1 Interdependence And The Gains From Trade Trade can make everyone better off

2 Revisiting how people interact Trade can make every one better off. Markets are a good way to organize economic activity Governments can sometimes improve market outcomes People provide you with goods and services they produce because they get something in return (recall the operation of Smith’s “Invisible hand”)

3 Demonstration of gains from trade There are two goods in the economy: Meat Oranges There are two producers in the economy: USA New Zealand Gains from trade are obvious if each of them produces only one type of good the second good can be produced only at a great cost

4 Demonstration of gains from trade The gains from trade are less obvious when one person/country is better at producing both goods. Is it better to remain self-sufficient?

5 Demonstration of gains from trade USA and New Zealand CountryQuantity (kg) produced in 1 hr Quantity (kg) produced in 8 hrs MeatOrangesMeatOranges USA3324 NZ

6 Demonstration of gains from trade The PPF shows all the production possibilities that each of the countries can produce In the absence of trade (self-sufficiency) the PPF becomes the consumption possibilities frontier. With trade, both the countries can produce more of one commodity and consume more of both commodities

7 Demonstration of gains from trade Meat Oranges PPF Why is the PPF a straight line instead of being concave? Is it something to do with technology?

8 Demonstration of gains from trade With out tradeWith trade Production & Consumption ProductionTradeConsumptionGains USA12 kg Meat &12 kg Oranges 0 kg Meat & 24 kg Oranges* Gets 14 kg Meat for 7 kg Oranges 14 kg Meat & 17 kg Oranges 2 kg Meat & 5 kg Oranges NZ96 kg Meat & 24 kg Oranges 120 kg Meat & 18 kg Oranges** Gives 14 kg Meat for 7 kg Oranges 106 kg Meat & 25 kg Oranges 10 kg Meat &1 kg Oranges *All 8 hours are spent on production of oranges **5 hours are spent on meat production and 3 hours on production of oranges

9 Interdependence and the gains from trade Principle of absolute advantage compares producers of a good according to their productivity Principle of comparative advantage compares producers of a good according to their opportunity cost With trade, both countries can produce more of one commodity and consume more of both commodities (founded upon principle of comparative advantage)

10 Demonstration of principle of comparative advantage The producer with a lower opportunity cost of producing a good has a comparative advantage in producing that good and should specialize in the production of that good. CountryOpportunity Cost of oranges in terms of meat Opportunity Cost of meat in terms of oranges USA11 NZ41/4

11 Interdependence and the gains from trade It is impossible for a producer to have a comparative advantage in the production of both the goods. Why? If two producers have different opportunity costs they gain from trade as the price of the good they buy is less than their opportunity cost for that good

12 Interdependence and the gains from trade To summarize: Comparative advantage Specialization Economic well-beingIncrease in production Gains from trade Trade

13 Applications of comparative advantage: International trade Countries: Canada and Japan Commodities: Food and Cars Food Cars Food Canada's PPF Japan's PPF

14 Applications of comparative advantage: International trade Who should export cars? Who should import food? Why should Canada and Japan trade? Try to figure out on your own! If not, look into your textbook.