3 Interdependence and the Gains from Trade P R I N C I P L E S O F F O U R T H E D I T I O N Ask your students in advance to bring calculators to class, as this PowerPoint requires them to do some calculations. Students are more likely to learn that trade allows both countries to consume more of both goods if they figure it out themselves rather than merely being told. And most students will be eager to try these problems if you tell them that they are good practice for the upcoming exam. While this PowerPoint chapter covers the same topics as Chapter 3 in the textbook (comparative & absolute advantage, the gains from trade), there is a difference in approach that is likely to benefit your students. In the textbook, students see these topics covered in the context of an example involving two individual producers (the farmer & rancher). After the example, the textbook states that the lessons from this example apply to countries as well as individual producers. This PowerPoint presentation takes the opposite approach, illustrating the concepts with an example that involves two countries, and then stating that that the lessons of the example apply to individuals as well as countries. Seeing the analysis both ways will help students learn it better. The example in this PowerPoint builds on the PPF example introduced in the Chapter 2 PowerPoint. (However, it is not essential to cover the Chapter 2 PowerPoint before this one.) This PowerPoint does not include “Should Tiger Woods Mow His Own Lawn?” That precious little section of the book provides an additional example of comparative advantage that students can easily understand on their own, and does not introduce any new concepts. This PowerPoint also excludes the very last item before the chapter’s conclusion, “Should the United States Trade with Other Countries?” In the textbook, the function of this last section is to assert that the concepts of comparative advantage and gains from trade apply to countries as well as individual producers. This is superfluous here, because the example in this PowerPoint involves trade between countries rather than between individuals.

In this chapter, look for the answers to these questions: Why do people – and nations – choose to be economically interdependent? How can trade make everyone better off? Exports: goods produced domestically, sold abroad Imports: goods produced abroad, sold domestically What is comparative and absolute advantage, and how does this affect gains from trading? How do you divide household tasks? CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Household living: cleaning up for a party Household living: cleaning up for a party ..we have to clean kitchen & living room who should do what? Exhausted roommate: clean living room (1 hour) or clean kitchen (3 hrs). Me: clean living room (1/2 hr) or kitchen (1 hr). Hint: what are the opportunity costs of cleaning the living room? Roommate 1/3 kitchen cleaned Me ½ kitchen cleaned Solution? CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Our Example Two countries: the U.S. and Japan Two countries: the U.S. and Japan Two goods: computers and wheat Labor is the only input (measured in hours): US. 50,000 hrs Japan 30,000 hrs. We will look at how much of both goods each country produces and consumes if the country chooses to be self-sufficient if it trades with the other country The lessons illustrated by this international trade example also apply to trade between two individual producers. Note that this chapter in the textbook does the reverse: It develops the lessons in the context of an example involving two individual producers, and then states that the lessons also apply to international trade. So, between this PowerPoint and the textbook chapter, students will see the same concepts and lessons developed in two different but entirely consistent approaches and examples. The example in this PowerPoint is highly contrived and unrealistic in order to illustrate complex concepts as simply as possible. The example has some qualities that make it especially valuable: * The two goods are fundamentally different (one is agricultural, the other manufactured), which makes gains from trade based on comparative advantage very likely. An example using more similar goods, say laptop computers and MP3 players, would not be appropriate for this chapter because it would more likely give rise to inter-industry trade, and the gains would likely arise from a source other than comparative advantage (probably increasing returns to scale). * In the example here, it turns out that the U.S. has an absolute advantage in both goods, yet both countries gain from trade. Students see, therefore, that comparative advantage, not absolute advantage, is what’s necessary for trade to be mutually beneficial. * In the real world, one often sees gains from trade based on comparative advantage occurring between countries that are very different – such as between rich industrialized countries and poor developing countries. This example shows that trade based on comparative advantage can also occur between countries that are at similar levels of industrialization and income. (Of course, the U.S. and Japan are very different; but they are far more similar than are the U.S. and, say, Botswana or Cameroon.) CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Production Possibilities in the U.S. The U.S. has 50,000 hours of labor available for production, per month. Producing one computer requires 100 hours of labor. Producing one ton of wheat requires 10 hours of labor. Production Possibilities Frontier has slope: 10 wheat / 1 computer. If you just covered Chapter 2, point out to your students that the U.S. PPF here is the same as in the Chapter 2 PowerPoint. In a few moments, students will be asked to derive Japan’s PPF. Warning them of this now may increase their attention, because they will have to follow the same steps that you are about to show them in your derivation of the U.S. PPF on the next slide. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

