The Theory of TradeThe Theory of Trade

Phillip J. BrysonPhillip J. Bryson

Marriott SchoolMarriott School

Production and Production and TransformationTransformation

►Production Production Possibilities Curve, Possibilities Curve, or Transformation or Transformation Curve Curve

►Resource scarcity Resource scarcity and social choice.and social choice.

►Ricardian vs. Modern Ricardian vs. Modern PPCsPPCs

►Law of increasing Law of increasing opportunity costsopportunity costs

Unattainable combinations

. .

Attainable (butInefficient) combination

.

Line of attainable Combinations .

.

Def Goods

C Goods

Increasing opportunity costs Increasing opportunity costs transformationtransformation

► More and more More and more resourcesresources

must be must be transferred from transferred from defense to defense to consumer consumer

goods, to provide goods, to provide increases of increases of equal increments equal increments in consumer in consumer goods. goods.

∆C1 ∆C2 ∆C3 ∆C4

∆D1∆D2

∆D3

∆D4

Some resources are Poorly suited to produceD goods, others to produce C goods.

Increasing opportunity costs Increasing opportunity costs transformationtransformation

► Increasing Increasing amounts must amounts must be sacrificed be sacrificed from defense from defense goods to goods to produce produce additional, additional, constant constant increments of increments of C goods.C goods. ∆C1 ∆C2 ∆C3 ∆C4

∆D1∆D2

∆D3

∆D4

The slope of the TransCurve shows the rate at which one commodity can be traded for the other in production

Modern vs. Ricardian Modern vs. Ricardian TransformationTransformation

Note that Ricardo’s lineartransformation curve hasconstant opportunity costsof transformation.Inputs are perfect substitutes.Specialization can be complete.

After specialization20 bushels (40 hours) ---- 20 --- 40 yards (40 hours) 40

Trading (Not $) Prices in Commodity Trading (Not $) Prices in Commodity SpaceSpace

Remember how we calculated costs with Ricardo?Remember how we calculated costs with Ricardo?

Costs were based on pre-trade labor costsCosts were based on pre-trade labor costs USUS ROW ROW

1 bushel of wheat 2 hours1 bushel of wheat 2 hours < < 2.5 hours2.5 hoursI yard of clothI yard of cloth 4 hours 4 hours > > 1 hour1 hour

In the U.S. how much wheat will one give for a yard of In the U.S. how much wheat will one give for a yard of

cloth?cloth? How much cloth with the ROW give for a bushel of How much cloth with the ROW give for a bushel of

wheat?wheat?

United StatesUnited States ROW ROW Price of wheat 0.5 yard/bushel 2.5 yards/bush Price of wheat 0.5 yard/bushel 2.5 yards/bush (=2/4) (=2.5/1)(=2/4) (=2.5/1)

The price of wheat is how many yards of cloth we have to The price of wheat is how many yards of cloth we have to give up to get one more bushel.give up to get one more bushel.

The price of a bushel of wheatThe price of a bushel of wheatin terms of yards of clothin terms of yards of cloth

►The price in The price in commodity commodity space can be space can be seen as the seen as the slope of a line slope of a line showing how showing how much X you much X you give up to get give up to get more Y.more Y.

Wheat

Cloth

20 yards

10bushels

.51

The price of a bushel of wheatThe price of a bushel of wheatin terms of yards of clothin terms of yards of cloth

► Starting at anyStarting at any

point point (combination of (combination of wheat and wheat and cloth), and trade cloth), and trade from that point from that point along the line along the line (at the rate of 2 (at the rate of 2 bushels for 1 bushels for 1 yard).yard).

Wheat

Cloth

.

.

..

.

Attaining the UnattainableAttaining the Unattainable► Through trade, we Through trade, we

can move from a can move from a point on the PPC point on the PPC to points outside to points outside it, points that it, points that were previously were previously unattainable.unattainable.

W

Cl

.

Starting at some point where our nation is producing and consuming, we discover we could trade a bushel of wheat for more than 2 yards of cloth in foreign markets.

0

We could actually gain more by specializing in wheat before trading for cloth.

.

Attaining the UnattainableAttaining the Unattainable► Through trade, Through trade,

we can move we can move from a point on from a point on the PPC to points the PPC to points outside it, points outside it, points that were that were previously previously unattainable.unattainable.

W

Cl

.

Starting at some point where our nation is producing and consuming, we discover we could trade a bushel of wheat for more than 2 yards of cloth in foreign markets.

0

We could actually gain more by specializing in wheat before trading for cloth. With a modern PPC, we will not specialize completely.

.

Attaining the UnattainableAttaining the UnattainableDifferent countries will face different prices (line Different countries will face different prices (line

slope) asslope) asthey look for ways to trade beyond their PPC.they look for ways to trade beyond their PPC.

W

Cl0

.

W

Cl0

An important question is: where will we choose to produce, trade, and consume outside the PPC?

At point A?

. .A A

At point B?

. BB.

At point C?

.C. C

.

Choosing A, B, or CChoosing A, B, or C

►The specific point of consumption, which The specific point of consumption, which a nation produces and trades to achieve, a nation produces and trades to achieve, will be a matter of social choice.will be a matter of social choice.

►A “community indifference curve” A “community indifference curve” reflects community choice and reflects community choice and determines the point.determines the point.

►An indifference curve shows a huge An indifference curve shows a huge number of points of equal value to a number of points of equal value to a consumer.consumer.

