Gains From Trade Antu Panini Murshid

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics2 Today’s Agenda Gains from specialization and trade Absolute and comparative advantage Ricardian model

3 Why Trade? Individuals and countries specialize in production and trade with each other in order to address problems created by scarcity Patterns in production and trade are based on differences in opportunity costs Individuals or countries typically specialize in what they are good at

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics4 A Parable of a Modern Economy… Imagine that there are… …only two goods—apples and bread …only two people—Jean and Joe In a given day… …Jean can either pick 5 buckets of apples or bake 10 loaves of bread …Joe can either pick 12 buckets of apples or bake 6 loaves of bread

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics5 Production Opportunities

6 Jean and Joe’s Production Possibilities Apples (buckets) Bread (loaves) Jean’s PPF… Joe’s PPF… Joe Jean

7 Consumption Possibilities Under Self-Sufficiency Apples (buckets) Bread (loaves) If Jean and Joe are self- sufficient, the production possibilities frontier is also the consumption possibilities frontier Jean’s consumption possibilities set is… Joe’s consumption possibilities set is… Joe Jean 0

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics8 Self-Sufficiency They each devote half a day to each activity

9 Self-Sufficiency Using PPFs Apples (buckets) Bread (loaves) If Jean and Joe devote 50% of their time to each activity then… …Jean can produce… Jean 5 5 loaves of bread and 2.5 buckets of apples 2.5

10 Self-Sufficiency Using PPFs Apples (buckets) Bread (loaves) …Joe can produce… Joe loaves of bread and 6 buckets of apples

11 Self-Sufficiency Using PPFs Apples (buckets) Bread (loaves) 0 Jean and Joe combined are producing… (3,6) (5,2.5) Economy 8.5 8

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics12 Specialization and Trade Suppose… …Jean specializes in baking bread …Joe specializes in picking apples Economy-wide output is now 10 loaves of bread 12 buckets of apples Jean trades 4 loaves of bread for 4 buckets of apples Jean has 6 loaves of bread and 4 buckets of apples Joe has 4 loaves of bread and 8 buckets of apples

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics13 Gains From Trade

14 Trade and Self-Sufficiency Compared Using PPFs Apples (buckets) Bread (loaves) Self-Sufficiency… Jean 5 loaves of bread & 2.5 buckets of apples Joe has 3 loaves of bread & 6 buckets of apples Economy: 8 loaves of bread, 8.5 buckets of apples Joe’s PPF Jean’s PPF Economy Jean’s bundle before trade Joe’s bundle before trade

15 Trade and Self-Sufficiency Compared Using PPFs Apples (buckets) Bread (loaves) Trade… Jean has 6 loaves of bread & 4 buckets of apples Joe has 4 loaves of bread and 8 buckets of apples Economy: 10 loaves of bread, 12 buckets of apples 4 Jean’s bundle after trade 4 Joe’s bundle after trade 8 Economy after trade

16 Trade and Self-Sufficiency Compared Using PPFs Apples (buckets) Bread (loaves) 0 6 Jean is better off after trade… …so is Joe 4 Jean’s bundle after trade 4 Joe’s bundle after trade 8 Jean’s bundle before trade Joe’s bundle before trade

17 Consumption Opportunities After Trade After Trade… Jean consumes a bundle which lies outside her production possibilities set So does Joe Jean’s bundle Joe’s bundle Apples (buckets) Bread (loaves) 0

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics18 Who Should Specialize in What? Why should… …Jean specialize in making bread? …and Joe specialize in picking apples? Because Jean is relatively better at making bread… …and Joe is relatively better at picking apples

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics19 Comparative Advantage Can we be precise in what we mean by “relatively better”? Comparative advantage… A producer has a comparative advantage in a good, if he/she can produce it at a lower opportunity cost than his/her competitor

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics20 Costs of Production

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics21 Principle of Comparative Advantage For trade to be beneficial, producers should specialize in their comparative advantage Whenever trading partners have differing opportunity costs, they can benefit form trade Jean has a comparative advantage in bread Joe has a comparative advantage in apples

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics22 David Ricardo and Adam Smith David Ricardo formalized the principle of comparative advantage in Principles of Political Economy and Taxation Earlier Adam Smith had developed the concept of absolute advantage in the Wealth of Nations This formed the early logic behind the notion that trade could be beneficial However, the principle of comparative advantage is more general, but also less intuitive

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics23 Absolute Advantage and Trade To have an absolute advantage in the production of a good means being able to produce that good more efficiently than one’s competitors In his Wealth of Nations, Adam Smith suggested that individuals/countries should specialize in their absolute advantage This is exactly what Jean and Joe did… …since Jean has an absolute advantage in bread..and Joe has an absolute advantage in apples

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics24 Comparative Advantage and Absolute Advantage If an individual has an absolute advantage in the production of some good, must he/she also have a comparative advantage in that good, and vice versa? No!

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics25 A More Complex Parable… Consider our economy with two inhabitants—Jean and Joe—and two goods—apples and bread… Suppose that in a given day… …Jean can either pick 5 buckets of apples or bake 10 loaves of bread …Joe can either pick 12 buckets of apples or bake 12 loaves of bread

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics26 Costs of Production

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics27 Self Sufficiency They each devote half a day to each activity

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics28 After Specialization Jean specializes completely in bread Joe devotes most of his time to picking apples

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics29 After Trade Jean trades 5 loaves for 4 buckets of apples Jean is better off by 1.5 buckets of apples Joe is better off by 1 loaf of bread

30 Quantity of Computers Produced Quantity of Cars Produced 3, ,000 Relative Slopes of PPFs:Trade Opportunities PPF Country A PPF Country B 750 1,500 Country A’s PPF is steeper and everywhere above country B’s PPF. Should the two countries trade?

31 Relative Slopes of PPFs:Trade Opportunities Country A’s PPF is steeper and everywhere above country B’s PPF. Should the two countries trade? Position of the PPFs doesn’t matter… …all that matters is that the slopes are different So long as that is true, trade will be beneficial

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics32 Predictions of the Ricardian Model Trade occurs due to differences in production technology Even a technologically inferior country can benefit from free trade

11/16/2015 Antu Panini Murshid--Principles of Macroeconomics33 Summary Specialization and trade allows consumption outside of production possibilities A country/individual has an absolute advantage in the production of a good if they are more efficient at producing that good Comparative advantage is measured by opportunity costs (not monetary costs or resource costs) The Ricardian model states that for trade to be beneficial countries should specialize in their comparative advantage