1. Copyright © 2004 South-Western/Thomson Learning Mod 4 Interdependence and the Gains from Trade

2. Copyright © 2004 South-Western Interdependence and the Gains from Trade Remember: Economics is the study of how societies produce and distribute scarce goods & resources in an attempt to satisfy the wants and needs of its members.

3. Copyright © 2004 South-Western Interdependence and the Gains from Trade How do we satisfy our wants and needs in an economy? We can be economically self-sufficient OR We can specialize and trade with others, leading to economic interdependence.

4. Copyright © 2004 South-Western The Caveman Simulation FFarmerFood TTailorClothing BBuilderShelter

5. Copyright © 2004 South-Western The Caveman Simulation, V. 2.0 ProducerFoodShelterFood/Shel ter Skilled400 100/300 Unskilled30010075/75

6. Copyright © 2004 South-Western Interdependence and the Gains from Trade Individuals and nations rely on specialized production and exchange as a way to address problems caused by scarcity. But this gives rise to two questions: Why is interdependence the norm? What determines production and trade?

7. Copyright © 2004 South-Western Interdependence and the Gains from Trade Why is interdependence the norm? Because people are better off when they specialize and trade with others—Caveman Simulation What determines the pattern of production and trade? Differences in opportunity costs.

8. Copyright © 2004 South-Western Comp Adv Wksht

9. Copyright © 2004 South-Western The Farmer and the Rancher: A Classic Example of Absolute and Comparative Advantage Imagine... only two goods: potatoes and meat only two people: a potato farmer and a cattle rancher What should each produce? Why should they trade?

10. Copyright © 2004 South-Western Production Possibilities (amt produced/40 hrs) Meat Potatoes Farmer 2 lbs4 lbs Rancher 40 lbs5 lbs

11. Copyright © 2004 South-Western The Rancher has an absolute advantage in the production of both meat and potatoes— he can produce more of each in the same amount of time Absolute Advantage

12. Copyright © 2004 South-Western TWO Production Possibilities Self-Sufficiency By ignoring each other: Each consumes what they each produce. The production possibilities frontier limits their consumption Without trade, economic gains are diminished.

13. The Production Possibilities Curve Potatoes (lbs) 1 2 2 4 A 0 Meat (lbs) The Farmer’s PPC ’ If there is no trade, the farmer chooses this production and consumption level, so he can have some of both. Copyright©2003 Southwestern/Thomson Learning

14. The Production Possibilities Curve Copyright©2003 Southwestern/Thomson Learning Potatoes (lbs) 20 2.5 B 0 Meat (lbs) ’ 5 40 If there is no trade, the rancher chooses this production and consumption level, so he can have some of both. The Rancher’s PPC

15. Copyright © 2004 South-Western TWO Production Possibilities Trade By Specializing and Trade: Each would be better off if they specialized in producing the product they are more suited to produce, and then trade with each other.

16. Copyright © 2004 South-Western The Farmer and the Rancher So, what should they each produce?

17. Copyright © 2004 South-Western THE PRINCIPLE OF COMPARATIVE ADVANTAGE The producer who has the lower opportunity cost of producing a good is said to have a comparative advantage in producing that good. Compares producers of a good according to their opportunity cost. Whatever must be given up to obtain some item

18. Copyright © 2004 South-Western Steps to Figuring Opp Cost for Comp Adv Problems 1.Set up your Matrix as per the model

19. Copyright © 2004 South-Western Matrix Model ProducerItem:

20. Copyright © 2004 South-Western Figuring Opportunity Cost of Meat and Potatoes (amt produced/40 hrs) Meat Potatoes Farmer 2 lbs4 lbs Rancher 40 lbs5 lbs

21. Copyright © 2004 South-Western Steps to Figuring Opp Cost for Comp Adv 2.Determine whether it is an O utput or I nput problem

22. Copyright © 2004 South-Western Figuring Opportunity Cost of Meat and Potatoes (amt produced/40 hrs) Meat Potatoes Farmer 2 lbs4 lbs Rancher 40 lbs5 lbs

23. Copyright © 2004 South-Western Steps to Figuring Opp Cost for Comp Adv 3.Create ratios for Opportunity Cost Analysis a)Create ratios horizontally for each Producer

24. Copyright © 2004 South-Western Figuring Opportunity Cost of Meat and Potatoes (amt produced/40 hrs) Meat Potatoes Farmer 2 lbs4 lbs Rancher 40 lbs5 lbs

25. Copyright © 2004 South-Western Steps to Figuring Opp Cost for Comp Adv 3.Create ratios for Opportunity Cost Analysis a)Create ratios horizontally for each Producer b)Output Problem—use Outside value over inside value first, then the reciprocal c)Input Problem—use Inside value over outside value first, then the reciprocal

26. Copyright © 2004 South-Western Figuring Opportunity Cost of Meat and Potatoes (amt produced/40 hrs) Meat Potatoes Farmer 2 lbs4 lbs Rancher 40 lbs5 lbs 4/22/4 5/40 40/5

27. Copyright © 2004 South-Western Steps to Figuring Opp Cost for Comp Adv d) Compare ratios vertically for each Item/Good

28. Copyright © 2004 South-Western Figuring Opportunity Cost of Meat and Potatoes (amt produced/40 hrs) Meat Potatoes Farmer 2 lbs4 lbs Rancher 40 lbs5 lbs 4/22/4 5/40 40/5

29. Copyright © 2004 South-Western Points to Remember using Matrices 5. Lowest Opp. Cost for each good determines producer

30. Copyright © 2004 South-Western Figuring Opportunity Cost of Meat and Potatoes (amt produced/40 hrs) Meat Potatoes Farmer 2 lbs4 lbs Rancher 40 lbs5 lbs 4/2 2/4 5/40 40/5 Which is smaller?