Indifference CurvesIndifference Curves

► Pres. Bush will Pres. Bush will be be “indifferent” to “indifferent” to certain certain combinations combinations ofofHGs and HGs and Pretzels. As Pretzels. As points move points move from left to from left to right, the right, the president has president has more pretzels, more pretzels, but fewer hand but fewer hand grenades.grenades.

Some combinations of hand grenadesand pretzels will be found of equalvalue by President George W. Bush.

. . .

Pretzels

HGs

Indifference CurvesIndifference Curves

►Such points, Such points, and an and an infinite infinite number of number of others can be others can be joined joined together as together as an an indifference indifference curve.curve.

Some combinations of hand grenadesand pretzels would not be found of equal value by President Bush.

. . . Pretzels

HGs

. .

Assumptions behind Indifference Assumptions behind Indifference CurvesCurves

►Consumers are permitted to make Consumers are permitted to make choices in favor of goods and services choices in favor of goods and services they prefer.they prefer.

►Their choices are consistent (transitive)Their choices are consistent (transitive)►More is preferred to less.More is preferred to less.►Consumers have full knowledge of goods Consumers have full knowledge of goods

available and act rationally to optimize available and act rationally to optimize their consumption.their consumption.

► Implicitly, goods are scarce, so rational Implicitly, goods are scarce, so rational consumption requires making choices.consumption requires making choices.

Characteristics of IndifferenceCharacteristics of Indifference CurvesCurves

►A movement to the North-East is an A movement to the North-East is an improvement.improvement.

X

Y

Clear improvement: more of one good,no less of the other, or

more of both.

Clear loss: less of one good, no more The other, or

less of both.

Ambiguous: more of one, but lessof the other. We don’t know ifit’s an improvement until we knowhow each good is valued.

Characteristics of IndifferenceCharacteristics of Indifference CurvesCurves

► Diminishing slope Diminishing slope (“Marginal Rate of (“Marginal Rate of substitution of x for y,” substitution of x for y,” or MRSxy) along theor MRSxy) along theindifference curve.indifference curve.

The MRSxy is the amount The MRSxy is the amount of y the consumer is of y the consumer is just willing to give up to just willing to give up to get one more unit of x. get one more unit of x. The consumer is willing The consumer is willing to give up less of y as to give up less of y as his supply declines and his supply declines and his stock of x is his stock of x is continually increasing.continually increasing.

∆X1 ∆X2 ∆X3

∆Y1

∆Y2

∆Y3

Characteristics of IndifferenceCharacteristics of Indifference CurvesCurves

► Transitivity, or consistent tastes.Transitivity, or consistent tastes.► If A>B and B>C, A>C If A>B and B>C, A>C

(“If A is preferred to B and B is preferred to C, A is (“If A is preferred to B and B is preferred to C, A is preferred to C.”)preferred to C.”)

► For groups, or society as a whole, this may not For groups, or society as a whole, this may not work. Assume we have three individuals vote for work. Assume we have three individuals vote for their preferences. Will we get social transitivity?their preferences. Will we get social transitivity?1) A>B>C1) A>B>C Counting the votes forCounting the votes for2) B>C>A2) B>C>A 1 and 3 we see A>B.1 and 3 we see A>B.3) C>A>B3) C>A>B Counting for 1 and 2Counting for 1 and 2B>C. May we infer then, without further counting, B>C. May we infer then, without further counting, that A>C.that A>C.

The CIC and constraintsThe CIC and constraints

►We recognize that social transitivity cannot be We recognize that social transitivity cannot be taken for granted, but we can still gain a basic taken for granted, but we can still gain a basic understanding of social choice using them.understanding of social choice using them.

►We want the indifference curve where we are We want the indifference curve where we are ultimately located to be as far to the Northeast ultimately located to be as far to the Northeast as possible. If Alpha Centauri is not possible, or as possible. If Alpha Centauri is not possible, or even the moon, how about just atop Mount even the moon, how about just atop Mount Timpanogas? Timpanogas?

►What constrains how far to the northeast we What constrains how far to the northeast we can be situated?can be situated?

►Of course! How far out we get depends on howOf course! How far out we get depends on howwell we produce, then trade.well we produce, then trade.

Back to the social choice of A, B, and Back to the social choice of A, B, and CC

W

Cl0

.

W

Cl0

We asked earlier where we will choose to produce, trade, and consume once we are outside the PPC?

At point A?

. .A A

At point B?

. BB.

At point C?

.C. C

.

We will choose the point that is We will choose the point that is located on the indifference curve located on the indifference curve

furthest to the Northeast!furthest to the Northeast!

W

Cl0

.

W

Cl0

. .A A

. BB. .C

. C

.

The tangency of the indifference curve to the terms of trade line will determine the optimal point of consumption, given production and trade possibilities.

T

T’

CIC

CIC

T

T’

Let’s look at that one more Let’s look at that one more time!time!

►With the new prices that develop after With the new prices that develop after trade opens, specialization is greater.trade opens, specialization is greater.

England South Africa

.

.

..

Trade Theory bottom line: one more Trade Theory bottom line: one more time!time!

►With the new prices that develop after With the new prices that develop after trade opens, specialization is greater.trade opens, specialization is greater.

England South Africa

.

.

..

Old production points

New production: G2 ,

O2

O2 O2

G2

G2

T

T’

T

T’

Now, trading along TT’, the UK and SA can consume outside their PPC.

Trade Theory bottom line: one more Trade Theory bottom line: one more time!time!

►Trading along TT’, the UK and SA can consume outside their PPC.

England South Africa.

.

..T

T’

T

T’.C

.C

. D

. D

Social choice (the CIC) will determine whether the UK and SA will consume at C or D.

CICCIC