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1CHAPTER1THEWORLDOFINTERNATIONALECONOMICSIOUTLINEINTRODUCTIONTHENATUREOFMERCHANDISETRADETHEGEOGRAPHICALCOMPOSITIONOFTRADETHECOMMODITYCOMPOSITIONOFTRADEUSINTERNATIONALTRADEWORLDTRADEINSERVICESTHECHANGINGDEGREEOFECONOMICINTERDEPENDENCESUMMARYAPPENDIXAGENERALREFERENCELISTININTERNATIONALECONOMICSIIPURPOSEOFCHAPTERTHEPURPOSEOFTHISINTRODUCTORYCHAPTERISTOPROVIDETHESTUDENTWITHANOVERVIEWOFTHECURRENTNATUREOFINTERNATIONALTRADEINGOODSANDSERVICESFORTHEWORLDINGENERALANDFORTHEUNITEDSTATESINPARTICULARITISUSEFULTOMAKETHESTUDENTAWARENOTONLYOFTHEBROADNATUREOFINTERNATIONALTRANSACTIONS,BUTALSOOFTHEINCREASEDINTERNATIONALINTERDEPENDENCETHATNOWCHARACTERIZESTHEWORLDECONOMYALTHOUGHTHISCHAPTERCONTAINSAGREATAMOUNTOF“DATA,”WEHAVEFOUNDTHATDISCUSSINGTHISKINDOFINFORMATIONONTHEFIRSTDAYOFCLASSMOTIVATESSTUDENTINTERESTINTHESUBJECTANDINTHECOURSEINGENERAL2CHAPTER2EARLYTRADETHEORIESMERCANTILISMANDTHETRANSITIONTOTHECLASSICALWORLDOFDAVIDRICARDOIOUTLINEINTRODUCTIONMERCANTILISMTHEMERCANTILISTECONOMICSYSTEMTHEROLEOFGOVERNMENTMERCANTILISMANDDOMESTICECONOMICPOLICYTHECHALLENGETOMERCANTILISMBYEARLYCLASSICALWRITERSDAVIDHUMETHEPRICESPECIEFLOWMECHANISMADAMSMITHANDTHEINVISIBLEHANDSUMMARYIISPECIALCHAPTERFEATURESCASESTUDY1THEGEPHARDTAMENDMENTTHENEWMERCANTILISMBOX1CAPSULESUMMARYOFTHEPRICESPECIEFLOWMECHANISMBOX2CONCEPTREVIEWPRICEELASTICITYANDTOTALEXPENDITURESBOX3ADAMSMITH17231790IIIPURPOSEOFCHAPTERTHEPURPOSEOFTHISCHAPTERISTOTRACEOUTSOMEOFTHEEARLYIDEASREGARDINGTHEBASISFORINTERNATIONALTRADEANDTHEDISTRIBUTIONOFTHEBENEFITSTOBEGAINEDFROMTRADEITNOTONLYPROVIDESSOMEHISTORICALPERSPECTIVETOTRADETHEORY,BUTITALSOMAKESCLEARWHYCERTAINCONTEMPORARYPROTECTIONISTATTITUDESCANBESEENASBEINGBASEDINAMERCANTILISTVIEWOFTHEWORLDIVANSWERSTOENDOFCHAPTERQUESTIONSANDPROBLEMS1WEALTHWASVIEWEDASSYNONYMOUSWITHHOLDINGSOFPRECIOUSMETALSNATIONSTATESWISHEDTOBECOMEWEALTHYANDTHISMEANTOBTAININGLARGEHOLDINGSOFPRECIOUSMETALSITISALSOARGUEDBYSOMETHATTHESHORTAGEOFCOINAGECONSTRAINEDTHEGROWTHOFTHESENATIONSTATESANDTHATPRECIOUSMETALSWEREREQUIREDTOINCREASETHESUPPLYOFCOINAGEMONEYINORDERFORTHECOUNTRIESTOGROW2CRITICALPILLARSOFMERCANTILISMATHEZEROSUMNATUREOFINTERNATIONALTRADEBTHENEEDFORSTRONG,POWERFULGOVERNMENTS3CTHELABORTHEORYOFVALUEDTHENEEDTOREGULATEECONOMICACTIVITYETHENEEDFORAPOSITIVETRADEBALANCEBECAUSEWEALTHWASVIEWEDINTERMSOFHOLDINGSOFPRECIOUSMETALS,THEOBJECTIVEOFECONOMICACTIVITYANDPOLICYWASTOFOSTERINCREASEDHOLDINGSOFSPECIEMERCANTILISTSBELIEVEDTHATINDIVIDUALSPURSUINGTHEIROWNSELFINTERESTWOULDNOTACCOMPLISHTHISOBJECTIVEANDTHATCONSEQUENTLY,ECONOMICACTIVITYHADTOBECLOSELYREGULATEDANDSUPERVISED3THEPARADOXOFMERCANTILISMISTHATWEALTHYCOUNTRIESWOULDCONTAINLARGENUMBERSOFVERYPOORPEOPLEASECONDPARADOXISTHATWEALTHYCOUNTRIESHADTOSPENDGREATAMOUNTSOFSPECIETOPROTECTTHEIRHOLDINGSOFSPECIEWAGESWEREKEPTLOWATINSTITUTIONALSUBSISTENCELEVELSTOREDUCELABORCOSTS,ANDFAMILIESWEREENCOURAGEDTOHAVECHILDRENTHROUGHVARIOUSTAXESANDSUBSIDIESTHESEACTIONSCONTRIBUTEDTOAVERYLARGEPOORWORKINGCLASS4CRITICALASSUMPTIONSOFTHEPRICESPECIEFLOWMECHANISMASOMELINKBETWEENTHEMONEYSUPPLYANDTHEPRICELEVEL,EG,THEQUANTITYTHEORYOFMONEYBPERFECTCOMPETITION,WITHFLEXIBLEWAGESANDPRICESCPRICEELASTICDEMANDFORTRADEDGOODSDEXISTENCEOFAGOLDSTANDARD,WITHNOGOVERNMENTINTERFERENCEWITHTHEMOVEMENTOFGOLDANDNOACTIONSTOSTERILIZEGOLDSIMPACTONTHEMONEYSUPPLYIFTHEDEMANDFORTRADEDGOODSWEREPRICEINELASTIC,THEMOVEMENTOFGOLDANDPRICESWOULDWORSENTRADEBALANCES,NOTCORRECTTHEMTHISWOULDBEDESTABILIZING,NOTSTABILIZING5HUMESPRICESPECIEFLOWMECHANISMSUGGESTEDTHATACOUNTRYCOULDNOTSUSTAINAPOSITIVEBALANCEOFTRADEBECAUSEOFTHEEFFECTONMONEYANDPRICESTHEEXTERNALPAYMENTSPOSITIONHADREPERCUSSIONSONINTERNALECONOMICVARIABLESACONTINUALPOSITIVETRADEBALANCEWASTHUSNOTAVIABLEPOLICYTARGET,ANDNOTACONTINUOUSSOURCEOFINCREASEDWEALTHSMITHSCONCEPTOFABSOLUTEADVANTAGEINDICATEDTHATBOTHCOUNTRIESCOULDGAINFROMTRADE,INDIRECTCONTRASTTOTHEMERCANTILISTSZEROSUMGAMEVIEWOFTRADE6THEUNITEDSTATESHASANABSOLUTEADVANTAGEINTHEPRODUCTIONOFWHEAT3HRS/UNITPW/PSCOUNTRYB9CHAPTER4EXTENSIONSANDTESTSOFTHECLASSICALMODELOFTRADEIOUTLINEINTRODUCTIONTHECLASSICALMODELINMONEYTERMSWAGERATELIMITSANDEXCHANGERATELIMITSMULTIPLECOMMODITIESTHEEFFECTOFWAGERATECHANGESTHEEFFECTOFEXCHANGERATECHANGESTHEDORNBUSCHFISCHERSAMUELSONMODELTRANSPORTATIONCOSTSMULTIPLECOUNTRIESEVALUATINGTHECLASSICALMODELSUMMARYIISPECIALCHAPTERFEATURESBOX1WAGERATELIMITSANDEXCHANGERATELIMITSINTHEMONETIZEDRICARDIANFRAMEWORKBOX2DEMANDRELATIONSHIPSINTHEDFSMODELBOX3COMPARATIVESTATICSANALYSISINTHEDFSMODELCASESTUDY1THESIZEOFTRANSPORTATIONCOSTSCASESTUDY2LABORPRODUCTIVITYANDIMPORTPENETRATIONINTHEUSSTEELINDUSTRYIIIPURPOSEOFCHAPTERTHEPURPOSEOFTHISCHAPTERISTOPRESENTSEVERALEXTENSIONSOFTHECLASSICALRICARDIANMODELINORDERTODEMONSTRATEMOREFULLYTHEFACTORSTHATINFLUENCEINTERNATIONALTRADEBEYONDTHESIMPLETWOCOUNTRYTWOCOMMODITYLABORREQUIREMENTBARTERMODELDEVELOPEDINCHAPTER3IVANSWERSTOENDOFCHAPTERQUESTIONSANDPROBLEMS1ASARESULTOFTHETRADESURPLUS,FRANCEEXPERIENCES,UNDERAFIXEDEXCHANGERATE,ANETGOLDINFLOWANDTHEUNITEDKINGDOMEXPERIENCESANETGOLDOUTFLOWASSUMINGTHATTHEPRICESPECIEFLOWMECHANISMISINOPERATION,THESEGOLDMOVEMENTSWILLRESULTINANINCREASEINPRICESANDWAGESINFRANCEANDADECREASEINPRICESANDWAGESINTHEUNITEDKINGDOMSINCETHEDEMANDFORTRADEDGOODSISASSUMEDTOBEPRICEELASTIC,THISWILLCAUSETHEEXPENDITURESFORUKGOODSBYFRANCETORISEANDTHEEXPENDITURESFORFRENCHGOODSBYTHEUNITEDKINGDOMTOFALL10THESEADJUSTMENTSWILLTAKEPLACEUNTILTRADEISBALANCEDTHECHANGESINPRICESINTHETWOCOUNTRIESWILLLEADTOACHANGEINTHETERMSOFTRADETHATWILLMOVETHEMCLOSERTOTHOSEOFTHEUNITEDKINGDOMINAUTARKY,IE,THETERMSOFTRADEWILLDETERIORATEFORTHEUNITEDKINGDOMANDIMPROVEFORFRANCE2ATHEREISABASISFORTRADEHEREBECAUSETHERELATIVELABORCOSTSFORTHETWOCOMMODITIESAREDIFFERENTINAUTARKY,IE,6/8ISNOTTHESAMEAS4/4FROMANOTHERPERSPECTIVE,THEINDIVIDUALPRICERATIOSINAUTARKYAREDIFFERENTBETWEENTHETWOCOUNTRIES,IE,THEYARE1W067SOR1S15WINITALYAND1W05SOR1S2WINSPAINBITALYSHOULDEXPORTSHOESANDSPAINSHOULDEXPORTWINEBECAUSETHERELATIVELABORCOSTOFSHOESISLESSINITALYRELATIVETOWINEFROMSPAINSPOINTOFVIEW,ITSABSOLUTEDISADVANTAGEISLESSINWINECOMPAREDTOSHOESCTHEINTERNATIONALTERMSOFTRADEMUSTLIEBETWEEN1W067SAND1W05SOR1S15WAND1S2WDTHECOMMODITYTERMSOFTRADE1WINEPWINE/PSHOESSHOESOR1SHOEPSHOES/PWINEWINE,WHICHRESULTSIN1WINE14/24SHOES,IE,1WINE0583SHOESOR1SHOE24/14WINE,IE,1SHOE1714WINE3GIVENTHESPANISHWAGERATEOF35PESOSPERHOURANDTHE11EXCHANGERATE,THELIMITSTOTHEWAGEINITALYARE4BAND3LIRE/HRGIVENTHEITALIANWAGERATEOF4LIREPERHOURANDTHE11EXCHANGERATE,THELIMITSTOTHEWAGEINSPAINARE3AND4PESETAS/HRGIVENTHEITALIANWAGERATEOF4LIRE/HOURANDTHESPANISHWAGERATEOF35PESOS/HOUR,THELIMITSTOTHEEXCHANGERATEARE7/8AND11/6PESETA/LIRA4ITALYWILLEXPORTSHOESANDIMPORTCLOTHING,WINE,CUTLERY,ANDFISHSPAINWILLEXPORTCLOTHING,WINE,CUTLERY,ANDFISHANDIMPORTSHOESWITHTHEINCLUSIONOFTRANSPORTATIONCOSTS,CLOTHING,WINE,ANDFISHBECOMENONTRADEDGOODS,SPAINMAINTAINSITSCOMPARATIVEADVANTAGEINCUTLERYANDCONTINUESTOEXPORTIT,ANDTHECOSTOFSHOESISEXACTLYEQUALIZEDBETWEENTHETWOCOUNTRIESSHOESTHUSMAYORMAYNOTBETRADEDTHETRADEPATTERNCHANGESBECAUSETHERELATIVECOSTSOFTHEPRODUCTSCHANGEWHENTRANSPORTATIONCOSTSAREINCLUDEDANDASSUMEDTOBEPAIDBYTHEIMPORTERINTHECASESOFCLOTHING,WINE,ANDFISH,TRANSPORTATIONCOSTSEXCEEDTHEDIFFERENCEINPRODUCTCOSTSBETWEENTHETWOCOUNTRIESANDTHUSCAUSETHEMTOBECOMENONTRADEDGOODS5INCREASESINFOREIGNCOUNTRYPRODUCTIVITYWILLCAUSETHEAZCURVETOSHIFTDOWNWARDAS11A2/A1FALLSFOREACHGOODTHISWILLLEADTOAFALLINHOMECOUNTRYEXPORTGOODSANINCREASEINFOREIGNCOUNTRYEXPORTGOODSSINCETHEBOUNDARYGOODSHIFTSTOTHELEFTINTHEDFSDIAGRAMTHEREWILLBEADECLINEINTHEWAGELEVELINTHEHOMECOUNTRYRELATIVETOTHEFOREIGNCOUNTRYINADDITION,FOLLOWINGTHEANALYSISINBOX3INTHECHAPTER,THEFOREIGNCOUNTRYWILLEXPERIENCEAGAININREALINCOMEINTERMSOFBOTHHOMECOUNTRYGOODSANDFOREIGNCOUNTRYGOODS,ANDTHEHOMECOUNTRYWILLEXPERIENCEAGAININREALINCOMEWHENINCOMEISEXPRESSEDINFOREIGNGOODSANDNOCHANGEINREALINCOMEWHENINCOMEISEXPRESSEDINHOMEGOODSSINCETHEHOMECOUNTRYINFACTCONSUMESBOTHHOMEANDFOREIGNGOODS,ITTHUSATTAINSAHIGHERREALINCOME6THEREISABASISFORTRADEFORALLTHREECOUNTRIESSINCEALLTHREEAUTARKYPRICERATIOSAREDIFFERENTFROMEACHOTHERANDFROMTHEINTERNATIONALTERMSOFTRADEWITHANINTERNATIONALTERMSOFTRADEOF1FISH05POTATOES,SWEDENANDPOLANDWILLEXPORTPOTATOESANDIMPORTFISH,ANDDENMARKWILLEXPORTFISHANDIMPORTPOTATOES7YESSINCEPRODUCTIVITYINUSMANUFACTURINGISCONSIDERABLYHIGHERTHANINMEXICANMANUFACTURING,ONEWOULDEXPECTTHELEVELOFWAGESTOBECONSIDERABLYHIGHERINTHEUNITEDSTATESTHANINMEXICOFORTRADEDGOODS,IFUSPRODUCTIVITYISFIVETIMESASHIGHBUTUSWAGESARELESSTHANFIVETIMESASHIGH,USMANUFACTUREDGOODSPRICESWOULDTENDTOBELOWERPRICEDTHANMEXICANGOODSTHERELATIVELYGREATDEMANDFORUSGOODSRELATIVELYSMALLDEMANDFORMEXICANGOODSWOULDTHEREFOREDRIVEUPUSWAGESANDDRIVEDOWNMEXICANWAGESUNTILTHEWAGEDIFFERENCEROUGHLYMATCHESTHEPRODUCTIVITYDIFFERENCESIMILARLY,IFUSWAGESAREMORETHANFIVETIMESMEXICANWAGES,MEXICANGOODSWOULDBEINRELATIVELYGREATDEMANDANDUSGOODSINRELATIVELYSMALLDEMANDMEXICANWAGESWOULDTHENRISEANDUSWAGESWOULDFALLUNTILTHEWAGEDIFFERENCEAGAINISROUGHLYEQUALTOTHEPRODUCTIVITYDIFFERENCEINPRACTICE,THEMATTERISMADEMORECOMPLICATEDBYSUCHFACTORSASNONTRADEDGOODSANDADIFFERENTCOMPOSITIONOFGOODSINTHETWOCOUNTRIESHOWEVER,THEGENERALPRINCIPLEOFTHELINKBETWEENRELATIVEWAGESANDRELATIVEPRODUCTIVITYDIFFERENCESSTILLHOLDS8ATHERELATIVEWAGERATIOISWUS/WUK20/82/15/4THUSTHEUNITEDKINGDOMEXPORTSBREADANDBOOKSTHEUNITEDSTATESEXPORTSVCRS,RUGS,ANDLAMPSBTHEUPPERLIMITTOUKWAGESISFOUNDBYSETTING2/320/WUK2/1THEREFORETHEUPPERLIMITTOWUKIS15PERDAYBYSETTING4/2EQUALTO20/WUK2/1,THELOWERLIMITTOWUKOF5PERDAYISOBTAINEDCTHEUPPERLIMITTOTHEEXCHANGERATEISFOUNDBYSETTING2/320/8E,WHICHYIELDSTHERESULTOF375/1BYSETTING4/220/8E,THELOWERLIMITOF125/1ISOBTAINED9ATHENEWUKLABORTIMESAREBREAD16DAYSVCRS64DAYSLAMPS32DAYSRUGS24DAYSBOOKS16DAYSWITHTHESENUMBERSANDTHEORIGINALWAGERATIOOF5/4,THEUNITEDKINGDOMWILLEXPORTBREAD,VCRS,RUGS,ANDBOOKSTHEUNITEDSTATESWILLEXPORTLAMPSBTHENEWUPPERLIMITTOUKWAGESISFOUNDBYSETTING16/320/WUK2/112THEREFORETHEUPPERLIMITTOWUKIS1875PERDAYBYSETTING32/2EQUALTO20/WUK2/1,THELOWERLIMITTOWUKOF625PERDAYISOBTAINEDTHUS,WITHTHEUKPRODUCTIVITYIMPROVEMENT,BOTHTHEUPPERLIMITANDTHELOWERLIMITTOUKWAGESAREHIGHERTHANPRIORTOTHEIMPROVEMENT10THISISTOSOMEEXTENTANOPINIONQUESTION,BUTDEFICIENCIESOFTHECLASSICALMODELTHATCOULDBEINDICATEDCLEARLYINCLUDETHEUSEOFTHELABORTHEORYOFVALUE,THECONSTANTCOSTASSUMPTION,ANDTHEASSUMPTIONOFASMOOTHMONETARYADJUSTMENTMECHANISMTHELABORTHEORYOFVALUEOBVIOUSLYIGNORESTHEROLEOFOTHERFACTORSOFPRODUCTIONINTHEDETERMINATIONOFPRODUCTIONCOSTANDHENCEOFPRETRADEPRICERATIOSTHECONSTANTCOSTASSUMPTIONTYPICALLYYIELDSTHEUNREALISTICSITUATIONOFCOMPLETESPECIALIZATIONBYBOTHCOUNTRIESANDTHELACKOFASMOOTHMONETARYADJUSTMENTMECHANISMINPRACTICEMEANSTHATTHEACTUALTRADEPATTERNCANDIFFERFROMTHECOMPARATIVEADVANTAGEPATTERNOTHERDEFICIENCIESTHATCOULDBEMENTIONEDTHATRESULTINALACKOFCOMPLETEREALISMARETHESPECIFICASSUMPTIONTHATTHEQUANTITYTHEORYOFMONEYHOLDSANDTHEGENERALASSUMPTIONOFTHEEXISTENCEOFPERFECTCOMPETITION13CHAPTER5INTRODUCTIONTONEOCLASSICALTRADETHEORYTOOLSTOBEEMPLOYEDIOUTLINEINTRODUCTIONTHETHEORYOFCONSUMERBEHAVIORCONSUMERINDIFFERENCECURVESTHEBUDGETCONSTRAINTCONSUMEREQUILIBRIUMPRODUCTIONTHEORYISOQUANTSISOCOSTLINESPRODUCEREQUILIBRIUMTHEEDGEWORTHBOXDIAGRAMANDTHEPRODUCTIONPOSSIBILITIESFRONTIERTHEEDGEWORTHBOXDIAGRAMTHEPRODUCTIONPOSSIBILITIESFRONTIERSUMMARYIISPECIALCHAPTERFEATURESBOX1FRANCISYSIDROEDGEWORTH18451926CASESTUDY1CONSUMEREXPENDITUREPATTERNSINTHEUNITEDSTATESIIIPURPOSEOFCHAPTERSINCENEOCLASSICALTRADETHEORYATTHEUNDERGRADUATELEVELRELIESHEAVILYONAFEWBASICGRAPHICALMICROTOOLS,WETHINKITUSEFULTOGATHERTHESETOOLSINTOONECONVENIENTPLACEEARLYINTHEBOOKTHEPURPOSEOFTHECHAPTERISTOREINTRODUCETHESTUDENTTOTHINKINGINMARGINALTERMSANDTOREEMPHASIZEPRINCIPLESOFMAXIMIZATIONTHESTUDENTSHOULDBECOMEAWAREEARLYINTHECOURSETHATTHECONCEPTUALPRECISIONOFECONOMICANALYSISTOWHICHHEORSHEWASEXPOSEDINEARLIERWORKISGOINGTOBEEMPLOYEDINTHEINTERNATIONALTRADECOURSEASWELL14IVANSWERSTOENDOFCHAPTERQUESTIONSANDPROBLEMS1INTHEGRAPHBELOW,THEINITIALEQUILIBRIUMISATPOINTE1WITHRELATIVEPRICESPX/PY1IFTHEPRICEOFGOODXFALLSWHILETHEPRICEOFGOODYREMAINSCONSTANT,THENANEW,FLATTERPRICELINESUCHASTHEDASHEDPX/PY2LINEEMERGESFROMTHEORIGINALINTERCEPTATPOINTAONTHEVERTICALAXISSINCEMUX/PXISNOWGREATERTHANMUY/PYATE1,THECONSUMERWILLSUBSTITUTETOWARDGREATERCONSUMPTIONOFTHEXGOODANDLESSCONSUMPTIONOFTHEYGOODINORDERTOINCREASETOTALSATISFACTIONEQUILIBRIUMWILLMOVEFROME1TOE2,ANDTHECONSUMERWILLBEONAHIGHERINDIFFERENCECURVEANDWILLHAVEINCREASEDTHERELATIVECONSUMPTIONOFGOODXONLYIFGOODXISASUFFICIENTLY“INFERIOR”GOODWILLTHERELATIVEINCREASEINTHEQUANTITYOFXCONSUMEDNOTOCCUR2CONSIDERANINDIFFERENCECURVEDIAGRAMSUCHASFIGURE5INTHETEXTASHIFTINTHEINCOMEDISTRIBUTIONTOWARDCONSUMERSWITHARELATIVELYSTRONGERPREFERENCEFORGOODYTHANINTHEORIGINALDISTRIBUTIONWILLMAKEEACHCURVE“FLATTER”ANDWILLSHIFTEACHCURVELEFTWARDTOWARDTHEVERTICALAXISTHECURVESBECOMEFLATTERBECAUSE,FORANYTOTALAMOUNTOFYTAKENAWAYFROMCONSUMERSATTHEMARGININPROPORTIONTOTHEIRINCOMES,MOREXMUSTBEGIVENTOTHECOMMUNITYASAWHOLEINORDERTORESTOREEACHCONSUMERTOHISORHERORIGINALLEVELOFSATISFACTIONTHELEFTWARDSHIFTOCCURSBECAUSE,ATEACHGIVENTOTALAMOUNTOFGOODYCONSUMEDWHICHISNOWMOREPREFERRED,LESSXISNECESSARYINORDERFORTHECOMMUNITYASAWHOLETOATTAINAGIVENUTILITYLEVEL3INFIGURE10INTHETEXT,CONSIDERTHELOWERINTERSECTIONPOINTNOTLABELEDOFISOQUANTQ0WITHBUDGETLINEB1ATTHATPOINT,MPPL/MPPKISLESSTHANW/R,SINCETHEISOQUANTISFLATTERTHANTHEISOCOSTLINETHISINDICATESTHATMPPL/WMPPK/R,ORTHAT,ATTHEMARGIN,THEOUTPUTOBTAINEDPERDOLLARSPENTONLABORBYTHEFIRMISLESSTHANTHEOUTPUTOBTAINEDPERDOLLARSPENTONCAPITALTHEPROFITMAXIMIZINGENTREPRENEURWILLTHEREFORE,WITHTHEGIVENBUDGET,REALLOCATESPENDINGTOWARDCAPITALANDAWAYFROMLABORTHEREALLOCATIONWILLSTOPATPOINTE,WHERE,ATTHE15MARGIN,THEOUTPUTPERDOLLARSPENTONLABORISEQUALTOTHEOUTPUTPERDOLLARSPENTONLABORTHEHIGHERISOQUANTQ1WILLHAVEBEENREACHED,ANDEQUALITYBETWEENMPPL