Copyright © 2004 South-Western/Thomson Learning 3 Interdependence and the Gains from Trade

Copyright © 2004 South-Western Objectives Understand formally why agents, households, and nations trade? Absolute advantage – greater output per unit input Comparative advantage – Producer with lower opportunity cost Mk: we know already that both parties – absent force or fraud - are made better off through trade History: David Ricardo’s theory of comparative advantage

Copyright © 2004 South-Western Just Think Consider your typical day: You wake up to an alarm clock made in Korea. You pour yourself orange juice made from Florida oranges and coffee from beans grown in Brazil. You put on some clothes made of cotton grown in Georgia and sewn in factories in Thailand. You watch the morning news broadcast from New York on your TV made in Japan. You drive to class in a car made of parts manufactured in a half-dozen different countries. and... and you haven’t been up for more than two hours yet!

Copyright © 2004 South-Western Interdependence and the Gains from Trade Remember, economics is the study of how societies use limited resources in the attempt to satisfy needs/wants – to maximize utility.

Copyright © 2004 South-Western Question to provoke thought How do we satisfy our wants and needs in a global economy? Two options at either end of the spectrum… think about our small island. We can be economically self-sufficient. We can specialize and trade with others, leading to economic interdependence.

Copyright © 2004 South-Western Specialization/Exchange Specialization implies trade How else would we get the stuff that we’re not good at producing?

Copyright © 2004 South-Western Who produces what? What determines the particulars of production and trade? Patterns of production are determined by differences in opportunity costs. -We, people, regions, and nations, have different resource endowments. Mk: Florida produces citrus, Vermont – Maple syrup, Colorado – skiing, Latin America – coffee, Hamburg – shipping etc.

Copyright © 2004 South-Western A PARABLE FOR THE MODERN ECONOMY Imagine... only two goods: potatoes and meat only two people: a potato farmer and a cattle rancher ( a two-person, two-good society ) What should each produce? Why should they trade?

Table 1 The Production Opportunities of the Farmer and Rancher Copyright © 2004 South-Western

In 8 hour day Farmer produces 8 units of meat or 32 units of potatoes Rancher produces 24 units of meat or 48 units of potatoes

Copyright © 2004 South-Western Production Possibilities Self-Sufficiency By ignoring each other (no trade): Each consumes what they each produce. The production possibilities frontier is also the consumption possibilities frontier.

Figure 1 The Production Possibilities Curve Potatoes (ounces) Meat (ounces) (a) The Farmer’s Production Possibilities Frontier Copyright©2003 Southwestern/Thomson Learning

Figure 1 The Production Possibilities Curve Copyright©2003 Southwestern/Thomson Learning Potatoes (ounces) 0 Meat (ounces) (b) The Rancher’s Production Possibilities Frontier 48 24

Copyright © 2004 South-Western Measuring Opportunity Costs The slope of the PPF (rise/run) reveals the opportunity cost. - For Farmer Fred (8/32) = (1/4) - For Rancher Rick (24/48) = (1/2) Or, for farmer 1 unit of meat costs 4 units of potatoes (b/c 8 units meat cost 32 units taters) While for rancher 1 unit meat costs just 2 units of potatoes (b/c 24 units meat cost 48 units taters) * Rancher is a lower (opportunity) cost producer of meat

Copyright © 2004 South-Western Question Who has the lower (opportunity) cost for potato production? -Farmer Fred gives up (trades, sacrifices) 1 unit of meat to produce 4 units of potatoes -Rancher Rick gives up (trades, sacrifices) 1 unit of meat to produce 2 units of potatoes Therefore, Farmer Fred has a lower (opportunity) cost producer of potatoes… gives up fewer units of taters per unit of meat produced. Point: Rancher Rick has a comparative advantage – a lower opportunity cost - in meat production. Farmer has the comparative advantage in potato production.

Copyright © 2004 South-Western Opportunity Cost and Comparative Advantage Whoever has a lower opportunity cost has a comparative advantage… Lower opportunity cost = comparative advantage

Copyright © 2004 South-Western Without Trade Without trade the PPF is also the Consumption Possibility Frontier. Each producer is constrained to consume what he/she can produce. m p p m p FF RR

Copyright © 2004 South-Western. Specialization and Trade Suppose each producer focused production on that good where a comparative advantage existed? - Farmer Fred would produce potatoes: 32 units of potatoes - Rancher Rick would produce meat: 24 units of meat

Copyright © 2004 South-Western Terms of Trade Suppose someone informed Farmer Fred and Rancher Rick that you could trade at this rate: (1 meat / 3 potatoes) How would that change Farmer Fred’s material well-being? Rancher Rick’s?

