Interdependence and the Gains from Trade Copyright 2004

Interdependence and the Gains from Trade Copyright © 2004 South-Western/Thomson Learning 3

Consider your typical day: • 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 that you enjoy. • You wake up to an alarm clock made in Korea. • 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. • You drive to class in a car made of parts manufactured in a half-dozen different countries. Copyright © 2004 South-Western

Trade can make everyone better off. • people provide you and other consumers with the goods and services they produce because they get something in return. trade can make everyone better off. • This principle explains why • people trade with their neighbors and • why nations trade with other nations. Copyright © 2004 South-Western

What exactly do people gain • What exactly do people gain when they trade with one another? • Why do people choose to become interdependent? Copyright © 2004 South-Western

Interdependence and the Gains from Trade Economics • Remember, is the study of • how societies produce and distribute goods in an attempt to satisfy the wants and needs of its members. Copyright © 2004 South-Western

Interdependence and the Gains from Trade • How do we satisfy our wants and needs in a global economy? • We can be economically • self-sufficient. We can specialize and trade with others, leading to economic interdependence. Copyright © 2004 South-Western

Interdependence and the Gains from Trade • Individuals and nations rely on specialized production and exchange as a way to address problems caused by scarcity. • But this gives rise to two questions: • Why is interdependence the norm? • What determines production and trade? Copyright © 2004 South-Western

Interdependence and the Gains from Trade • Why is interdependence the norm? • Interdependence occurs because people are better off when they specialize and trade with others. • What determines the pattern of production and trade? • Patterns of production and trade are based upon differences in opportunity costs. Copyright © 2004 South-Western

• To understand why people choose to depend on others for goods and services and • how this choice improves their lives, let’s look at a simple economy. Copyright © 2004 South-Western

A PARABLE FOR THE MODERN ECONOMY • Imagine. . . • only two goods: potatoes and meat • only two people: a potato farmer and a cattle rancher • What should each produce? • Why should they trade? Copyright © 2004 South-Western

Table 2 The Gains from Trade: A Summary Copyright © © 2004 South-Western

The potato farmer& The cattle rancher • Suppose, for example, that the potato farmer is able to raise cattle and produce meat, but that he is not very good at it. • Similarly, suppose that the cattle rancher is able to grow potatoes, but that her land is not very well suited for it. Copyright © 2004 South-Western

Combination of production • ½ of the time for meat production & • ½ of potatoes production Copyright © 2004 South-Western

Figure 1 The Production Possibilities Curve (a) The Farmer ’s Production Possibilities Frontier Meat (ounces) If there is no trade, the farmer chooses this production and consumption. 8 4 0 A 16 32 Potatoes (ounces) Copyright© 2003 Southwestern/Thomson Learning Copyright © 2004 South-Western

Figure 1 The Production Possibilities Curve (b) The Rancher ’s Production Possibilities Frontier Meat (ounces) 24 If there is no trade, the rancher chooses this production and consumption. 12 0 B 24 48 Potatoes (ounces) Copyright © 2004 South-Western Copyright© 2003 Southwestern/Thomson Learning

Question to be answered • suppose that the rancher is better at raising • cattle and better at growing potatoes than the farmer. • In this case, should the rancher or farmer choose to remain self-sufficient? • Or is there still reason for them to trade with each other? • To answer this question, we need to look more closely at the factors that affect such a decision. Copyright © 2004 South-Western

Without Trade • If the farmer and rancher choose to be self-sufficient, rather than trade with each other, then each consumes exactly what he or she produces. Copyright © 2004 South-Western

Production Possibilities Self-Sufficiency , By ignoring each other: 1. Each consumes what they each produce. 2. In this case, the production possibilities frontier is also the consumption possibilities frontier 3. Without trade, economic gains are diminished. Copyright © 2004 South-Western

Figure 1 The Production Possibilities Curve (a) The Farmer ’s Production Possibilities Frontier Meat (ounces) If there is no trade, the farmer chooses this production and consumption. 8 4 0 A 16 32 Potatoes (ounces) Copyright© 2003 Southwestern/Thomson Learning Copyright © 2004 South-Western

