a CHAPTER COMMUNITY IN FIVE DIFFE C REN! OMPARATIVE ADVANTAGE e This chapter is divided into two parts. The first part discusses the fundamental concept of social indifference. The second part discusses the problems of how to portray general equilibrium (a) in a closed economy, and (b) in a simple open ice taker in the international market; in addition, it pro- economy which is a pri sides a neoclassical demonstration of comparative advantage. . - PART A. COMMUNITY DIFFERENCE ied i Jassical Inaddition to the concept of opportunity cost studied in oben, te ret Reg theory of international trade is also based on the fundamen al eae Fe aoe ds, the neoclassiog theory OFC ay inierence tieustence ofa logically acceptable social indie 8 a up qualitatively smilar to the wellknown idl serl questions pe “onsumer that portrays the tastes of the society at ers Sere enc? ist, what meaning should be attach ats the inlerence : ies as rence “ther, do social indifference maps having the Gans Lhasa they be derived” Oe a ee consumer exist? Hf Mey £7. should be ° et tat 'S section is concerned mainly with these que + nlllerenee © main rite for the continued YE Cp results Wat se t0 fies their simplicity, the fact that the? ny ye use of #101 a) Similar to those derived mor? labo! . Baled model. Scanned with CamScanner130. THE NEOCLASSICAL ‘THEORY F LTIES 5.1 DEFINITION AND DIFFICU ws all the alternative combina- providing the consumer mer is thus indifferent to the alterna- ‘on to a social indifference curve, along a social indifference {fare levels are impos- ce curve Sho’ s indifferen capable of ) which a ¢ consul his defin in constant onsumer we ‘An individual consume " aan tions of two commodities (X ane with the same amount of utility. ; ; tives. One might be inclined to app! ly a But in what sense does social welfare r ie curve? Since interpersonal comparisons cia sible, this seems tO be a rather difficult q! The Scitovsky Social Indifference Curves rence curve as the locus of all those re capable of putting each and every ciety on arbitrarily prescribed levels of well-being. That is, umers, an indifference curve Is arbitrarily erected from every map. What minimal combinations of X and Y are needed to put every consumer on his arbitrarily selected indifference curve? Note that, since every consumer remains by assumption on the same indifference curve, the society may be said to be indifferent between one or another combination on the social indifference curve (SIC). Scitovsky’s definition is illustrated in fig. 5.1. Assume two consumers, A and B. Given their indifference maps, select arbitrarily an indifference curve from each’ map, as shown in fig. 5.1 by the indifference curves I’, and I'y 1, where the subscripts indicate the individuals. Note that 4’s indifference map is drawn with He to the O, origin and B's with respect to O,. That is, B’s indifference map ae Se i i placed in such a way that the two arbitrarily What are the minimal Sacha tangent to each other at point K. to the origin 0,) which are capable of putt: and ¥ (measuring them with respect 14.1%, and B on Ty's? One such combinatio fe ee A on int ecie "Yo detemine al tch combinations tnd thas he eee ori Ona slide B's indifference curve, 1, [rh thus the social indifference curve, simply always tangent to each other, ander geass inaiflerence curve so that they are ¢ origin Op trace out the curve SICx. The latter is the social i indifference cury i ew i SIC, curve at a particular point is nec rally ac aking for. The slope ofthe each other if indifference curves t ee the slope of the correspond indiferees coe Proof of this statement, ie, thatthe vee they are tangent t@ corresponding indiferences en Point is equal to the ae ofa Scitovsky so For instance, the slope of SIC a. of A and B, see the a ponding slope o| ; TT at K. The slope at N’ ri K at Oy is equal to the pendix to this chaptes! the [51% curve is tangent t etermined by the origin common slope of I’, 1%, a" (0F the slope of fg 1-at N") Nat4 at point N, is equal 3 : indiference map whet ; e slope of I',1% al (1942) defines an indife Tibor Scitovsky tions of X and ¥ that a minimal combinal consumer in the so given the indifference maps of all cons meni Scanned with CamScannergee $1 Derivation of a Scitovsky social indifference curve. The social indifference curve SIC, has been derived on the basis of the arbi- sat selected indifference curves I’, 1’, and I'y ig. In order to bring out clearly the sasequences of this construction, suppose for the moment that the rectangle 0,10,R is a box diagram. Our two-man economy is endowed With the fixed tities O, Vand O, R of X and Y, respectively. The indifference maps of A and ve been drawn as before, with the solid curve 0, KOg being the contract ane, ie, the locus of tangencies between the two sets of indifference curves. It ould be noted again that all points on the contract curve are Pareto-optimum nts. In other words, starting from a point on the contract curve, it is impossible ‘improve the well-being of one consumer without making the other consumer “urs off. No other points in the box have this important property. Now arbi- me select some other point (besides K) on the contract curve, such as M. _Mowly, the two indifference curves passing through point M are by construc “ langential to each other at M. Suppose now that another social indifference vay ycelied in relation to the indifference curves passing one Nae tial ReW Social indifference curve compare with SICx? oeviets WA “ily pass through point Og, but, in general, it will intersect S1Cx At Os ge Of coinciding with i This is i d by the broken curve inci is illustrated by i Se. iding with it throughout. This ayo curves will in genera, 4 Which int at Og. That t ‘i lersects the curve SICx at Og. Tha’ wie “each other at point O, follows from the fact that the common slope of the "ence curve: i lope at M. Sat K is different from the slope at M- eee Sp @*"*"al, there will be an infinite number of social indifference Cvve! Pa Tough point Oy, each curve being associated with a certain distributi Scanned with CamScanner132 THE NEOCLASSICAL THEORY . « sividuals (in other words, a point on the welfare betweet ue wal in Ae social indifference Curves can, rect se Non en ininile number of social indifference curves, (usualy net pi Aco fas through any point of the positive qua drant Th in sath sna social utility index t0 any given combination it impossible to assign as ine ition, we ox to ay ven combi and Y available to the ie y. DA he ase it he so rate of substitution ore a by knowing te anrami te o et available to the sori umber of social indifference curves passing ie olan ae commodity space) will eventually be the relevant one, Marginal} MMOditieg The Utility Frontier Social welfare does not depend only on the total quantities of X and Y available g the society. It also depends on their distribution among the varlous members of the society. To put it differently, it depends on the distribution of income, Figure 5.2 shows the so-called (unique) utility frontier of the society, which is derived on the basis of the information given in fig. 5.1. Consumer 4's total utility (U,)is measured along the horizontal axis and B’s (U,) is measured along the vertical axis. Each point on the utility frontier (fig. 5.2) corresponds to a point on the contract curve (fig. 5.1). The utility frontier necessarily slopes downward because, as we move along the contract curve, one consumer becomes better off and the other worse off. In other words, when the economy is on the contract curve (and Scanned with CamScannerTIVE, ADVANTAGE 13 utility frontier), it is impose; onthe 10 make or the utility frontier is Pareto-optimal, Poin ‘Keine ‘ints K and On the contract é and M " fig. 52) correspond to the syno i, on the utility itis ig. YNonymous points on the contract sai’ fig men y frontier co; mom eX and Y available to the society but t tvand Y that lie on a Scitovsky social i Fach combination of X and ¥ (that is, each poi pat Opin fig. $1) corresponds to an inf ce, ie, the whole uti ity frontier. Thus, the ints K ie on the tility fronticr) of fig. 52 eorresronnt at M (and al other fe Si-A diferent combination of X and Y ina sew utility frontier which might or might not int 52 JUSTIFICATION OF SOCIAL INDIFFERENCE CURVES IN SOME SPECIAL CASES The analysis of the preceding section shows convincingly that, indiference curves with the desired properties do not exist. Ei sveral cases in the literature where the use of social indifferer 5wsiifed. The purpose of this section is to review these cases, in general, social lowever, there are nce curves can be Two Types of Social Indifference Curve Before Proceeding with the discussion of these cases, let us distinguish between 1 CoReePIs of social indifference curves. Social indifference curves can be drawn (0) to describe Positive behavior irrespective of the level of social welfare attached '© cach social indifference curve, or (b) to represent social welfare. In addition, Welfare Statements can be made if either (1) we have an optimizing income- veto Policy or (2) we talk about potential welfare as opposed to actual 'elfare, ‘ imizing i ibution policy is pursued, the sant that, when an optimizing income-redistribution policy is pi the eoulference map can be used to describe both the consumption —— incon o"OMY and changes in social welfare. But in the absence ofan optimizing hinge, “distribution policy, the social indifference Inep nest not indicat ‘diferent, SOCial Welfare. Thus, a movement from a joe + higher sock imply 2° curve need not imply an