G AINS FROM T RADE ETP Economics 101 Lecturer: Jack Wu

R ECALL The production possibilities frontier is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology.

S HAPE OF P RODUCTION P OSSIBILITIES F RONTIER Concave curve (bowed outward): The opportunity cost of producing one good increases as the production of this good rises. REASON: Some resources are better suited to the production of this good than another good (and vice versa). Straight line: The opportunity cost of producing one good is constant as the production of this good rises.

N OW Let’s use the “Production Possibilities Frontier” to analyze trade problems.

A UTARKY OR T RADE ? How do we satisfy our wants and needs in a global economy? We can be economically self-sufficient (Autarky). We can specialize and trade with others, leading to economic interdependence.

C ASE 1 only two goods: potatoes and meat only two people: a potato farmer and a cattle rancher Each only works 8 hours/day What should each produce? Why should they trade?

C ASE 1 ( CONTINUED ) Minutes needed to make 1 ounce of ___________________________________ Meat Potatoes ___________________________________ Farmer 60min/oz 15min/oz Rancher 20min/oz 10min/oz

C ASE 1 ( CONTINUED ) Amounts produced in 8 hours ___________________________________ Meat Potatoes ___________________________________ Farmer 8 oz 32 oz Rancher 24 oz 48 oz

T HE F ARMER ’ S P RODUCTION P OSSIBILITIES F RONTIER Potatoes (ounces) Meat (ounces) (a) The Farmer’s Production Possibilities Frontier

T HE R ANCHER ’ S P RODUCTION P OSSIBILITIES F RONTIER Potatoes (ounces) 0 Meat (ounces) (b) The Rancher’s Production Possibilities Frontier 48 24

OPPORTUNITY COST Opportunity cost Whatever must be given up to obtain some item Measures the trade-off between the two goods that each producer faces

O PPORTUNITY C OSTS 1oz of meat1oz of potatoes Farmer4 oz of potatoes¼ oz of meat Rancher2 oz of potatoes½ oz of meat

A BSOLUTE A DVANTAGE The comparison among producers of a good according to their productivity — absolute advantage 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.

C OMPARATIVE A DVANTAGE Compares producers of a good according to their opportunity cost. Whatever 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.

APPLICATION Should Tiger Woods mow his own lawn? Woods Mow his lawn in 2 hours Film a TV commercial and earn $10,000 (2 hours)

Q UICK Q UIZ 1 Who has the absolute advantage? The farmer or the rancher? Who has the comparative advantage? The farmer or the rancher?

S PECIALIZATION AND T RADE Comparative advantage and differences in opportunity costs are the basis for specialized production and trade.

Q UICK Q UIZ 2 What should farmer produce (or specialize in)? What should rancher produce (or specialize in)?

B ENEFITS OF T RADE Whenever potential trading parties have differences in opportunity costs, they can each benefit from 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.

S ELF -S UFFICIENCY (A UTARKY ) By ignoring each other: Each consumes what they each produce. The production possibilities frontier is also the consumption possibilities frontier. Without trade, economic gains are diminished.

S ELF -S UFFICIENCY (A UTARKY ) Assume: Farmer spends 4 hours on meat and 4 hours on potatoes. Rancher spends 4 hours on meat and 4 hours on potatoes.

W ITHOUT T RADE Production: Farmer produces 4 oz of meat and 16 oz of potatoes. Rancher produces 12 oz of meat and 24 oz of potatoes. Consumption: Farmer consumes 4 oz of meat and 16 oz of potatoes. Rancher consumes 12 oz of meat and 24 oz of potatoes.

T HE F ARMER ’ S P RODUCTION AND C ONSUMPTION W ITHOUT T RADE Copyright©2003 Southwestern/Thomson Learning Potatoes (ounces) A 0 Meat (ounces) (a) The Farmer’s Production and Consumption Farmer's production and consumption without trade

T HE R ANCHER ’ S P RODUCTION AND C ONSUMPTION W ITHOUT T RADE Copyright © 2004 South-Western Potatoes (ounces) B 0 Meat (ounces) (b) The Rancher’s Production and Consumption Rancher's production and consumption without trade

P ROPOSALS FOR S PECIALIZATION Farmer devotes all his time to growing potatoes. Rancher spends 6 hours a day raising cattle and 2 hours growing potatoes.

P RODUCTION WITH T RADE Farmer’s production with trade: 0 oz of meat and 32 oz of potatoes Rancher’s production with trade: 18 oz of meat and 12 oz of potatoes.

P ROPOSAL FOR T RADE The price of trade Must lie between the two opportunity costs Trade deal: Farmer gives rancher 15 oz of potatoes, and rancher gives farmer 5 oz of meat in return. Note: Price of Meat: 2~4 oz of potatoes Note: Price of Potatoes: 1/4 oz ~1/2 oz of meat

H OW TRADE EXPANDS THE SET OF CONSUMPTION OPPORTUNITIES 28 The gains from trade: A summary FarmerRancher MeatPotatoesMeatPotatoes Without trade: Production and consumption With trade: Production Trade Consumption GAINS FROM TRADE: Increase in consumption 4 oz 0 oz Gets 5 oz 5 oz +1 oz 16 oz 32 oz Gives 15 oz 17 oz +1 oz 12 oz 18 oz Gives 5 oz 13 oz +1 oz 24 oz 12 oz Gets 15 oz 27 oz +3 oz

C ONSUMPTION WITH T RADE Farmer’s consumption with trade: 5 oz of meat and 17 oz of potatoes Rancher’s consumption with trade: 13 oz of meat and 27 oz of potatoes.

H OW T RADE E XPANDS THE F ARMER ’ S S ET OF C ONSUMPTION O PPORTUNITIES Potatoes (ounces) 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

H OW T RADE E XPANDS THE R ANCHER ’ S S ET OF C ONSUMPTION O PPORTUNITIES Potatoes (ounces) B 0 Meat (ounces) (b) The Rancher’s Production and Consumption B* Rancher's consumption with trade Rancher's production with trade Rancher's production and consumption without trade

I NTERNATIONAL T RADE Each country has many citizens with different interests. International trade can make some individuals worse off, even as it makes the country as a whole better off. Imports — goods produced abroad and sold domestically Exports — goods produced domestically and sold abroad

Q UICK Q UIZ 3 Martha and Stewart each spend 8 hours a day wallpapering and painting: Hours needed to Do 1 Room Paint Wallpaper Martha 2 hours/room 8 hours/room Stewart 4 hours/room 10 hours/room

QUICK QUIZ 4 Suppose that a worker in Cornland can grow either 40 bushels of corn or 10 bushels of oats per year, and a worker in Oatland can grow either 20 bushels of corn or 5 bushels of oats per year. There are 20 workers in Cornland and 20 workers in Oatland. Which of the following statements is true? a.Both countries could gain from trade with each other. b.Neither country would gain from trade because Cornland has an absolute advantage in both goods. c.Neither country would gain from trade because neither one has a comparative advantage. d.Only Oatland could possibly gain from trade.