Transcript Chapter 22

3
Interdependence and the
Gains From Trade
Why Should We Study Trade?
• People trade with each other
– Do you know anyone who makes all the things he or she
consumes?
• To understand our world we need to understand
why people trade so much
• We need to understand whether trade is good for us
or bad for us.
– Understanding this is important precisely because we
trade a lot.
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A Parable For The Modern
Economy
• Imagine a world with …
– only two goods: potatoes and meat
– only two people: a potato farmer and a cattle
rancher
• What amounts should each produce?
• Should they trade?
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By the way…
• Q: Why am I assuming a world with only two
goods and two people?
• A: Simplicity is often key to clarifying an idea
• Q: Okay, but in that case why not assume a
world with just one good and/or one person?
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Opportunity cost
• Suppose the farmer can produce both meat and
potatoes
• As the farmer has a finite amount of the
resources needed for production, the production
of an additional ounce of meat necessarily
reduces the quantity of potatoes the farmer can
produce
• The reduction in potato production caused by the
production of an additional ounce of meat is
called the opportunity cost of meat
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Opportunity cost and trade
• Suppose the opportunity cost of an ounce of
meat is 3 ounces of potatoes for both famer
and rancher
• Will they trade?
• No. Trade would be pointless in this case.
Opportunity Costs
Meat
Potatoes
Farmer
3
1/3
Rancher
3
1/3
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
By the way,
can you fill in
the blank
cells in the
table?
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Opportunity cost and trade
• Now will they trade?
• Yes!
– Rancher will offer to sell meat to farmer at a price
between 2 and 4 ounces of potatoes per ounce of meat
– Farmer will gladly accept
– Both farmer and rancher will be better off
Opportunity Costs
Meat
Potatoes
Farmer
4
1/4
Rancher
2
1/2
4
Again, can
you fill in the
blank cells in
the table?
2
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Opportunity cost and trade
• Therefore, we have just seen that opportunity cost is key
to understanding virtually every aspect of trade
– If opportunity costs are equal, there will be no trade
– If opportunity costs are different, there will be trade
– The price at which the trading occurs will be somewhere
between the two traders’ opportunity costs
– The person with the lower opportunity cost of meat will be
the meat seller (exporter) and potato buyer
• This person is said to have a comparative advantage in meat
production
– The person with the higher opportunity cost of meat will be
the meat buyer (importer) and potato seller
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Opportunity cost and trade
• Trade makes people specialize in the production of the
good they have a comparative advantage in
• Rancher has a comparative advantage in producing meat.
• Trade gives the rancher the incentive to expand meat
production for sale (export) to the farmer
• That is, trade gives the rancher the incentive to specialize in
what he does best
Opportunity Costs
4
2
½
Meat
Potatoes
Farmer
4
¼
Rancher
2
½
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
¼
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Opportunity costs
• We have just seen that opportunity costs are
key to trade
• What makes opportunity costs vary from
person to person or from country to country?
• One answer is technology: different people
may have different technologies
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Production Technologies of the Farmer and
Rancher
These technology numbers can be used
to calculate opportunity costs
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Opportunity Costs of Farmer
• 1 ounce of meat → 60 minutes → 4 ounces of
potatoes.
• Therefore, Farmer’s opportunity cost of 1 ounce of
meat is 4 ounces of potatoes.
Table 1
Opportunity Costs
Meat
Farmer
Rancher
4
Potatoes
Opportunity Costs of Farmer
• 1 ounce of potatoes → 15 minutes → 1/4 ounces of
meat.
• Therefore, Farmer’s opportunity cost of 1 ounce of
potatoes is 1/4 ounces of meat.
Table 1
Farmer
Rancher
Opportunity Costs
Meat
Potatoes
4
¼
Opportunity Costs of Rancher
• 1 ounce of meat → 20 minutes → 2 ounces of
potatoes.
• Therefore, Rancher’s opportunity cost of 1 ounce of
meat is 2 ounces of potatoes.
Table 1
Opportunity Costs
Meat
Potatoes
Farmer
4
¼
Rancher
2
Opportunity Costs of Rancher
• 1 ounce of potatoes → 10 minutes → 1/2 ounces of
meat.