increase in social we ssi) nave wel Wu2 decrease if the income distribution becomes worse, Under these circum » We can, only talk about potential welfare. For nee pet A ea * although we cannot be sure that free trade improves atl wel we iin’ {hat free trade could potentially make everybody "Ves potential welfare. Scanned with CamScanner“ORY 134 THE NEOCLASSICAL THEOR’ i e Economy )binson Crusoe . “ time most trivial case is Where the econo, ame A my nal (ies # Robinson Crusoe economy), i single De aM maps does not arise because there gyi ion 0 indil a Kis ia the soa inference map, Ney and at the sa The simple composed of sing geregal roblem of agere i ny one indierence map. which not be taken seriously. se ea this ca A Totalitarian State : state (or even when a planning cae exists, the indie, In a toalita tor (or ofthe planning burcau) becomes the social indifference ma map ofa le case, the problem of aggregation does not ari, eae Identical Tastes and Factor Endowments An apparently more realistic case is a country inhabited with individuals having identical tastes and factor endowments. Thus, these individuals must be equally endowed capitalists (or land owners) and also equally Productive workers, The identity of tastes is not unrealistic, particularly within one nation and culture, However, the identity of factor endowments is most certainly violated in the real world. This case corresponds to Pigou’s (1932) concept of the representative citizen The box-diagram technique used in the preceding section can be used in the Present case to yield a single nonintersecting social indifference map. Thus, con- sidering again two individuals, 4 and B, endowed with X, and Yo units of commo- dities X and Y, respectively, study the box diagram in fig. 5.3. The contract curve must necessarily pass through point K (on the diagonal) which lies halfway be- beso because of the assumed identity of tastes. ime the same bundle of commodities, and there- sere have tution must be identical. Now, since both con- e same income, the Consumption of quantities Xo and Yo equilibrium point on the contract curve. The rence curve SIC, has been derived as before on the basis of auniquecune on K.On the assumption of the iden that both consumers are consuming exase and Point on SICy., suchas Me shown by points §, and Sy Point g exactly the same bundles of commodities, : Ons Points Ou and S; point srg fs ee Midpoint of the straight-line sant OaSe- That this s so follows From the hor ios distance from O, is eau be equal; because tastes are assumed id mien tit the Slopes at S, and'S, mil ame bundles onl this occurs only when both consumets oF commodities, iS shows ig tit 10 the present case of identical tastes « the origi illetence curve can be constructed a rigin ‘Mtersecting a common {to all consumes) Scanned with CamScanner Thus, at K both consumers consuiConstruction of social indifference curves when tastes and factor endowments are identical individuals, indlerence curve at a point, such as K. Then, in the case of two consumers, determine the point on the ray whose distance from the origin is twice as long as tuto K. For instance, O4 Op = 2(0, K) and 04S = 2(0,5,). When the number sleonsumers ig not two but n, the point on the social indifference curve is that nont on the ray which lies n times the distance 0, K from the origin. Repeating esame experiment for all points on the chosen indifference curve, we can con- suc the whole social indifference curve that corresponds to it. Note that in this case we have been able to select only one Scitovsky social ‘diference curve passing through a point in the commodity space, because of the ‘sumed identity of incomes and tastes. If these assumptions are dropped, then “cording to the analysis of the preceding section, there does not exist a noninter- “lng social indifference map.t aa should be obvious that a social indil vg ol the common indifference map of all {periment for all such common indifference curves, | a indifference map. lop, Utdamental property of this social eee “®2lower ta higher indifference curve implies that the eee es better off because the welfare of each and every col corresponds to a single -peating, therefore, the we can construct the ifference curve c 11 consumers. Re} is that a movement ‘economy as a whole mer goes UP; i.e, | indifference map ‘exists in the cas indifference map also o*nO TT (but not * Bigg Aig, Setberg. in ial “eg Pte (1961) has shown that a monintersecting SOPi4 TT and homow vel indniduete ot sai, ‘ iduals have the same proportionate share in ical) tases Scanned with CamScanner136 THE NEOCLASSICAL THEORY _ + to a higher indifference city used for predicting both fe le .s in social welfare. a lowel ecessirily MOV ie ye nap can be nce W al indifference 7 economy and chang every consumer Thus, the present soci consumption behavior of the pastes Identical and Homothetic T ase in which the Use ofa al tastes Which at + social indifference map is justified is when gy Min addition, homothetic in the sense sion curves are straight lines through the origin. In this the contract curve in the box diagram coincides with the diagonal which rence curves at points with the same slope. This case also yields fa single nonintersecting social indifference map which is actually identical with any of the individual indifference maps The technique of the preceding section can be used to show that, whatever point on the contract curve Is chosen, the same social indifference curve will be derived. Although this social indifference map is capable of describing the consumption hehavior of the economy, it cannot be used to discuss changes in social welfare, This follows from the fact that the present social indifference map is independent of the distribution of income, on which it gives absolutely no information. Put dif- ferently, through any point in commodity space there pass an infinite number of social indifference curves which happen to be identical. Each social indifference curve, however, corresponds to a different distribution of income and thus social welfare. Even though this social indifference map can be used to predict th marginal rate of substitution in consumption when only the aggre } are there is no way of knowing what the eaoeietan wee a ow it changes as we mi ; ii 2 eae eu “s ee pone ote toa higher social indifference curve. Asa 2 (by looking at the aggregates of X and ¥) whether social welfa ire improves as th i 7 indifference curve, the society moves from a lower to a higher Another ca individuals have identies that all income-consump! ease, in the intersects all indiffet Samuelson’s Social Indifference Curves i among ii a we ig individua elfare, itis possible to derive iduals in such a way as to maximize social ties of an individu a social indifferen i ‘social wena ponsumer’s indiferee eae? map with all the usual prope ‘are functi map. where W = socia on is a fang 5 social welfare a ction of the for = case ofa soci sonnet Us = lly enjoyed by the abel Uns ove Usk the highest welfa, A Samuelso: commodities X ay re contour lit ng the point acs n social indi where the utility frontier tou © curve ind Y tributed bitled all alternative combinations Ptimally among the members Of" Scanned with CamScannerCOMMUNITY IND IFFERENCE FERENCE AND COMPARATIVE ADA: | NFAGE 137 roduce the same amount of welfare, We y. i it e curves hav 6 e wish t *inditferene have the following pro © show tha operties: Samuelson’s _, do not intersect cach other (i,, ont hey t zi ther (i.¢., only one Sai ; 1 pve PASSES: through each point in the commodi muelson social indifference ‘ney store downward. ly space), 2 TIN gre convex 10 the origin. 3 Mnovement from & lower to a higher indifference curve implies an i * cial welfare. implies an increase in consider fig. 5-4 Panel (a) gives a welfare contour line WW’ associated with a witha der welfare Wp. (Because the utility indi ap level of Wel fo utility indicators U, and Upa - i a re arbitrar} 2" jae contour Tine WIV” can be made to assume any curvature.) To aie social indifference curve for W = Wo, determine all alternative com- samuelson's pinations of X and Yin panel (b) which generate utility frontiers just touching the Jfare contour line WW’. Suppose that S is such a combination. The utility en wel ai ss” in panel (a), which is tangent to the welfare contour line WW’ at V. ‘ids to point S in panel (b). From this we can immediately conclude that ociated with the unique level of welfare Wo, and therefore only 1 indifference curve can pass through S. This proves the first difference curves do not intersect ")- ie now to the second property ("Samuelson’s social indifference curves ope downward”). Clearly any point in region | (ie, the rectangle ONSM in- ‘ising the boundaries) cannot generate the same social welfare as point S (panel ib, The utility frontiers associated with these points necessarily lie inside the wily frontier S'S” (panel (a)). On the other hand, it must also be clear that any pont in region II generates higher welfare than S. ‘Accordingly, only points in tegons [ll and IV can produce the same welfare as S. This is sufficient to conclude that the slope of the jal indifference curve at § is negative since it tus pass from region III to region IV. This also Prove the fourth property navtnat ram lower toa higher Samuelson social indilference curve implies an incase in social welfare”). As it tums out, we can restrict the Samuelson social indifference curve trough even more, Consider the downward-stoping Scitovsky social indiffer- ‘tet curve through S (panel (b)). BY definition, any point on this curve generates & uility frontier (panel (a) which passes through V. In general, all other pone sts 5, on Scitovsky's social indifference ‘curve generate wility Fy Pad intersect the welfare contour line wi" at V. Inany case iH Sito cau! indifference curve is an uppet Hn for the Samuelor Sei re Ye through $, We therefore conclude That the Samuelson SoC '€ through § must lie in the two shaded ates below the on's social the Scitovsky curve Consider } + Samuels 1 indifference curves finally the third property ("Samet convey to a a a Ea ty, Samuelson 2 vexity, ssumes thatthe ve convexis _ . i ropert inartllre function satisfies the follows, onvexiy ror S ofa ood are taken away from one indl¥s ual uve corte mint 5 is always ass ‘oe Samuelson social sroperty("Samuelson’s social in ing amounts must Scanned with CamScanner‘AL THEE E NEOCLASSIC! 