Interdependence and the Gains from Trade PRINCIPLE #5: Trade Can Make Everyone Better Off!

Superficial explanations for why there is trade u Heterogeneity in the conditions of production u decreasing costs u differences in tastes

The Principle of Comparative Advantage is the deeper explanation for why there is specialization and trade.

A model of production showing the gains from trade Assumptions: u Gilligan and the Professor live on nearby islands. u Initially each is self sufficient. u Two goods: food and clothing u Labor is the only input and technology is fixed. u Each works 600 hours. u Both are indifferent between the production activities

Gilligan’s PPF foodclothing Professor’s PPF foodclothing

C F C F Figure 2.a Gilligan Figure 2.b Professor

C F C F Figure 2.a Gilligan Figure 2.b Professor This model illustrates Principle 7: Standards of living are determined by the productivity of labor.

Gilligan’s PPF foodclothing Gilligan’s opportunity cost of production clothing: 1/2 unit of food per unit of clothing food: 2 units of clothing per unit of food

The producer who can produce relatively more output using a given quantity of input(s) is said to have an absolute advantage. Equivalently, the producer having the absolute advantage can produce a given level of output using the smallest quantity of inputs.

The producer who has the lowest opportunity cost of production is said to have a comparative advantage. Gilligan has a comparative advantage in the production of clothing. The Professor has a comparative advantage in the production of food.

u The concept of absolute advantage focuses on the relative abilities of producers to transform inputs into outputs. u The concept of comparative advantage focuses on the relative abilities of producers to substitute one output into another output.

Insight: Even if one producer has an absolute advantage in the production of every good, the producer cannot have a comparative advantage in the production of all goods.

C F C F Figure 2.a Gilligan Figure 2.b Professor Example: Gilligan initially produces and consumes 200 units of F and 200 units of C (point a). The Professor only produces clothing and consumes the 200 units (point a’). a a’

Gilligan, proposes that he specialize in the production of clothing (produce less food) and that the Professor specialize in the production of food, in order for them to exploit their comparative advantages.

C F C F Figure 2.a Gilligan Figure 2.b Professor Gilligan proposes that he will give the professor 250 units of C in exchange for the Professor giving Gilligan 150 units of F. a a’

C F C F 250 a b c a’ b’ c’ Figure 4.a Gilligan Figure 4.b Professor

Through specialization and trade, each individuals, regions and countries can consume more than it is able to produce. How can this be? Trade allows each producer to specialize in the production of that good for which he (it) has a comparative advantage (i.e., lower opportunity cost) and trade for desired units of other goods.

250 units of C were exchanged for 150 units of F. u 5/3 units of C was exchanged for each on unit of F. u one unit of C was exchanged for 3/5 units of F. u The terms of trade measure the number of units of one good that must be given up in exchange for each additional unit of the other.

Terms of trade in example: One unit of food can be traded for 5/3 units of clothing. One unit of clothing can be traded for 3/5ths of a unit of food. Gilligan: His opportunity cost of producing a unit of food is 2 clothing units. His opportunity cost of trading for a unit of food is 5/3 units of clothing. Gilligan has an incentive to obtain food through trade because it is less costly. The Professor: His opportunity cost of producing a unit of clothing is ¾ food units. His opportunity cost of trading for a unit of clothing is 2/3 food units. It is less costly for the Professor to obtain clothing through trade. Note that trade will be mutually beneficial for any of a range of values for the terms of trade. Gilligan and the Professor will find trade advantageous as long as the terms of trade are between 2 units of clothing per unit of food and 4/3 units of clothing per unit of good or, equivalently, between 1/2 and ¾ units of food per unit of clothing.

C F Figure 2.a Gilligan Suppose Gilligan is initially self sufficient, producing and consuming the output combination at “a”. He has the opportunity to trade F and C in a barter market where the exchange rate is 5/3 units of C for each unit of F. Can he do better than produce and consume at “a”. a Opportunity cost of a unit of F in exchange: 5/3 C Opportunity cost of a unit of F in production: 2 C

C F Gilligan’s production possibilities Suppose Gilligan is initially self sufficient, producing and consuming the output combination at “a”. He has the opportunity to trade F and C in a barter market where the exchange rate is 5/3 units of C for each unit of F. Can he do better than produce and consume at “a”. a Opportunity cost of a unit of F in exchange: 5/3 C Opportunity cost of a unit of F in production: 2 C 360 Gilligan’s consumption possibilities with trade

Specialization is beneficial when inputs are used to produce the goods and services for which they are relatively best suited (i.e., have a comparative advantage or, equivalently, relatively low opportunity cost). Such specialization is required for there to be production efficiency.

Gilligan’s Production Possibilities The Professor’s Production Possibilities FoodClothingFoodClothing Joint Production Possibilities FoodClothing A 0800 B C D 300 E 4500

C F a b c r Figure 5