Interdependence and the Gains From Trade-1

transcript

Chapter 3: Interdependence and the Gains from Trade

Chapter 3: Interdependence and the Gains fromTrade

AGEC 217

Patrick S. Ward

Purdue University

June 17, 2009

Overview

1 Overview

2 An Example of Trade

3 Absolute vs. Comparative Advantage

4 The Price of Trade

5 Applications

6 Conclusions

Overview

Interdependencies in the Modern Global Economy

Every day, you depend on many people from many countriesaround the world

...and many people from many countries around the worlddepend on you!

Such interdependencies are possible because people tradewith one another

People engage in trade because it is mutually beneficial

Trade can make everyone better of

Overview

People engage in trade because it is mutually beneficialTrade can make everyone better of

Overview

How Can Individuals Satisfy Their Wants?

Two basic ways:

1 Be economically self-sufficient

2 Specialize in the production of one good and trade with others

With rare exceptions, individuals and nations tend to rely onspecialization and trade

Overview

A Parable of Trade

When are there gains from trade?

We can analyze this question through the use of economic models

Assumptions:

2 goods (Meat & Potatoes)2 agents (Cattle Rancher & Potato Farmer)Both agents would like to consume both of the goodsCattle rancher is very skilled in the raising of cattlePotato farmer is very skilled in growing potatoes

Overview

A Parable of Trade

There are gains from trade:

When both agents can produce only 1 good (completespecialization)

Cattle rancher only produces cattle and the potato farmer onlyproduces potatoesTrade allows the agents to consume the good they don’tproduce

When the farmer can raise cattle as well as grow potatoes(but he is not as good at it) and the rancher can growpotatoes as well as raise cattle (but he is not as good at it)

Trade allows the agent to specialize and produce what they aremost efficient at producing

Even when one of the agents is better at the production ofboth potatoes and cattle

Overview

A Parable of Trade

Overview

A Parable of Trade

Overview

A Parable of Trade

An Example of Trade

1 Overview

5 Applications

6 Conclusions

An Example of Trade

An Example

Assumptions:

Two actors: Farmer and RancherEach works 8 hours per dayEach can produce both potatoes and cattle (either specializingor mixing)Production opportunities are given as:

AmountProduced in 8 HoursMeat Potatoes

Farmer 8 oz. 32 oz.Rancher 24 oz. 48 oz.

An Example of Trade

Production Possibilities

Farmer’s Production Possibilities Rancher’s Production Possibilities

An Example of Trade

What Do We Observe in this Example?

The Rancher has an absolute advantage in the production ofboth meat and potatoes

Rancher is able to produce 24 oz. of meat and 48 oz. ofpotatoes in an 8 hour period, while the farmer is only able toproduce 8 oz. of meat and 32 oz. of potatoes in that sameperiod

Since both the Farmer and the Rancher would like to consumeboth meat and potatoes, in the absence of trade they willproduce and consume some combination of the two goods.

An Example of Trade

What Do We Observe in this Example? (cont’d)

If the Farmer and the Rancher choose to be self-suffieicnt,they will each consume what they produce

Production decisions are determined by consumption decisionsIn the PPF diagrams, these consumption combinations (ofmeat and potatoes) are given by points A and BThese points are dependent upon the individuals’ tastes andpreferencesIn this example, we assume that both the Farmer and theRancher like meat and potatoes equally

An Example of Trade

Production Possibilities

Farmer’s Production Possibilities Rancher’s Production Possibilities

An Example of Trade

With and Without Trade

Farmer Rancher

Meat Potatoes Meat Potatoes

Without Trade:Production andConsumption 4 oz. 16 oz. 12 oz. 24 oz.

With Trade:Production 0 oz. 32 oz. 18 oz. 12 oz.Trade Gets 5 oz. Gives 15 oz. Gives 5 oz. Gets 15 oz.Consumption 5 oz. 17 oz. 13 oz. 27 oz.

Gains from Trade:Increase inConsumption +1 oz. + 1 oz. +1 oz. + 3 oz.

Absolute vs. Comparative Advantage

1 Overview

5 Applications

6 Conclusions

Absolute Advantage

Question: If the rancher is better at producing both meat andpotatoes, how can the farmer ever specialize in doing what he doesbest?