The U.S. Without Trade 4,000 100 5,000 2,000 1,000 3,000 500 200 300 400 Computers Wheat (tons) U.S. resources 50,000 hours. U.S. Costs: 1 comp =100 hours, 1 wheat = 10 hours. Cost ratio of 10/1. Splitting its resources, it will produce and consume 250 computers and 2500 tons of wheat. Of course, the U.S. could choose a different point. The actual choice will depend on the preferences of society. It’s important to note that, without trade, a country consumes what it produces. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

A C T I V E L E A R N I N G 1: Derive Japan’s PPF Use the following information to draw Japan’s PPF. Japan has 30,000 hours of labor available for production, per month. Producing one computer requires 125 hours of labor. Producing one ton of wheat requires 25 hours of labor. ** Using this information to draw Japan’s PPF requires a calculator (or the ability to do long division). ** If your students have a “gutted handout” of these slides, have them draw their PPF on the axes provided on the following slide. This activity should take only 3 minutes of class time. It’s good practice & review for students, and helps break up the lecture. Your graph should measure computers on the horizontal axis. 6

Japan Without Trade Japan costs: 1 comp requires 125 hours, 1 wheat requires 25 hours. Cost ratio of 5/1. Note it could produce 240 computers or 1,200 wheat. Suppose Japan also splits its labor resources. Computers Wheat (tons) 2,000 1,000 200 100 300 Then it will produce and consume 120 computers and 600 tons of wheat. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Consumption With and Without Trade Can nations do better with trade than without? It depends on Comparative advantage: the ability to produce a good at a lower opportunity cost than another producer. Comparative advantage exists whenever relative costs differ, hence opportunity costs differ. Nations will trade at a “terms of trade” ratio that will lie between the differences in the opportunity costs in each nation. We shall see that absolute costs do not matter! CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

A C T I V E L E A R N I N G 2: Production under trade Given the relative costs in the two nations, who has comparative advantage in which good? At what rate would the U.S. and Japan be willing to trade wheat for computers ? Why is trading possible at a trading rate between 10/1 and 5/1? Which trading rate does each country prefer? Suppose they negotiate to trade at 7.5/1, i.e 7.5 wheat = 1 computer. Give your students a few minutes to solve these problems before showing the answers on the next slides. This will break up the lecture, get the students involved, and give them practice with “word problems.” It is not necessary that all students finish both problems before moving on. It’s fine if most finish the first, and a few finish the second. Note that most students will need a calculator to solve these problems. 9

Two Measures of the Cost of a Good Absolute advantage measures the cost of a good in terms of the inputs required to produce it. Recall: Another measure of cost is opportunity cost – what is foregone if one good is produced. In this instance, what is foregone if someone makes a computer is the wheat it could otherwise produce. ** Opportunity cost is the key to comparative advantage and the gains from trade. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Absolute Costs vs. Opportunity Costs. lowest opp costs creates Comp Absolute Costs vs. Opportunity Costs ** lowest opp costs creates Comp. Adv. United States Japan Absolute Costs wheat 10 hours 25 hours computer 100 hours 125 hours 10/1 cost ratio 5/1 cost ratio Opportunity Costs 1/10 computer ** 1/5 computer 10 wheat 5 wheat ** CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Japan’s Outcome With Trade (Produces only computers, trades for wheat computers wheat produced 240 + imported 750 – exported 100 = amount consumed 140 Computers Wheat (tons) 2,000 1,000 200 100 300 CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