138 THE N Figure 54 (a) Maxim ‘ust lie in the shadeq ony 6) Scitovsky social indifference curve ization of s, areas 5 eee elite. 8) The Ssmucison social indifference curve throu8* ‘Scanned with CamScannerCOMMUNITY INDIFE INDIFFERENCE AND COMPARATIVE ADVANTAGE. 139 _ given to another if social welfare is to remai ‘ © ishing socal marginal rate of substitution or Sa eens a din consumption By another. As Samuelson (1956, p11) posse aun tis es mption " is stronger than realism can justify." Once mae the th oe ssf Samuelson's soeal indifference curves is immediate. Bh theconvex: v asider two specific commodity distributions between individual ees Dy = DalXhs V4: Xf, VB) and Dy = D(X, Ve ¥2). Ase Mand B these commodity di ributions are associated with two pohits ta a Samuel a the aiference curve: Py = Py(X4+X$, Yi + V3) and Py = PAKS + i ssl yp respectively. Because of the assumed! convenity of the soial-welfare diction, any weighted average of D, and D2, say D.,, must generate a maximum {me welfare which is at least as high as that attained by ether D, or D,. Further, see nmodity distributions Dy = 2D, + (I~ A)Dz, for any 0< 2 I, neces- qarily give rise to points P, = AP, +(1—A)P2 which lie on the straight line ning points P, and P>. Accordingly, the Samuelson social indifference curve rust lie below the straight-line P, P2, that is, it must be convex to the origin. ys oll Each Individual as a Separate Country? ts that the problem of aggregation can be bypassed by try as a separate country. If factor endow- or proportional to aggregate endowments, the production-possibilities frontier of each country can be scaled down in pro- portion to the relative factor endowments of each individual. In this case, we can jllow Samuelson’s suggestion and treat each individual as a separate country. In the case of the classical theory where there is a single factor of production, this suggestion can indeed be carried through because the condition of proportionality in factor endowments is indeed satisfied. However, with dissimilar factor endow- ments, the income distribution changes continuously as the economy moves along the production-possibilities frontier, and the simple idea ‘of scaling down the Production-possibilities frontier becomes exceedingly complex—though not 'mpossible, Samuelson (1956) sugges treating each individual within a coun ments are the same among individuals, ‘ohnson’s A pproach e 5 nape A’ Considered so far refer to total aggre ‘arty G. Joh 1959) offers what ape f F h ich ig i si ion, On <8 Problem, which is vay ‘a compromise between ical dangregtion oe «te hand, and total aggregation, on the other. In particular, the tw, ital) as separate con- 0 factors F - and capital) as separa irre pelo ae teterational individual. Since the 8 Broups, wi he c ee, in Ps, With each group behaving vid nee Pome drag enth each group Defi ny point on the Production Te = ion is perfectly fixed a ey eye from one point 19 ane Tt Hi perfectly determined for any given com- gation of individual indilference me to be a more fruitful approach Xa though it usually varies W Mogiyy «Quantities consumed are t Price ratio, Scanned with CamScannerport ASSICAL THEORY uM AND COMPARATIVE 140 rat ADVANT, AGE cence map can be made logical, difference ema lly 1 the concent row 40 portray general arn (a) ing oblems A. pen economy which is a ‘ . in the yin a simple OP counts two-commodity model. The firs, and (¢) in @ WP {the third problem only tenta. ef lem Jered EO national equilibrium in deta, iuestio of a so Assuming tha acceptable, the Dr closed economy. (P kel, international market, two problems will be const tively, Chapter 6 considers “rigorously @ of inte ‘LOSED ECONOMY 5,3 GENERAL. EQUILIBRIUM INA CLOSED Despite all the limitations and shortcomings of the social indifference map, let us arial tool of analysis. The only justification for its use, as mentioned my a oe enon that it makes possible with regard to the prob carl he rerum in addition, the conclusions so derived are similar i laborious ways. those derived by more rigorous and I j Figure 5.5 portrays the general equilibrium of a closed economy. Curve RSis the production-possibilities frontier of the economy. It is a curve concavet to the origin and exhibits increasing opportunity costs. As explained in the previous chapter, such a production-possibilities frontier is derived under the assumptions of fixed endowments of labor and land and constant returns to scale. In addition, superimposed on the same diagram are three illustrative social indifference curves. General equilibrium occurs at point E, where the production-possibilities frontier is tangent to the highest possible social indifference curve (that is, SIC,). There- fore, the economy will produce and consume X, units of commodity X and Yr units of ¥. The common absolute slope of the production-possibilities frontier and | sce point E gives the eum Price ratio py /py, or p for short. There ee eet both (0 the marginal rate of transformation, oF st of X in terms of Y (that is, the absolute slope of the production-possibilites front ; ier at the equi i imal rate of substitution in consumption of X for Hibrium point), and to the marginal ra Its usually said thatthe eco analysis of part A of the prose i certain conditions. However. th let us refrain from passing aj omy maximizes social welfare at point E. As the nt chapter reveals, this may be legitimate under a judgement is not generally true. For this 1e880% ton social welfare by means of the tenuous 1 The description ofthe Some would lke 10 say thet mee 9 fig. 55, Ht ay that he set rps 8 4 eoneave cry ise. ‘conver in the se Set of poi ema confus canes nh re ha any aight D8 Win the produce is ack OSER! With ether characterin 8 WO points of the ser rae eoesities i eon, ba congas eet stay within thes can oeeur ist Scanned with CamScannerFigure 5.5 General equilibrium in a closed economy. concept of the social indifference map. For the moment, let us use the social indifference map for predicting the demand behavior of the economy alone. The question of the effects of trade on welfare is taken up later in chaps. 15 and 16 In the classical theory, the production-possibilities frontier is’ straight line and the (pretrade) equilibrium price ratio can be predicted from the production data (ie, the labor coefficients) alone without any knowledge about demand assuming, of course, that both commodities are produced and ‘consumed in equili- brium, Under the more general assumptions of the neoclassical theory, however, increasing opportunity costs are the rule (and constant costs, the exception). Therefore, we can no longer predict the (pretrade) equilibrium price ratio without ll information about demand, which now becomes as important * supply In the presence of increasing opportunity costs, the most that ca be accom ished Nithout full information about demand (assuming only that both comm ‘1 oe Sinsumed in equilibrium) ts finding the limits within whieh the Pret pill price ratio must lie. These limits are, of course, BT a inrfig. $3). “Oduction-possibilities frontier at the intercepts (ie. Poln's 5, Y 4 EQUILIBRIUM IN A SIMPLE OPEN ECONOM n economy which is le imple o| too grectding analysis can easily be extended (0 8 simp preciabe influence onthe format I relative to the rest of the world to have any now that our economy can i e 8 Of international prices. Therefore, assum Scanned with CamScanner142. THE NEOCLASSICAL THEORY y y at given international prices, pt ted quantities of X and Yat g! we thal is aR /Pf ona au FP Ratt ee ar oy ntrested in relate prices, tha or ml, oh foe Rte show how equilibrium is reached whe ot The problem is tos eee aneas our economy will each general equ, ¢ classical theory, 6 As in the case of the classic brium in the following two steps: choose to produce at that particular point on the ease ccs ronr where nation income (expressed inet Heer Penman Mathematiealy, this problem can be stated as follows: bald to ler an subject tothe constraint F(X, ¥) = 0, where Q is pr eae Qxpresed in Y and the function F(X, ¥) =0 is the algebret expression for the production-possibilities frontier. . Having chosen the production point, the economy will then have to decide what to consume. Optimization of Production The determination of the optimum production point is illustrated in fig. 5.6. The curve RS is the familiar production-possibitities frontier of the economy. The family of parallel straight lines with sl lope equal to p* is the geometric representa- tion of the function Q=p'xay (51) {2 family af contour lines, with each line being the locus of all those combina- tions of X and Y which have the same value in the 1 object of the economy i mys 40 maximize national