2. Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001) Ch. 3: Interdependence and the Gains From Trade

3. Econ 202 Dr. Ugur Aker 2 Why Do People Trade With Each Other? If one person produces bread and another butter, they would be both better off exchanging some of their produce with the other and have a variety in their diet. If they can both produce bread and butter, they each will have a PPF. The total output of bread and butter would be much higher if each specialized on the product s/he can produce more.

4. Econ 202 Dr. Ugur Aker 3 Bread and Butter Production

5. Econ 202 Dr. Ugur Aker 4 Opportunity Costs What is the implied price of butter for Farmer A? –Each time FA increases her butter production she has to give up 5 breads. What is the implied price of butter for Farmer B? –Each time FB increases his butter production he has to give up 1 bread.

6. Econ 202 Dr. Ugur Aker 5 Combined Production Suppose both are producing only bread. How many breads will be produced? Suppose they decide to reduce bread production by 10 and allocate that effort to butter production. Who should be the one to produce butter? How much butter will be produced?

7. Econ 202 Dr. Ugur Aker 6 Suppose that the rest of the world is willing to trade 2 breads for 1 butter. How would each farmer decide what to do?

8. Econ 202 Dr. Ugur Aker 7

9. 8 Total Production If Farmer A produced 15 breads and 3 butters, and Farmer B produced 10 breads and 5 butters, their combined consumption would be 25 breads and 8 butters. If Farmer A specialized in bread and Farmer B specialized in butter, their combined production would be 30 breads and 15 butters.

10. Econ 202 Dr. Ugur Aker 9 Specialization and Trade If the price of butter were 2 breads, what strategy would be advantageous for both farmers? Farmer A can only acquire 1 butter for 5 breads when she is self-sufficient. She would be better off producing bread and exchanging for butter. Farmer B can only acquire 1 bread for 1 butter when he is self-sufficient. He would be better off producing butter and exchanging for bread.

11. Econ 202 Dr. Ugur Aker 10 Consumption After Trade If Farmer A gave up 6 breads out of the 30 she produced, she can get 3 butters. Her consumption would be 24 breads and 3 butters. If Farmer B gave up 5 butters out of the 15 he produced, his consumption would be 10 breads and 10 butters. They are both better off than what they were consuming under self-sufficiency.

12. Econ 202 Dr. Ugur Aker 11 Bread and Butter Production Consumption before trade Consumption after trade Consumption after trade Consumption before trade

13. Econ 202 Dr. Ugur Aker 12 Absolute and Comparative Advantage The example before showed absolute advantage because FA was more productive in bread production and FB was more productive in butter production. What if FA were more productive in both bread and butter production? Would there be a reason to trade?

14. Econ 202 Dr. Ugur Aker 13 Comparative Advantage

15. Econ 202 Dr. Ugur Aker 14

16. Econ 202 Dr. Ugur Aker 15 Opportunity Costs Farmer A can produce either 30 breads or 30 butters. Her opportunity cost is 1br=1bt. Farmer B can produce 15 breads or 9 butters. His opportunity cost is 1br=0.6bt. As long as different opportunity costs exist, there is room for specialization, trade and improvement of well being.

17. Econ 202 Dr. Ugur Aker 16 Trade If the “world” exchange rate (price) were 1br=0.8bt, FA would be interested in giving up butter to get bread and FB would be interested in giving up bread to get butter. Start at self-sufficiency for both. Pick a point on the PPF of each to show consumption before specialization and trade. Allow full specialization and exchange some of the production for the production of the other farmer. Show that they are both better off.

18. Econ 202 Dr. Ugur Aker 17

19. Econ 202 Dr. Ugur Aker 18 US Foreign Trade US is more productive than Mexico and China in many products. Yet it engages in trade, freeing resources to be put to use in products where US has a comparative advantage. This way all countries can enjoy a higher standard of living.

20. Econ 202 Dr. Ugur Aker 19 Assignment American and Japanese workers can each produce 4 cars a year. An American worker can produce 10 tons of grain a year, a Japanese worker can produce 5 tons of grain a year. Each country has 100 million workers. –Graph the PPF for both countries. –Make a table showing the opportunity costs. –If half of the workers in each country is working on cars, how many cars and how many tons of grain are produced? –How could both countries be better off through trade? What range of world prices would bring this outcome? –Suppose world price is 2 tons of grain for 1 car. Show numerically that specialization and trade improves both Japanese and American societies.