Absolute advantage: the ability to produce a good usingfewer inputs than another producer

The rancher has an absolute advantage in the production ofboth goodsIt requires less time (labor) to produce an ounce of meat or anounce of potatoes

Comparative Advantage

We can also think of advantage in production by comparingopportunity costs

Time spent producing potatoes takes away from producingmeat

...and vice versa

The opportunity cost measures the trade-off between the twogoods that each producer faces

Comparative Advantage: the ability to produce a good at alower opportunity costs than another producer

...and vice versa

Recall the production opportunities:

AmountProduced in 8 Hours

Meat Potatoes

Rancher can produce 1 oz. of potatoes in 10 minutes (48 oz. of potatoesin 480 minutes = 1 oz. in 10 minutes)

When the rancher uses these 10 minutes producing potatoes, she spends10 minutes less producing meat

These 10 minutes cost the Rancher 1/2 oz. of meat (24 oz. of meat in480 minutes = 1/2 oz. in 10 minutes)

The Rancher’s opportunity cost of 1 oz. of potatoes is 1/2 oz. of meat

Likewise, the Rancher’s opportunity cost of 1 oz. of meat is 2 oz. ofpotatoes

Meat Potatoes

Farmer can produce 1 oz. of potatoes in 15 minutes (32 oz. of potatoesin 480 minutes = 1 oz. in 15 minutes)

The Farmer can only produce 1 oz. of meat in 60 minutes (8 oz. ofpotatoes in 8 hours = 1 oz. in 1 hour)

The 15 minutes spent growing potatoes “costs” the Farmer 1/4 oz. ofmeat

The Farmer’s opportunity cost of 1 oz. of potatoes is 1/4 oz. of meat

Likewise, the Farmer’s opportunity cost of 1 oz. of meat is 4 oz. ofpotatoes

Meat Potatoes

Comparative Advantage and Trade

Opportunity cost of:

1 oz. of Meat 1 oz. of Potatoes

Farmer 4 oz. potatoes 1/4 oz. meatRancher 2 oz. potatoes 1/2 oz. meat

The Farmer has the lower opportunity cost of producingpotatoes (1/4 oz. meat vs. 1/2 oz. meat)

The Farmer will produce potatoes and trade with the Rancherto get meat

The Rancher has the lower opportunity cost of producingmeat (2 oz. potatoes vs. 4 oz. potatoes)

The Rancher will produce more meat (and fewer potatoes)than when he was self-sufficient, and will trade meat to theFarmer for potatoes

Absolute and Comparative Advantage

It is possible for an agent to have an absolute advantage inthe production of both goods

It is not possible for an agent to have a comparativeadvantage in the production of both goods

Unless two agents have exactly the same opportunity cost,one agent will have a comparative advantage in one goodwhile the other agent will have a comparative advantage inthe other good.

What Factors Contribute to Comparative Advantage

There are many determinants of comparative advantage. Theinclude (but are not limited to) cross-country differences in:

1 Climate

2 Soil composition

3 Education

4 Training of the labor force

5 Capital stock (for example, machinery)

6 Infrastructure

Gains from Trade

Both the Farmer and the Rancher gain from the trade ofgoods (compared with being self-sufficient)

Farmer consumes more meat and more potatoesRancher consumes more meat and more potatoes

When each person specializes in the production of the good orservice for which he/she has a comparative advantage, totalproduction increases

Total potato production increases from 40 to 44 oz.Total meat production increases from 16 to 18 oz.The total size of the “economic pie” is bigger

Each person is able to obtain a good at a price lower thanhis/her opportunity cost of that good

Trade can benefit everyone in society because it allowspeople to specialize in activities in which they have acomparative advantage

Gains from Trade

The Price of Trade

1 Overview

5 Applications

6 Conclusions

The Price of Trade

What is the Price of Trade?

General Rule for Trade: For both parties to gain from trade,the price at which they trade must lie between the twoopportunity costs

The Farmer gives up 15 oz. of potatoes for 5 oz. of meatWhat is the price of exchange?One oz. of meat costs 3 oz. of potatoes

The price of meat lies between the Farmer’s and theRancher’s opportunity costs for meat

Farmer’s opportunity cost for meat: 4 oz. potatoesRancher’s opportunity cost for meat: 2 oz. potatoes

What if the price of exchange was not in this range?

