11

Trade and Gains from Trade and Gains from TradeTrade

22

Main ConceptsMain Concepts

You should know how to effectively You should know how to effectively use, define and numerically analyze use, define and numerically analyze the following:the following:– Production Possibilities TableProduction Possibilities Table– Production Possibilities FrontierProduction Possibilities Frontier– Opportunity CostOpportunity Cost– ScarcityScarcity– Productive EfficiencyProductive Efficiency– Growth/Technology ChangeGrowth/Technology Change

33

Recall Gilligan’s Island Recall Gilligan’s Island

http://www.metacafe.com/watch/http://www.metacafe.com/watch/2315010/2315010/gilligans_island_opening_theme_in_cgilligans_island_opening_theme_in_color/olor/

There are 7 people stranded on the There are 7 people stranded on the island: Gilligan, The Skipper, island: Gilligan, The Skipper, Maryanne, Ginger, Mr. and Mrs. Maryanne, Ginger, Mr. and Mrs. Howell, and the Professor.Howell, and the Professor.

44

Production on the IslandProduction on the Island

Suppose on the Island they only Suppose on the Island they only produce 2 things:produce 2 things:– Huts (from Palm Trees)Huts (from Palm Trees)– Radios (from coconuts)Radios (from coconuts)

Due to scarcity of goods and the Due to scarcity of goods and the current technology on the island, if current technology on the island, if everyone makes huts they can everyone makes huts they can produce 60 huts in one month and produce 60 huts in one month and implicitly no radios.implicitly no radios.

55

Production on the IslandProduction on the Island

Suppose the gang decides it is a good idea Suppose the gang decides it is a good idea to make some radios. Who do they ask to to make some radios. Who do they ask to stop making huts?stop making huts?

The ProfessorThe Professor– Crew now makes 3 radios and 50 huts in a Crew now makes 3 radios and 50 huts in a

monthmonth– The opportunity cost of Professor making The opportunity cost of Professor making

radios rather than huts is 10 huts.radios rather than huts is 10 huts.– Opportunity Cost- the highest valued, next best Opportunity Cost- the highest valued, next best

alternative that must be sacrificed to obtain alternative that must be sacrificed to obtain something or to satisfy a want.something or to satisfy a want.

66

Production on the IslandProduction on the Island

What if they want more radios? Who What if they want more radios? Who should also make radios and not huts?should also make radios and not huts?

Who ever is next best at making radios Who ever is next best at making radios relative to making huts – relative to making huts – – Lets say that’s MaryanneLets say that’s Maryanne

The Professor and Maryanne can produce The Professor and Maryanne can produce 6 radios and everyone else can produce 41 6 radios and everyone else can produce 41 huts in one monthhuts in one month– The opportunity cost of Maryanne making The opportunity cost of Maryanne making

radios is 9 huts.radios is 9 huts.

77

Production on the IslandProduction on the Island

At this point we have three At this point we have three production possibilities for the crew:production possibilities for the crew:– They all make hutsThey all make huts– All but Professor makes hutsAll but Professor makes huts– All but Professor and Maryanne make All but Professor and Maryanne make

hutshuts Let’s look at this information in a Let’s look at this information in a

tabletable

88

Production on the IslandProduction on the Island

Number Number Producing Producing

HutsHuts

Huts Huts ProducedProduced

Number Number Producing Producing

RadiosRadios

Radios Radios ProducedProduced

77 6060 00 00

66 5050 11 33

55 4141 22 66

99

Production on the IslandProduction on the Island

This is known as a Production This is known as a Production Possibilities TablePossibilities Table– PPT- a table that shows all of the PPT- a table that shows all of the

combinations of goods and services that combinations of goods and services that can be produced given the resources of can be produced given the resources of society and the existing state of society and the existing state of technology.technology.

– This table lets us know how much our This table lets us know how much our island economy can produce.island economy can produce.

1010

Production on IslandProduction on Island

Now let’s consider what would happen Now let’s consider what would happen if one by one, the rest of the crew if one by one, the rest of the crew moved into radio production from hut moved into radio production from hut productionproduction

Remember, the people who are best Remember, the people who are best at making radios and not very good at at making radios and not very good at making huts relatively should move making huts relatively should move out of hut production and into radio out of hut production and into radio production first.production first.

Let’s see the production possibilities..Let’s see the production possibilities..

