Interdependence and the Gains from Trade zAn Example of Benefiting from Trade zAbsolute Advantage & Comparative Advantage

Absolute & Comparative Advantage zAbsolute advantage tells us who can produce something with fewer resources or produce more of something with the same resources (who is more productive) zComparative advantage tells us who can produce something at a lower opportunity cost (who gives up the least) zCan a country that has an absolute advantage, benefit from trade?

Benefiting from Trade zSuppose Mu and Les produce food and clothing zIn Mu one worker can produce 6 units of food or 3 units of clothing zIn Les, one worker can produce 1 unit of food or 2 units of clothing zMu has the absolute advantage in both goods

Benefiting from Trade zWould these countries be better off with trade; could they consume more?

Benefiting from Trade zIf there are 10 million workers in Mu and 20 million in Les we get the following PPFs

Benefiting from Trade MU LES Food Clothing

Absolute & Comparative Advantage zOpportunity cost of 1 food (What they give up for a unit of food) yMu = 1/2 clothing (give up 1/2 clothing) yLes = 2 clothing (give up 2 clothing) zOpportunity cost of 1 clothing (What they give up for a unit of clothing) yMu = 2 food (give up 2 food) yLes = 1/2 food (give up 1/2 food)

Absolute & Comparative Advantage zMu has a comparative advantage in the production of food (costs them less in terms of clothing) zLes has a comparative advantage in the production of clothing (costs them less in terms of food)

Benefiting from Trade zSuppose they decide to trade with each zSuppose 1 unit of food trades for 1 unit of food yIf Mu gives up 10 units of food, it gets 10 units of cloth yIf Les gives up 10 units of cloth, it gets 10 units of food zCountries have same PPFs, but different consumption opportunities

Benefiting from Trade yWith trade, Mu produces 60 units of food yThey can trade away 10 units of food and receive 10 units of clothing yThis will give them the consumption opportunity of 50 units of food and 10 units of clothing yWithout trade their consumption opportunity was 50 units of food and 5 units of clothing

Benefiting from Trade yWith trade, Les produces 40 units of clothing yThey can trade away 10 units of clothing and receive 10 units of food yThis will give them the consumption opportunity of 30 units of clothing and 10 units of food yWithout trade their consumption opportunity was 5 units of food and 30 units of clothing

Benefiting from Trade zBoth countries are made better off by trade based on comparative advantage zThey are able to consume more goods and services with trade, than if they were self-sufficient

Absolute & Comparative Advantage zWhen Mu and Les join forces to trade, we get MULES zObviously, MULES are an awesome force and trade is a good thing

Absolute & Comparative Advantage zSpecialization and trade should be based on comparative advantage - specialize in what you produce at the lowest opportunity cost and trade for other stuff zSpecialization and trade based on comparative advantage will make both parties better off

Absolute & Comparative Advantage zThis is true not just for nations, but also for states, cities, and individuals zAll can be made better off by trade based on comparative advantage