Transcript Chapter 3 Trade Introduction

Trade and Gains from
Trade
1
Main Concepts

You should know how to effectively use,
define and numerically analyze the
following:
– Production Possibilities Table
– Production Possibilities Frontier
– Opportunity Cost
– Scarcity
– Productive Efficiency
– Growth/Technology Change
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Recall Gilligan’s Island
http://www.metacafe.com/watch/2315010
/gilligans_island_opening_theme_in_color/
 There are 7 people stranded on the island:
Gilligan, The Skipper, Maryanne, Ginger,
Mr. and Mrs. Howell, and the Professor.

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Production on the Island

Suppose on the Island they only produce
2 things:
– Huts (from Palm Trees)
– Radios (from coconuts)

Due to scarcity of goods and the current
technology on the island, if everyone
makes huts they can produce 60 huts in
one month and implicitly no radios.
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Production on the Island
Suppose the gang decides it is a good idea to
make some radios. Who do they ask to stop
making huts?
 The Professor

– Crew now makes 3 radios and 50 huts in a month
– The opportunity cost of Professor making radios
rather than huts is 10 huts.
– Opportunity Cost- the highest valued, next best
alternative that must be sacrificed to obtain
something or to satisfy a want.
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Production on the Island
What if they want more radios? Who should
also make radios and not huts?
 Who ever is next best at making radios relative
to making huts –

– Lets say that’s Maryanne

The Professor and Maryanne can produce 6
radios and everyone else can produce 41 huts in
one month
– The opportunity cost of Maryanne making radios is 9
huts.
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Production on the Island

At this point we have three production
possibilities for the crew:
– They all make huts
– All but Professor makes huts
– All but Professor and Maryanne make huts

Let’s look at this information in a table
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Production on the Island
Number
Producing
Huts
7
Huts
Produced
Radios
Produced
60
Number
Producing
Radios
0
6
50
1
3
5
41
2
6
0
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Production on the Island

This is known as a Production Possibilities
Table
– PPT- a table that shows all of the
combinations of goods and services that can
be produced given the resources of society
and the existing state of technology.
– This table lets us know how much our island
economy can produce.
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Production on Island
Now let’s consider what would happen if
one by one, the rest of the crew moved
into radio production from hut production
 Remember, the people who are best at
making radios and not very good at
making huts relatively should move out of
hut production and into radio production
first.
 Let’s see the production possibilities..

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Production on the Island
Number Producing
Huts
Huts Produced
Number Producing
Radios
Radios Produced
7
60
0
0
6
50
1
3
5
41
2
6
4
32
3
9
3
23
4
12
2
15
5
15
1
7
6
18
0
0
7
20
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Production on the Island

The Production Possibilities Table can be
represented graphically …
– To do this we plot each production possibility
from the previous table possibility.
– The quantity of each good is measured on the
X and Y axis.
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Production on the Island
Huts
60
When we connect the points, we
have a Production Possibilities
Frontier/Curve.
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Notice the inverse relationship!
41
This relationship is mostly linear
for ease of numbers, this is not
always the case!
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23
15
7
3
6
9
12
15
18 20 Radios
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Production on the Island
The production possibilities frontier is a
graph that shows all combinations of
goods and services that can be produced
given the resources of society and the
existing state of technology.
 PPF follows the scarcity principal - given
limited resources, having more of one
good thing generally means having less of
another.

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Production on the Island
Huts
60
Outside Production
Possibilities – Not possible
with current resources.
50
41
32
23
15
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Inside of
Production
Possibilities
– Not all
resources
are used.
3
6
9
12
15
18 20 Radios
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Trade
Suppose Gilligan’s Island gets in contact
with the Swiss Family Robinson.
 Knowing that trade can make everyone
better off, the two island occupants decide
to trade huts for radios
 But who should produce what? How
much should they trade? What should be
the terms of trade?

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Trade

Recall, points on the GI PPF (Production
Possibilities Frontier) are
Number of Huts built in Number of Radios built
a month
in a month
60
0
15
15
0
20
-Notice GI (Gilligan’s Island) can produce either 60 huts a month or 20 radios a
month. So the opportunity cost for 60 huts is 20 radios.
-Reducing this number, 60 huts/20 radios = 3 huts/1 radio.
-Suppose GI is currently making and consuming 15 huts and 15 radios.
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Trade

Suppose the Production Possibilities Table for
the Swiss Family Robinson is as follows:
Number of Huts built in
a month
20
15
0
Number of Radios built
in a month
0
15
60
-Notice SFR can produce either 20 huts a month or 60 radios a month. So the
opportunity cost for 20 huts is 60 radios.
-Reducing this number, 20 huts/60 radios = 1 huts/3 radio.
-Suppose SFR is currently making and consuming 15 huts and 15 radios.
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Trade

Thus the two PPFs are as follows:
Huts
60
GI PPF
20
SFR PPF
20
60 Radios
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Trade
– Recall currently GI and SFR are producing
(and consuming) 15 huts and 15 radios.
– The total economy thus has 30 huts and 30
radios
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Trade