• Therefore, Rancher ’s opportunity cost of 1 ounce of
potatoes is 1/2 ounces of meat.
Table 1
Opportunity Costs
Meat
Potatoes
Farmer
4
¼
Rancher
2
½
Opportunity Costs and Comparative
Advantage
• It follows that,
– Farmer has a comparative advantage in potatoes
and
– Rancher has a comparative advantage in meat.
Table 1
Opportunity Costs
Meat
Potatoes
Farmer
4
¼
Rancher
2
½
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Technological differences are an
important reason why we trade
• To sum up, we have so far seen that
– Trade happens if and only if opportunity costs
vary from person to person (or from country to
country)
– Differences in technological abilities can lead to
differences in opportunity costs
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Differences Make Trade Useful
• Had the opportunity costs of Farmer and
Rancher been equal, the proof of the Theory
of Comparative Advantage would not have
worked.
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But Differences Can’t be the Whole
Story
• Why is Canada our main trade partner despite
being so similar to the US?
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Other Reasons Why Trade Is Good
for Us
• Trade allows us to fully utilize the benefits of
bulk production by allowing each country’s
production to be sold everywhere.
• Trade intensifies competition and squeezes
out inefficient production.
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Exercise: calculation of opportunity
costs from technology
• We have seen how opportunity
costs can be calculated from
the 2nd and 3rd columns (blue
border) of the technology table
below
• But can you do it using the 4th
and 5th columns (brown
border) instead?
Table 1
Opportunity Costs
Meat
Farmer
Rancher
Potatoes
GRAPHING PRODUCTION
POSSIBILITIES
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Rancher’s Production
Possibilities: Further Details
Time Spent on Production of…
Amount Produced
Meat
Potatoes
Meat
Potatoes
0
8
0
48
2
6
6
36
4
4
12
24
6
2
18
12
8
0
24
0
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Figure 1 The Rancher’s Production
Possibilities Frontier
(b) The Rancher ’s Production Possibilities Frontier
Meat (ounces)
24
18
If there is no trade,
the rancher might choose
this production and
consumption.
C
Amount Produced
Meat
Potatoes
0
48
6
36
12
24
18
12
24
0
B
12
6
0
12
24
36
48
Potatoes (ounces)
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The Production Possibilities Frontier
• If either person increases his production of meat, his
production of potatoes must decrease.
– See the table in the previous slide
– and the Production Possibilities Curve in Figure 1
• When there is no trade, each person must consume
what he produces.
• In that case, if either person increases his
consumption of meat, his consumption of potatoes
must decrease.
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Farmer’s Production
Possibilities
Time spent on production of…
Amount Produced
Meat
Potatoes
Meat
Potatoes
0
8
0
32
2
6
2
24
4
4
4
16
6
2
6
8
8
0
8
0
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Figure 1 The Farmer’s Production
Possibilities Frontier
(a) The Farmer ’s Production Possibilities Frontier
Meat (ounces)
Amount Produced
2. If the farmer
wants more meat,
he can go from A to
B.
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If there is no trade,
the farmer might choose
this production and
consumption.
B
3. Gain 4 ounces
of meat
A
4
4. Lose 16 ounces
of potatoes
5. The opportunity
cost of 1 ounce of
meat is, therefore, 4
ounces of potatoes.
0
8. Lose 4 ounces
of meat
16
6. If the farmer
wants more
potatoes, he can go
from A to C.
7. Gain 16 ounces
of potatoes
Meat
Potatoes
0
32
2
24
4
16
6
8
8
0
C
32
Potatoes (ounces)
9. The opportunity cost of 1
ounce of potatoes is
therefore ¼ ounces of meat
The Production Possibilities Frontier Can Shift
(a) The Farmer ’s Production Possibilities Frontier
Meat (ounces)
If more or better resources become
available or if more advanced technology
becomes available, the PPC will move
outward. In that case it might be possible to
produce more of both goods, as in the
move from A to B.
8
B
A
4
0
16
32
Potatoes (ounces)
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More Meat and More Potatoes?
• It may be possible to increase one’s consumption of
both meat and potatoes—as in the last slide—if…
– More resources or better resources become available, or
– Technology becomes more advanced, or
– Farmer and Rancher begin to trade
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More Meat and More Potatoes?