1111

Production on the IslandProduction on the Island

Number Number Producing HutsProducing Huts

Huts ProducedHuts Produced Number Number Producing Producing RadiosRadios

Radios ProducedRadios Produced

77 6060 00 00

66 5050 11 33

55 4141 22 66

44 3232 33 99

33 2323 44 1212

22 1515 55 1515

11 77 66 1818

00 00 77 2020

1212

Production on the IslandProduction on the Island

The Production Possibilities Table can The Production Possibilities Table can be represented graphically …be represented graphically …– To do this we plot each production To do this we plot each production

possibility from the previous table possibility from the previous table possibility.possibility.

– The quantity of each good is measured The quantity of each good is measured on the X and Y axis.on the X and Y axis.

1313

Production on the IslandProduction on the Island

Huts

Radios20

60

41

6

50

3

32

9

23

15

7

12 15 18

When we connect the points, we have a Production Possibilities Frontier/Curve.

Notice the inverse relationship!

This relationship is mostly linear for ease of numbers, this is not always the case!

1414

Production on the IslandProduction on the Island The The production possibilities frontierproduction possibilities frontier is is

a graph that shows all combinations a graph that shows all combinations of goods and services that can be of goods and services that can be produced given the resources of produced given the resources of society and the existing state of society and the existing state of technology.technology.

PPF follows the PPF follows the scarcity principalscarcity principal - - given limited resources, having more given limited resources, having more of one good thing generally means of one good thing generally means having less of another.having less of another.

1515

Production on the IslandProduction on the Island

Huts

Radios20

60

41

6

50

3

32

9

23

15

7

12 15 18

Outside Production Outside Production Possibilities – Not possible Possibilities – Not possible

with current resources.with current resources.

Inside of Inside of Production Production Possibilities Possibilities – Not all – Not all resources resources are used.are used.

1616

TradeTrade

Suppose Gilligan’s Island gets in contact Suppose Gilligan’s Island gets in contact with the Swiss Family Robinson.with the Swiss Family Robinson.

Knowing that trade can make everyone Knowing that trade can make everyone better off, the two island occupants better off, the two island occupants decide to trade huts for radiosdecide to trade huts for radios

But who should produce what? How But who should produce what? How much should they trade? What should much should they trade? What should be the terms of trade?be the terms of trade?

1717

TradeTrade Recall, points on the GI PPF (Production Recall, points on the GI PPF (Production

Possibilities Frontier) arePossibilities Frontier) areNumber of Huts built Number of Huts built

in a monthin a monthNumber of Radios Number of Radios built in a monthbuilt in a month

6060 00

1515 1515

00 2020-Notice GI (Gilligan’s Island) can produce either 60 huts a month or 20 -Notice GI (Gilligan’s Island) can produce either 60 huts a month or 20 radios a month. So the opportunity cost for 60 huts is 20 radios.radios a month. So the opportunity cost for 60 huts is 20 radios.

-Reducing this number, 60 huts/20 radios = 3 huts/1 radio.-Reducing this number, 60 huts/20 radios = 3 huts/1 radio.

-Suppose GI is currently making and consuming 15 huts and 15 -Suppose GI is currently making and consuming 15 huts and 15 radios.radios.

1818

TradeTrade

Suppose the Production Possibilities Table Suppose the Production Possibilities Table for the Swiss Family Robinson is as for the Swiss Family Robinson is as follows:follows:Number of Huts built Number of Huts built

in a monthin a monthNumber of Radios Number of Radios built in a monthbuilt in a month

2020 00

1515 1515

00 6060

-Notice SFR can produce either 20 huts a month or 60 radios a -Notice SFR can produce either 20 huts a month or 60 radios a month. So the opportunity cost for 20 huts is 60 radios.month. So the opportunity cost for 20 huts is 60 radios.

-Reducing this number, 20 huts/60 radios = 1 huts/3 radio.-Reducing this number, 20 huts/60 radios = 1 huts/3 radio.

-Suppose SFR is currently making and consuming 15 huts and 15 -Suppose SFR is currently making and consuming 15 huts and 15 radios.radios.

1919

TradeTrade

Thus the two PPFs are as follows:Thus the two PPFs are as follows:Huts

Radios

20

60

20 60

GI PPF

SFR PPF

2020

TradeTrade

– Recall currently GI and SFR are Recall currently GI and SFR are producing (and consuming) 15 huts and producing (and consuming) 15 huts and 15 radios.15 radios.

– The total economy thus has 30 huts and The total economy thus has 30 huts and 30 radios30 radios

2121

TradeTrade

Comparative Advantage – The advantage in Comparative Advantage – The advantage in the production of a product enjoyed by one the production of a product enjoyed by one country over another when that product can country over another when that product can be produced at lower cost in terms of other be produced at lower cost in terms of other goods than it could be in the other country. goods than it could be in the other country.