Figure 2 How Trade Expands the Set of Consumption Opportunities Copyright©2003 Southwestern/Thomson Learning Potatoes (ounces) A A* 0 Meat (ounces) (a) The Farmer’s Production and Consumption Farmer's production with trade

Figure 2 How Trade Expands the Set of Consumption Opportunities Copyright © 2004 South-Western Potatoes (ounces) B 0 Meat (ounces) (b) The Rancher’s Production and Consumption

Copyright © 2004 South-Western THE PRINCIPLE OF COMPARATIVE ADVANTAGE Differences in the (opportunity) cost of production determine the following: Who should produce what? - producer with lower opportunity cost has a comparative advantage

Copyright © 2004 South-Western Absolute Advantage The comparison among producers of a good according to their productivity—absolute advantage Describes the productivity of one person, firm, or nation compared to that of another. The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good (or that producer who can make more with the same amount of inputs) * Trade is based on comparative advantage

Copyright © 2004 South-Western The Rancher has an absolute advantage in the production of both meat and potatoes. Absolute Advantage Rancher Rick needs only 10 minutes to produce an ounce of potatoes, whereas the Farmer needs 15 minutes. Rancher Rick needs only 20 minutes to produce an ounce of meat, whereas the Farmer needs 60 minutes.

Copyright © 2004 South-Western Opportunity Cost and Comparative Advantage Compares producers of a good according to their opportunity cost. Value of what must be given up (sacrificed) to obtain some item The producer who has the lower opportunity cost of producing a good is said to have a comparative advantage in producing that good.

Copyright © 2004 South-Western Comparative Advantage and Trade Who has the absolute advantage? The farmer or the rancher? Who has the comparative advantage? The farmer or the rancher? -Rancher Rick has comparative advantage in meat production -Farmer Fred has comparative advantage in potato production

Copyright © 2004 South-Western Table 3 The Opportunity Cost of Meat and Potatoes Figuring Opportunity costs

Copyright © 2004 South-Western Comparative Advantage and Trade The Rancher’s opportunity cost of an ounce of meat is 2 ounces of potatoes, while the Farmer’s opportunity cost of an ounce of meat is 4ounces of potatoes... - therefore, Farmer must give up (sacrifice) more. Sooooo, Rancher has a comparative advantage in meat production. Rancher has a lower opportunity cost. The Rancher’s opportunity cost to produce an ounce of potatoes is 1/2 an ounce of meat, whereas the Farmer’s opportunity cost of an ounce of potatoes is 1/4 an ounce of meat. ( ½ > ¼) - therefore, Rancher gives up (sacrifices) more meat to produce an ounce of potatoes. Farmer has a lower opportunity cost – a comparative advantage - in potato production

Copyright © 2004 South-Western Again… …so, the Rancher has a comparative advantage in the production of meat but the Farmer has a comparative advantage in the production of potatoes. Comparative Advantage and Trade

Copyright © 2004 South-Western Comparative Advantage and Trade Comparative advantage and differences in opportunity costs are the basis for specialized production and trade. Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade. The “terms of trade” will be determined through trade – no person needs to figure the “terms of trade”, markets determine what the “terms of trade” will be and money is used to quantify the terms of trade.

Copyright © 2004 South-Western Comparative Advantage and Trade Benefits of Trade Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage.

Copyright © 2004 South-Western FYI—The Legacy of Adam Smith and David Ricardo Adam Smith In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith performed a detailed analysis of trade and economic interdependence, which economists still adhere to today. David Ricardo In his 1816 book Principles of Political Economy and Taxation, David Ricardo developed the principle of comparative advantage as we know it today.

Copyright © 2004 South-Western APPLICATIONS OF COMPARATIVE ADVANTAGE Should Tiger Woods Mow His Own Lawn? Should a CPA paint his/her own home? Should a successful insurance agent change his own oil? Should a house painter do his own taxes? * What Shouldn’t you do… put another way, what should you do?

Copyright © 2004 South-Western APPLICATIONS OF COMPARATIVE ADVANTAGE Should the United States Trade with Other Countries? Each country has many citizens with different interests/abilities. International trade can make some individuals worse off, even as it makes the country as a whole better off (consider the railroad track example) Imports—goods produced abroad and sold domestically Exports—goods produced domestically and sold abroad

Copyright © 2004 South-Western Summary Each person consumes goods and services produced by many other people both in our country and around the world. Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services.

Copyright © 2004 South-Western Summary There are two ways to compare the ability of two people producing a good. The person who can produce a good with a smaller quantity of inputs has an absolute advantage. The person with a smaller opportunity cost has a comparative advantage.

Copyright © 2004 South-Western Summary The gains from trade are based on comparative advantage, not absolute advantage. Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage. The principle of comparative advantage applies to countries as well as people. There are arguments against trade: -jobs/wages -National security -Infant industry