Principles of Microeconomics - Lecture - Gains from Trade

8/9/2019 Principles of Microeconomics - Lecture - Gains from Trade

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Interdependence and the

Gains from Trade

Chapter 3

Dr. Katherine Sauer

Principles of Microeconomics


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In England, it takes 100 minutes to produce a bottle of

wine and 120 minutes to produce a bolt of cloth.

In Portugal, it takes 80 minutes to produce a bottle of

wine and 90 minutes to produce a bold of cloth.

Consider a 10 hour work day.

Complete the table with each countrys maximum

output of each good.

wine cloth

England

Portugal


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England:

If it devotes the entire 10 hours to wine, it can produce

600 / 100 = 6 bottles of wine

If it devotes the entire 10 hours to cloth, it can produce

600 / 120 = 5 bolts of cloth

wine cloth

England 6 5

Portugal


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Portugal:

If it devotes the entire 10 hours to wine, it can produce

600 / 80 = 7.5 bottles of wine

If it devotes the entire 10 hours to cloth, it can produce

600 / 90 = 6.67 bolts of cloth

wine cloth

England 6 5

Portugal 7.5 6.67


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wine cloth

England 6 5

Portugal 7.5 6.67

In 10 hours, Portugal can produce more wine.

Economists would say that Portugal has absolute

advantage in producing wine.

Absolute advantage is the ability to produce

- more of a good than another producer, with a

given amount of resourcesor

- the good at the lowestmonetarycost


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wine cloth

England 6 5Portugal 7.5 6.67

In 10 hours, Portugalcan produce more cloth, so wed

say it has absolute advantage in the production of cloth.

Given the information in the table above, plot eachnations PPF for wine and cloth.


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wine

cloth5

6

PPF

If England spent some of its time on each activity, itcould produce some of each good.

England


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Portugal

wine

cloth

PPF

6.67

7.5


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Suppose that Portugal chooses to produce 3 bottles of

wine and 4 bolds of cloth.

Confirm that this production takes 10 hours.

1 bottle of wine takes 80 minutes

3 bottles of wine takes (3)(80) = 240 minutes

1 bolt of cloth takes 90 minutes

4 bolts of cloth takes (4)(90) = 360 minutes

240 + 360 = 600 minutes / 60 minutes = 10 hours


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Illustrate eachs choice on their PPF.

England Portugal

wine

cloth

PPF

wine

cloth

PPF

5

6

6.67

7.5


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Suppose now the two decide to specialize in the

production of one good and trade with the other country.

What good should each specialize in?

Well look at opportunity cost to find out.

We dont have money in this example.

Englands total cost of one bottle of wine is the cloth

it forgoes making during that time.

Portugals opportunity cost of one bottle of wine is the

cloth it forgoes making during that time.


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Formula for calculating per-unit opportunity cost:

opportunity cost of

getting one unit of = amount of B sacrificed = ___ units of Bgood A amount of A gained


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Englands opportunity cost

of 1 bottle of wine=

loss of

gain of

5 cloth

6 wine = 0.83 cloth

Portugals opportunity cost

of 1 bottle of wine= loss ofgain of6.67 cloth7.5 wine = 0.89 cloth

England gives up fewer bolts of cloth while

producing wine.


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England gives up fewerbolts of cloth while making wine

than Portugal does.

England has a loweropportunity cost of making wine than

Portugal does.

Economists would say England has comparative

advantage in producing wine.

Comparative advantage is the ability to produce at the

lowest opportunity cost.


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Portugal gives up fewer bottles of wine while making

cloth.

Portugal has comparative advantage in making cloth.

Englands opportunity cost

of 1 bolt of cloth=

loss of

gain of

6 wine

5 cloth = 1.2 wine

Portugals opportunity cost

of 1 bolt of cloth= loss ofgain of7.5 wine6.67 cloth = 1.12 wine


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So what if they each specialized in the production of thegood that they had comparative advantage in and then

traded?

England would specialize in wine and Portugal wouldspecialize in cloth.

The two of them would need to negotiate a rate to trade

wine for cloth.


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The trade price

Englands cost of 1 bottle of wine is 0.83 bolts of cloth.

It would be willing topart with a bottle of wine for 0.83 ormore bolts of cloth.

- minimum price for a bottle of wine is 0.83 bolts of

cloth

Portugals cost of 1 bottle of wine is 0.89 bolts of cloth.

It would be willing topay0.89 or less bolts of cloth for 1

bottle of wine.

- maximum price for a bottle of wine is 0.89 bolts of

cloth


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The price of bottle of wine will be between0.83

and 0.89 bolts of cloth.

(typo!!!)


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The price of a bolt of cloth will be between 1/0.83 and1/0.89 bottles of wine.

1.20 to 1.12


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The trade price of good A will be between each partys

opportunity cost in terms of good B.

Suppose that they agree to a price of 1.15 bottles of wine

for 1 bolt of cloth. Plot each nations consumptionpossibilities on your original graphs.


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Englands consumption

- could keep all 6 bottles of wine for self

If it traded away all 6 bottles, how much cloth could itget?

1C

1.15W

= ?C

6W 5.21C

With specialization and trade,

England can end up with more

wine and cloth than if it did nottrade.

Trade makes England better off.

wine

cloth

5

6

PPF

5.21

CPF


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Portugals consumption

- could keep all 6.67 bolts of cloth

If it traded away all 6.67 bolts, how much wine could itget in return?

1C

1.15W

= 6.67

?W 7.67W

With specialization and trade,

Portugal can end up with more

cloth and wine than if it wereself-sufficient.

Trade makes Portugal better off.

wine

cloth

PPF

CPF

7.67

6.67

7.5


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In general with specialization and trade, both parties can

be made better off.

What do we mean by better off?

consumption possibilities > consumption possibilities

with trade with no trade


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Historical Economic Theory

Adam Smith (1776)An Inquiry Into the Nature and

Causes of the Wealth of Nations

~ never attempt to make at home what will cost

more to make than buy

- absolute advantage

David Ricardo (1817) Principles of Political Economy

and Taxation

~ developed the principle of comparative advantage


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Summary:

Absolute Advantage is the ability to produce more witha given amount of resources or to produce at the lowest

cost.

Comparative Advantage is the ability to produce at thelowest opportunity cost.

When countries specialize according to comparative

advantage, both can gain.


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On a half sheet of paper,

1. Note the concept that you find the most fuzzy.

2. Explain how your future career is an example of

specialization, interdependence, and the gains from trade

for you personally.

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Principles of Microeconomics - Lecture - Gains from Trade

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