1. Module Comparative Advantage and Trade KRUGMAN'S MACROECONOMICS for AP* 4 Margaret Ray and David Anderson

2. What you will learn in Module 4 : How trade leads to gains for an individual or an economy The difference between absolute advantage and comparative advantage How comparative advantage leads to gains from trade in the global marketplace REMEMBER, economics is the study of how societies produce and distribute goods in an attempt to satisfy the wants and needs of their members

3. GAINS FROM TRADE Who made your shoes? What have you eaten today? Who grew/manufactured the food you ate? Why didn’t you perform these tasks yourself? Are you better off because you can focus on being a student while someone else focuses on growing food or manufacturing our clothes?

4. Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services. Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage Gains from Trade Trade Gains from trade Specialization The importance of markets

5. SPECIALIZATION and TRADE Countries/Individuals trade to maximize production- specialization is the KEY!  Specialization is concentrating on the task/production of only one good.  The economy, as a whole, can produce more when each person specializes in a task and trades with others.  Countries/Individuals can get more of what they want through trade than attempting to be self- sufficient

6. GAINS FROM TRADE You wake up to an alarm clock made in China. Check your phone made in China or Korea You pour yourself orange juice made from Florida oranges and coffee from beans grown in Brazil. You put on some clothes made of cotton grown in Georgia and sewn in factories in Thailand. You watch the morning news broadcast from New York on your TV made in Korea. You drive to class in a car made of parts manufactured in a half-dozen different countries.... and you haven’t been up for more than two hours yet!

7. The basic principle of comparative advantage rests on differing opportunity costs of producing various G/S. Trading partners can both benefit if they specialize and trade based upon comparative advantage Comparative Advantage and Gains from Trade Comparative Advantage Terms of Trade Absolute Advantage

8. GAINS FROM TRADE and SPECIALIZATION A person has a comparative advantage in an activity if he or she can perform the activity at lower opportunity cost than someone else People gain from specializing in production according to comparative advantage and then trade with others An absolute advantage occurs when one person is more productive than another person in several or even all activities A person can have an absolute advantage in all activities but cannot have a comparative advantage in all activities

9. Interdependence and the Gains from Trade Why is interdependence the norm? Interdependence occurs because people are better off when they specialize and trade with others. What determines the pattern of production and trade? Patterns of production and trade are based upon differences in opportunity costs.

10. Absolute and Comparative Advantage  Specialization is the KEY—specialize a in what a country/individual is good at and trade with others!  Absolute Advantage- One nation can produce more output with the same quantity of inputs (factors of production) as the other.  Comparative Advantage- One nation can produce a good at a lower opportunity cost than the other- determines how countries specialize

11. DIFFERENCES between Absolute and Comparative Advantage  Absolute versus relative productivity differences  Comparative Advantage incorporates the concept of opportunity cost  Value of what is given up to get the good

12. Absolute and Comparative Advantage CAUSE AND EFFECT OF NATIONS TRADING RESOURCE DISTRIBUTION ABSOLUTE and COMPARATIVE ADVANTAGE TRADE  Natural resources  Human and physical capital  Resources distributed unevenly  Best for countries to specialize and trade  Absolute: greater production with given amount of resources  Comparative: country that can produce with lowest opportunity cost  Countries specialize in goods in which they have comparative advantage  Comparative advantage and world trade result in interdependence

13. Absolute and Comparative Advantage CAUSE AND EFFECT OF NATIONS TRADING--Quick facts:  The distribution of natural resources, capital, and labor help determine what goods and services nations will export and import.  Absolute advantage and comparative advantage cause countries to specialize in making some products and to trade for others.  The U.S. is the world’s second-largest exporter of goods, the largest exporter of services, and the world’s top importer.  Trade can change a nation’s employment patterns by creating new jobs opportunities while causing other jobs to be lost.

14. © 2007 Thomson South-Western Imagine an economic system with only two goods, potatoes and meat and only two people, a potato farmer and a cattle rancher What should each person produce? Why should these people trade? A PARABLE FOR THE MODERN ECONOMY

15. © 2007 Thomson South-Western Interdependence and Trade As a result of specialization and trade, both farmers will consume outside their production possibilities curve (PPC) and both gain from trade.

16. © 2007 Thomson South-Western

17. Production Possibilities Suppose the farmer and rancher decide not to engage in trade: Each consumes only what he or she can produce alone. The production possibilities frontier is also the consumption possibilities frontier. Without trade, economic gains are diminished.

18. © 2007 Thomson South-Western Figure 1 The Production Possibilities Frontier Potatoes (ounces) 4 16 8 32 A 0 Meat (ounces) (a) The Farmer’s Production Possibilities Frontier If there is no trade, the farmer chooses this production and consumption. Copyright©2003 Southwestern/Thomson Learning

19. © 2007 Thomson South-Western Figure 1 The Production Possibilities Curve Copyright©2003 Southwestern/Thomson Learning Potatoes (ounces) 12 24 B 0 Meat (ounces) (b) The Rancher’s Production Possibilities Frontier 48 24 If there is no trade, the rancher chooses this production and consumption.

20. © 2007 Thomson South-Western Production and Consumption Without Trade

21. © 2007 Thomson South-Western The farmer should produce potatoes. The rancher should produce meat. Specialization and Trade Suppose instead the farmer and the rancher decide to specialize and trade… Both would be better off if they specialize in producing the product they are more suited to produce, and then trade with each other.

