The Theory of Trade
Phillip J. Bryson
Marriott School
Production and Transformation
► Production
Possibilities
Curve, or
Transformation Curve
► Resource scarcity and
social choice.
► Ricardian vs. Modern
PPCs
► Law of increasing
opportunity costs
Unattainable combinations
C Goods
.
.
Line of attainable
Combinations
.
Attainable (but
Inefficient) combination
.
.
Def Goods
Increasing opportunity costs transformation
and more
resources
must be
transferred from
defense to
consumer
goods, to provide
increases of equal
increments in
consumer goods.
Some resources are
Poorly suited to produce
D goods, others to
produce C goods.
► More
∆D1
∆D2
∆D3
∆D4
∆C1
∆C2
∆C3
∆C4
Increasing opportunity costs transformation
► Increasing
amounts must
be sacrificed
from defense
goods to
produce
additional,
constant
increments of C
goods.
∆D1
∆D2
∆D3
The slope of the Trans
Curve shows the rate at
which one commodity can
be traded for the
other in
production
∆D4
∆C1
∆C2
∆C3
∆C4
Modern vs. Ricardian Transformation
Note that Ricardo’s linear
transformation curve has
constant opportunity costs
of transformation.
Inputs are perfect substitutes.
Specialization can be
complete.
After specialization
20 bushels (40 hours)
-----40 yards (40 hours)
20
40
Trading (Not $) Prices in Commodity Space
Remember how we calculated costs with Ricardo?
Costs were based on pre-trade labor costs
US
ROW
1 bushel of wheat
I yard of cloth
2 hours
4 hours
<
>
2.5 hours
1 hour
In the U.S. how much wheat will one give for a yard of cloth?
How much cloth with the ROW give for a bushel of wheat?
Price of wheat
United States
0.5 yard/bushel
(=2/4)
ROW
2.5 yards/bush
(=2.5/1)
The price of wheat is how many yards of cloth we have to
give up to get one more bushel.
The price of a bushel of wheat
in terms of yards of cloth
► The
price in
Wheat
commodity
space can be
seen as the
slope of a line
showing how
much X you give
up to get more
Y.
.5
1
10
bushels
20 yards
Cloth
The price of a bushel of wheat
in terms of yards of cloth
► Starting
at any
Wheat
point (combination
of wheat and
.
cloth), and trade
from that point
along the line (at
the rate of 2
bushels for 1
yard).
.
.
.
Cloth
.
Attaining the Unattainable
►
Through trade, we
can move from a
point on the PPC to
points outside it,
points that were
previously
unattainable.
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.
We could actually gain
more by specializing in
wheat before trading for
cloth.
W
.
.
0
Cl
Attaining the Unattainable
►
Through trade, we
can move from a
point on the PPC to
points outside it,
points that were
previously
unattainable.
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.
We could actually gain
more by specializing in
wheat before trading for
cloth. With a modern
PPC, we will not
specialize completely.
W
.
.
0
Cl
Attaining the Unattainable
Different countries will face different prices (line slope) as
they look for ways to trade beyond their PPC.
An important question is: where will we choose to
produce, trade, and consume outside the PPC?
W
W
At point A?
At point B?
.
At point C?
. . B C
. .
A
0
Cl
0
C
.
B
.A
.
Cl
Choosing A, B, or C
► The
specific point of consumption, which a
nation produces and trades to achieve, will
be a matter of social choice.
► A “community indifference curve” reflects
community choice and determines the point.
► An indifference curve shows a huge number
of points of equal value to a consumer.
Indifference Curves
► Pres.
Bush will
be “indifferent”
to certain
combinations of
HGs and
Pretzels. As
points move
from left to
right, the
president has
more pretzels,
but fewer hand
grenades.
HGs
Some combinations of hand grenades
and pretzels will be found of equal
value by President George W. Bush.
.
.
.
Pretzels
Indifference Curves
points,
and an infinite
number of
others can be
joined together
as an
indifference
curve.
Some combinations of hand grenades
and pretzels would not be found of
equal value by President Bush.
► Such
HGs
.
.
.
.
.
Pretzels
Assumptions behind Indifference Curves
► Consumers
are permitted to make choices in
favor of goods and services they prefer.
► Their choices are consistent (transitive)
► More is preferred to less.
► Consumers have full knowledge of goods
available and act rationally to optimize their
consumption.
► Implicitly, goods are scarce, so rational
consumption requires making choices.
Characteristics of Indifference Curves
►A
movement to the North-East is an
improvement.
Clear improvement: more of one good,
Y
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 less
of the other. We don’t know if
it’s an improvement until we know
how each good is valued.
X
Characteristics of Indifference Curves
►
Diminishing slope
(“Marginal Rate of
substitution of x for y,” or
MRSxy) along the
indifference curve.
The MRSxy is the amount of y
the consumer is just willing
to give up to get one more
unit of x. The consumer is
willing to give up less of y
as his supply declines and
his stock of x is continually
increasing.
∆Y1
∆Y2
∆Y3
∆X1
∆X2 ∆X3
Characteristics of Indifference Curves
► Transitivity,
or consistent tastes.
► If A>B and B>C, A>C
(“If A is preferred to B and B is preferred to C, A is
preferred to C.”)
► For groups, or society as a whole, this may not
work. Assume we have three individuals vote for
their preferences. Will we get social transitivity?
1) A>B>C
Counting the votes for
2) B>C>A
1 and 3 we see A>B.
3) C>A>B
Counting for 1 and 2
B>C. May we infer
then, without further counting, that A>C.
The CIC and constraints
► We
recognize that social transitivity cannot be
taken for granted, but we can still gain a basic
understanding of social choice using them.
► We want the indifference curve where we are
ultimately located to be as far to the Northeast as
possible. If Alpha Centauri is not possible, or even
the moon, how about just atop Mount
Timpanogas?
► What constrains how far to the northeast we can
be situated?
► Of course! How far out we get depends on how
well we produce, then trade.
Back to the social choice of A, B, and C
We asked earlier where we will choose to
produce, trade, and consume once we are outside
the PPC?
W
W
At point A?
At point B?
.
At point C?
. . B C
. .
A
0
Cl
0
C
.
B
.A
.
Cl
We will choose the point that is located on
the indifference curve furthest to the
Northeast!
The tangency of the indifference curve to the terms of
trade line will determine the optimal point of consumption,
given production and trade possibilities.
W
W
T’
CIC
T’
. . B C
. .
A
T
.
C
.
B
.A
CIC
.
T
0
Cl
0
Cl
Let’s look at that one more time!
► With
the new prices that develop after trade
opens, specialization is greater.
England
.
South Africa
.
.
.
Trade Theory bottom line: one more time!
► With
the new prices that develop after trade
opens, specialization is greater.
T’
G2
England
.
South Africa
T’
.
New production: G2 , O2
.
T
G2
O2
Old production points
Now, trading along TT’,
the UK and SA can
consume outside
their PPC.
T
.
O2
Trade Theory bottom line: one more time!
► Trading
along TT’, the UK and SA can
consume outside their PPC.
Social choice (the CIC) will determine whether
the UK and SA will consume at C or D.
T’
.
England
..C
South Africa
.D
T’
CIC
T
. D CIC
. .C
.
T