Gains From Trade Antu Panini Murshid. 11/16/2015 Antu Panini Murshid--Principles of Macroeconomics2...

Gains From Trade Antu Panini Murshid

04/20/23Antu Panini Murshid--

Principles of Macroeconomics 2

Today’s Agenda

Gains from specialization and trade Absolute and comparative

advantage Ricardian model

3

Why Trade? Individuals and countries specialize in

production and trade with each other in order to address problems created by scarcity

Patterns in production and trade are based on differences in opportunity costs

Individuals or countries typically specialize in what they are good at



A Parable of a Modern Economy… Imagine that there are…

…only two goods—apples and bread …only two people—Jean and Joe

In a given day… …Jean can either pick 5 buckets of

apples or bake 10 loaves of bread …Joe can either pick 12 buckets of

apples or bake 6 loaves of bread



Production Opportunities

Production per DayApples Bread

Jean 5 buckets or 10 loavesJoe 12 buckets or 6 loaves

6

Jean and Joe’s Production Possibilities

Apples (buckets)

Bread (loaves)

5

100

12

6

Jean’s PPF… Joe’s PPF…

Joe

Jean

7

Consumption Possibilities Under Self-Sufficiency

Apples (buckets)

Bread (loaves)

5

10

12

6

If Jean and Joe are self-sufficient, the production possibilities frontier is also the consumption possibilities frontier

Jean’s consumption possibilities set is…

Joe’s consumption possibilities set is…

Joe

Jean

0



Self-Sufficiency


Jean 2.5 buckets & 5 loavesJoe 6 buckets & 3 loavesEconomy 8.5 buckets & 8 loaves

They each devote half a day to each activity

9

Self-Sufficiency Using PPFs

Apples(buckets)

Bread(loaves)

5

100

If Jean and Joe devote 50% of their time to each activity then…

…Jean can produce…Jean

5

5 loaves of bread and 2.5

buckets of apples

2.5

10


Apples(buckets)

Bread(loaves)

0

12

6

…Joe can produce…

Joe

3

6

3 loaves of bread and 6 buckets of

apples

11


Apples(buckets)

Bread(loaves)

0

Jean and Joe combined are producing…

(3,6)

(5,2.5)

Economy8.5

8



Specialization and Trade Suppose…

…Jean specializes in baking bread …Joe specializes in picking apples

Economy-wide output is now 10 loaves of bread 12 buckets of apples

Jean trades 4 loaves of bread for 4 buckets of apples Jean has 6 loaves of bread and 4 buckets of

apples Joe has 4 loaves of bread and 8 buckets of

apples



Gains From Trade

Gains from TradeApples Bread

Jean +1.5 buckets +1 loafJoe +2 buckets +1loafEconomy +3.5 buckets +2 loaves

14

Trade and Self-Sufficiency Compared Using PPFs

Apples(buckets)

Bread(loaves)

5

100

12

6

Self-Sufficiency… Jean 5 loaves of

bread & 2.5 buckets of apples

Joe has 3 loaves of bread & 6 buckets of apples

Economy: 8 loaves of bread, 8.5 buckets of apples

Joe’s PPF

Jean’s PPF

53

6

2.5

8.5

8

Economy

Jean’s bundle before trade

Joe’s bundle before trade

15


Apples(buckets)

Bread(loaves)

100

12

6

Trade… Jean has 6 loaves

of bread & 4 buckets of apples

Joe has 4 loaves of bread and 8 buckets of apples

Economy: 10 loaves of bread, 12 buckets of apples

4

Jean’s bundle after

trade

4

Joe’s bundle after trade8

Economyafter trade

16


Apples(buckets)

Bread(loaves)

0 6

Jean is better off after trade…

…so is Joe

4

Jean’s bundle after

trade

4

Joe’s bundle

after trade8

Jean’s bundle before trade

Joe’s bundle before trade

2.5

53

6

17

Consumption Opportunities After Trade

After Trade… Jean consumes a

bundle which lies outside her production possibilities set

So does JoeJean’s bundle

Joe’s bundleApples (buckets)

Bread (loaves)

0



Who Should Specialize in What?