income Q. In this effort, it is Constrained by the produetion-possibilites frontier, (Remember that the economy a ee tier, but not beyond it Production-possibilities fron- From fig. $6, i ee » at the point where the production- Production ata point cakes, HgEM" 10 the highest income contour line, Ox & national income stale: ye UNE is impossible ouch ae Z) or hes ret tach per cone ena eet aX) Acorn the economy canes ? € contour fine than becau: © constraint it sed by Ihe Production-possiblities fronts Wilh ete ofthe constraint impo scimological progres, labor growth the e¢o Possibilities frontier will, of course, shi With given technology an gy {© EACH a higher income comin Hlowevet Possibilities frontier (fg So) mecowments, giving rise to the production Possibly reach is Q : “maximum income that the economy a? Following th income contour fine 9 nORY introduced in chap. 3, let us call the highest “Senomy.by producing at poing 3 "O%-possbilties jrontrar ty ten words i Point E,can consume at any point on the consumption” — Scanned with CamScannerCOMMUNIT Y INDIFFERENCE AND COMPARATIVE ADVANTAGE 143 igure 5.6 Maximization of na- tional income occurs at E where the production-possibilities fron- tier touches the highest income contour line. possibilities frontier, i.e. the income contont line Qs, because of the possibility of Prernational trade. Therefore, as the classical theory demonstrates, international trade makes it possible for an economy 10 ‘consume beyond its production- possibilities frontier despite the fact that it can never produce beyond the boun- Jaries of the production-possibilities frontier. To use Haberler’s metaphor. the building (ie, the possibility of consumit he production-possibilities frontier) remains after the scaffolding (ie, the labor theory of value) is removed. Observe that the income contour line Qs lies totally outside the production- possibilities frontier RS, except at the singular point E. “Therefore, neglecting the singular point E, we can say immediately that free trade increases potential welfare, for it is possible, with an appropriate distribution of income after trade. 10 make everybody better off relative to the pretrade position. This question is ximized if the discussed in detail in chap. 16. ; The preceding discussion shows that national income Ts ma economy produces at point E, But how sare know that the economy will * actually produce at £? This is 4 Tepitimate question, because it a perfectly com- | petitive economy there is no planning board” (0 m3 this important cecsion. Nevertheless, this important function is performed by the forces of competition. Since our economy is a price taker in the ried market and transportation costs Pill necessarily coincide with intent ional are assu estic. prices le i med zero, dome on the production-possbilties frontier where ve that at any other depot ne eae Fn addition, obse! estic and international prices are ed . : Point on the production-possiilities fuitier, the value of output produced at —_ Scanned with CamScanner ing beyond t144 THE NEOCLASSICAL THEORY could increase by merely changing the production pattern. Therefg, Mr soener or later guide the economy to produce g at world price: Adam Smith’s invisible hand ' point E. In summary, the economy possibilities frontier whose abso p*. The tangent to the production selected becomes the consumption will produce at that point on the product lute slope is equal to the international price aa possibilities frontier at the production poj ‘tio possibilities frontier of the economy. INt so Optimization of Consumption Once the consumption-possbilities frontier is determined, the next step is to f out where the economy should consume. Figure 5.7 shows how this part of dl problem can be handled. The curves RPS and KPV are the produc As possiblities and consumption-possibilities frontiers, respectively. In additi es the same diagram are thre illustrative social indifference curves. Consu aria gallu securs at point C. where the consumption-possibilities tronic Touches the highest posible social indifference curve. Therefore, the economy ee p and consumes at C; that is, it produces Xpand Yp units of Yap ly, and consumes X¢ and Yc units of X and Y, ingly. the economy must be exporting DP tits of ¥ ie Vnperting De cain eee Figure 5.7 Oy timizaton Louch the Highest poo consump tion ocey le social in Urs at C Wher lilerencecarce Bee the consumption-posibiies fost? KY” Scanned with CamScannerCommuni | YINDIFERENCE AND COMPARATIVE ADVANTAGE {4S Finally, note that the value of DC units of of Y. Geometrically, this follows from the absolute slope of the consumption-possibiti national price ratio p*. Thus, DP/p¢ exports is equal to the value of in equality follows from the fact that the valu value of output consumed: ic., both th on the same income contour line. Thus N is equal to the value of DP units ‘ct that the ratio DP/DC gives the frontier that is equal to the inter- P*. oF DP = p*(DC). That is, the value of of output produced is equa ¢ production to the and consumption points lie PX e+ Ve = PX + Yo .. Y— Yo= p'(Xe~ xy) But ¥p— Ye = DP and Xe— x tion DP = p*(DC). (5.2) » = DC. Therefore, eq, (5.2) reduces to the equa- The Offer Curve The preceding analysis shows how to determine the quantities of X and Y that the economy would be willing to export or import, as the case may be, for a given value of the international price ratio p. But this is precisely the information that is required for the determination of a point on the offer curve of the economy involved. Therefore, repeating the same process for all possible values of p, we can determine all points on the country's offer curve: ie, we con giraine the “country’s ofer curve Compared with the classical theor the determination ofthe ofer curve’ the present ease Becomes much ars Nea cure the peattnss Trontier is linear, the production point coieides with the vertical-axis ilercept Of the production-possibilities frontier for all values of p lower than the Piettade price ratio. Similarly, for all values of p higher than the pretrade price ‘allo, The production point coincides with the horizontal-axis intercept of the production-possibilities frontier. As a result of this simplification, the deriva- tion of the offer curve did not seem to be an impossible task In the presence of sing opportunity costs, the production point necessarily changes as p Changes. This makes the derivation of the offer curve much more diflicult lowever, thanks to Meade’s ingenious technique (explained in the following Pler), theoTTer curve can still be derived with little effort. Consumption and Production Gains ~ Note that the preceding analysis can be used to improve our unde Eranelng ove Bains from trade. For this purpose, assume that the social Genisaines . tibes not only consumption behavior but also change : Sere aly antler Toted in part A of the present chapter, this assumption B a (eases discussed in ain conditions. In particular, it is legitimate in all Selick tastes With only one exception the case of identical an‘ Scanned with CamScannereseribing social welfare in addition to con, . free international trade enables ‘a social indifference map 4 7) that is jous (see MB - ot indi naobviows (6 FE Th social indilference curve, ie, tg a lower (0 y divided into_thefollawing. two 146 THE NEOCLASSICAL THEORY Given sumption behavior. i the econom, increase social welfare The total gait de is_usuall y to move from from or the consumption gain, which accrues to mal exchanges dities that was produced under bundle of commot free trade. duction gain, which accrues to the econ. ‘as a result of the shift of the een the pretrade and posttrade n the same duced under ‘zation, of the pro’ sumption gain difference betw the economy autarky is also pro' 2, The gain from speciali omy over and above the co production point due to the commodity prices. Figure 58 illustrates the reduction of the total gain into a consumption and production gain. The curve MP; Po is the economy's production-possibiliti : frontier. Before trade, equilibrium occurs at point Po» where the rrodctons posits oer tures the highest possible social indifference curve isic,) » Ci : statin that pases thou P a any cons ih por sibilities frontier. Social welfare improves becaus nN aries social indifference curve (SIC,) to a higher one ‘sic, bea aera 3). To isolate the consumption Ree $8 The total gain fom hase i died tag consumption A (les the movement from Pot movie ‘a production gain (i¢+" ment from Ey to Es} Scanned with CamScannerCOMMUNITY INDIFFERENCE IFFERENCE AND COMPARATIVE ADVANTAGE 147 gain. assume for the moment th; Id js frozen at Po. Th ening Up of trade, he production point jpetween IndUSTies and factor-pri i he case of perfect factor immobility possibilities frontier becomes 1 My, where the e oductlc angle OVP, U. Ey ‘conomy’s production- t Po. the ec y wi frozen at Po. the scononsy wil sill Benet rat tale he oe eetastOn a ption point would move from Py to Ey. Thatis, the ex indiference curve (SIC,) to a higher one (Sle) The ce a omer socal SIC; is the consumption gain. The production gain ic me nent fom SIC to ment from E, to E, asa result of the change in the produ tion pan wean ne iction pattern (from P, to 5,5 NEOCLASSICAL DEMONSTR. SOYANTAGE ATION OF COMPARATIVE The Setting Assume two countries, A and B, endowed with fixed quantities of two factors of production, labor (L) and land (T), and producing two commodities, X and Y, under constant returns to scale. Denote the pretrade equilibrium price ratios py/py in countries A and B by p and