U.S. Outcome With Trade (Produces both, sells wheat for some computers) Computers Wheat (tons) computers wheat produced 160 3400 + imported 100 – exported 750 = amount consumed 260 2650 4,000 100 5,000 2,000 1,000 3,000 500 200 300 400 CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Trade Makes Both Countries Better Off U.S. consumption without trade consumption with trade Result (gains) computers 250 160 + 100 260 (10) wheat 2,500 3,400 - 750 2650 (150) Japan consumption without trade consumption with trade gains from trade computers 120 240 - 100 140 (20) wheat 600 +750 750 (150) CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Where Do These Gains Come From? Absolute advantage (the ability to produce a good using fewer inputs than another producer)? NO! The U.S. has an absolute advantage in the production of wheat: producing a ton of wheat uses 10 labor hours in the U.S. vs. 25 labor hours in Japan. It also has an absolute advantage in producing computers: a computer uses 100 hours in the U.S. and 125 hours in Japan. YET, both nations gain from trading. This definition of absolute advantage is new to the 4th edition. The definition from the 3rd edition read “the comparison among producers of a good according to their productivity.” The new definition is more precise. The last bullet point states that gains from trade will arise if each country has an absolute advantage in something. We will see next, though, that absolute advantage is not required for both countries to gain from trade. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Opportunity Cost and Comparative Advantage Opportunity cost, what is foregone if a good is produced, underlies the determination of comparative advantage. The opportunity cost of a computer is 10 tons of wheat in the U.S., because producing one computer requires 100 labor hours, which instead could produce 10 tons of wheat. 5 tons of wheat in Japan, because producing one computer requires 125 labor hours, which instead could produce 5 tons of wheat. So, Japan has a comparative advantage in computers. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Another example Labor hrs needed to make one Amount done in 90 hours QUILT DRESS QUILTS DRESSES HELEN 50 10 1.8 9 CAROLYN 90 45 1 2 CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Questions for the example Opportunity cost of a quilt for Helen is … Opportunity cost of a quilt for Carolyn is … Opportunity cost of a dress for Helen is … Helen has a comparative advantage in ….. and Carolyn has a comparative advantage in …… CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Summary of Chapter 3: Comparative Advantage and Trade Differences in opportunity cost and comparative advantage create the gains from trade. These exist anytime relative production costs differ in the two countries – implying different opportunity costs. When each country specializes in the good(s) in which it has a comparative advantage, total production and consumption in all countries is higher and all countries can gain from trade. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Resolving trade disputes. Who is the absolute authority among nations? In Ch. 9 on International Trade, look for the answers to these questions: Who benefits and who loses from trade? Do the gains outweigh the losses? If policymakers restrict imports, what are the benefits, costs and net effects? What are the common arguments for restricting trade? Do they have merit? Resolving trade disputes. Who is the absolute authority among nations? CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Describing the Trade Model with Prices. Countries gain from trade if each exports the goods in which it has a comparative advantage. We describe trade in terms of world and domestic prices: PW = the world price of a good PD = domestic price without trade If PD < PW, a country exports the good. If PD > PW, a country imports the good. We assume all nations are price takers in the world market. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

A Country That Exports Soybeans Without trade, PD = $4 Q = 500 PW = $6 Under free trade, domestic consumers demand 300 domestic producers supply 750 exports = 450 P Q Soybeans D S exports $6 300 750 $4 500 Fun soybean facts (all for 2004): U.S. farmers grew 3.1 billion bushels of soybeans. The average price was $5.65/bushel, for a total of nearly $18 billion. The U.S. exported 1.1 billion bushels, comprising nearly half of international trade in soybeans. China purchased $2.3 billion worth of U.S. soybean exports, making China the U.S. soybean farmer’s biggest foreign customer. Japan was second with $1.0 billion in purchases. Source: American Soybean Association, http://www.soystats.com/ You might alert your students that, in just a moment, they will be asked to do some analysis very similar to this analysis. This will make them pay close attention. In this case, PD < PW, so this country will export soybeans. The quantity of exports is simply the difference between the domestic quantity supplied and the domestic quantity demanded at the world price. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