/MPPKHASBEENACHIEVEDBYARISINGMPPLASLESSLABORISUTILIZEDANDAFALLINGMPPKASMORECAPITALISUTILIZED4NO,ITCANNOTBEUNAMBIGUOUSLYDETERMINEDWITHCAPITALONTHEVERTICALAXISANDLABORONTHEHORIZONTALAXIS,THENEW,FLATTERISOCOSTLINEWILLHAVEAVERTICALAXISINTERCEPTLOWERTHANORIGINALLYANDAHORIZONTALAXISINTERCEPTTOTHERIGHTOFTHEORIGINALINTERCEPTIFTHISNEWISOCOSTLINEPASSESABOVETHEORIGINALEQUILIBRIUMPOINT,THENEWLEVELOFOUTPUTWILLBEGREATERTHANBEFORETHEFACTORPRICECHANGESIFITPASSESBELOWTHEORIGINALPOINT,OUTPUTWILLHAVEFALLEN5WITHLABORONTHEHORIZONTALAXISANDCAPITALONTHEVERTICALAXIS,THEORIGINALISOCOSTLINEHASAVERTICALAXISINTERCEPTOF120HOURSOFCAPITALUSAGEANDAHORIZONTALAXISINTERCEPTOF1,200HOURSOFLABORUSAGETHESLOPEOFTHISISOCOSTLINEIS1/10OR010WITHTHESPECIFIEDCHANGESINFACTORPRICES,THEISOCOSTLINESHIFTSINWARDONBOTHAXESSINCETHEPRICESOFBOTHINPUTSHAVEINCREASEDTHENEWINTERCEPTSAREAT100HOURSOFCAPITALAND800HOURSOFLABOR,ANDTHENEWISOCOSTLINEISSLIGHTLYSTEEPERHAVINGASLOPEOF15/120OR0125THANTHEOLDONETHEEQUILIBRIUMLEVELOFOUTPUTHASFALLENBECAUSEALLINPUTSHAVERISENINPRICETHEFIRMHASALSOSHIFTEDTOWARDUSINGMORECAPITALRELATIVETOLABOR,SINCEW/RHASRISEN6THEPPFWOULDEXHIBITCONSTANTOPPORTUNITYCOSTSSUPPOSETHATTHEEMPLOYMENTOFALLOFTHEECONOMYSCAPITALANDLABORINTHEXINDUSTRYANENDPOINTOFTHEEDGEWORTHBOXDIAGONALYIELDS100UNITSOFXOUTPUTAND0UNITSOFYOUTPUTALTERNATIVELY,SUPPOSETHATEMPLOYMENTOFALLCAPITALANDLABORINTHEYINDUSTRYYIELDS200UNITSOFYOUTPUTAND0UNITSOFXOUTPUTWITHCONSTANTRETURNSTOSCALEINBOTHINDUSTRIES,PRODUCTIONATTHEMIDPOINTOFTHEDIAGONALUSINGONEHALFOFTHEECONOMYSCAPITALANDLABORINEACHINDUSTRYWOULDTHEREFOREYIELD50XAND100YEMPLOYMENTOFONEFOURTHOFTHEECONOMYSCAPITALANDLABORINTHEXINDUSTRYANDTHREEFOURTHSOFTHEECONOMYSCAPITALANDLABORINTHEYINDUSTRYIE,ATAPOINTONEFOURTHOFTHEDISTANCEALONGTHEDIAGONALFROMTHEXORIGINTOTHEYORIGINWOULDYIELD25XAND150YPLOTTINGTHESEVARIOUSOUTPUTCOMBINATIONSANDTHEOUTPUTCOMBINATIONSOFALLOTHERPRODUCTIONPOINTSONTHEDIAGONALYIELDSASTRAIGHTLINEPPFTHISPPFWOULDBEANALOGOUSTOTHEDASHEDLINERTMWQINFIGURE15BINTHETEXT7THISSTATEMENTISINCORRECTTHEDISCUSSIONINTHETEXTREGARDINGTHEPRODUCTIONPOSSIBILITIESFRONTIERINDICATESTHATAPPFWITHINCREASINGOPPORTUNITYCOSTSEMERGESWHENCONSTANTRETURNSTOSCALEEXISTINEACHINDUSTRY,PROVIDEDTHATTHEINDUSTRIESHAVEDIFFERENTFACTORINTENSITIESTHUSNEITHERINDUSTRYNEEDSTOBEOPERATINGINACONTEXTOFDECREASINGRETURNSTOSCALEINORDERTOGENERATEANINCREASINGOPPORTUNITYCOSTSPPF8LESSMORETHEOVERALLDEMANDFORLABORWOULDRISEANDTHEOVERALLDEMANDFORCAPITALWOULDFALLASTHEINDUSTRYWITHTHEHIGHERK/LRATIOLOWERL/KRATIO,INDUSTRYY,CONTRACTS,WHILETHEINDUSTRYWITHTHELOWERK/LRATIOHIGHERL/KRATIO,INDUSTRYX,EXPANDSHENCE,RELATIVEFACTORPRICESW/RWILLRISEORR/WWILLFALLNO,THEABSOLUTEVALUESOFTHEISOQUANTSLOPESATVWILLBEHIGHERTHANATSBECAUSE,INEQUILIBRIUM,THESEABSOLUTEVALUESOFTHESLOPESAREEQUALTO16THENOWHIGHERW/RANALTERNATIVEGEOMETRICEXPLANATIONISTHAT,WITHHOMOTHETICISOQUANTS,ARAYFROM0X0YTHROUGHSWOULDHITISOQUANTX2Y4ATAPOINTBELOWANDTOTHERIGHTABOVEANDTOTHELEFTOFV,APOINTTHATWOULDHAVETHESAMESLOPEASISOQUANTX1Y6ATSGIVENTHECONVEXSHAPESOFISOQUANTS,VWOULDTHENHAVEASTEEPERSLOPETHANS9THEEDGEWORTHBOXWOULDBECOME“TALLER”SINCETHEVERTICALCAPITALAXESBECOMELONGERANDTHEHORIZONTALLABORAXESSTAYTHESAMELENGTHTHEPPFWILLALSOBECOME“TALLER”SINCETHEGOODYINTERCEPTSHIFTSUPWARDBYAGREATERPERCENTAGETHANTHEGOODXINTERCEPTSHIFTSRIGHTWARDNOTE,HOWEVER,THATTHEGOODXINTERCEPTDOESSHIFTTOTHERIGHTBECAUSE,WITHALARGERCAPITALSTOCK,MOREXCANBEOBTAINEDWHENALLRESOURCESAREDEVOTEDTOXPRODUCTION10IFTHEPRICEOFLABORRISESWITHNOCHANGEINTHEPRICEORRENTALRATEOFCAPITAL,W/RINCREASESR/WDECREASESPRODUCERSINBOTHINDUSTRIESWOULDRESPONDBYUSINGRELATIVELYLESSLABORANDRELATIVELYMORECAPITAL,ANDTHEK/LRATIOWOULDRISEINBOTHINDUSTRIESNOTETHAT,INTHISQUESTION,WEDONOTSPECIFYTHECAUSEOFTHERISEINTHEPRICEOFLABORTHEEFFECTSONOUTPUTOFEACHGOODANDONTOTALOUTPUTWOULDDEPENDONTHISCAUSEANDWOULDBEDIFFERENT,FOREXAMPLE,IFTHECAUSEWERETECHNOLOGICALCHANGETHATINCREASEDTHEDEMANDFORLABORRATHERTHANADESIREONTHEPARTOFLABORTOTAKEMORELEISURETIME17CHAPTER6GAINSFROMTRADEINNEOCLASSICALTHEORYIOUTLINEINTRODUCTIONAUTARKYEQUILIBRIUMINTRODUCTIONOFINTERNATIONALTRADETHECONSUMPTIONANDPRODUCTIONGAINSFROMTRADETRADEINTHEPARTNERCOUNTRYMINIMUMCONDITIONSFORTRADETRADEBETWEENCOUNTRIESWITHIDENTICALPPFSTRADEBETWEENCOUNTRIESWITHIDENTICALDEMANDCONDITIONSCONCLUSIONSSOMEIMPORTANTASSUMPTIONSINTHEANALYSISCOSTLESSFACTORMOBILITYFULLEMPLOYMENTOFFACTORSOFPRODUCTIONTHEINDIFFERENCECURVEMAPCANSHOWWELFARECHANGESSUMMARYIISPECIALCHAPTERFEATURESBOX1THECASEOFDIFFERINGTASTESANDIDENTICALCONSTANTCOSTSOFPRODUCTIONCASESTUDY1INCOMEDISTRIBUTIONCHANGESWITHINCREASEDTRADEINTHEUNITEDSTATESBOX2“ACTUAL”VERSUS“POTEN