply Conditions
Y
Y2
Y1
C'
E
Y3
E’, e'
e
Y4
Y5
c'
X2 X1
X3
X4
X5
X
Identical Supply Conditions
Y
Y2
C'
A’s imp.
Y3
Y5
E’, e'
F
A’s exp.
B’s exp.
c'
f
B’s imp.
X2
X3
X5
X
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