ECO1000 Economics Semester One, 2004 Lecture Two

Outline or Plan of Today’s Lecture Material Covered: Module One, Part Two Reading: Chapter 3 of the Text and Chapter 3 of the Study Guide (Hakes and Parry) Topics Considered: Interdependence and Gains From Trade

Objectives of Today’s Lecture You will learn about: The benefits of trade Absolute and comparative advantage How comparative advantage explains the benefits of trade How comparative advantage and trade applies to your daily lives and your nation’s policies

Relevant Economic Principles The cost of something is what you give up to get it Trade can make everyone better off

How do we satisfy our wants and needs? We can be economically self- sufficient; or We can specialise and trade with others, leading to economic interdependence.

The Production Possibilities Frontier A Model of Production Capacity

The Production Possibility Frontier A representation of two choices of production based on full utilisation of known resources All points within the PPF are also combinations of production of goods Illustrates opportunity cost movement along the frontier means giving up production of one to gain production in another

Building the Model Start with individual behaviour & capacity ‘Robinson Crusoe’ economics Add more people to the model Used to illustrate a general tendency, not detailed reality Assume the principles are still valid in a complex society

Scenario One person (George) on an island Only producing two goods Food & cloth Limited by: Physical capacity Skill Trade-off between the 2 goods

George’s production possibilities in relation to food & cloth

Graphing George’s PPF Food (Kgs/wk) Cloth (m/wk) * * * Point A Point B Point C * * Point D Point E 0

Principles of a PPF Food (Kgs/wk) Cloth (m/wk) * * Point A: possible but can produce more Point B: At full capacity * Point C: Not possible under current conditions 0 2

Shifting along the PPF Food (Kgs/wk) Cloth (m/wk) Give up 2 kgs of food Gain 3 m of cloth * * *

Calculating opportunity cost George gives up 2 kgs of food/wk to gain 3 m of cloth/wk Converting this to single units, each extra metre of cloth ‘costs’ 2/3 (0.66) kgs of food Therefore, the opportunity cost of increasing cloth production by 1 m/wk = 0.66 kgs/wk of food

Points to note George could gather 10 kgs/wk of food and make no cloth or make 15 m of cloth and gather no food NB. There is always a time factor per/day, per/wk, per month etc It is likely that opportunity cost will vary, usually increasing with any shift of resources This is based on constant opportunity cost

John’s PPF

Comparing PPFs Food (Kgs/wk) Cloth (m/wk) John George * * * * * Gives up 3 kgs/wk Gains 3 m/wk

Comparing the Cost of Food: John’s Absolute Advantage Absolute advantage is a term used when comparing productivity. In our example, John has an absolute advantage in producing food because he requires less time than George to produce a unit of this good.

Another Way of Comparing Costs: Opportunity Cost and Comparative Advantage John’s opportunity cost of producing cloth: John gives up 3 kgs of food/wk to gain 3 m of cloth/wk Opportunity cost for 1 m/wk of cloth = 1 kg of food/wk Compared with George’s opportunity cost of 0.66 kg of food/wk George has a lower opportunity cost than John for the production of cloth (he gives up less food) John has a lower opportunity cost than George for the production of food (he gives up less cloth) WORK IT OUT!

Comparative Advantage The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good. George has a comparative advantage in cloth production and John has a comparative advantage in food production

Comparative Advantage and Specialisation George could specialise in cloth production (where he has a comparative advantage) and John could specialise in food production (where he has a comparative advantage) The result of specialisation is a greater total production of both goods

The logic of specialisation Food (Kgs/wk) Cloth (m/wk) Maximum combined production john george

George & John Trade… George specialises in cloth production and produces 15 m/wk John specialises in food production and produces 12 kgs/wk John eats 6 kgs of food and trades the other 6 kgs for 8 m of cloth He ends up with 6 kgs of food and 8 m of cloth

John’s Consumption Possibilities Food (Kgs/wk) Cloth (m/wk) * * The PPF (does not change) Consumption with trade 8 Consumption without trade

George’s Situation With Trade George uses 7 m of cloth and trades the other 8 m for 6 kgs of food. George ends up with 7 m of cloth and 6 kgs of food.

George’s Consumption Possibilities Food (Kgs/wk) Cloth (m/wk) Consumption with trade * * PPF (does not change) 7

Points to Note Interdependence and trade can allow people to enjoy a greater quantity and variety of goods and services. 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. The gains from trade are based on comparative advantage, not absolute advantage.

National Production Possibilities Applying the Same Principles to National Economies

A National PPF Information gigabytes/yr Textiles cu m/yr 750,000 1 m 500,000 8 m4 m 16 m *Assume full use of resources

Points to note Country produces either textiles or information At 750,000 gb/yr & 4 m cu metres/yr, an increase of 4 m cu metres will mean giving up 250,000 gb/yr Opp cost of 4 m cu m. = 250,000 gb of info. Opp cost of 1 cu m = gb of info

A Positive Change in the PPF Information gigabytes/yr Textiles cu m/yr * NB: It is a change in potential production Increase in population, discovery of new resources, invention of new technology, higher education

A Negative Change in the PPF Information gigabytes/yr Textiles cu m/yr * NB: It is a change in potential production Decrease in population, depletion of resources, environmental degradation, natural disaster, human disaster

A Positive Change in Textile Technology Information gigabytes/yr Textiles cu m/yr

Changes within the PPF Information gigabytes/yr Textiles cu m/yr * * There has been no change in population, resources or technology, but there has been a change in policy or work practices

The Impact of Policy Information gigabytes/yr Textiles cu m/yr 750,000 1 m 500,000 5m6.5 m 16 m * * 1. Government cuts assistance to industry 2. Resources shift to another industry and production moves closer to PPF. (Greater efficiency) *This is a more realistic situation. There is not full use of all resources. Initial production

Towards PPF & Away from PPF More efficient use of resources Low unemployment Change in government policy Less efficient use of resources High unemployment Change in government policy Political favours for some inefficient sectors of groups

An Example of Production Without Trade Televisions million/yr Wheat million tonnes/yr Japan Australia

Opportunity Costs Japan can either produce 1 tonne of wheat or 1 TV. Opp Cost of 1 t. of wheat = 1 TV Australia can produce 1 TV or 3 tonnes of wheat. Opp cost of 1 TV = 3 tonnes of wheat

Opportunity Costs Compared

The Development of Trade Japan wants to get wheat cheaper than at a cost of 1 TV/tonne if possible Australia wants to get TVs cheaper than at a cost of 3 tonnes of wheat/TV if possible Suppose they agree to specialise and trade

New Consumption Possibility with trade Televisions million/yr Wheat million tonnes/yr Australia’s PPF * * Australia produces 16 million tonnes of wheat, keeps 7 million tonnes and trades 9 million tonnes for 5 million televisions. Australia’s consumption with trade

New Consumption Possibility with trade Televisions million/yr Wheat million tonnes/yr Japan produces 10 million TVs, keeps 5 million and trades the other 5 million for 9 million tonnes of wheat ** Japan’s PPF Japan’s consumption with trade

Points to note The PPF (production) cannot increase, but consumption can It just shows the potential for an increase in goods and services No country fully specialises However, this idea is the basis for free trade arguments

Conclusions Lower opportunity cost creates the conditions for benefits from exchange In the absence of other impediments & costs, countries will increase possible consumption through trade This is true even where one country has an absolute advantage over another

Next Week Next week’s lecture: Material: Module Two, Part One Reading: Text Chapter Four plus Hakes and Parry Chapter Four Topics: Supply and Demand

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