A Country That Exports Soybeans: economic welfare analysis. Without trade, CS = A + B PS = C Total surplus = A + B + C With trade, CS = A PS = B + C + D Total surplus = A + B + C + D P Q Soybeans D S exports A $6 D B gains from trade $4 C Trade benefits soybean producers, because they can sell at a higher price. Producer surplus rises by the area B + D. Trade makes domestic buyers worse off, because they have to pay a higher price. Consumer surplus falls by the area B. The gains to producers are greater than the losses to consumers, so trade increases total welfare: total surplus rises by the amount D. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

A C T I V E L E A R N I N G 1: Analysis of trade Without trade, PD = $3000, Q = 400 In world markets, PW = $1500 Under free trade, how many TVs will the country import or export? Identify CS, PS, and total surplus without trade, and with trade. P Q Plasma TVs D S $3000 400 The two preceding slides show students the analysis of trade when the country exports. The next step is to cover the analysis of trade when the country imports the good. Instead of lecturing on this material, I suggest you have students work on this exercise, which students to do this analysis themselves. It’s an activity that breaks up the lecture and gives students a chance to apply the techniques you’ve just presented. I suggest you have students work on it in pairs. Give them about 5 minutes, then go over the answers on the following two slides. While students are working, circulate around the room and offer to assist any students that ask for help. This will also give you a sense of how well students are understanding the material. If you prefer to lecture on the material instead, replace these slides with the two “hidden” slides that immediately follow the CHAPTER SUMMARY. You will then have to “unhide” those slides by unselecting “Hide Slide” from the “Slide Show” drop-down menu. $1500 200 600 CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 24

A C T I V E L E A R N I N G 1: Analysis of trade Without trade, PD = $3000, Q = 400 In world markets, PW = $1500 Under free trade, how many TVs will the country import or export? Identify CS, PS, and total surplus without trade, and with trade. P Q Plasma TVs D S $3000 400 The two preceding slides show students the analysis of trade when the country exports. The next step is to cover the analysis of trade when the country imports the good. Instead of lecturing on this material, I suggest you have students work on this exercise, which students to do this analysis themselves. It’s an activity that breaks up the lecture and gives students a chance to apply the techniques you’ve just presented. I suggest you have students work on it in pairs. Give them about 5 minutes, then go over the answers on the following two slides. While students are working, circulate around the room and offer to assist any students that ask for help. This will also give you a sense of how well students are understanding the material. If you prefer to lecture on the material instead, replace these slides with the two “hidden” slides that immediately follow the CHAPTER SUMMARY. You will then have to “unhide” those slides by unselecting “Hide Slide” from the “Slide Show” drop-down menu. $1500 200 600 CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 25

A C T I V E L E A R N I N G 1: Answers. A welfare analysis Without trade, CS = A PS = B + C Total surplus = A + B + C With trade, CS = A + B + D PS = C Total surplus = A + B + C + D P Q Plasma TVs D S gains from trade A $3000 B D Trade benefits consumers in this case, because it allows them to buy plasma TVs at lower prices, so more consumers can afford plasma TVs if imports are allowed. The gains to consumers appear on the graph as the area (B+D), which represents the increase in consumer surplus when the country allows trade. In this example, trade harms domestic producers, because they now must sell their plasma TVs at a lower price. As a result, they produce a smaller quantity, earn less revenue, and likely let go of some of their workers. These losses are represented on the graph by the area B , which represents the fall in producer surplus resulting from trade. As the graph shows, the gains to consumers outweigh the losses to producers: total surplus increases by the amount D, which represents the gains from trade in plasma TV sets. $1500 C imports CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 26

Summary: The Welfare Effects of Trade rises falls exports PD < PW rises falls imports PD > PW direction of trade consumer surplus producer surplus total surplus Whether a good is imported or exported, trade creates winners and losers. But the gains exceed the losses. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Other Benefits of International Trade Consumers enjoy increased variety of goods. Producers sell to a larger market and may achieve lower costs through economies of scale. Competition from abroad may reduce market power of some firms at home, which would increase total welfare. Trade enhances the flow of ideas, facilitates the spread of technology around the world. Wealth created abroad fosters better ‘trading partners’. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE