Trade and Interdependence

Minutes needed to make one ounce of: Amount produced in 8 hours: MeatPotatoesMeatPotatoes Farmer60 min/oz.15 min/oz.8 oz.32 oz. Rancher20 min/oz.10 min/oz.24 oz.48 oz. Note that the Production Possibilities Frontier is also the Consumption Possibilities Frontier if the two farmers do not trade. Why? The straightness of the curves show that the trade-off of one good for the other is constant for these producers and these goods. Why? These trade-offs are also the opportunity costs of producing one good rather than the other: What is the Opportunity Cost to the Farmer of one ounce of meat? What is the Opportunity Cost to the Rancher of one ounce of meat? Consider the Production Productivity Frontiers of a Farmer and a Rancher… Assume: Nobody else in the economy, each can work only 8 hours a day and the only two goods they can produce are beef and potatoes Farmer’s PPFRancher’s PPF Meat Potatoes Without trade, the farmer chooses this level (4oz. Meat, 16 oz. potato) Without trade, the farmer chooses this level (12 oz. Meat, 24 oz. potatoes) 1 : 4 1 : 2

Meat Potatoes FarmerRancher MeatPotatoesMeatPotatoes Without Trade With Trade Production TradeGets 5Gives 15Gives 5Gets 15 Consumption (P + T) Gains from Trade (C – WT)+1 +3 To trade or not to trade, that is the question… Both side, in this case, gain meat and potatoes from trading. Why? Trade allowed both sides to specialize and do what they do best, producing more of their specialty (at less opportunity cost) No trade Farmer production with trade Rancher production with trade After trade, farmer gains outside of PPF alone After trade, rancher gains outside of PPF alone Note that with trade, both farmer and rancher are able to consume more meat and potatoes than they could producing on their own: They are able to consume outside of their PPFs Suppose the farmer agrees to produce only potatoes (32 oz.) and the rancher produces 18 oz. meat and only 12 oz. of potatoes – they trade 5 meat for 15 potatoes

To fully understand why the rancher (who produces both products better than the farmer) gains from trade, we must compare their relative costs of production: Absolute and Comparative Advantage Minutes needed to make one ounce of: Amount produced in 8 hours: MeatPotatoesMeatPotatoes Farmer60 min/oz.15 min/oz.8 oz.32 oz. Rancher20 min/oz.10 min/oz.24 oz.48 oz. The producer who uses fewer resources/inputs (in this case time) to produce a good has an absolute advantage over the other: Who has the absolute advantage in producing potatoes? (Rancher: 10 min/oz. – 15 min/oz. OR 48 oz. – 32 oz. per 8 hours) Who has the absolute advantage in producing meat? (Rancher: 20 min/oz. – 60 min/oz. OR 24 oz. – 8 oz. per 8 hours) Absolute Advantage is the ability to produce a good using fewer resources (inputs) than other producers of that good.

Minutes needed to make one ounce of: Amount produced in 8 hours: MeatPotatoesMeatPotatoes Farmer60 min/oz.15 min/oz.8 oz.32 oz. Rancher20 min/oz.10 min/oz.24 oz.48 oz. The producer who has a lower opportunity cost (smaller trade-off) for producing a good has a comparative advantage over the other: Opportunity Cost of: 1 oz. of meat1 oz. of potatoes Farmer Rancher 1.For the farmer, 1 oz. of potatoes takes 15 minutes, time that can’t be spent on meat. Since it takes him 60 minutes for an ounce of meat, a loss of 15 minutes for potatoes costs him ¼ an ounce of meat. Similarly, 1 oz. of meat takes 60 minutes, time that can’t be spent on potatoes. Since 15 minutes are needed for an oz. of potatoes, 1 oz. of meat costs 4 potatoes. 1.For the rancher, 1 oz. of potatoes takes 10 minutes. Since it takes 20 minutes for an ounce of meat, a loss of 10 minutes for potatoes costs ½ oz. of meat. Similarly, 1 oz. of meat takes 20 minutes. Since potatoes take 10 minutes, each ounce of meat costs 2 potatoes. 4 oz. potatoes ¼ oz. meat 2 oz. potatoes ½ oz. meat So who has the comparative advantage (the smallest opportunity costs): The farmer gives up less meat (1/4 oz.) for an ounce of potatoes, he has the comparative advantage for potatoes. The rancher gives up less potatoes (2 oz.) for an ounce of meat, he has the comparative advantage for meat.

In the deal between the farmer and the rancher, the farmer gave 15 oz. potatoes for 5 oz. of meat – 1 oz. of meat cost 3 oz. potatoes. His opportunity cost, however, is 4 oz. potatoes for 1 oz. of meat. Since his price (3 for 1) is less than his opportunity cost (4 for 1), he wins!! The rancher gave 5 oz. meat for 15 oz. potatoes – 3 oz. potatoes cost 1 oz. of meat. His opportunity cost, however, is 2 oz. of potatoes for 1 oz. meat. Since his price (1 for 3) is less than his opportunity cost (1 for 2), he wins too!! OC (Farmer): 4 potato = 1 meat Trade Price: 3 potato = 1 meat OC Rancher: 2 potato = 1 meat Rule of Thumb: Trade benefits both sides when the price of the trade lays between the two opportunity costs So who cares? Gains from trade come from comparative advantage (not absolute advantage). Here’s why: When each person/nation specializes in the goods for which they have a comparative advantage, they produce more with less opportunity cost. This raises the production in the entire economy All thing equal, more production (output) helps everyone (makes the economic pie bigger) If the price was 1 oz. potato for 1 oz. meat, both would be meat buyers, since the price would be less than their opportunity cost. (Price < OC for both) – no trade would happen If the price was 5 oz. potato for 1 oz. meat, both would be meat sellers, since price would be above their opportunity cost. (Price > OC for both) – no trade would happen Trade happens when both have goods they can buy and sell for a price less than their opportunity costs.