p$, respectively. Figure 5.9 summarizes the pretrade equilibrium positions of the two countries. Panel (a) illustrates 4's pre- trade general equilibrium and panel (b) illustrates B's. The curve ME, N (KER) is 4's (B's) production-possibilities frontier, while the curve SIC, (SIC,) is the highest social indifference curve that 4’s (B's) production-possibilities frontier can teach. Thus, before trade, A (B) produces and consumes at E4 (Ey). Country 4’s 59 Autarkic equilibria. Scanned with CamScanner148 THE NEOCLASSICAL THEORY * the slope of the tangent Eq V (Ex U). It hag (B's) pretrade price ratio is given by ively cheaper in A and Y in g Cie a0 is, that X is F been assumed that p< ph that iss th before trade. ‘Trade Limits of the Terms of Trade and Structure of Tra can be said that country A has a comparative Under the preceding assumptions in oe per when ride is opened upg advantage in the production ae alae (or B will export Y and import x}. Finally, it ean be shown tha paaelee ae feteaea the pretrade price ratios of the two countries; that is, PL pa > Pp’. Therefore, when trade is introduced, both countries tend to specialize in the production of X; that is, they both increase the production of X and decrease the production of Y. Further, when p = pj, country A exports commodity Y and B commodity X—quite contrary to the classical expectations. It should be pointed out that, had As pretrade price ratio been pj instead of p&, the classical conclusions would have been entirely correct. The existence of multiple pretrade equilibria does not affect the classical conclusions in the following special case. In the presence of increasing opportunity costs, a country cannot be determined Denote the lower limit of the pretrade price rati Se * and the upper limit by pi. Thus, any i i country A (p,) must satisfy the condition . Pi iagrangian multipliers. For minimization of y, i, eee atnel ih ef anal derivatives be zero: he following partis required that oz _, Way, 0 ‘d ax, diay ts (As2y Up, _ =, 8 +4,=0 Free nay, 1 ) U, Baitang! 0 (asa) ra i apn (AS, ay, | * "oy, = (A53) i =UAX4, 4) - 0, (as6) 1 Z z = Up(Xp, Ys) — Uy =0 (as) Ay . Fen XatXy—Xp=0 (As8) Equations (A5.6) through (A5.8) imply that the three Constraints of the problem are indeed satisfied. Combining eqs. (AS.2) and (AS.3), we get OU4/0X,_ A, SeaeX4 _ Ay 5.9) 8Up/OXy~ 3, se Further, combining eqs, (AS) and (A5.5), we get BU 4/0¥, a, i St we 0 OU g/0¥, ~ 3, ee Finally, substituting eq, (AS.10) into ©q. (AS.9), we get OU 4/0X, OU, /0X, or U4/0X 4 OU, /6 = WalO¥ 2U,/0¥, ~ Uy /0x, 4 Uy /d¥, (Aa5.11) Scanned with CamScanner4 COMMUNITY \ INDIFFERENCE AND COMPARATIVE ADVANTAGE 153 cessary condition for minimizati at is, Ne ion for minimizatio sated between A and ninimization of ¥ is that the two commodities as beter aan aie way that the marginal rates of substitution $a al. This is illustrated in fi \ 7 q sp ‘i ig, 5. ° jfference ea and T'yIh, are tangent to cach other, eae s the slope of a Sci ial indi pe of a Scitovsky social indifference curve at a certain point what i Jay (Xo. Yo)? To answer this question, rewrite eq, (AS.11) in the following form: AYa Yn dX, dX, (A5.12a) _ Ys Wa ay Xa (5.12) onsider now the differentials dX_=dX4+dXp5 (5.13) d¥ = d¥, + d¥y (as.14) pstitute eq. (AS.12b) into eq. (AS.14) and get — 1% Yo = Gy, (Xa + Mn (A5.15) Now consider the ratio _ dYald) AX 4 + VMAX) Ae Ye A% _ (aYp/dXp) AX. do dXo dX,+4Xp aX, +dXp5 dXp (A5.16) ‘Combining eqs. (A5.12a) and (A5.16), we finally get dYo _ Yn _ Ya oe = 5.17 Xo WX, AX, (as.7) rence curve at a certain point is .ce curves of A and re, the slope of a Scitovsky social indiffe he corresponding slope ofthe corresponding iniferen ‘ich the latter are tangent to each other). SELECTED BIBLIOGRAPHY Chacholindes, M. (1972) " Precrade Multiple Equilibria and ‘Metroeconomica, vol. XXIV. fase. It, pp. 18 139. Eisenberg, E. (1961). “Aggregation of Utility Function’ * Management et, G. (1936). The Theory of International Trae. W. Hodge and son, HG. a ‘rade, Income Distributior and t G. (1959) "Intermaional Trade Ishin T4260 el aAE se! ‘of Economie and Socal Stull: OV 7" PP 1, 1968 ternational Economics. R. D. Irwin, Inc, Homewood: Hh. —, (1960). = Income mi BO er Cura te EES TAS “Manchester School of Economic and Social Stuties, vol. 28: PP. 215-242. he Theory of Comparative Advantage.” Science, Vol. 7, pp. 337-350. ‘Company, London, chap. 12 he Offer Curve.” Manchester A Readings i Scanned with CamScanner _—184 THE NEOCLASSICAL THEORY “The Use of Indifference Curves in the Analysis of Foreign Trade.” ore 3-503. Journal of Economics, vol. 47, pp. 493-5 oom Lerner, A. P. (1932). “The Diagrammatical Representa Trade.” 346-356. Reprinted 1d Compa London, 1953. | isa The Diagn jon of Demand Conditions in International Trade» : 1934). ° The Diagrammatical Representa U (1934). “The 1 v 319-334. Reprinted in A. P. Lerner, Essays in Economic Analysis, Macmil. Leontief, W. W. (1933). " n of Cost Conditions in Internat A. P. Lerner, Essays in Economic An, ional alysis, mica, vol. 12, PP. Economica, N. lan and Company, London, 1953. . Marshall 8 (1924) Money, Cradit and Commerce. Macmillan and Company, New York, app. 3, Pigou, A. C. (1952). “The Effect of Reparations on the Ratio of International Exchange.” Economic Journal, vol. 42 (December), pp. $32-543. . Samuelson, P. A. (1956). “Social Indifference Curves.” Quarterly Journal of Economics, vol, 79, Pp. . Savosnik, K. M, (1958). “The Box Diagram and the Production Possibility Curve.” Ekonomisk Tidsk. rift, vol. 60, pp. 183-197. Scitovsky, T. (1942). “A Reconsideration of the Theory of Tariffs.” Review of Economic Studies, vol, 9 pp. 89-110. Reprinted in AEA Readings in the Theory of International Trade. R. D. Irwin, Inc. Homewood, Ill, 1949. ms Vanek, J. (1959). “An Afterthought on the Real Cost-Opportunity Cost Dispute and Some Aspects of General Equilibrium under Conditions of Variable Factor Supplies.” Revi i Caner! Enuilbsiam pp view of Economic Studies, Viner, J. (1937). Studi v0 )- Studies in the Theory of International Trade. Harper and Brothers, New York, chaps. 7 Scanned with CamScanneree oe CHAPTER SIX INTE Tl TERNATIONAL EQUILIBRIUM ‘As we saw in chap. 3, international equilibrium is usually portrayed in terms of offer curves. Our first problem is to derive the offer curve of a single country. This can be repeated for a second country, and then the analysis of international equilibrium can proceed along the familiar lines of chap. 3. ‘The derivation of the offer curve in the absence of constant opportunity costs is not an easy task, Edgeworth (1905, p. 70) summarized the difficulties in the following well-known statement: “There is more than meets the eye in Professor Marshall's foreign trade curves. As it has been said by one who used this sort of curve, a movement along a supply-and-demand curve of international trade should be considered as attended with rearrangements of internal trade; as the movement of the hand of a clock corresponds to considerable unseen nore of the machinery.” Edgeworth was actually quoting himself (Edgeworth, 189% Pp. 424-425), ded a geometric In the early 1930s, Leontiet (1933) and Lemnet (1934) ro enc aS technique for obtaining a country’s offer curve from tsi need and production-possibilities frontier. Twenty years orkY ein his Geometry of by these two writers was finally perfected by a ie technique the subject Inernational Trade (1952)t. Meade's ingen fs f international of part A ofthis chapter. Part B deals with the pro! equilibrium. geomet n iplem of stability 0 curves which were ar indeed se oer sures whi 6s # In retrospect, it becomes evident that prageworth (1898) Afar insane eo 4 All derivable by the techniques of Leonviel, Lemme a7 965.688) e¥PreS thst oe Along with his commentary on pp. 48-434 CHP 188 _— Scanned with CamScanner* , GEOMETRIC TECHNIQU, parT A. MEAD 61 INTRODUCTION .y value of the terms of trade, a point oh fora givel erms chapter shows how, for a 8! jue of the terms Of trae The previous chapter how pe derived from its social indi UFVeS ang "e offer curve ¢ a country’s offer curve ar, gi he terms of trade, ities frontier. In particular, Lec lifanlicriwiiens ae * sduction-possibilitie tere national mie point on the production-possibilities fron. imasimnzedy ea highest income contour line, known as the frontier. Further, consumption occurs at the point on 5 frontier at which the latter is tangent to the highest yy, the quantities traded (i.