Interdependence and The Gains From Trade Chapter 3 Interdependence and The Gains From Trade 1

Interdependence and Trade Economics studies how society produces and distributes goods and services so that wants and needs are satisfied. 2

How Do We Satisfy Our Wants and Needs? We can be economically Self-Sufficient. We can specialize and trade with others leading to Economic Interdependence. 3

Interdependence & Trade A general observation . . . Individuals and nations rely on specialized production and exchange as a way to address problems caused by scarcity. This gives rise to two questions. . . Why is interdependence the norm? What determines production & trade? 4

Interdependence & 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 & trade? Patterns of production and trade are based upon differences in opportunity costs. 5

Interdependence and Trade: “A Parable for the Modern Economy” Imagine... … only two goods (potatoes and meat) … only two people (potato farmer and a cattle rancher) What should each produce? Why should they trade? 6

A World of Self-Sufficiency Farmer Rancher PPF PPF Meat Meat Potatoes Potatoes 7

A World of Self-Sufficiency By ignoring each other: the farmer and rancher will produce a limited amount of meat and potatoes. each consumes what they each produce. each is not subject to tradeoffs between meat and potatoes. 8

Self-Sufficiency: without trade, economic gains are limited. Farmer Rancher 2 40 Meat Meat 1 20 2.5 5 2 4 Potatoes Potatoes 9

Specialization and Trade [Table 3-2 & Figure 3-2] If the farmer and the rancher were to specialize in producing the product that they were more suited to produce, and then trade with each other, they would be better off. Farmer should produce potatoes. Rancher should produce meat. Farmer and Rancher should trade. 10

The Principle of Comparative Advantage What determines who should produce what? And how much should be traded for each product? Differences in Costs of Production Who can produce products (e.g. potato, meat) at a lower cost? There are two ways to measure... 11

The Principle of Comparative Advantage Measuring differences in costs of production: Hours required to produce a standardized unit of output. One pound of potatoes Opportunity Cost - amount of one item sacrificed to obtain another. 12

Absolute Advantage Describes the productivity of one person, firm, or nation to that of another. - The producer that can produce more with the same quantity of inputs is said to have an absolute advantage in producing that good. 13

Comparative Advantage Compares producers of a good according to their opportunity cost. - The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good. 14

Specialization and Trade Who has the absolute advantage: The Farmer or The Rancher? Who has the comparative advantage: 15

Self-Sufficiency: without trade, economic gains are limited. Farmer Rancher 2 40 Meat Meat 1 20 2.5 5 2 4 Potatoes Potatoes 9

Specialization and Trade If the Rancher and the Farmer trade, who will trade meat and who will trade potatoes?

The Principle of Comparative Advantage 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. 16

The Principle of Comparative Advantage Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage. 17

Applications of Comparative Advantage Michael Jordan mowing his lawn or shooting a commercial? Opportunity Costs. . . Absolute Advantage. . . Gains from trade. . . 18

Applications of Comparative Advantage Should the United States trade with Other Countries (e.g. Japan)? Imports Exports Opportunity costs 19

Trade: U.S. and Japan Food Food U.S. Japan 4 2 2 2 Cars Cars 20

Opportunity Cost: Sacrifice of Food Production for Car Production U.S. Computing Opportunity Cost Slope of PPF: (0-4) ÷ (2-0) = 2 Units of food given up to get 1 Unit of a car. 4 2 Cars 21

Opportunity Cost: Sacrifice of Food Production for Car Production U.S. Computing Opportunity Cost Slope of PPF: (0-4) ÷ (2-0) = 1/2 Unit of a car given up to get 1 Unit of food 4 2 Cars 23

Opportunity Cost: Sacrifice of Food Production for Car Production U.S. Computing Opportunity Cost Slope of PPF: (0-4) ÷ (2-0) = 2 Units of food given up to get 1 Unit of a car 4 2 Cars 23

Opportunity Cost: Sacrifice of Food Production for Car Production Japan Computing Opportunity Cost Slope of PPF: ( - ) ÷ ( - ) = __ Units of food given up to get __Unit of a car 2 2 Cars 24

Interdependence: U.S. & Japan Who should produce cars and who should produce food? Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services. Founded upon the. . . Principle of Comparative Advantage 25