GI has a comparative advantage in producing GI has a comparative advantage in producing huts, to produce a hut, it costs 1/3 of a radio. huts, to produce a hut, it costs 1/3 of a radio. For SFR to produce a hut, it costs 3 radios.For SFR to produce a hut, it costs 3 radios.

SFR has a comparative advantage in producing SFR has a comparative advantage in producing radios. To produce a radio, it costs 1/3 of a radios. To produce a radio, it costs 1/3 of a hut. For GI to produce a radio, it costs 3 huts.hut. For GI to produce a radio, it costs 3 huts.

2222

TradeTrade

– Now suppose GI, who has the Now suppose GI, who has the comparative advantage in huts only comparative advantage in huts only produces huts and SFR, who has the produces huts and SFR, who has the comparative advantage in radios only comparative advantage in radios only produced radios. produced radios.

– This is called specialization- the division This is called specialization- the division of productive activities among persons of productive activities among persons and regions so that no one individual or and regions so that no one individual or one area is totally self-sufficient.one area is totally self-sufficient.

2323

TradeTrade

GI specializes in huts and produces 60 huts.GI specializes in huts and produces 60 huts. SFR specializes in radios and produces 60 SFR specializes in radios and produces 60

radiosradiosHuts

Radios

20

60

20 60

GI PPF

SFR PPF

Current Consumption (15 Current Consumption (15 huts, 15 Radios) each. huts, 15 Radios) each. (Just happens to be at (Just happens to be at the cross point.)the cross point.)

2424

TradeTrade

Now suppose that GI and SFR tradeNow suppose that GI and SFR trade Terms of trade are 1 radio for 1 hut.Terms of trade are 1 radio for 1 hut.

– This means GI buys radios from SFR for This means GI buys radios from SFR for less huts than the opportunity cost for GI less huts than the opportunity cost for GI to produce them (1 radio for 1 hut instead to produce them (1 radio for 1 hut instead of 1 radio for 3 huts).of 1 radio for 3 huts).

– And, SFR buys huts from GI for less radios And, SFR buys huts from GI for less radios than the opportunity cost for SFR to than the opportunity cost for SFR to produce them (1 hut for 1 radio instead of produce them (1 hut for 1 radio instead of 1 hut for 3 radios). 1 hut for 3 radios).

2525

TradeTrade

Suppose GI trades SFR 30 huts for 30 Suppose GI trades SFR 30 huts for 30 radios.radios.– Now, GI consumes their 30 remaining Now, GI consumes their 30 remaining

huts and the 30 radios they received huts and the 30 radios they received from SFR. This is more than the 15 huts from SFR. This is more than the 15 huts and 15 radios they consumed before and 15 radios they consumed before trading.trading.

– SFR consumes their 30 remaining radios SFR consumes their 30 remaining radios and the 30 huts they received from GI. and the 30 huts they received from GI. This is more than the 15 huts and 15 This is more than the 15 huts and 15 radios they consumed before trading.radios they consumed before trading.

2626

TradeTrade

Note the consumption after trade, GI Note the consumption after trade, GI and SFR each have more Huts and and SFR each have more Huts and Radios than their resources allowed Radios than their resources allowed them to have if they did not trade.them to have if they did not trade.

Ricardo’s Theory of Comparative Ricardo’s Theory of Comparative Advantage – Specialization and free Advantage – Specialization and free trade will benefit all trading partners, trade will benefit all trading partners, even those that may be absolutely even those that may be absolutely more efficient producers.more efficient producers.

2727

TradeTrade

Note, neither island had an absolute Note, neither island had an absolute advantage.advantage.

Absolute Advantage – The advantage Absolute Advantage – The advantage in the production of a product in the production of a product enjoyed by one country over another enjoyed by one country over another when it uses fewer resources to when it uses fewer resources to produce than the other country does.produce than the other country does.

2828

Trade – Gillies and SwissiesTrade – Gillies and Swissies

Suppose there exists a tribe of Suppose there exists a tribe of natives on Gilligan’s Island called the natives on Gilligan’s Island called the Gillies. Gillies.

Suppose there also exists a tribe of Suppose there also exists a tribe of natives on Swiss Family Robinson’s natives on Swiss Family Robinson’s island called the Swissies. island called the Swissies.

The two tribes both cut logs for fire The two tribes both cut logs for fire and gather nuts for food.and gather nuts for food.