• Trade can increase the overall production—and
consumption—of both goods even if resources and
technology remain unchanged.
• This is the miracle of trade.
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The Production Possibilities Frontier
• The production possibilities frontier is a graph
that shows the combinations of output that
the economy can produce, given
– the available factors (resources) of production and
– the available production technology.
• This and the next three slides are from
Chapter 2.
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The Production Possibilities Frontier
Quantity of
Computers
Produced
This PPF illustrates Increasing
Opportunity Costs or
Diminishing Returns: as
production of a commodity
increases, so does its
opportunity cost
3,000
E
C
A
2,200
2,000
B
From E to A, the opp. cost of a
car is (3000 – 2200)/600 = 1.33
From A to B, the opp. cost of a
car is (2200 – 2000)/(700 – 600) =
2
From B to F, the opp. cost of a
car is 2000/(1000 – 700) = 6.67
D
1,000
0
300
600 700
F
1,000
Quantity of
Cars Produced
The Production Possibilities Frontier
• Concepts illustrated by the production
possibilities frontier
–
–
–
–
Efficiency
Trade-offs
Opportunity cost
Economic growth
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A Shift in the Production Possibilities Frontier
Quantity of
Computers
Produced
4,000
Can trade
alone take us
from A to G?
3,000
2,300
2,200
0
G
A
600 650
of
1,000 CarsQuantity
Produced
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REVISITING THE THEORY OF
COMPARATIVE ADVANTAGE
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Why Is Trade Good for Us?
• Trade benefits both the Farmer and the Rancher by
enabling each person to do only what he is better
suited to do.
• Imagine what it would be like if you were required to
produce everything that you needed.
• The situation would be similarly awful for a country
that either chose not to trade with other countries
or was forced to end all trade with other countries.
– There are additional reasons why trade is good for us.
Those reasons will be briefly discussed later.
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Theory of Comparative Advantage
• The Theory of Comparative Advantage says that if each
person specializes in producing what he or she has a
comparative advantage in, then total production of every
good can increase and,
• As a result, trade can benefit everybody.
• In our example, the theory says that if Farmer specializes in
potatoes and Rancher specializes in meat, the total
production of meat can be increased and the total production
of potatoes can also be increased.
• As a result, if Rancher and Farmer then trade, they could both
benefit.
• But is this theory true?
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Theory of Comparative
Advantage—Proof
• Suppose Farmer increases his production of potatoes by 4
ounces.
• Then, according to Table 1, his production of meat must
decrease by 1 ounce.
• Suppose Rancher increases his production of meat by 1.5
ounces. Then his production of potatoes must decrease by 3
ounces.
• Therefore, by making these two people specialize according to
their comparative advantages, it is possible to increase the
total output of meat by 0.5 ounces and of potatoes by 1 ounce.
Table 1
Opportunity Costs
Meat
Potatoes
Farmer
4
¼
Rancher
2
½
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Wow!
• We have just witnessed a miracle—the miracle of trade. For an
individual, it is impossible to make more of one good without
making less of some other good. But for the world as a whole,
it is possible to produce more of all goods simultaneously if we
embrace trade.
Change in Production
Potatoes
Meat
Farmer
+4
-1
Rancher
Total
-3
+1
+1.5
+0.5
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Applications Of Comparative
Advantage
• Should Tiger Woods mow his own lawn?
• Should the United States trade with other countries?
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The Legacy of Adam Smith and David
Ricardo
• Adam Smith In his 1776 book An Inquiry into the
Nature and Causes of the Wealth of Nations, Adam
Smith performed a detailed analysis of trade and
economic interdependence, which economists still
adhere to today.
• David Ricardo In his 1816 book Principles of Political
Economy and Taxation, David Ricardo developed the
principle of comparative advantage as we know it
today.
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Terms of Trade
• In showing how trade can make Farmer and Rancher
better off, I worked out an example of how trade
could occur.
– Specifically, I showed that if 1.25 ounces of meat are traded
for 3.5 ounces of potatoes, both Farmer and Rancher would
be better off.
• But will trade take place?
• And if it does, at what price will people trade?
• That’s the subject of the next chapter.
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