Question

Draw a neoclassical graph of a country in autarky equilibrium. Label the graph carefully, and label the autarky equilibrium point E. Suppose the international relative price of the good on the Y-axis is lower than the country’s autarky relative price (that is, (P_Y/P_X)^Aut > (P_Y/P_X)^Int. Draw the international price line on your graph. Label the new trade production point F, and the new trade consumption point C. Which good will this country import?

Answer 1

The classical theory is limited in their analysis by the labour theory of value and assumption of constant costs. The Neo-classical trade theory provides tools of analysis and studies the impact of trade in a more rigorous and less restricted manner. The application of neoclassical theory and later refinements of these ideas constitute the basis of modern theory of international trade.

Autarky equilibrium

Autarky is a situation where a country does not conduct international trade.

In the graph, we have Good X on the x axis and Good Y on the y axis with a Production Possibility Curve PPC, a price line Px/Py and the community indifference curve IC₁. The equilibrium is at point E. At E, the slope of the price line (Px/Py) is tangent to the slope of the PPC. The slope of PPC is called marginal rate of transformation (MRT). It is also known that the slope of the PPC is equal to relative marginal costs. So at E:

(Px/Py) = (MCx/MCy)

At E, the producers would have no incentive to change the production pattern unless relative price ratio changes.

The community indifference curve IC is tangent to the budget constraint and the PPC. So we have

MRT = MCx/MCy = Px/Py = MUx/MUy = MRS

Where,

MRT = Marginal Rate of Transformation

MCx/MCy = Relative marginal costs

Px/Py = Relative price of good x and good y

MUx/MUy = Relative marginal utility

When the economy opens up to trade it would face a different set relative prices. Consequently, domestic producers and consumers would adjust by reallocating their production and consumption patterns. Such reallocation would lead to gains from trade.

Under autarky, the equilibrium is at point E and welfare level is indicated by indifference curve IC₁. Now, suppose the international relative price of the good on the Y-axis is lower than the country’s autarky relative price (that is,

(PY/PX)^Aut > (PY/PX)^Int

The new relative price is steeper than the price in autarky. This new steeper relative price means that for the home country before trade, the price of X is lower and the price of Y is higher than in international trade. So the home country has a comparative advantage in the production of good X and comparative disadvantage in the production of good Y.

So the home country would shift the production toward X at pint F on the production possibility curve (PPC) where the new price line Px/Py₂ tangents the PPC with the new trade consumption point C.International trade permits consumers to consume a bundle that lies beyond the previous indifference curve. Thus,

MRT = MCx/MCy = Px/Py₂ = MUx/MUy = MRS

Where,

MRT = Marginal Rate of Transformation

MCx/MCy = Relative marginal costs

Px/Py₂ = The new relative price of good x and good y because of international trade

MUx/MUy = Relative marginal utility

Thus, the production of X would increase and the production of Y would fall. Now the country will export good X for which it has comparative advantage in the production and will import the good Y for which it has comparative disadvantage.