neoclassical theory
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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 - PowerPoint PPT PresentationTRANSCRIPT
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
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
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
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
Producer Equilibrium
Y
X
PPF
At point Q, MCX/MCY < PX/PY,so more X and less Y will beproduced
Q
PX/PY
MCX/MCY
Producer Equilibrium
Y
X
PPF
At point Z, MCX/MCY > PX/PY,so less X and more Y will beproduced
MCX/MCY
PX/PY
Z
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
X
A
B
Consumers are indifferent between pt. Aand pt. B, and all other pts. on the CI
Community Indifference Curves
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
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
Autarky Equilibrium
• In equilibrium, supply and demand jointly determine PX/PY, and therefore how much X and Y is produced (and consumed)
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
Steeper int’l price linemeans PX/PY has increased
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
Exports, Imports in A and B
Country A Country BY Y
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 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
E’, e'
X3
Y3
C'
c'
X5
Y5
X2
Y2
F
f
A’s imp.
A’s exp.
B’s exp.
B’s imp.