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

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  • Chapter 3Interdependenceand theGains From Trade

    Ratna K. Shrestha

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

  • Changes in What Canadian Produce

  • OverviewA Parable for the Modern EconomyPrinciple of Comparative AdvantageApplication of Comparative Advantage

  • 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. OrWe can specialize and trade with others, leading to Economic Interdependence.

  • InterdependenceEvery 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.0

  • Interdependence & TradeA general observationIndividuals 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.This gives rise to two questions. Why is interdependence the norm?What determines production & trade?

  • Interdependence & TradeWhy is interdependence the norm?Interdependence occurs because people are better off when they specialize (in the goods which they can produce at lower costs) and trade with others.What determines the pattern of production & trade?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 EconomyImagine...only two goods (potatoes and meat)..only two people (farmer and rancher)What should each produce?Why should they trade?

  • Productivity Table 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 ...

    Amount Produced In One Hour

    (in Kilograms)

    Meat

    Potatoes

    Farmer

    1 Kg

    1 Kg

    Rancher

    8 Kg

    2 Kg

  • PPF(Assuming an 8 hour day)Meat in KgFarmerPotatoes in Kg88Meat in KgPotatoes in KgRancher6416PPFPPF

  • A World of Self-SufficiencySuppose with no trade, the Farmer produces and consumes combination A, while the Rancher is at combination BMeat in KgFarmerPotatoes in Kg88Meat in KgPotatoes in KgRancher6416B484A62

  • Specialization and TradeIf 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.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:Meat in KgFarmerPotatoes in Kg88Meat in KgPotatoes in KgRancher6416B484A62A*tradeB*trade310545

  • Specialization and TradeMeat in KgFarmerPotatoes in Kg88Meat in KgPotatoes in KgRancher6416B484A62A*tradeB*trade310545With trade the Farmer is at A*With trade the Rancher is at B*

  • Examples of Specialization

  • The Principle of Comparative AdvantageWhat determines who should produce what? And how much should be traded for each product?

    It depends on the opportunity costs of production for each trading partner.Not on the total amount of resources required for production by each partner.

  • Comparative and Absolute Advantage The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good.

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

    Amount Produced In One Hour

    (in Kilograms)

    Meat

    Potatoes

    Farmer

    1 Kg

    1 Kg

    Rancher

    8 Kg

    2 Kg

  • What is the Problem with this Picture?

  • The Principle of Comparative AdvantageComparative advantage is the basis for specialized production and trade.

    Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade.

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

    Cost of 1 Kg of each product in real terms

    1 Kg of Meat Costs

    1 Kg of Potatoes costs

    Farmer

    1 Kg of Potatoes

    1 Kg of Meat

    Rancher

    .25 Kg of Potatoes

    4 Kg of Meat

  • Applications of Comparative AdvantageShould Canada trade with Other countries (e.g. Japan or USA)?Who has a comparative advantage in producing lumber: Canada or US?

    Comparative advantage depends on Opportunity Costs and it determines the nature of trade: who Imports or Exports.

  • Trade: Canada and JapanCarsFoodCanadaJapan42Food22Cars

  • Opportunity Cost: Sacrifice Food Production for Car ProductionOpportunity Cost = Slope of PPF = 2/1(2 Units of food given up to get 1 Unit of a car)CarsCanada42Food21

  • Opportunity Cost: Sacrifice Food Production for Car ProductionOpportunity CostSlope of PPF =1/11 Unit of food given up to get 1 Unit of a carCarsJapan22Food

  • CarsCarsFoodCanadaJapan42Food22Who should produce Cars/Food?Trade ratio = between 2 and 1112.51.5

  • Conclusion Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services.

    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 TradeSuppose 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 TradeMeat in KgFarmerPotatoes in Kg88Potatoes in KgRancher6416B484A62A*tradeB*trade310983238

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