Figure 1 The Production Possibilities Curve (b) The Rancher ’s Production Possibilities Frontier Meat (ounces) 24 If there is no trade, the rancher chooses this production and consumption. 12 0 B 24 48 Potatoes (ounces) Copyright © 2004 South-Western Copyright© 2003 Southwestern/Thomson Learning

SPECIALIZATION AND TRADE Copyright © 2004 South-Western

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. Copyright © 2004 South-Western

Table 2 The Gains from Trade: A Summary Rancher ( 12, 24) ( 12 meet potatoes = 6 meat) Copyright © © 2004 South-Western

Figure 2 How Trade Expands the Set of Consumption Opportunities (a) The Farmer’s Production and Consumption Meat (ounces) 8 Farmer's consumption with trade A* 5 4 Farmer's production and consumption without trade A Farmer's production with trade 0 32 16 Potatoes (ounces) 17 Copyright © 2004 South-Western Copyright© 2003 Southwestern/Thomson Learning

Figure 2 How Trade Expands the Set of Consumption Opportunities (b) The Rancher’s Production and Consumption Meat (ounces) Rancher's production with trade 24 Rancher's consumption with trade 18 13 B* B 12 0 12 24 27 Rancher's production and consumption without trade 48 Potatoes (ounces) Copyright © 2004 South-Western

SPECIALIZATION AND TRADE Copyright © 2004 South-Western

THE PRODUCTION OPPORTUNITIES OF THE FARMER AND THE RANCHER HOURS NEEDED TOMAKE 1 POUND OF: AMOUNT PRODUCEDIN 40 HOURS MEAT POTATOES FARMER 20 hours/lb 10 hours/lb 2 lbs 4 lbs RANCHER 1 hour/lb 8 hours/lb 40 lbs 5 lbs Meat (pounds) (a) The Farmer’s Production Possibilities Frontier 2 40 (b) The Rancher’s Production Possibilities Frontier B 20 1 A 0 0 0 2 4 Potatoes (pounds) 0 2. 5 5 Potatoes (pounds Copyright © 2004 South-Western

Making a deal The rancher gets an idea and goes to talk to the farmer: • The rancher: if you work 40 hours a week growing potatoes, you’ll produce 4 pounds of potatoes. • If you give me 1 of those 4 pounds, I’ll give you 3 pounds of meat in return. • In the end, you’ll get to eat 3 pounds of potatoes and 3 pounds of meat every week, instead of the 2 pounds of potatoes and 1 pound of meat you now get. Copyright © 2004 South-Western

Making a deal FARMER: That seems like a good deal for me. But I don’t understand why you are offering it. If the deal is so good for me, it can’t be good for you too. RANCHER: Oh, but it is! If I spend 24 hours a week raising cattle and 16 hours growing potatoes, I’ll produce 24 pounds of meat and 2 pounds of potatoes. After I give you 3 pounds of meat in exchange for 1 pound of potatoes, I’ll have 21 pounds of meat and 3 pounds of potatoes. In the end, I will also get more of both foods than I have now Copyright © 2004 South-Western

THE GAINS FROM TRADE THE OUTCOME WITHOUT TRADE: THE OUTCOME WITHTRADE THE GAINS FROM TRADE: WHAT THEY PRODU CE WHAT THEY TRADE THE INCREASE IN CONSUMPTION Point A 0 lbs Meat 4 lbs potatoes Gets 3 3 lbs meat for 1 lb 3 lbs potatoes point B 24 lbs meat 2 lbs potatoes Gives 3 21 lbs meat for 1 lb 3 lbs potatoes WHAT THEY PRODUCE AND CONSUME FARMER 1 lb meat 2 lbs potatoes RANCHER 20 lbs meat 2 1/2 lbs potatoes WHAT THEY CONSUME point A* 2 lbs meat 1 lb potatoes Point B* 1 lb meat 1/2 lb potatoes A* –A B* –B Copyright © 2004 South-Western

