Chapter 3 Interdependence and the Gains From Trade

Chapter 3 Interdependence and the Gains From Trade Ratna K. Shrestha

Changes in What Canadian Produce Over the past 50 years, the number of Canadians who produce farm goods have decreased, while the number who produce services has expanded. q Yet Canadians now enjoy a greater varieties/quantities of farm goods than before. q What explains this seemingly paradoxical outcome ? q

Changes in What Canadian Produce

Overview A Parable for the Modern Economy u Principle of Comparative Advantage u Application of Comparative Advantage u

How Do We Satisfy Our Needs? Economics studies how society produces and distributes goods and services so that wants and needs are satisfied. We can be economically Self-Sufficient. Or We can specialize and trade with others, leading to Economic Interdependence.

Interdependence Every day you rely on many people from around the world, most of whom you do not know, to provide you with the goods and services you enjoy. hair gel from Cleveland, OH cell phone from Korea dress shirt from China coffee from Brazil

Interdependence & Trade u. A general observation – Individuals and nations rely on specialized production (they produce only certain goods and not all) and exchange as a way to address problems caused by scarcity. u This gives rise to two questions. – Why is interdependence the norm? – What determines production & trade?

Interdependence & Trade u Why is interdependence the norm? Ø Interdependence occurs because people are better off when they specialize (in the goods which they can produce at lower costs) and trade with others. u What determines the pattern of production & trade? Ø The differences in opportunity costs. You produce the good which you can produce at a lower opportunity cost.

Interdependence and Trade: “A Parable for the Modern Economy” Imagine. . . …only two goods (potatoes and meat). . only two people (farmer and rancher) What should each produce? Why should they trade?

Productivity Table u Note that based on the Productivity Table above the Rancher is more productive in producing both of the products. u Yet, we will see that both the Rancher and the Farmer can gain from trade. . .

PPF(Assuming an 8 hour day) Rancher Farmer PPF 8 8 Potatoes in Kg Meat in Kg 64 PPF 16 Potatoes in Kg

A World of Self-Sufficiency 64 Farmer 8 6 A 2 8 Potatoes in Kg Meat in Kg Suppose with no trade, the Farmer produces and consumes combination A, while the Rancher is at combination B 48 Rancher B 4 16 Potatoes in Kg

Specialization and Trade u If the farmer and the rancher were to specialize in producing the product that they were best suited to produce, and then trade with each other, they would be better off. – Farmer should produce potatoes. – Rancher should produce meat. – Farmer and Rancher should trade. u In the next slide, farmer produces 8 potatoes and no meat. Similarly, rancher 16 meat and no potatoes.

Specialization and Trade In this example, farmer trades 5 Kg Potatoes for 10 Kg Meat: 10 8 6 A*trade A 2 3 8 Potatoes in Kg Meat in Kg Farmer 64 54 48 Rancher B*trade B 4 5 16 Potatoes in Kg

Specialization and Trade 10 8 6 Farmer A*trade A 2 3 8 Potatoes in Kg With trade the Rancher is at B* Meat in Kg With trade the Farmer is at A* 64 54 48 Rancher B*trade B 4 5 16 Potatoes in Kg

Examples of Specialization

The Principle of Comparative Advantage u What determines who should produce what? And how much should be traded for each product? u It depends on the opportunity costs of production for each trading partner. u Not on the total amount of resources required for production by each partner.

Comparative and Absolute Advantage u The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good. u The producer that has a lower opportunity cost in producing a good is said to have a comparative advantage in producing that good.

Productivity Table u Who has the Absolute Advantage in each product? Rancher, in both products. u Yet, both the Rancher and the Farmer can gain from trade. Why?

What is the Problem with this Picture?

The Principle of Comparative Advantage u Comparative advantage is the basis for specialized production and trade. u Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade.

Opportunity Cost Table u The Rancher has the Comparative Advantage in producing Meat (lower opportunity cost). u The Farmer has the Comparative Advantage in producing Potatoes (lower opportunity cost).

Applications of Comparative Advantage u Should Canada trade with Other countries (e. g. Japan or USA)? u Who has a comparative advantage in producing lumber: Canada or US? u Comparative advantage depends on Opportunity Costs and it determines the nature of trade: who Imports or Exports.

Trade: Canada and Japan 4 Food Japan Canada 2 Cars 2

Opportunity Cost: Sacrifice Food Production for Car Production Food 4 Canada 2 1 Cars Opportunity Cost = Slope of PPF = 2/1 (2 Units of food given up to get 1 Unit of a car) 2

Opportunity Cost: Sacrifice Food Production for Car Production Food 2 Japan Opportunity Cost Slope of PPF =1/1 1 Unit of food given up to get 1 Unit of a car Cars 2

Who should produce Cars/Food? Trade ratio = between 2 and 1 Food 4 Food Canada Japan 2. 5 2 1. 5 1 Cars 2

Conclusion Ø Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services. Ø Founded upon the. . . Principle of Comparative Advantage (developed by David Ricardo in his 1816 book “Principle of Political Economy and Taxation)

Should Joe Sakic Mow His Own Lawn? § § § Joe Sakic is a great hockey player. Perhaps he can also mow his lawn faster than anyone else. Does that mean he should mow his own lawn?

Specialization and Trade § Suppose Rancher wants to consume more than 8 Potatoes that the Farmer can possibly produce. In this case, Rancher has to produce some of the potatoes on its own (even though Farmer has the comparative advantage in producing it). § For example, if the Rancher wants 9 potatoes, then she/he can get 5 from the farmer and produce 4 on its own.

Specialization and Trade Rancher 64 Meat in Kg Farmer 10 8 6 A*trade B*trade 48 38 32 B A 2 3 8 Potatoes in Kg 4 89 16 Potatoes in Kg