The Price of Trade

The Farmer gives up 15 oz. of potatoes for 5 oz. of meat

What is the price of exchange?One oz. of meat costs 3 oz. of potatoes

The Price of Trade

The Farmer gives up 15 oz. of potatoes for 5 oz. of meatWhat is the price of exchange?

One oz. of meat costs 3 oz. of potatoes

The Price of Trade

Applications

1 Overview

5 Applications

6 Conclusions

Applications

Should Kobe Bryant Mow His Own Lawn?

Imagine that Kobe Bryant can

mow his lawn faster than anyone

else can

Absolute advantage!

Suppose it takes him 1.5 hours tomow his lawn

In that same 1.5 hours, he couldfilm a commercial for Nike forwhich he would earn $15,000

What is the opportunity cost of

mowing his lawn?

$15,000

Applications

else can

Absolute advantage!

mowing his lawn?

$15,000

Applications

else can

Absolute advantage!

mowing his lawn?

$15,000

Applications

else can

Absolute advantage!

mowing his lawn?

$15,000

Applications

else can

Absolute advantage!

mowing his lawn?

$15,000

Applications

It is likely that someone else (just

about anybody!!) would have a

lower opportunity cost of mowing

Bryant’s lawn

This other individualwould have a comparativeadvantage in mowinglawns

Both parties would gain fromtrade as long as Kobe pays thisindividual more than theiropportunity cost and less than hisopportunity cost of $15,000

Applications

Bryant’s lawn

Applications

Bryant’s lawn

Applications

International Trade

A quick introduction to trade

Imports

Goods produced abroad and sold domestically

Exports

Goods produced domestically and sold abroad

Trade can benefit entire countries rather than just individualsas we have studies so far

Applications

International Trade: US & Japan

Two countries: US and Japan

Two goods: food and cars

Each country produces cars equally well

In both US and Japan, one worker produces one car in onemonth

The US is better at producing food

In the US, one worker produces 2 tons of food in one monthIn Japan, one worker produces 1 ton of food in one month

Applications

The rules of comparative advantage say that each goodshould be produced by the country with the lower opportunitycost of producing that good

What are the opportunity costs of cars in Japan and the US?

Japan: Opportunity cost of a car is 1 ton of foodUS: Opportunity cost of a car is 2 tons of food

Applications

Japan: Opportunity cost of a car is 1 ton of food

US: Opportunity cost of a car is 2 tons of food

Applications

Japan: Opportunity cost of a car is 1 ton of foodUS: Opportunity cost of a car is 2 tons of food

Applications

In this case, Japan should make cars (opportunity cost is 1ton of food, compared to 2 tons of food for US)

The US should make food (opportunity cost of 1 ton of foodis 1/2 car, compared to 1 car in Japan)

What is a reasonable price for trading food for cars?

Applications

In this case, Japan should make cars (opportunity cost is 1ton of food, compared to 2 tons of food for US)

The US should make food (opportunity cost of 1 ton of foodis 1/2 car, compared to 1 car in Japan)

What is a reasonable price for trading food for cars?

Applications

Should the United States Trade With Other Countries

Just as individuals benefit from specialization and trade, socan the populations of different countries

The United States could probably be somewhat self-sufficient,but the opportunity costs associated with producing goods forwhich we do not hold a comparative advantage are very high

Through specialization and trade, countries can have more ofall goods to consume

Conclusions

1 Overview

5 Applications

6 Conclusions

Conclusions

Conclusions I

1 Interdependence and trade are desirable because they alloweveryone to enjoy a greater quantity and variety of goods andservices

2 The person who can produce a good with a smaller quantityof inputs is said to have an absolute advantage in producingthat good

3 The person who can produce a good at a lower opportunitycost is said to have a comparative advantage in producingthat good

Conclusions

Conclusions II

4 The gains from trade are based on comparative advantage,not absolute advantage

5 Trade makes everyone better off because it allows people tospecialize in those activities for which they have a comparativeadvantage

6 Comparative advantage applies to countries as well as people

Interdependence and the Gains From Trade-1

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