31. Copyright © 2004 South-Western …so, the Rancher has a comparative advantage in the production of meat, but the Farmer has a comparative advantage in the production of potatoes. Comparative Advantage and Trade

32. Copyright © 2004 South-Western Matrices for Comp Adv Calculations ProducerItem:

33. Copyright © 2004 South-Western Caveman Simulation ProducerItem:

34. Copyright © 2004 South-Western Hatfield’s and McCoy’s Problem ProducerItem:

35. Copyright © 2004 South-Western Figuring Opportunity Cost of Corn and Cloth (1 unit/amt hours) Corn Cloth Hatfields 8 hrs10 hrs McCoys 15 hrs12 hrs 8/10 10/8 15/12 12/15 Which is smaller?

36. Copyright © 2004 South-Western Types of Input vs Output Problems INPUT Problems: # of hours to produce 1 unit # of acres to produce 1 unit # of certain ingredients to produce 1 unit OUTPUT Problems: Tons per acre Miles per gallon Words per minute Apples per tree ETC

37. Copyright © 2004 South-Western Sample Word Problem In Italy, an automobile can be produced by 8 workers in 1 day and a washing machine by 3 workers in 1 day. In the U.S., an automobile can be produced by 6 workers in 1 day, and a washing machine by 2 workers in 1 day. Draw the matrix Absolute Advantage in autos? Absolute Advantage in washers? Comp Adv in washers? Comp Adv in autos?

38. Copyright © 2004 South-Western Bert and Betsy Another Classic example of looking at Opportunity Costs, Absolute and Comparative Advantage

39. Copyright © 2004 South-Western Household Chores (output/hr) Dishwashing (Number of sink loads) Sweeping (Number of trash loads) Bert11 Betsy23

40. Copyright © 2004 South-Western Points to Remember using Matrices 1.Set up your Matrix as per the model 2.Determine whether it is an Output or Input problem 3.Create your ratios of Opportunity Cost a)Create ratios horizontally for each Producer b)Output Problem—use Outside value over inside value first, then the reciprocal c)Input Problem—use Inside value over outside value first, then the reciprocal d) Compare ratios vertically for each Item/Good 5.Lowest Opp. Cost for each good determines producer

41. Copyright © 2004 South-Western Other Comp Adv Methods Using PPC curves and reading them to create a matrix, or for slope and opportunity cost

42. Copyright © 2004 South-Western Here’s the Matrix ProducerItem: Timber Item: Apples Oregon 4010 Washington 1040

43. Copyright © 2004 South-Western Here’s the PPC

44. Copyright © 2004 South-Western Read the PPC Slope calculations: For Oregon Slope is 40/10 (4) for Apples Slope is 10/40 (1/4) for Timber For Washington Slope is 10/40 (1/4) for Apples Slope is 40/10 (4) for Timber So…Oregon will produce Timber and Washington will produce apples—40 each.

45. Copyright © 2004 South-Western Figuring Terms of Trade Once you have figured Opportunity Costs… and seen who has Comp Adv in what—the two parties would produce that good totally and then trade some of that good to get some of the other. They would want to trade to better themselves overall from when they were self-sufficient

46. Copyright © 2004 South-Western Figuring Terms of Trade So…as long as the trading terms are set somewhere between their Opp. Costs, the two parties will be satisfied. Their Opp. Costs were between ¼ and 4 timbers for each apple. We can set trade at 1 timber for 1 apple. Let’s have them trade 20 for 20. Now, their consumption can be beyond where their PPC’s were with no trade.

47. Copyright © 2004 South-Western Figuring Terms of Trade

48. Copyright © 2004 South-Western Review The most efficient outcome/use of resources comes from production based on comparative advantage and then trading to get the different items. Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage. Trade can benefit countries because it allows nations to specialize in activities in which they have a comparative advantage.

49. Copyright © 2004 South-Western What is the basis for Comp Adv differences? Between PEOPLE: Temperament Skills Natural talents Between NATIONS: Climate Workforce skills Natural Resources Capital Stock

50. Copyright © 2004 South-Western Comp Advantage Trade Problems Find a Partner Get slates, markers, and Kleenex for erasers. Get Problem set cards from me Solve the comp advantage problem Write Number of Problem Listen for Instructions for method Show answers and Check Take home Germany/Poland wksht problem for practice