Chapter 6 Gains from Trade in Neoclassical Theory

Chapter 6 Gains from Trade in Neoclassical Theory Mc. Graw-Hill/Irwin Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Learning Objectives § Describe economic equilibrium in a country that has no trade. § Discover the welfare enhancing impact of opening a country to trade. § Demonstrate that either supply differences or demand differences between countries are sufficient to generate a basis for trade. § Distinguish the implications of key assumptions in the neoclassical trade model. 6 -2

Problems With Classical Theory § Labor theory of value is unrealistic. § Assumption of constant opportunity costs is too restrictive. § Demand is largely ignored. 6 -3

Autarky Equilibrium § In the absence of trade • producers will seek to maximize profits. • consumers will seek to maximize utility. 6 -4

Production Equilibrium In Autarky § 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. 6 -5

Producer Equilibrium in Autarky Y At point E, MCX/MCY = PX/PY. E Autarky Price Line PPF X 6 -6

Consumer Equilibrium in Autarky § Given relative prices (PX/PY) and income, consumers will choose a combination of X and Y that puts them on the highest possible community indifference curve. § Consumer equilibrium occurs where (MUX/MUY) = (PX/PY). 6 -7

Consumer Equilibrium Y Budget constraint E CI 4 CI 3 CI 2 CI 1 X 6 -8

Autarky Equilibrium § In equilibrium, supply and demand jointly determine PX/PY, and therefore how much X and Y is produced (and consumed). 6 -9

Autarky Equilibrium Y E Y 1 Community indifference curve Price line PPF X 1 X 6 -10

The Introduction of International Trade § Trade will cause relative prices to change. § Producers will respond to this by altering relative production of goods X and Y. § Consumers will respond to this by altering relative consumption of goods X and Y. 6 -11

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). 6 -12

Production in Trade Y Steeper int’l price line means PX/PY has increased. E Y 1 E' Y 2 Autarky Price Line Int’l Price Line X 1 X 2 X 6 -13

Trade Equilibrium Y Y 3 Country A exports X 3 X 2 (the distance FE’), and imports Y 3 Y 2 (the distance FC’). C' imports Y 2 F E' exports X 3 X 2 X 6 -14

Movement From Autarky to Trade § Movement to trade causes relative price of good X to rise. § Higher relative price means 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. 6 -15

Production and Consumption Gains from Trade § There are two distinct sources of trade gains • Consumption gain: even if producers don’t change production levels, welfare is enhanced. • Production gain: specialization in the comparative advantage product leads to higher welfare. 6 -16

Consumption Gains Y Even if producers don’t change production levels in response to a change to (Px/Py)2, the new consumer equilibrium at C is on a higher indifference curve. C' C E E' (Px/Py)2 X 6 -17

Production Gains Y Eventually producers adjust production levels to E’. This permits additional gains to C’. C' C E E' (Px/Py)2 X 6 -18

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. 6 -19

Exports, Imports in A and B Y Country A Y 1 e' Y 5 C' Y 3 Country B Y Exp. E Imp. E' Y 2 c' Imp. Exp. X 3 X 1 e Y 4 Y 6 X 2 X X 5 X 4 X 6 -20

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. 6 -21

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. 6 -22

Identical Demand Conditions (PX/PY)T Y Y 5 CI 1 f C’, c’ CI 2 Y 3 F (PX/PY)T X 5 X 2 X 3 X 6 -23

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. 6 -24

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? 6 -25

Identical Supply Conditions Y PPF for both countries X 6 -26

Identical Supply Conditions Y Y 1 (CI 1)A E (PX/PY)A e Y 4 (PX/PY)B (CI 1)B X 1 X 4 X 6 -27

Identical Supply Conditions Y Y 1 E Y 3 E’, e' e Y 4 X 1 X 3 X 4 (PX/PY)T X 6 -28

Identical Supply Conditions Y Y 2 Y 1 C' E Y 3 E’, e' e Y 4 Y 5 X 2 X 1 X 3 X 4 c' X 5 X 6 -29

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. 6 -30