: Why do people – and nations – choose to be economically interdependent? How can trade make everyone better off? What is absolute advantage? What is comparative advantage? How are these concepts similar? How are they different?

hair gel from Cleveland, OH Interdependence Every day you rely on many people from around the world, most of whom you’ve never met, to provide you with the goods and services you enjoy. hair gel from Cleveland, OH cell phone from Taiwan dress shirt from China coffee from Kenya 1

Interdependence One of the main principles in almost every intro text is : Trade can make everyone better off. We now learn why people – and nations – choose to be interdependent, and how they can gain from trade. INTERDEPENDENCE AND THE GAINS FROM TRADE

The Production Possibilities Frontier The Production Possibilities Frontier (PPF): a graph that shows the combinations of two goods the economy can possibly produce given the available resources and the available technology THINKING LIKE AN ECONOMIST 3

The PPF: What We Know So Far Points on the PPF possible efficient: all resources are fully utilized Points under the PPF not efficient: some resources underutilized (e.g., workers unemployed, factories idle) Points above the PPF not possible THINKING LIKE AN ECONOMIST 4

The PPF and Opportunity Cost Recall: The opportunity cost of an item is what must be given up to obtain that item. Moving along a PPF involves shifting resources (e.g., labor) from the production of one good to the other. Society faces a tradeoff: Getting more of one good requires sacrificing some of the other. The slope of the PPF tells you the opportunity cost of one good in terms of the other. THINKING LIKE AN ECONOMIST 5

The PPF and Opportunity Cost The slope of a line equals the “rise over the run,” the amount the line rises when you move to the right by one unit. –1000 slope = = –10 100 Here, the opportunity cost of a computer is 10 tons of wheat. Here, the “rise” is a negative number, because, as you move to the right, the line falls (meaning wheat output is reduced). Moving to the right involves shifting resources from the production of wheat (which causes wheat output to fall) to the production of computers (which causes computer production to rise). Producing an additional computer requires the resources that would otherwise produce 10 tons of wheat. THINKING LIKE AN ECONOMIST 6

A C T I V E L E A R N I N G 2 PPF and Opportunity Cost In which country is the opportunity cost of cloth lower? FRANCE ENGLAND This exercise reinforces the material on the preceding slide. It is especially useful if you plan to cover Chapter 3 (Interdependence and the Gains from Trade) after completing Chapter 2. 7

Economic Growth and the PPF With additional resources or an improvement in technology, the economy can produce more computers, Economic growth shifts the PPF outward. more wheat, The PPF shows the tradeoff between the outputs of different goods at a given time, but the tradeoff can change over time. For example, over time, the economy might get more workers (or more factories or more land). Or, a more efficient technology might be invented. Both events – an increase in the economy’s resources or an improvement in technology – cause an expansion in the set of opportunities. That is, both allow the economy to produce more of one or both goods. This is a simple example of economic growth, an important subject that gets its own chapter in the macroeconomics portion of the textbook. In the example shown on this slide, economic growth causes a parallel outward shift of the PPF. Since the new PPF is parallel to the old one, the tradeoff between the two goods is the same. However, this need not always be the case. For example, if a new technology had more impact on the computer industry than on the wheat industry, then the horizontal (computer) intercept would increase more than the vertical (wheat) intercept, and the PPF would become flatter: the opportunity cost of computers would fall, because the technology has made them relatively cheaper (relative to wheat). Going into more detail here is probably beyond the scope of this chapter. or any combination in between. THINKING LIKE AN ECONOMIST 8

Why the PPF Might Be Bow-Shaped As the economy shifts resources from beer to mountain bikes: PPF becomes steeper opp. cost of mountain bikes increases Mountain Bikes Beer THINKING LIKE AN ECONOMIST 9

Why the PPF Might Be Bow-Shaped At A, opp. cost of mtn bikes is low. At point A, most workers are producing beer, even those that are better suited to building bikes. So, do not have to give up much beer to get more bikes. A Beer Here, we are using “workers” for the more general “resources,” to keep things simple and consistent with the previous examples. Mountain Bikes THINKING LIKE AN ECONOMIST 10