22. © 2007 Thomson South-Western Figure 2 How Trade Expands the Set of Consumption Opportunities Copyright©2003 Southwestern/Thomson Learning Potatoes (ounces) 4 16 5 17 8 32 A A* 0 Meat (ounces) (a) The Farmer’s Production and Consumption Farmer's production and consumption without trade Farmer's consumption with trade Farmer's production with trade

23. © 2007 Thomson South-Western Figure 2 How Trade Expands the Set of Consumption Opportunities Copyright © 2004 South-Western Potatoes (ounces) 12 24 13 27 B 0 Meat (ounces) (b) The Rancher’s Production and Consumption 48 24 12 18 B* Rancher's consumption with trade Rancher's production with trade Rancher's production and consumption without trade

24. © 2007 Thomson South-Western COMPARATIVE ADVANTAGE Differences in the costs of production determine the following: –Who should produce what? –How much should be traded for each product?

25. © 2007 Thomson South-Western COMPARATIVE ADVANTAGE Two ways to measure differences in costs of production: –The number of hours required to produce a unit of output (for example, one pound of potatoes). –The opportunity cost of sacrificing one good for another.

26. © 2007 Thomson South-Western Absolute Advantage The comparison among producers of a good according to their productivity. Describes the productivity of one person, firm, or nation compared to that of another. The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good.

27. © 2007 Thomson South-Western The Rancher has an absolute advantage in the production of both meat and potatoes. Absolute Advantage The Rancher needs only 10 minutes to produce an ounce of potatoes, whereas the Farmer needs 15 minutes. The Rancher needs only 20 minutes to produce an ounce of meat, whereas the Farmer needs 60 minutes.

28. © 2007 Thomson South-Western Opportunity Cost and Comparative Advantage Compares producers of a good according to their opportunity cost, that is, what must be given up to obtain some item The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good. Who has the comparative advantage in the production of each good? ? ?

29. © 2007 Thomson South-Western Comparative Advantage and Trade Potato costs… The Rancher’s opportunity cost of an ounce of potatoes is ¼ an ounce of meat. The Farmer’s opportunity cost of an ounce of potatoes is ½ an ounce of meat. Meat costs… The Rancher’s opportunity cost of a pound of meat is only 4 ounces of potatoes. The Farmer’s opportunity cost of an ounce of meat is only 2 ounces of potatoes...

30. © 2007 Thomson South-Western Comparative Advantage and Trade … so, the Rancher has a comparative advantage in the production of meat but the Farmer has a comparative advantage in the production of potatoes.

31. © 2007 Thomson South-Western Comparative Advantage and Trade Comparative advantage and differences in opportunity costs are the basis for specialized production and trade. Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade.

32. © 2007 Thomson South-Western Gains from Trade

33. © 2007 Thomson South-Western Comparative Advantage and Trade Benefits of Trade Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage.

34. Production Possibilities for Two Countries

35. Will these two countries gain from trade if 100 units of malaria medicine are traded for 200 cotton shirts? To find out: 1. Calculate the opportunity costs of production for each country 2. Determine the comparative advantage for each country 3. Determine if the terms of trade are mutually beneficial Production Possibilities for Two Countries

36. BangladeshUnited States Cotton Shirts (C) 750C = 250M 1C = 1/3M 1000C =1000M 1C = 1M Malaria Medicine (M) 250M = 750C 1M = 3C 1000M =1000C 1M = 1C Production Possibilities for Two Countries

37. BangladeshUnited States Cotton Shirts (C) 750C = 250M 1C = 1/3M 1000C =1000M 1C = 1M Malaria Medicine (M) 250M = 750C 1M = 3C 1000M =1000C 1M = 1C The United States has a comparative advantage in Malaria Medicine (M) because they only give up 1 cotton shirt while Bangladesh must give up 3 cotton shirts to gain 1 unit of medicine. Bangladesh has a comparative advantage in Cotton Shirts (C) because they only give up 1/3 unit of medicine while The United States must give up 1 unit of medicine to gain 1 cotton shirt. Production Possibilities for Two Countries

38. BangladeshUnited States Cotton Shirts (C) 750C = 250M 1C = 1/3M 1000C =1000M 1C = 1M Malaria Medicine (M) 250M = 750C 1M = 3C 1000M =1000C 1M = 1C The terms of trade are mutually beneficial as long as they are between the two countries’ opportunity costs. For example, any amount of medicine greater than 1/3 and less than 1 traded for 1 cotton shirt would represent mutually beneficial terms of trade. Likewise, any number of cotton shirts greater than 1 and less than 3 traded for 1 unit of medicine would represent mutually beneficial terms of trade. Production Possibilities for Two Countries

39. © 2007 Thomson South-Western FYI—The Legacy of Adam Smith and David Ricardo Adam Smith In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith performed a detailed analysis of trade and economic interdependence, which economists still adhere to today. David Ricardo In his 1816 book Principles of Political Economy and Taxation, David Ricardo developed the principle of comparative advantage as we know it today.

40. © 2007 Thomson South-Western APPLICATIONS OF COMPARATIVE ADVANTAGE Should Tiger Woods Mow His Own Lawn? ? ? ? ?