HOW TRADE EXPANDS THE SET OF CONSUMPTION OPPORTUNITIES. • The proposed trade between the farmer and the rancher offers each of them a combination of meat and potatoes that would be impossible in the absence of trade. Copyright © 2004 South-Western

• In this case, it is easy to see that the farmer and the rancher can each benefit by specializing in what he or she does best and then trading with the other. Copyright © 2004 South-Western

ASSIGMENT # Draw an example of a production possibilities frontier for Robinson Crusoe, a shipwrecked sailor who spends his time gathering coconuts and catching fish. Does this frontier limit Crusoe’s consumption of coconuts and fish if he lives by himself? Does he face the same limits if he can trade with natives on the island? Copyright © 2004 South-Western

That is the End Copyright © 2004 South-Western

COMPARATIVE ADVANTAGE Copyright © 2004 South-Western

If the rancher is better at both raising cattle and growing potatoes, how can the farmer ever specialize in doing what he does best? The farmer doesn’t seem to do anything best. HOURS NEEDED TOMAKE 1 POUND OF: AMOUNT PRODUCEDIN 40 HOURS MEAT POTATOES FARMER 20 hours/lb 10 hours/lb 2 lbs 4 lbs RANCHER 1 hour/lb 8 hours/lb 40 lbs 5 lbs To solve this puzzle, we need to look at the? Copyright © 2004 South-Western

THE PRINCIPLE OF COMPARATIVE ADVANTAGE • Differences in Costs of Production • Two ways to measure differences in costs of production: 1. The number of hours required to produce a unit of output (for example, one pound of potatoes). ( absolute advantage ) 1. The opportunity cost of sacrificing one good for another. ( comparative advantage ) Copyright © 2004 South-Western

Absolute Advantage • The comparison among producers of a good according to their productivity—absolute advantage • Describes the productivity of one person, firm, or nation compared 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. Copyright © 2004 South-Western

Table 2 The Gains from Trade: A Summary Copyright © © 2004 South-Western

Absolute Advantage • The Rancher needs only 10 minutes to produce an ounce of potatoes, whereas the Farmer needs 15 minutes. • The Rancher needs only 20 minutes to produce an ounce of meat, whereas the Farmer needs 60 minutes. The Rancher has an absolute advantage in the production of both meat and potatoes. Copyright © 2004 South-Western

• There is another way to look at the cost of producing potatoes. • Rather than comparing inputs required, we can compare the opportunity costs. • The opportunity cost of some item is what we give up to get that item Copyright © 2004 South-Western

The opportunity cost measures the tradeoff that each of farmer and the rancher faces. • we assumed that the farmer and the rancher each spend 40 hours a week working. • Time spent producing potatoes, therefore, takes away from time available for producing meat. • As the rancher and farmer change their allocations of time between producing the two goods, they move along their production possibility frontiers; in a sense, they are using one good to produce the other. Copyright © 2004 South-Western

Farmer and the Rancher opportunity cost • Let’s first consider the rancher’s opportunity cost. • Producing 1 pound of potatoes takes her 8 hours of work. Because the rancher needs only 1 hour to produce 1 pound of meat, 8 hours of work would yield 8 pounds of meat. • Hence, the rancher’s opportunity cost of • 1 pound of potatoes = is 8 pounds of meat. HOURS NEEDED TOMAKE 1 POUND OF: AMOUNT PRODUCEDIN 40 HOURS MEAT POTATOES FARMER 20 hours/lb 10 hours/lb 2 lbs 4 lbs RANCHER 1 hour/lb 8 hours/lb 40 lbs 5 lbs Copyright © 2004 South-Western

• • • Now consider the farmer’s opportunity cost. Producing 1 pound of potatoes takes him 10 hours. he needs 20 hours to produce 1 pound of meat, 10 hours would yield 1/2 pound of meat. Hence, the farmer’s opportunity cost of • 1 pound of potatoes is 1/2 pound of meat. HOURS NEEDED TOMAKE 1 POUND OF: AMOUNT PRODUCEDIN 40 HOURS MEAT POTATOES FARMER 20 hours/lb 10 hours/lb 2 lbs 4 lbs RANCHER 1 hour/lb 8 hours/lb 40 lbs 5 lbs Copyright © 2004 South-Western