Why the PPF Might Be Bow-Shaped At B, most workers are producing bikes. The few left in beer are the best brewers. Producing more bikes would require shifting some of the best brewers away from beer production, would cause a big drop in beer output. At B, opp. cost of mtn bikes is high. Beer B Mountain Bikes THINKING LIKE AN ECONOMIST 11

Why the PPF Might Be Bow-Shaped So, PPF is bow-shaped when different workers have different skills, different opportunity costs of producing one good in terms of the other. The PPF would also be bow-shaped when there is some other resource, or mix of resources with varying opportunity costs (E.g., different types of land suited for different uses). The bow-shaped PPF is more realistic. However, the linear PPF is simpler to work with, and we can learn a lot about how the economy works using the linear PPF. In Chapter 3, we will use a linear PPF to show how trade can make two countries (or two individuals) better off. Note: In the “Problems and Applications” at the end of the chapter, problem 4 asks students to construct a PPF for an economy with three different workers (Larry, Moe, and Curly), each with a different opportunity cost. The PPF ends up having three line segments (one for each worker), which--very roughly--approximates a bow-shape. After students work through and understand this problem, it should not be hard for them to understand the following: the more different kinds of workers (or, more generally, resources) there are, the closer the PPF will resemble a smooth bow shape. In an actual economy like the U.S., there are millions of different workers with different opportunity costs, so a smooth bow-shaped PPF is a nearly perfect approximation to the actual PPF. THINKING LIKE AN ECONOMIST 12

Our Example Two countries: the U.S. and Japan Two countries: the U.S. and Japan Two goods: computers and wheat One resource: labor We will look at how much of both goods each country produces and consumes if the country chooses to be self-sufficient if it trades with the other country The lessons illustrated by this international trade example also apply to trade between two individual producers. Note that this chapter in the textbook does the reverse: It develops the lessons in the context of an example involving two individual producers, and then states that the lessons also apply to international trade. So, between this PowerPoint and the textbook chapter, students will see the same concepts and lessons developed in two different but entirely consistent approaches and examples. The example here is highly contrived and unrealistic in order to illustrate complex concepts as simply as possible. The example has some qualities that make it especially valuable: * The two goods are fundamentally different (one is agricultural, the other manufactured), which makes gains from trade based on comparative advantage very likely. An example using more similar goods, say laptop computers and MP3 players, would not be appropriate for this chapter because it would more likely give rise to inter-industry trade, and the gains would likely arise from a source other than comparative advantage (probably increasing returns to scale). * In the example here, it turns out that the U.S. has an absolute advantage in both goods, yet both countries gain from trade. Students see, therefore, that comparative advantage, not absolute advantage, is what’s necessary for trade to be mutually beneficial. * In the real world, one often sees gains from trade based on comparative advantage occurring between countries that are very different – such as between rich industrialized countries and poor developing countries. This example shows that trade based on comparative advantage can also occur between countries that are at similar levels of industrialization and income. (Of course, the U.S. and Japan are very different; but they are far more similar than are, say, the U.S. and Botswana.) INTERDEPENDENCE AND THE GAINS FROM TRADE 13

The U.S. PPF The U.S. has enough labor to produce 500 computers, 4,000 100 5,000 2,000 1,000 3,000 500 200 300 400 Computers Wheat (tons) The U.S. has enough labor to produce 500 computers, or 5000 tons of wheat, or any combination along the PPF. Deriving the intercepts, or endpoints of the PPF: The U.S. has 50,000 labor hours. It takes 100 hours to produce a computer. If the U.S. uses all its labor to produce computers, then it will produce 50,000/100 = 500 computers. Hence, the horizontal intercept is (500 computers, 0 wheat). It takes 10 hours to produce a ton of wheat. If the U.S. uses all its labor to produce wheat, then it will produce 50,000/10 = 5000 tons of wheat. Hence, the vertical intercept is (0 computers, 5000 tons of wheat). The PPF is the straight line that connects the two endpoints. INTERDEPENDENCE AND THE GAINS FROM TRADE 14