2929

Trade - Gillies and SwissiesTrade - Gillies and Swissies

Suppose the two tribes’ production Suppose the two tribes’ production information for cutting logs & gathering information for cutting logs & gathering nuts is below:nuts is below:

TribesTribes # of logs cut in a # of logs cut in a dayday

# of barrels of # of barrels of nuts collected in a nuts collected in a

dayday

GilliesGillies 1010 55

SwissiesSwissies 66 22

3030

Trade - Gillies and SwissiesTrade - Gillies and Swissies

Will it benefit the Gillies to trade with the Will it benefit the Gillies to trade with the Swissies? Swissies? – YES!!!!!!!!!!!!!!!YES!!!!!!!!!!!!!!!

Gillies opportunity cost to cut 10 logs is 5 Gillies opportunity cost to cut 10 logs is 5 barrels of nuts or the opportunity cost to barrels of nuts or the opportunity cost to cut 2 logs is 1 barrel of nuts.cut 2 logs is 1 barrel of nuts.

Swissies opportunity cost to cut 6 logs is 2 Swissies opportunity cost to cut 6 logs is 2 barrels of nuts or the opportunity cost to barrels of nuts or the opportunity cost to cut 3 logs is 1 barrel of nuts.cut 3 logs is 1 barrel of nuts.

3131

Trade - Gillies and SwissiesTrade - Gillies and Swissies

Suppose the Gillies currently Suppose the Gillies currently consume 6 logs and 2 barrels of nuts.consume 6 logs and 2 barrels of nuts.

Suppose the Swissies currently Suppose the Swissies currently consume 3 logs and 1 barrel of nuts. consume 3 logs and 1 barrel of nuts.

So the total economy consumes 9 So the total economy consumes 9 cut logs and 3 barrels of nuts. cut logs and 3 barrels of nuts.

3232

Trade – Gillies and SwissiesTrade – Gillies and Swissies

The Production Possibility Frontiers The Production Possibility Frontiers are as follows:are as follows:

Barrels of Nuts Gathered

Logs Cut

5

10 Gillies PPF

Swissies PPF

2

6

Gillies Current Consumption

1

3

Swissies Current Consumption

3333

Trade - Gillies and SwissiesTrade - Gillies and Swissies

The Gillies have the comparative The Gillies have the comparative advantage in gathering barrels of nuts. It advantage in gathering barrels of nuts. It costs them 2 logs to gather a barrel of costs them 2 logs to gather a barrel of nuts. It costs the Swissies 3 logs to gather nuts. It costs the Swissies 3 logs to gather a barrel of nuts.a barrel of nuts.

The Swissies have the comparative The Swissies have the comparative advantage in cutting logs. It costs them advantage in cutting logs. It costs them 1/3 of a barrel of nuts to cut one log. It 1/3 of a barrel of nuts to cut one log. It costs the Gillies ½ of a barrel of nuts to cut costs the Gillies ½ of a barrel of nuts to cut one log.one log.

3434

Trade - Gillies and SwissiesTrade - Gillies and Swissies

Suppose the Swissies specialize in Suppose the Swissies specialize in cutting logs. cutting logs.

The Gillies move along their The Gillies move along their production possibility curve and production possibility curve and partially specialize. They produce 3 partially specialize. They produce 3 barrels of nuts and 4 cut logs.barrels of nuts and 4 cut logs.

The total economy thus has 3 barrels The total economy thus has 3 barrels of nuts and 10 cut logs, and is better of nuts and 10 cut logs, and is better off with the specialization of the off with the specialization of the Swissies.Swissies.

3535

Trade - Gillies and SwissiesTrade - Gillies and Swissies

Suppose the Gillies and Swissies trade. Their Suppose the Gillies and Swissies trade. Their terms of trade is 1 barrel of nuts for 2½ cut logs.terms of trade is 1 barrel of nuts for 2½ cut logs.

Both end up benefitting from the trade!Both end up benefitting from the trade! The Gillies and Swissies goods are tracked below:The Gillies and Swissies goods are tracked below:

TribeTribe

Goods Goods with no with no tradetrade

Production Production with partial with partial specializatispecializati

ononTerms of Terms of

TradeTradeEnding Ending GoodsGoods

GilliesGillies Logs: 6Logs: 6

Nuts: 2Nuts: 2Logs: 4Logs: 4

Nuts: 3Nuts: 3Logs: Logs: +2½+2½

Nuts: -1Nuts: -1

Logs: 6½Logs: 6½

Nuts: 2Nuts: 2

SwissiesSwissies Logs: 3Logs: 3

Nuts: 1Nuts: 1Logs: 6Logs: 6

Nuts: 0Nuts: 0Logs: -2½Logs: -2½

Nuts: +1Nuts: +1Logs: 3½Logs: 3½

Nuts: 1 Nuts: 1