1. eStudy.us copyright © michael.roberson@eStudy.us 2010, All rights reserved Interdependence and the Gains from Trade

2. eStudy.us copyright © michael.roberson@eStudy.us 2010, All rights reserved Two goods: Corn and Wheat Two counties: U.S.A. and Canada If U.S.A produces only corn and Canada produces only wheat – both gain from trade If both U.S.A. and Canada produce both corn and wheat – they still gain from specialization and trade

3. eStudy.us copyright © michael.roberson@eStudy.us 2010, All rights reserved U.S.A. production possibilities frontier The left graph shows the combinations of corn and wheat that can be produced in the U.S.A. The right graph shows the combinations of corn and wheat that the can be produced in Canada. If there is no trade, each country’s production possibilities frontier is also the consumption possibilities frontier. Canada production possibilities frontier Wheat 0 20 50 Corn 60 100 A If there is no trade, then U.S.A. produces and consumes. 10 40 30 40 Wheat 0 Corn B If there is no trade, then Canada produces and consumes. Production Possibilities Frontier

4. eStudy.us copyright © michael.roberson@eStudy.us 2010, All rights reserved Specialization and trade – U.S.A specializes in growing corn more land growing corn less land raising wheat – Canada specializes in growing wheat more land growing wheat less land growing corn

5. eStudy.us copyright © michael.roberson@eStudy.us 2010, All rights reserved Comparative Advantage Absolute advantage – Produce a good using fewer inputs than another producer Opportunity cost – Whatever must be given up to obtain some item – Measures the trade-off between the two goods that each producer faces The opportunity cost of corn and wheat U.S.A.: 100 / 50 = 2 (opportunity cost of one bushel of wheat is two bushels of corn in the U.S.A.) Canada: 40 / 40 = 1 (opportunity cost of one bushel of wheat is one bushel of corn in Canada)

6. eStudy.us copyright © michael.roberson@eStudy.us 2010, All rights reserved Gains from trade (expands consumption opportunities) With specialization and trade the world adds 10 corn and 10 wheat that can not be produced otherwise 60 Would without Trade Corn Wheat U.S.A. Canada 20 3010 World 9030 100 Would with Trade Corn Wheat U.S.A. Canada 0 040 World 10040

7. eStudy.us copyright © michael.roberson@eStudy.us 2010, All rights reserved A country has a comparative advantage if opportunity cost is less than in other countries for a product A country – can have absolute advantage in both goods – can’t have comparative advantage in both goods Gains from specialization and trade – Based on comparative advantage – Total production in economy rises Increase in the size of the economic pie Everyone – better off

8. eStudy.us copyright © michael.roberson@eStudy.us 2010, All rights reserved Trade can benefit everyone in society – Allows people to specialize in activities The price of trade – Must lie between the two opportunity costs Principle of comparative advantage explains: – Interdependence – Gains from trade

9. eStudy.us copyright © michael.roberson@eStudy.us 2010, All rights reserved Should Tiger Woods mow his own lawn? Tiger Woods or Forrest Gump – Tiger Woods (Mow his lawn in 2 hours) – Forrest Gump (Mow Woods’s lawn in 4 hours) – Film a TV commercial and earn $10,000 (2 hours) – Work at McDonald’s and earn $36 (4 hours) Tiger Woods has the absolute advantage, but Forrest Gump has the comparative advantage. Forrest Gump should mow Tiger’s yard

10. eStudy.us copyright © michael.roberson@eStudy.us 2010, All rights reserved Should the U.S. trade with other countries? – Imports Goods produced abroad and sold domestically – Exports Goods produced domestically and sold abroad Principle of comparative advantage – Each good – produced by the country Smaller opportunity cost of producing that good Specialization and trade All countries – greater prosperity

11. eStudy.us copyright © michael.roberson@eStudy.us 2010, All rights reserved The U.S.A. produces a Corvette valued at $100,000 Germany products a Porsche valued at €100,000 Suppose one dollar can purchase 1.25 euros or it cost 80 cents to purchase one euro 0.80 = ($1/ €1.25) A Corvette would cost $100,000(1.25) = €125,000 A Porsche would cost €100,000 In the U.S.A. A Corvette would cost $100,000 A Porsche would cost only €100,000 (0.80) = $80,000 In Germany Only cost 80 cents to buy a euro A dollar cost 1.25 euros Both German and U.S.A. citizens will purchase Porsche cars. Currency Values and Trade

12. eStudy.us copyright © michael.roberson@eStudy.us 2010, All rights reserved The U.S.A. produces a Corvette valued at $100,000 Germany products a Porsche valued at €100,000 Now suppose one dollar can purchase 4/5 of a euro then one euro can purchase 1.25 dollars 1.25 = ($1/ €0.80) A Corvette would cost $100,000(0.80) = €80,000 A Porsche would cost €100,000 In the U.S.A. A Corvette would cost $100,000 A Porsche would cost only €100,000 (1.25) = $125,000 In Germany Both German and U.S.A. citizens will purchase Corvettes. Cost 1.25 dollars to buy a euro A dollar cost 0.80 euros Currency Values and Trade