The U.S. Without Trade 4,000 100 5,000 2,000 1,000 3,000 500 200 300 400 Computers Wheat (tons) Suppose the U.S. uses half its labor to produce each of the two goods. Then it will produce and consume 250 computers and 2500 tons of wheat. Of course, the U.S. could choose a different point. The actual choice will depend on the preferences of society. (In the following chapter – on supply and demand – we will learn what determines how much of each good society produces.) Important note for students: Without trade, a country consumes what it produces. INTERDEPENDENCE AND THE GAINS FROM TRADE 15

Japan’s PPF Japan has enough labor to produce 240 computers, Computers Wheat (tons) 2,000 1,000 200 100 300 Japan has enough labor to produce 240 computers, or 1200 tons of wheat, or any combination along the PPF. Horizontal intercept: (30,000 labor-hours)/(125 hours per computer) = 240 computers. Vertical intercept: (30,000 labor-hours)/(25 hours per ton of wheat) = 1200 tons of wheat. INTERDEPENDENCE AND THE GAINS FROM TRADE 16

Japan Without Trade Computers Wheat (tons) 2,000 1,000 200 100 300 Suppose Japan uses half its labor to produce each good. Then it will produce and consume 120 computers and 600 tons of wheat. INTERDEPENDENCE AND THE GAINS FROM TRADE 17

Consumption With and Without Trade Without trade, U.S. consumers get 250 computers and 2500 tons wheat. Japanese consumers get 120 computers and 600 tons wheat. We will compare consumption without trade to consumption with trade. First, we need to see how much of each good is produced and traded by the two countries. INTERDEPENDENCE AND THE GAINS FROM TRADE 18

Basic international trade terms Exports: goods produced domestically and sold abroad To export means to sell domestically produced goods abroad. Imports: goods produced abroad and sold domestically To import means to purchase goods produced in other countries. These terms are so basic that many instructors skip this slide. There’s a subtle point that you might want to mention (if you’re anal like me), or that your students might ask about (especially if tourism is an important part of your local economy). Someone from Germany or South Korea visits Las Vegas and spends $200 on a pair of tickets to a show. How should we classify this and other expenditures by foreign tourists on lodging and entertainment while they are vacationing here? Answer: we count it in U.S. exports. It doesn’t matter that the service was consumed here. What matters is that it was produced here but sold to a foreign buyer. Hence, a more precise definition of exports would be goods and serviced produced here and purchased by foreign buyers. This stricter definition of exports doesn’t care whether the good or service was consumed in the buyer’s home country or in the exporting country. Similarly, a stricter and more precise definition of imports would include purchases by domestic residents of goods and services produced abroad – including entertainment and lodging services that tourists from the U.S. consume in the foreign countries they visit. INTERDEPENDENCE AND THE GAINS FROM TRADE 19

Where Do These Gains Come From? Absolute advantage: the ability to produce a good using fewer inputs than another producer The U.S. has an absolute advantage in wheat: If each country has an absolute advantage in one good and specializes in that good, then both countries can gain from trade. The last bullet point states that gains from trade will arise if each country has an absolute advantage in something. We will see next, though, that absolute advantage is not required for both countries to gain from trade. INTERDEPENDENCE AND THE GAINS FROM TRADE 20

Two Measures of the Cost of a Good Another measure of cost is opportunity cost. In our example, the opportunity cost of a computer is the amount of wheat that could be produced using the labor needed to produce one computer. INTERDEPENDENCE AND THE GAINS FROM TRADE 21

Opportunity Cost and Comparative Advantage Comparative advantage: the ability to produce a good at a lower opportunity cost than another producer Which country has the comparative advantage in computers? INTERDEPENDENCE AND THE GAINS FROM TRADE 22

Opportunity Cost and Comparative Advantage So, Japan has a comparative advantage in computers. Lesson: Absolute advantage is not necessary for comparative advantage! INTERDEPENDENCE AND THE GAINS FROM TRADE 23