Comparative Advantage – The advantage in the
production of a product enjoyed by one country
over another when that product can be produced at
lower cost in terms of other goods than it could be
in the other country.
GI has a comparative advantage in producing huts,
to produce a hut, it costs 1/3 of a radio. For SFR to
produce a hut, it costs 3 radios.
SFR has a comparative advantage in producing
radios. To produce a radio, it costs 1/3 of a hut.
For GI to produce a radio, it costs 3 huts.
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Trade
– Now suppose GI, who has the comparative
advantage in huts only produces huts and
SFR, who has the comparative advantage in
radios only produced radios.
– This is called specialization- the division of
productive activities among persons and
regions so that no one individual or one area
is totally self-sufficient.
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Trade
GI specializes in huts and produces 60 huts.
 SFR specializes in radios and produces 60 radios

Huts
60
GI PPF
Current Consumption (15
huts, 15 Radios) each. (Just
happens to be at the cross
point.)
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SFR PPF
20
60 Radios
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Trade
Now suppose that GI and SFR trade
 Terms of trade are 1 radio for 1 hut.

– This means GI buys radios from SFR for less huts
than the opportunity cost for GI to produce them
(1 radio for 1 hut instead of 1 radio for 3 huts).
– And, SFR buys huts from GI for less radios than
the opportunity cost for SFR to produce them (1
hut for 1 radio instead of 1 hut for 3 radios).
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Trade

Suppose GI trades SFR 30 huts for 30
radios.
– Now, GI consumes their 30 remaining huts
and the 30 radios they received from SFR.
This is more than the 15 huts and 15 radios
they consumed before trading.
– SFR consumes their 30 remaining radios and
the 30 huts they received from GI. This is
more than the 15 huts and 15 radios they
consumed before trading.
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Trade
Note the consumption after trade, GI and
SFR each have more Huts and Radios than
their resources allowed them to have if
they did not trade.
 Ricardo’s Theory of Comparative
Advantage – Specialization and free trade
will benefit all trading partners, even
those that may be absolutely more
efficient producers.

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Trade
Note, neither island had an absolute
advantage.
 Absolute Advantage – The advantage in
the production of a product enjoyed by
one country over another when it uses
fewer resources to produce than the other
country does.

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Trade – Gillies and Swissies
Suppose there exists a tribe of natives on
Gilligan’s Island called the Gillies.
 Suppose there also exists a tribe of
natives on Swiss Family Robinson’s island
called the Swissies.
 The two tribes both cut logs for fire and
gather nuts for food.

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Trade - Gillies and Swissies

Suppose the two tribes’ production information
for cutting logs & gathering nuts is below:
Tribes
# of logs cut in a
day
# of barrels of nuts
collected in a day
Gillies
10
5
Swissies
6
2
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Trade - Gillies and Swissies

Will it benefit the Gillies to trade with the
Swissies?
– YES!!!!!!!!!!!!!!!
Gillies opportunity cost to cut 10 logs is 5 barrels
of nuts or the opportunity cost to cut 2 logs is 1
barrel of nuts.
 Swissies opportunity cost to cut 6 logs is 2
barrels of nuts or the opportunity cost to cut 3
logs is 1 barrel of nuts.

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Trade - Gillies and Swissies
Suppose the Gillies currently consume 6
logs and 2 barrels of nuts.
 Suppose the Swissies currently consume 3
logs and 1 barrel of nuts.
 So the total economy consumes 9 cut logs
and 3 barrels of nuts.

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Trade – Gillies and Swissies
The Production Possibility Frontiers are as
follows:
Logs Cut

10 Gillies PPF
Gillies Current Consumption
6
Swissies PPF
3
Swissies Current Consumption
1
2
5
Barrels of Nuts Gathered
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Trade - Gillies and Swissies
The Gillies have the comparative advantage in
gathering barrels of nuts. It costs them 2 logs
to gather a barrel of nuts. It costs the Swissies
3 logs to gather a barrel of nuts.
 The Swissies have the comparative advantage in
cutting logs. It costs them 1/3 of a barrel of
nuts to cut one log. It costs the Gillies ½ of a
barrel of nuts to cut one log.

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Trade - Gillies and Swissies
Suppose the Swissies specialize in cutting
logs.
 The Gillies move along their production
possibility curve and partially specialize.
They produce 3 barrels of nuts and 4 cut
logs.
 The total economy thus has 3 barrels of
nuts and 10 cut logs, and is better off with
the specialization of the Swissies.

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Trade - Gillies and Swissies
Suppose the Gillies and Swissies trade. Their
terms of trade is 1 barrel of nuts for 2½ cut logs.
 Both end up benefitting from the trade!
 The Gillies and Swissies goods are tracked below:

Goods with
no trade
Production
with partial
specialization
Gillies
Logs: 6
Nuts: 2
Logs: 4
Nuts: 3
Logs: +2½ Logs: 6½
Nuts: -1
Nuts: 2
Swissies
Logs: 3
Nuts: 1
Logs: 6
Nuts: 0
Logs: -2½
Nuts: +1
Tribe
Terms of
Trade
Ending
Goods
Logs: 3½
Nuts: 1
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