• Economists use the term comparative advantage when describing the opportunity cost of two producers. • The producer who has the smaller opportunity cost of producing a good—that is, who has to give up less of other goods to produce it—is said to have a comparative advantage in producing that good. OPPORTUNITY COST OF: 1 POUND OF MEAT POTATOES FARMER RANCHER 2 lbs potatoes 1/8 lb potatoes 1/2 lb meat 8 lbs meat Copyright © 2004 South-Western

Opportunity Cost and Comparative Advantage • Compares producers of a good according to their opportunity cost. Whatever must be given up to obtain some item • The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good. Copyright © 2004 South-Western

THE RESULT • The rancher has a lower opportunity cost of producing meat than the farmer (1/8 pound versus 2 pounds of potatoes). • Thus, the farmer has a comparative advantage in growing potatoes, and the rancher has a comparative advantage in producing meat. • rancher : 1 pound of potatoes = is 8 pounds of meat • Farmer 1 pound of potatoes is = 1/2 pound of meat. Copyright © 2004 South-Western

Comparative Advantage and Trade …so, the Rancher has a comparative advantage in the production of meat but the Farmer has a comparative advantage in the production of potatoes. Copyright © 2004 South-Western

IMPORTANT NOTE 1. Notice that it would be impossible for the same person to have a comparative advantage in both goods. Because the opportunity cost of one good is the inverse of the opportunity cost of the other, if a person’s opportunity cost of one good is relatively high, his opportunity cost of the other good must be relatively low. 2. Comparative advantage reflects the relative opportunity cost. Unless two people have exactly the same opportunity cost, one person will have a comparative advantage in one good, and the other person will have a comparative advantage in the other good. Copyright © 2004 South-Western

COMPARATIVE ADVANTAGE AND TRADE Copyright © 2004 South-Western

Comparative Advantage and Trade • Who has the absolute advantage? • The farmer or the rancher? • Who has the comparative advantage? • The farmer or the rancher? Copyright © 2004 South-Western

• Differences in opportunity cost and comparative advantage create the gains from trade. • When each person specializes in producing the good for which he or she has a comparative advantage, total production in the economy rises, and this increase in the size of the economic pie can be used to make everyone better off. Copyright © 2004 South-Western

• Consider the proposed deal from the viewpoint of the farmer. • The farmer gets 3 pounds of meat in exchange for 1 pound of potatoes. • In other words, the farmer buys each pound of meat for a price of 1/3 pound of potatoes. This price of meat is lower than his opportunity cost for 1 pound of meat, which is 2 pounds of potatoes. • Thus, the farmer benefits from the deal because he gets to buy meat at a good price. Copyright © 2004 South-Western

• Now consider the deal from the rancher’s viewpoint. • The rancher buys 1 pound of potatoes for a price of 3 pounds of meat. This price of potatoes is lower than her opportunity cost of 1 pound of potatoes, which is 8 pounds of meat. Thus, the rancher benefits because she gets to buy potatoes at a good price Copyright © 2004 South-Western

THE RESULT AND CONCLUSION • These benefits arise because each person concentrates on the activity for which he or she has the lower opportunity cost: • The farmer spends more time growing potatoes, and the rancher spends more time producing meat. • As a result, the total production of potatoes and the total production of meat both rise, and the farmer and rancher share the benefits of this increased production. Copyright © 2004 South-Western

• The moral of the story of the farmer and the rancher should now be clear: • Trade can benefit everyone in society because it allows people to specialize in activities in which they have a comparative advantage. Copyright © 2004 South-Western

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. Copyright © 2004 South-Western

FYI—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. Copyright © 2004 South-Western

APPLICATIONS OF COMPARATIVE ADVANTAGE • Should the United States 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 Copyright © 2004 South-Western

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. Copyright © 2004 South-Western

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. Copyright © 2004 South-Western

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. Copyright © 2004 South-Western

That is the End Copyright © 2004 South-Western