Chapter 3 Interdependence and the Gains from Trade

Chapter 3 Interdependence and the Gains from Trade 2002 by Nelson, a division of Thomson Canada Limited

In this chapter you will… • • Consider how everyone can benefit when people trade with another country. Learn the meaning of absolute advantage and comparative advantage. See how comparative advantage explains the gains from trade. Apply theory of comparative advantage to everyday life and national policy. Chapter 3: Page 2

Interdependence and the Gains from Trade • Consider your typical day: – You pour yourself orange juice made from Florida oranges and coffee from beans grown in Brazil. – You put on some clothes made of cotton grown in Georgia and sewn in factories in Thailand. – You watch the morning news broadcast from New York on your TV made in Japan. Chapter 3: Page 3

Interdependence and the Gains from Trade • Consider your typical day (more): – You drive to class in a car made of parts manufactured in a half-dozen different countries. – Then you open your economics textbook written by authors living in Massachusetts, Alberta, and Quebec, published by a company located in Ontario, and printed from paper made from trees grown in New Brunswick. Chapter 3: Page 4

Interdependence and the Gains from Trade • Economics studies how society produces and distributes goods and services so that wants and needs are satisfied. • Trade can make everyone better off. Chapter 3: Page 5

Interdependence and the Gains from Trade • How do we satisfy our wants and needs? • We can be economically Self- Sufficient. • We can specialize and trade with others leading to Economic Interdependence Chapter 3: Page 6

Interdependence and the Gains from Trade • A general observation. . . – Individuals and nations rely on specialized production and exchange as a way to address problems caused by scarcity. • This gives rise to two questions. . . – – Why is interdependence the norm? What determines production & trade? Chapter 3: Page 7

Interdependence and the Gains from Trade • Why is interdependence the norm? ü • Interdependence occurs because people are better off when they specialize and trade with others. What determines the pattern of production & trade? ü Patterns of production and trade are based upon differences in opportunity costs. Chapter 3: Page 8

A PARABLE FOR MODERN ECONOMY • Imagine that there are… … two goods in the world: 1. Potatoes 2. Meat … and two people in the world: 1. Potato farmer 2. Cattle rancher • What should each produce? • Why should they trade? Chapter 3: Page 9

Table 3 -1: the Production Opportunities of the Farmer and the Rancher Amount produced in 1 Hour (in Kg) § § Amount produced in 8 Hours (in Kg) Meat Potatoes Farmer 1 1 8 8 Rancher 8 2 64 16 Note that based on the Productivity Table above the Rancher is more productive in producing both of the products. Yet, we will see that both the Rancher and the Farmer can gain from trade. . . Chapter 3: Page 10

Figure 3 -1(A): The Farmer’s Production Possibilities Frontier Meat (kilograms) Derived from Table 3 -1 by working 8 hours a day 8 A 4 0 4 8 Potatoes (kilograms) Chapter 3: Page 11

Figure 3 -1(B): The Rancher’s Production Possibilities Frontier Meat (kilograms) Derived from Table 3 -1 by working 8 hours a day 64 B 32 0 8 16 Potatoes (kilograms) Chapter 3: Page 12

Specialization and Trade • The Farmer and the Rancher Specialize and Trade – Each would be better off if they specialized in producing the product they are more suited to produce, and then trade with each other. The farmer should produce potatoes. The rancher should produce meat. They should trade Chapter 3: Page 13

Figure 3 -2 (A): How Trade Increases the Framer’s Consumption Meat (kilograms) 8 A* 6 Consumption with trade A Consumption without trade 4 0 4 5 8 Potatoes (kilograms) Chapter 3: Page 14

Figure 3 -2 (B): How Trade Increases the Rancher’s Consumption Meat (kilograms) 64 B* 34 Consumption without trade 32 B 0 Consumption with trade 8 9 16 Potatoes (kilograms) Chapter 3: Page 15

THE PRINCIPLE OF COMPARATIVE ADVANTAGE • Differences in the costs of production determine the following: – Who should produce what? – How much should be traded for each product? Who can produce potatoes at a lower cost? The farmer or the rancher! Chapter 3: Page 16

THE PRINCIPLE OF COMPARATIVE ADVANTAGE • Measuring differences in costs of production: – Number of hours required to produce a standardized unit of output. v One pound of potatoes – Opportunity Cost: Whatever must be given up to obtain some item. Chapter 3: Page 17

Absolute Advantage • Describes the productivity of one person, firm, or nation to that of another. - The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good Chapter 3: Page 18

Table 3 -3: The Opportunity Cost of Meat and Potatoes Opportunity Cost of 1 Kg of Farmer Rancher • • • Meat (in terms of Potatoes (in terms of potatoes given up) meat given up) 1 1 1/4 4 Who has the Absolute Advantage in each product? Rancher, in both products! Yet, we have seen that both the Rancher and the Farmer can gain from trade? Chapter 3: Page 19

Opportunity Cost and Comparative Advantage • The comparison among producers of a good according to their opportunity cost. - The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good. Chapter 3: Page 20

Opportunity Cost and Comparative Advantage • Comparative advantage, which refers to differences in opportunity costs, is the basis for specialized production and trade. • Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade. Chapter 3: Page 21

Comparative Advantage and Trade • Based on the earlier Productivity Table (Table 3 -3 - Slide 19)… – The Rancher’s opportunity cost of 1 Kg of potatoes is 4 Kg of meat, whereas the Farmer’s opportunity cost of a Kg of potatoes is 1 Kg of meat. – The Rancher’s opportunity cost of 1 Kg of meat is only 1/4 Kg of potatoes, while the Farmer’s opportunity cost of 1 Kg of meat is only 1 Kg of potatoes. . . Chapter 3: Page 22

Comparative Advantage and Trade • • The Rancher has the Comparative Advantage in producing Meat (lower opportunity cost). The Farmer has the Comparative Advantage in producing Potatoes (lower opportunity cost) Chapter 3: Page 23

Comparative Advantage and Trade • Comparative advantage and differences in opportunity costs are the basis for specialized production and trade. • Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade. Chapter 3: Page 24

Comparative Advantage and Trade Moral of the Story: “Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage. ” Chapter 3: Page 25

APPLICATIONS OF COMPARATIVE ADVANTAGE • The principle of comparative advantage has many applications. Here are two examples: – Joe Sakic and his lawn. – Canada and other countries. Chapter 3: Page 26

Should Joe Sakic Mow His Own Lawn? • Absolute Advantage. . . • Opportunity Costs. . . • Gains from trade. . . Chapter 3: Page 27

Should Canada Trade with other Countries? • Each country has many citizens with different interests. International trade can make some individuals worse off, even as it makes the country as a whole better off. – Imports: goods produced abroad and sold domestically – Exports: goods produced domestically and sold abroad Chapter 3: Page 28

Summary • Each person consumes goods and services produced by many other people both in our country and around the world. • Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services. Chapter 3: Page 29

Summary • There are two ways to compare the ability of two people producing a good. – The person who can produce a good with a smaller quantity of inputs has an absolute advantage. – The person with a smaller opportunity cost has a comparative advantage. Chapter 3: Page 30

Summary • The gains from trade are based on comparative advantage, not absolute advantage. • Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage. • The principle of comparative advantage applies to countries as well as people. Chapter 3: Page 31

The End Chapter 3: Page 32