Chapter 3 Exchange and Markets

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 drive to class in a car made of parts manufactured in a half-dozen different countries.... and you haven’t been up for more than two hours yet!

Interdependence and the Gains from Trade How do we satisfy our wants and needs in a global economy? How do we satisfy our wants and needs in a global economy? –We can be economically self-sufficient. –We can specialize and trade with others, leading to economic interdependence.

Interdependence and the Gains from Trade Why is interdependence the norm? Why is interdependence the norm? –Interdependence occurs because people are better off when they specialize and trade with others. What determines the pattern of production and trade? What determines the pattern of production and trade? –Patterns of production and trade are based upon differences in opportunity costs.

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. Adam Smith

Adam Smith believed that specialization and trade should be based on absolute advantage. Adam Smith believed that specialization and trade should be based on absolute advantage. Absolute Advantage

The comparison among producers of a good according to their productivity. The comparison among producers of a good according to their productivity. –The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good.

Minutes needed to make one Boxes of cookies cake Emily4030 Julia2060 Who has an absolute advantage in making cookies? Julia Example

Minutes needed to make one Boxes of cookies cake Emily4030 Julia2060 Who has an absolute advantage in making cake? Emily Example

Pattern of specialization and trade According to Adam Smith specialization and trade should be based on absolute advantage: According to Adam Smith specialization and trade should be based on absolute advantage: –Emily should specialize in making cakes. –Julia should specialize in making cookies.

Minutes needed to make one Box of cookies cake Emily4030 Julia2060 Amount produced in 8 hrs Box of cookies cake Emily Julia Production Possibilities Assuming for simplicity that time is the only resource and that each has a total of 8 hours of work

Minutes needed to make one Box of cookies cake Emily4030 Julia2060 Amount produced in 8 hrs Box of cookies cake Emily1216 Julia248 Production Possibilities Assuming for simplicity that time is the only resource and that each has a total of 8 hours of work

Julia’s Production Possibilities Frontier cookies A 0 cakes If there is no trade, Julia chooses this production and consumption. Copyright©2003 Southwestern/Thomson Learning

Emily’s Production Possibilities Frontier cookies 8 6 A 0 cakes If there is no trade, Emily chooses this production and consumption. Copyright©2003 Southwestern/Thomson Learning 12 16

After Trade Specialization and Trade results in more total output. Both are better off Specialization and Trade results in more total output. Both are better off Boxes of Cookies Cakes Total output before trade 12+6=184+8=12 Total output after trade 2416

Problems What if one person has an absolute advantage in making both goods, will there be gains from specialization and trade? What if one person has an absolute advantage in making both goods, will there be gains from specialization and trade? According to Adam Smith: there will be no gains from specialization and trade. According to Adam Smith: there will be no gains from specialization and trade.

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. David Ricardo

Comparative Advantage According to Ricardo specialization and trade should be based on comparative advantage. According to Ricardo specialization and trade should be based on comparative advantage. Even if one person is better at making all goods, there are still gains from trade. Even if one person is better at making all goods, there are still gains from trade.

Example  Consider an economy with two people: Fred and Kate.  Two goods: coconut and fish. Fred’s maximum output in a day if he produces only CoconutsFish 26 Kate’s maximum output in a day if she produces onlyCoconutsFish 11 Clearly, Fred is better at making both goods

Fred’s PPC Fred’s maximum output in a day if he produces only CoconutsFish 26 Fish A 0 If there is no trade, assume Fred chooses this production and consumption. Copyright©2003 Southwestern/Thomson Learning Assume that he works 6 days a week, we can construct his PPC as follows Coconuts

Kate’s PPC Kate’s maximum output in a day if she produces only CoconutsFish 11 Copyright©2003 Southwestern/Thomson Learning Assume that she works 6 days a week, we can construct her PPC as follows 1 5 B 0 Coconuts 6 6 If there is no trade, Assume Kate chooses this production and consumption. Fish

Opportunity Cost and Comparative Advantage Opportunity cost is what must be given up to obtain some item. Opportunity cost is what must be given up to obtain some item. The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good. The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good. Who has the comparative advantage in the production of each good? ? ?

The Opportunity Cost Fred’s maximum output in a day if he produces only CoconutsFish 26 Kate’s maximum output in a day if she produces onlyCoconutsFish 11 What is the opportunity cost of one coconut for Fred? 3 Fish What is the opportunity cost of one coconut for Kate? 1 Fish Who has a comparative advantage in Coconut? Kate

The Opportunity Cost Fred’s maximum output in a day if he produces only CoconutsFish 26 Kate’s maximum output in a day if she produces only CoconutsFish 11 What is the opportunity cost of one fish for Fred? 1/3 coconut What is the opportunity cost of one fish for Kate? 1 coconut Who has a comparative advantage in fish? Fred

You can calculate the opportunity cost using the PPF. The opportunity cost of –the x-axis good = the slope of the PPF. –the y-axis good equals 1/ the slope of the PPF. Rule: Opportunity cost and slope.

The opportunity costs The Opportunity cost of CoconutFish Fred 3 fish 1/3 coconut Kate 1 fish 1 coconut Who produces coconut cheaper? Who produces fish cheaper? Kate has a comparative advantage in coconut Fred has a comparative advantage in fish.

Fred produces fish. Kate produces coconuts. Specialization and Trade Suppose instead Kate and Fred decide to specialize and trade… Suppose instead Kate and Fred decide to specialize and trade… –Both would be better off if they specialize in producing the product they are more suited to produce, and then trade with each other.

Specialization and Trade After specialization, they agreed to trade. After specialization, they agreed to trade. The terms of trade: 1 fish for ½ coconut. The terms of trade: 1 fish for ½ coconut. Fred gives Kate 10 fish for 5 coconuts Fred gives Kate 10 fish for 5 coconuts Who will benefit from trade?

How Trade Expands the Set of Consumption Opportunities Copyright©2003 Southwestern/Thomson Learning Fish A A* 0 Coconuts Fred’s Production and consumption Fred’s consumption with trade Fred’s production with trade Fred gives Kate 10 fish for 5 coconuts.

How Trade Expands the Set of Consumption Opportunities Copyright©2003 Southwestern/Thomson Learning Kate gives Fred 5 coconuts for 10 fish. Fish B 0 Kate’s Consumption and Production ’ 6 6 B* Kate’s consumption with trade Coconuts Kate’s production With trade Consumption and Production without trade

Gains from Trade CoconutFish Fred12 Kate05 Total17

Comparative Advantage and Trade Benefits of 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.

Comparative Advantage and Trade Comparative advantage and differences in opportunity costs are the basis for specialized production 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. Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade.

APPLICATIONS OF COMPARATIVE ADVANTAGE Should the United States trade Should the United States trade with other countries? with other countries? Each country has many citizens with different interests. International trade can make some individuals worse off, even as it makes the country as a whole better off. Each country has many citizens with different interests. International trade can make some individuals worse off, even as it makes the country as a whole better off. –Imports —goods produced abroad and sold domestically –Exports —goods produced domestically and sold abroad