Why should… …Jean specialize in making bread? …and Joe specialize in picking apples?

Because Jean is relatively better at making bread…

…and Joe is relatively better at picking apples



Comparative Advantage

Can we be precise in what we mean by “relatively better”?

Comparative advantage… A producer has a comparative

advantage in a good, if he/she can produce it at a lower opportunity cost than his/her competitor



Costs of Production



Opportunity CostApples Bread

Jean 2 loaves 1/2 bucketJoe 1/2 loaf 2 buckets



Principle of Comparative Advantage For trade to be beneficial, producers

should specialize in their comparative advantage

Whenever trading partners have differing opportunity costs, they can benefit form trade

Jean has a comparative advantage in bread

Joe has a comparative advantage in apples



David Ricardo and Adam Smith David Ricardo formalized the principle

of comparative advantage in Principles of Political Economy and Taxation

Earlier Adam Smith had developed the concept of absolute advantage in the Wealth of Nations

This formed the early logic behind the notion that trade could be beneficial

However, the principle of comparative advantage is more general, but also less intuitive



Absolute Advantage and Trade To have an absolute advantage in the

production of a good means being able to produce that good more efficiently than one’s competitors

In his Wealth of Nations, Adam Smith suggested that individuals/countries should specialize in their absolute advantage

This is exactly what Jean and Joe did… …since Jean has an absolute advantage in

bread ..and Joe has an absolute advantage in apples



Comparative Advantage and Absolute Advantage

If an individual has an absolute advantage in the production of some good, must he/she also have a comparative advantage in that good, and vice versa?

No!



A More Complex Parable… Consider our economy with two

inhabitants—Jean and Joe—and two goods—apples and bread…

Suppose that in a given day… …Jean can either pick 5 buckets of

apples or bake 10 loaves of bread …Joe can either pick 12 buckets of

apples or bake 12 loaves of bread



Costs of Production



Opportunity CostApples Bread

Jean 2 loaves 1/2 bucketJoe 1 loaf 1 bucket



Self Sufficiency

Devoting Half a Day to Each ActivityApples Bread

Jean 2.5 buckets & 5 loavesJoe 6 buckets & 6 loavesEconomy 8.5 buckets & 11 loaves

They each devote half a day to each activity



After Specialization

After Specializing*Apples Bread

Jean 0 buckets & 10 loavesJoe 10 buckets & 2 loavesEconomy 10 buckets & 12 loaves

Jean specializes completely in breadJoe devotes most of his time to picking apples



After Trade

After TradeApples Bread

Jean 4 buckets & 5 loavesJoe 6 buckets & 7 loavesEconomy 10 buckets & 12 loaves

Jean trades 5 loaves for 4 buckets of applesJean is better off by 1.5 buckets of applesJoe is better off by 1 loaf of bread

30

Quantity ofComputersProduced

Quantity ofCars Produced

3,000

0 1,000

Relative Slopes of PPFs:Trade Opportunities

PPF Country A

PPF Country B

750

1,500

Country A’s PPF is steeper and

everywhere above country B’s PPF. Should the two

countries trade?

31

Relative Slopes of PPFs:Trade Opportunities

Country A’s PPF is steeper and

everywhere above country B’s PPF. Should the two

countries trade?

Position of the PPFs doesn’t matter…

…all that matters is that the slopes are different

So long as that is true, trade will be beneficial



Predictions of the Ricardian Model

Trade occurs due to differences in production technology

Even a technologically inferior country can benefit from free trade



Summary Specialization and trade allows consumption

outside of production possibilities A country/individual has an absolute

advantage in the production of a good if they are more efficient at producing that good

Comparative advantage is measured by opportunity costs (not monetary costs or resource costs)

The Ricardian model states that for trade to be beneficial countries should specialize in their comparative advantage

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Gains From Trade Antu Panini Murshid. 11/16/2015 Antu Panini Murshid--Principles of Macroeconomics2...

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