¢., the coordinates of g point on the offer curve) are shown by the differences between the quantities a eraumed and the quantities produced. This procedure can be repeated for ai possible values of the terms of trade, until the whole offer curve is derived. Ob. viously, the same procedure can be repeated for a second country; and then the analysis of international equilibrium can proceed along the familiar lines of chap. 3, This procedure, though formally ccrrect, is abandoned for three reasons. First, it i cumbersome: too much time and effort are required for the job. Second, it is inadequate for the analysis of the effects of, say, tariffs on the welfare of the tarifi-imposing country, assuming that the social indifference map does indeed portray welfare. The imposition of a tariff causes the offer curve of the tariff. imposing country to shift, and it is extremely difficult to determine whether the Country moves to a higher social indifference curve after the impositi a position of ihe Bae ae an alternative approach distinctly superior to lure above. i i is ‘ technique 10 which we ae This alternative approach is Meade's THEORY 156 THE NEOCLASSIC production-poss tion occurs at t consumption-possibilities f the consumption-possibilities social indifference curve. Finall 62 7 N THE NEED FOR A TRADE INDIFFERENCE MAP Tequires that the value of exports simple open economy which can where Ey and By dey denot (61) (Since py is positive oUt country’ POSitive, it TY'S excess a ’ OPPoSite signs, unless thes tld be obvious persian for X and Y, respectively. a Figure 6.1 illustrates prise oth 28 aa sie pales Braphically th of points which Satisfy’ " x and Ey must necessarily have ich is usually ait sum 6.1). . a marized by eq. (6 &4. (6.1), ¥ Called the terms-of-trade line, is in locus Scanned with CamScanner‘ INTERNATIONAL PQUILIBRIUM 157. serve that when Ey > 0, commodity y OPsity X is exported. A similgr nee pyported, and when Ey <0, 6.1 shows exports of X (that j Tegative Ee for Ey. The first quad- nid the third quadrant shows ineae aaah imports of ¥ (that is, sirts of Y (that is, negative Ey), (that is, positive Ey) and Pete terms-of-trade line ROK is another form or snomy. It shows all combinations of exports or he requirement that the value ofexports Ths for a given amount of exports, such as OV units of X, our economy will be able to get only VU units of Y. Although it could get less than VU units of ¥ (by destroying. for instance, part of VU), it can Never get more. This suggests that our economy can never reach any point Which lies above and to the left of the terms- gfarade line. It can, however, reach points in the shaded area, i, below and to the right of the terms-of-trade line. Nevertheless, our economy will not be able to reach the highest social indifference curve unless it actually operates on the terms- of-trade line. Accordingly, in what follows, let us concentrate on the points which lie on the terms-of-trade line and ignore the rest. | . Once it is understood that the terms-of-trade line is a budget constraint, it must be clear that, given po, the corresponding point on our country’s offer curve, ie, the optimum trade point, could easily be determined if, somehow, indifference somnmodit he budget constraint for our and imports of X and ¥ which be equal to the value of imports. F ampons of Y) {mpors of =} (exports of 1 for the economy. Araint the budget cons 61 The terms-of-trade line ROK is another" of Scanned with CamScanner( ' Id_be plotted j onsumption, cou in ves for cr determined by the tangency of a urve for trade. Hence, the rea] indiferene e Meade called them, trad Tor Aifow can they be derived? 158 THE NEOCLASSICAL THEORY nee cu il jeren euves for trades} not iniferenes id fig. 6.1. Then the optimum trad a the terms-of-trade line to the high question is: do indifference ae ‘ indifference curves, exist? If they doe 'URVES 63 DERIVATION OF TRADE INDIFFERENCE C ‘A Simple Edgeworth Exchange Economy The main tool of Meade’s analysis is the concept of the trade indifference map, : i . We measure ver- Figure 6.2 illustrates this concept in Be ery cael tically, moving upward from the origin O, the economy, and we measure horizontally, moving leftward from O, the total amount of X consumed by the economy. Accordingly, the social indifference curves have been drawn in the second quadrant with 180° rotation. Fach social indifference curve shows (with respect to the origin Q) the alternative combinations of con- sumption levels of X and Y which yield the same level of social welfare. Assume now that the economy under consideration is an Edgeworth ex- change economy endowed with 00' units of commodity X only. Consider point 0’ as a new origin. Measure vertically, moving upward from 0’, the imports of Y; horizontally, moving leftward from 0’, the imports of X; and rightward from 0’, the exports of X. The indifference curves 1), 17,13, ..., viewed with respect to 0’ as origin, autamatically become trade indifference curves. That is, each indifference curve pas) with respect to the origin 0’, all ex Port-import combinations which, given the initial endowment of 00’ of X, allow the economy to reach the con- sumption levels indicated by the same curve with igi i Teach a certain level of welfare) an a h the level of soci ‘ social we indifference curve 1,. At the same time, the coor the origin O° (tha TP ‘dinates of point A wii 110. can no eae fe eae 24) show one eombinetina of eran aad curve I. Notice that, at point 4, ae to reach the same social indifference Imports of Y= UA = OV x ¢ = coi elfare indicated by the social "sumption of ¥ \ OU =00 We can say that th ; indifference eae coordinates of poi Exports of X = 0'u = gg Similarly, - on the social + Edgeworth (1894) id actually dg fg. 8 p. 433 and his comments on ‘i a ha iilference ey is B. 433-434 “rves for trade. For instance, see his Scanned with CamScanner1 INTERNATIONAL EQUILIBRIUM 159 (imports ot (Consumption ot Tepaw ot ¥) (Contumpion f y=? (Expore of 1) Figure 6.2The trade indifference map in a simple Edgeworth exchange economy. alternative combinations of consumption levels of X and Y which enable the economy to reach the level of social welfare indicated by the social indifference curve 1;. The coordinates of the same points A, B, C, and D give us, with respect to the origin O’, four alternative export-import combinations which (given the initial endowment of X) enable the economy to reach the same level of social welfare. In general, then, the indifference curves in fig. 6.2, when viewed with respect to the origin O, are the familiar social indifference curves (which, following Meade, might call consumption indifference curves). (To avoid confusion, the term ‘consumption indifference curve " will be used instead of the term * social indiffer- ce curve” which we have been using so far.) The same indifference curves ‘ome trade indifference curves, however, when viewed with respect to the origin of trade are given by Ps/P, = Po- fh slope equal to po, ts shown by y's consumption-possibilities gin 0. Consumption equilibrium nevessarity curs at point A, where the consumption-poss| ilitis frontier is ee ighest consumption indifference curve. What is the interpretation of eae ne O'AF when viewed with respect 10 the origin o'r itis ey neeoa athe ms-of-trade line. Hence, the tangency at point Acan a Re ee ee the terms-of-trade line becomes tangent (0 the highes Assume now that the international terms raw a straight line through O’ (fig. 6.2) wit ‘AF. The straight line O'AF is simply our econom. Scanned with CamScanner160 THE NEOCLASSICAL THEORY 6a e trade indifference map can be ma, Seopa eal cs thee econo poten pene Na tier knconame cae not merely a point asin the Preset ese) hs later interpretation becomes quite useful: the optimum i an be en trated in fig. 6.2 by point 4, when viewed with respect a ean enti aS the tangeney between the terms-of-trade line and the highes ; ence curve In addition, the economy becomes better off when it moves from a lower te a higher trade indifference curve, The concept of the trade indifference map becomes a powerful tool. Trade Indifference Curves in the General Case So far, the concept of the trade indifference map has been illustrated by means ofa simple exchange economy endowed with a fixed amount of commodity X only. But how is the trade indifference map derived in the general case where the economy's domestic availability of commodities is given by a production. Possibilities frontier exhibiting increasing Opportunity costs? The information needed for the construction of such a trade indifference map is contained in the tf ; ‘ations which enable the econ- Dini Sth the consumption indifference curve I? These export-import com- ar ich can be derived as follows. fs a (that is, the Production-possibilities frontier) is resis Fant nF ho wy ha a I ine: vit a a ition. The corner of the block OMB traces out the required gan c horizontal po vel. In interpreting fig. 6.3, recall indifference curve Ii. exports as negative quantities ieee teas How do we know that the > trade indiffere, oe , . one nengaking fr? Concentrate on le pon of BES us the information one point is true for all. Cone me Point on 1 » becaus at is true for (= DV) units of x 4 der, therefore, Point V. Ary the eines oc i seo) Utils (OF imports) of Y. Does this er, is 1 nO™Y 0 consume somewhere on the : 70t Possible that with this particular ‘© Feach a higher social indifference Scanned with CamScanner Imagine that the block 0, Moved up the consumptiINTERNATIONAL EQUILIBRIUM 161 Figure 63 Derivation of the trade indifference curves in the general case. en it is seen that, after our econ units of Y, the best it can do is to sere the straight line FH is perpendicular ivnere the production block is tangent "0 come obvious wh curve than 14? The answers be ts of X for OD omy makes the exchange of OC unit consume along the curve FHUG, Hibus, it actually consumes at point u( 11). 1 produces VJ units of X, out of which it exPor DV units and consumes only JD. Similarly, it produces VS (= TU) units of ¥ which along with the imports of given by CV (or RJ) make up the 1 omesticconsummpyon of (Chat & RU). Similar reasoning applies to all other poin's Hying on £2 Therefore the trade Indifference curve 1, shows the altern ive export-import combinations which enable the economy to reach the consumption indifference curve Ii. / In general, a trade indifference cH an be derived for each consumption indifference curve. Imagine ¢ the production-possibilities fromtier) placed tangentially “84 he block OMPN (that is." st a consumption indifference curve, such as 15, and then moved along this /3 curv® Anew trade indifference curve is traced by the Comer of the block OMPN, 3s inastrated by the Fy curve: Observe that 15 lies Consistently above and to the feft of J, since Ts lies consistently above and to the le of 16 n general, one trade indifferent ote corresponds f one consumo? indifference curve: “the higher the col jon indifference curve, the higher the corresponding trade indifference curve. e that the trade indiffer- Scanned with CamScanner( fae Ii (for is «on indifference curve [7 ist, consumption ind above [4 F. ve must lie totally to the left a 3+€Nd so 162. THE NEOCLASSICAL THEORY corresponds t0 th ence curve [i ! is higher than I .