Neoclassical Trade Theory! Chayun Tantivasadakarn! Faculty of Economics, Thammasat University! Chayun Tanti
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Outline! • Basic Tools – Production Theory – Edgeworth Box Diagram and PPC – Consumer Behavior Theory
• Gains from Trade in Neoclassical Theory – Autarky Equilibrium – Production and Consumption Gains from Trade
• Offer Curves and Terms of Trade !
Chayun Tanti
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Production Theory!
" " X = F(KX,LX),
Y = G(KY,LY)!
Chayun Tanti
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Production Theory!
" " X = F(KX,LX), X!
MPXL!
L 1!
L 1!
!
L 2!
L 2!
Chayun Tanti!
L!
MPXL(K2)! MPXL(K1)! L! 4!
Production Theory!
• Production function! " " X = F(KX,LX), Y = G(KY,LY)! • Constant returns to scale or homogeneous of degree 1! " " lX = F(lKX, lLX)! " " lY = G(lKY, lLY)! " the output grows at the same rate as the rate of both inputs! • Average products, marginal products, and MRTS are constant along the ray from the origin! Chayun Tanti
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Production Theory! (KX/LX)1 = 2!
K!
6! (KX/LX)2! 30X!
4! 20X! 2!
1!
2!
10X! 3!
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L!
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Production Theory! • From X = LbK(1-b), K(1-b) = X/Lb --> K = [X/Lb](1/1-b)! X = 10! the value of b influences substitution between K and L!
Chayun Tanti
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Production Theory! K!
KY/LY!
Y!
KY KX
• Least cost combination requires! MRTSX = w/r = MRTSY ! • If Y production is capital intensive relative to X, ! KX/LX! KY/LY > KX/LX ! for any w/r.! X!
LY
L!
LX Chayun Tanti
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Edgeworth Box Diagram! 50L!
0Y! X5!
Production Contract Curve!
15K
X1
Y2! !
Y3
Y4!
!
M!
B! A!
25L
Y5!
X4!
Y1! X3!
X2!
D!
0X!
C!
K in Y Production!
K in X Production!
30K!
L in Y Production!
Lr in X Production!
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50L!
30K! 9
Production Possibility Curve! Y! Y5! Y4! Y3! Y2 = Y5/2!
D! A!
B! M!
C!
0!
X1! X2 = X5/2! X3! X4! X5! Chayun Tanti
• PPC can be constructed from the production contract curve.! • For instance, point A comes from X2 and Y3 from on the contract curve.! X! 10
Consumer Behavior Theory Utility function: U = U(X,Y) U! Y!
30! 20!
U1! 0!
20!
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40!
X!
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Indifference Curves: Properties! • They slope downward to the right.! – Goods are substitutable! – If F rises, C must fall to maintain the same U1.!
• Any basket lying northeast of an IC is preferred to any on the IC! • Convex to the origin ! – Variety is preferred to extreme!
• Indifference curves can not cross! • Continuous: no gaps! Chayun Tanti
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Utility maximization! Y! I/PY!
• Budget line: I = PXX + PYY! Y = I/PY - [PX/PY ]X ! • Utility is maximize at point C where!
A! D!
"
C!
|MRS| = PX/PY! CIC3!
0!
B!
CIC1!
I/PX!
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X! 13
Aggregating Individual Preferences! • In order to aggregate individual preferences into community preferences without any problems, we need to assume that preferences are homothetic or the proportion of consumption bundle does not vary with income.! • Homothetic preferences imply that the summation of all individual demand is equal to the demand of a representative individual with the summation of all individual income or!
Assume: Income distribution does not change the total demand!14
Autarky equilibrium! Y! C!
A!
B! 0!
(PX/PY)A! CIC1! X!
Chayun Tanti
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International equilibrium! • Suppose the world relative price of X is higher.! • Production moves Y! C! (P /P )W to point Q.! Y C! X Y • Consumption Y A! CIC4! A! moves to point C.! CIC2! • Exports X = (PX/PY)A! XQ - XC.! F! YQ! Q! • Imports Y = YC - YQ.! X! 0!
XA! XC! XQ!
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Gains from trade! Y! Y C!
C/ ! A!
(PX/PY)W 0!
C!
• If production remains at A but the country trade at world price. -->! " Consumption gain or gains from exchange: movement from A to C/.! CIC4! • If production can change to CIC3! CIC2! Q --> Production gain or gains from specialization: A (PX/PY) ! movement from C/ to C.! Q! • Total gains from trade: X! movement from A to C.!
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Equilibrium Price: Partial equilibrium analysis! Home market!
P!
P! International market! S!
P 2! P 1!
X = BC! B!
P 3! P 2!
C!
E!
P 3!
S E!
P 2! D*M!
P 1! A!
P!
Foreign market! *! * S A! C *!
B *! M = B *C *!
D*!
D! Q!
X! = M!
Q!
• Home’s export supply curve, SE, comes from its excess supply.! • Foreign’s import demand curve, D*M, comes from its excess demand. ! • International equilibrium price occurs where SE = D*M at point E.! Chayun Tanti!
Q!
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Equilibrium relative price: Offer curves! III! II! I!
Y!
E!
H’s imports!
Y!
Home market!
C!
A! PA= 1/4! D!
B! G!
F!
International market! H’s Offer Curve! PC= 1! E! PB= 1/2!
PB= 1/2! PC= 1! X! 0!
• At PA, there is no imports or exports.! • At PB, H imports Y = CD exports X = DB.! • At PC, H imports Y = EG exports X = FG.!
C! D!
PA= 1/4! G!
X! H’s exports!
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Equilibrium relative price: Offer curves! Foreign market!
F*!
Y! F’s exports!
P*A= 4!
Y!
B*! G*!
A*! D *!
C *!
E*!
II! I! P*B= 2!
International market!
P*A= 4!
G*! D*!
III!
P*B= 2!
P*C= 1!
E*! C*!
F’s Offer Curve!
P*C= 1! X! 0!
• At P*A, there is no imports or exports.! • At P*B, F imports X = C*D* exports Y = B*D*.! • At P*C, F imports X = E*G* exports Y = F*G*.!
X! F’s imports!
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Equilibrium relative price: Offer curves! H’s imports! F’s exports!
Y
* = 2! P H’s Offer Curve! B
H!
P*A= 4!
E*!
G*! C*!
E!
F’s Offer Curve! PB= 1/2!
C! 0!
P*C= 1!
PA= 1/4! H’s exports! X! G! F’s imports!
• The equilibrium relative price is at the intersection of offer curves.!
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