-). Then, if on. DIFFERENCE MAP - THE | E 6.4 PROPERTIES OF THE TRADI { properties of the trade indifference map are describeq ortan Some of the most imps as follows. amit os between trade indifference curyes e-o-one corresponccres er the consumption indifference and consumption ince trade indifference curve. e of a tra , eee ding consumption inane ae the slope of the production. ‘bi er at the correspon 5 : . aero 4, the slope of the trade indifference curve Ty at Point Ty is necessarily equal to the slope of the consumption indifference curve J and the slope of the production-possibilities frontier at point C,. This can be Proved as follows. Let the production block slide along 1 from C, to C2, with its corner moving from T, to T;. The movement from T; to T; implies that the exports of X increase by T, N and the imports of Y by NT;. Further, the increase in exports of X (that is, T,N) can be decomposed into (a) a decrease in the consumption of X by MC; (since on Jj we move from C, to C2) plus (b) an increase in the production of X by C; K (since on the production block T;C, we move from C; to C,). Therefore, T, N= MC, + C; K. Similarly, the in- crease in imports of ¥ (that is, NT;) can be decomposed into (a) an increase in the consumption of Y by C, M plus (b) a decrease in the production of Y by — KC,. Thus, NT, = C,M + KC, (Note that point C’, on the production block TC, corresporlds D 1 production block 2C; corresponds to point C, on the production block T; Cy.) The slope of the straight-line segment joining poi pen I: NT/T,N = (C\M + KC,(MC, 4 K) Li ig points T, and T, on I equals slide along the consumption mie . Let the Production block 7,Cz © curve Ij until it coincides with the Production block T; C,. The r: . ‘all ‘i curve at point C,, and the ratio KOC a caches the sloee of he prod 2 1. There exists a one-t tion block at point C, (or C; K approaches the slope of the produc- 1 (Or Ci). Since at poi pe produc ‘angent to the 1; curve, we Bal have inthe lang} the production block is it GM Kc MCG" GK oF | OK _ Key Therefore, 2 ie, NT, TNT MC GK neat KC; /C,M)] +(e = OM the eae te slope ofthe Meurveat 7 *( 2K/MC.)] * Mc, © producti 1 is equal N00 Plock atthe point cn slope of the 15 curve and Scanned with CamScanner‘ INTERNATIONAL EQUILIBRIUM 163 Consumption ot yy MPO paper ot Figure 64 The slope of I; at 7; equals the slope of Ij and the stope of the production block 7,C, at Cy. 4, Asa result of property 2, it follows that ifthe Jf curve is negatively sloped, the If curve will also be negatively sloped. 4, Likewise, if the Jf curve is always com conditions of increasing opportunity costs.7 vex, the Jf curve will also be,convex under These properties are also discussed (more rigorously) in the appendix to this chapter. 65 THE OFFER CURVE Derivation of the Offer Curve The trade indifference map can be used for the As the preceding section demonstrates, there Sponding to every consumption indifference cur Sa ference curve, the higher the corres ding trade In vena i econom for any given international the : i fatter is tangent to the i i pe the point where the latter Is ' ighest con: ion indifferen -of-tra mum lead point ‘can be determined by the tangency of the terms Ee purpose of deriving the offer curve. is a trade indifference curve corre- We. the higher the consumption ference curve. Further, ny consumes on the , decreasing opportunity costs pe i snaiterence curves under COMET o ponporni aswell ie fee other aes amt properis rrr trade indifference I™4P- see Scanned with CamScanner164 THE NEOCLASSICAL THEORY , ilities frontier, to the highest pos. ssumption-pessibi io changes, the ee Bie internat its slope is again equal to the (new) ° tmagencY fs determined between the (new) terms. « hest possible trade indifference curve, giving Us another of-rade Tine and the highest possible Wat MT ins of trade to vary fron, point on the offer curve. By allows ei tangencies between the Successive terme, zero to infinity, we can thus (ete once curves, ie. all optimum trade point eared is eee ane cies, or optimum trade points, is the economy's offer our eure 645 illustrates the derivation of the offer curve. Consider the terms-of. trade tine TOT), which is tangent to the trade indifference curve I', at the origin, For the terms of trade implied by TOT,, say pi, our economy does not wish to participate in international trade. (Put differently, p, corresponds to our econ- pretrade equilibrium price ratio.) Imagine that commodity X becomes progressively more expensive in the international market. The terms-of-trade line rotates through the origin, becoming steeper and steeper, as illustrated by the terms-of-trade lines TOT, and TOTS. As this happens, the optimum trade point (ic,, the tangency between the rotating terms-of-trade line and the trade indiffer- ence curves) moves from the origin into the first quadrant, as illustrated by points E, and Ey. The locus of all optimum trade points in the first quadrant is given by the continuous curve OE, £3. In particular, this is the part of the offer carve which corresponds to terms of trade higher than p,. The remaining part of the offer curve 's derived by allowing the international terms of trade to fall continuously from p, to zero. As this happens, the terms-of-trade line rotates through the origin, becom- ing flatter and flatter than TOT,, as illustrated by the terms-of-trade lines TOT, and TOT. ‘The optimum trade point moves from the origin into the third quadrant, as illustrated by points Ey and Es. The locus of all optimum trade ae ingle bis peony oe Oe Es) is the other part of the offer curve. , : y the solid curve Es Ey OE; Ey. ig. 6.5 has three trade indifference curves eine 1 curve passes through the origin. 7 P the consumption indifference curve (say the absence of interational ttn Possbilts frontier touches tangentially in by the slope of th trad Pee the slope of 1, at the origin, as shown Pretrade price ratio ie, the slope of have Jout Necessarily corresponds to the i i he curve at the pretrade equilibrium point. curve—and theret © clear that our economy consumes on the fi na Point will be " if, and tio is equal to th on the 14 curve—if, al which is parallel to the cor trade indifference curve. A\ trade line rotates through the international price ratio. A new but five terms-of-trade It follows that the 1c Hy 1 CUrVe Corresponds t 1) which the coun lomposg { alice he pretrade price ratio, as shown ; dingt Price ratio, as the offer curve isthe origin g, 2" "© Only point of the 1, curve thar belongs © For any international i rice ra pretrede yang ie e is rauio other than ¢{ Fupumtion indifference cure ee TOT higher trade indifference curve th mi an he one that coincides with the 1 the fe wt S¢onomy consumes on a highet he I curve wy’ and, therefore, trades on 4 1 CUrve. For this reason, all trade indiffer- _ Scanned with CamScannerINTERNATIONAL EQUILIBRIUM 165 Imports of Taper of Exports of ¥ figue &5 Derivation of the offer curve, mitted from fig. 6.5 as irrelevant to ther trade indifference curve higher than the tN gent to it at two different becomes tan} ‘ional price ratio. For instance, points and points Ey and Es lie on ence curves lower than the /', curve have been o our problem. However, given any o' curve,t the terms-of-trade line necessarily points for two different values of the internat Ey and E, lie on the same trade indifference curve I’, 1. Why is this so? Consider fig. 6.6 which provides the explanation in tools. The curve RP3 E, P25 is the economy's producti while J, and 15 are two consumption indifference curves. In | ional trade, the economy produces ‘and consumes at point E, (which corre- nds to the origin of fig. 6.5). For the international price ratio given by the slope the consumption-possibilities frontier P2 B ‘and which is higher than the Pre- le price ratio (i, the slope of fi at E,), the economy produces at P2 and sumes at E, on the consumption indifference Sane Is. This sitwation corre- of fig. 6.5. In addition, our ceonomy ean consume on the if the international ‘price ratio becomes equal (0 slope of the congumption-possbilities frontier Px Es. This situation €04Te Iso point E, of fig. 6.5. Thus, the feonomy can reach the Sine consumption ference curve 1 for two distinct values va the internationall price ratio—one terms of more familiar ion-possibilities frontier, In the absence of inter- ich ie partially dn the first and third Mueve but lying totally im the second cotnade indiference curve Lying 8 the ij for convenience: fe are now interested in trade indifference curves WI oft trade indifference curves higher than the Ky ‘culof seach for our economy. The POsIbI second, or the second and third, quadrants Mas been ignore Scanned with CamScanner‘AL THEORY 166 THE NEOCLASSIC Figure 6.6 The economy can reach a consumption indifference curve at two distinet values of the international terms of trade higher and one lower than the pretrade price ratio. At the higher terms of trade, the economy exports X and imports ¥ (that is, the optimum trade point lies in the first quadrantjof fig. 6.5), and at the lower terms of trade, the economy imports X and exports Y (that is, the optimum trade point lies in the third quadrant of fig. 6.5). : Two Important Properties of the Offer Curve The offer curve illustrates through the origin and lies totally above TOT, whose slope is equal to the line TOT, is tangent to the 4 in fig. 6.5 has two important properties: (a) it passes and to the left of the terms-of-trade line offer Pretrade price ratio, and (b) the terms-of-trade at the origin shows the pretrade neue he Origin, ie, the slope of the offer curve from the fet tha al rade ae ie Faio. The first property Tollowe sivas indifference curve passin They ctt¥es higher than #4 (that is, the trade second propery follonstien ue Me Origin) Te above ny Athatits. the ety fact that the terms-oktra nen RE 488UMEd continutte pene LO Ue left of I. aes trade line TOT, ig tangent ity of the offer curve and the gorot angent to jg or oe are ‘ Sao of the second piopert. 4 at the origin, | 4: (6.1) reproduced beens ® KNOW that fog 2, the first should be obvious Ow for convenience, nant Point on the offer curve . * MUSt be satisfied : “ PEY + &, ° (6.1) Scanned with CamScannerINTERNATIONAL EQUILIBRIUM, 167 Conumption of 4 Imports oF Exports of Exper of. AI Figure 6.7 The offer curve can be used along with the production-possibilities frontier and the con- sumption indifference map to show the optimum points for trade, production, and consumption: ‘Taking the total differential, we have Ey dp + p dEx + dEy = 0, gr dEy dp ) de, PP NdEs When Ey = 0, this last equation reduces to dEy _ dEy yr This proves our proposition. How to Use the Offer Curve to Determine Trade, Consumption, and Production Having derived the offer curve, we can determine the optimum trade, consump- tion, and production points for any given value of the terms of trade, Assume that fig. 6.7 the terms of trade are given by the slope of TOT, , which intersects the curve at point 0’, Place the production block in position with its corner at 0". al the nature of the construction of the trade indifference curve (!) passing hrough Q’, the production block must be tangent to the corresponding consump- od indifference curve (J) at the corresponding point (C’). The common slope of Production block and the consumption indifference curve at point C is equal Scanned with CamScannert 168 THE NEOCLASSICAL THEORY » That is, the slope of the terms-of. ‘the trade indifference curve @? o.T ae hore possibilities fr ae ° the SSE Or ai equal to the slope of the const trade line TOT; is equ . < a i sct to the origi wre coordinates of point 0" (in the first quadrant) with respe rigino is willing to export and import, show the quantities of X and ¥ that ne nea tities of X and Y consumed are Teapectvely, at the given terms of rade. THe die) with respect to the shown by the coordinates of point’ € MI Shown by the coordinates of point ¢ origin O. Finally, the quantities produced are Soo. with respect tothe corner Sr gumed in terms of commodity X. is given by the horizontal distance OK. If commodity Y is used as the oe ere ie value of output consumed is given by the vertical distance OG. In addition, the same measurements show the value of output produced. This is easily verified if we imagine the production block sliding downward along the consumption. possibilities frontier and the terms-of-trade line until its corner O' coincides with the origin of the diagram (0). Since the production block continues to be tangen- tial to the consumption-possibilities frontier (say at point P), the value of output produced must be equal to the value of output consumed. It might be useful to consider the following relationships in fig. 6.7: |P = OB=O0'F = MD OA = BP = FC=UE EC =UF=O0D DC =0E OB — OD © DB = NP = UO' = OM = exports of X OE - OA = AE = NC = DC - FC = DF = OU = MO’ = imports of Y os INTERNATIONAL EQUILIBRIUM The same procedure can be repeated to deri International equilibrium can See : then be shown ii es Fi in terms of the b superimpos tw jab super P ing one diagram on the other, after one country’s wy, ae a ted 180° to match the axes of the other. tuntry's diagram has been Figure 68 illustrates cs e OW international i in Assume that B's diagram has been rotated Ho. btu can be determines measure along the horizontal axis t's jin the first along the vertical axi «7S exports o the second quadrant oe ee S of ¥ and B's i ta and along the vertical axis 4's conte ns POTZONIAL axis “5 conump along the horizontal axis B's congas 89! Y. In the fourth quadrant measo slong the horizon % consumption of nt alone guadrant ps “ , ng tl i xis 8 the vertical) : ‘asure alon; Scanned with CamScanner’ INTERN, ATI ONAL FOUtLAMRIUy4 169 gs Comumption Yr °) espera tH Mote TF) £5 (8) Imports of X(Y) £5 fs) Exports of ¥ (X) Figure 6.8 's Meade’s demonstration of international equilibrium. Internati ‘tthe rational equilibrium occurs at point E in the first quadrant where the exports OR units of X to Band B two of . ffer curves intersect each other. Country A -ms of trade are given by the slope exports : rts OS units of Y to A. The equilibrium ter he ratio OS/OR. Country 418 consuming at and of the Bintan which is equal to t on the second quadrant (that is, OV units of X and PC, units of) om vB at point C, in the fourth quadrant (that is, OD units of Y and DC, units pode eae producing EU units 0 d UC. , rite EZ units of Y and ZCx Yigg of X. Thus the fe) | ia ane is given by EU + ZCp= 20 | is piven by EZ + UCq= GU + UA oa ae na » ectangle G production of Xa | sides of the rectangle GCwHCa SON ie ot pro an | Z auGv + VCa = GCa | ies case “we of the same rectangle als a In Deen GD + DCn= GE8 a ons mT other words, the rectangle Pie HtCa en OP considered Pir production (OF a "dinates of point E with respect 10 the comet f oh respect (© +s show B'S “rwments) of X and ¥> while he Toordinates OFF YT point O wih PN wicaion of X and ¥. "Similarly, the coordi ts ge coon of rela) show as (B's) consumption of x andy and impor of ¥ ‘ Peet 10 E (or vice versa) show 4'5 © r Scanned with CamScanner jyction BOX The | | Pro c170 THE NEOCLASSICAL THEORY ** Figure 6.9 The limits of the terms of trade. Note that the terms-of-trade line OE is tangent to 4’s trade indifference curve 1, and B’s curve I', at point E. Note, too, that ’s consumption-possibilities frontier KC, M is tangent to 4’s consumption indifference curve IS, and that B's consumption-possibilities frontier is tangent to B's consumption indifference curve If;. Therefore, all equilibrium conditions are indeed satisfied. Figure 6.8 brings together production, consumption, and trade in an ingen- ious way. A multitude of relationships are brought to light in fig. 6.8. This diagram, which we owe to Meade, is the culmination of the neoclassical model. The Limits of the Terms of Trade Again offer curves of fig. 6.8 at the origin have been ade price ratio (p,)and ratio (Py). Country 4’s offer curve Mas a 8's below and to the right of TOTs- : ‘© offer curves can intersect is the shaded quadrant, This mes Can intersect is the es deity eben og py, Neans that the equilibrium terms of trade will What the preceding analysi i ; ceding analysis and fig, 6.9 g iti i i brium exists it will necessarily oceur inte rae i that it international eau eces sarily exists? 4+ Py). But how do we essa Scanned with CamScanner1 INTERNATIONAL F would 4’s offer curve behave as the _ QUILIBRIUM 171 ie commodity X tends to become infnitel mviously; aS P— 2, country A can acquire unl only an infinitesimal amount of X. But this meat vill end t0 approach asymptotically the vertic, zxirmain in the shaded area of fg. 69 but will eventuct Applying the same argument to country B, we observe iia oe une wll start from the origin with slope equal to py. lc hay oot _pyoach the horizontal axis asymptotically. Therefore on the neww oreo ie wo offer curves are indeed continuous, they will necessarily inenor cat aie at least once in the shaded area of fig, 69. oe Ii should be noted that ifp4 > pg, then TOT,, will become steeper than TOT, and the shaded cone will move into the third quadrant. 7 The above conclusion depends upon the assumption that the pretrade equili- trum price ratios are unique. As was shown earlier, the existence of multiple sietrade equilibria might violate this conclusion. ‘onal price ratio t tends to infinity + ¥ more expensive relative to ¥9 a amounts of Y by offering m1 that, as p+ co, A’s offer curve axis. Thus, 4’s offer curve will P. . TICITIES, STABILITY, AND MULTIPLE ART B, ELASTIC! . EQUILIBRIA a of international equilibrium, in particu- This sect ties i FO eee ene rt anigue, The necessary and sufcient conditions {Esbether oF not itis stable and unique. “'subilty are discussed also. : ° THREE IMPORTANT ELASTICITIES sin relation to this offer {oie he offer curve in fig. 6.10. Define the elas “eal any selected point, such as K, as flier «is defined as (9) The elasticity of the offer curve, denoted 2Y & ax (620) pore = avy ¥, change in im| % change in exports is the count ag fatio¥/¥° along the offer cH" US ach unit 4, OW the number of units of Y impor al ay ie ihe 4 On the other hand, the ratio (derival his Mot Mal NUty exchanges X for ¥ on the mardi". asticity a oe “st rade ine average Pigg ted the marginal terms ire ie er *Y kiven by the ratio of the mare a vs average ers of wade ye tr of X exported on the vs the rate at which he ratio dY/dN is ¢ offer curve 8 at is, margin . “ad al terms of IEE average ferms Scanned with CamScanner