Interdependence and the Gains From Trade 3 Interdependence and the Gains From Trade

Why Should We Study Trade? People trade with each other Do you know anyone who makes all the things he or she consumes? To understand our world we need to understand why people trade so much We need to understand whether trade is good for us or bad for us. Understanding this is important precisely because we trade a lot. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

A Parable For The Modern Economy Imagine a world with … only two goods: potatoes and meat only two people: a potato farmer and a cattle rancher What amounts should each produce? Should they trade? CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE By the way… Q: Why am I assuming a world with only two goods and two people? A: Simplicity is often key to clarifying an idea Q: Okay, but in that case why not assume a world with just one good and/or one person? CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE Opportunity cost Suppose the farmer can produce both meat and potatoes As the farmer has a finite amount of the resources needed for production, the production of an additional ounce of meat necessarily reduces the quantity of potatoes the farmer can produce The reduction in potato production caused by the production of an additional ounce of meat is called the opportunity cost of meat CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Opportunity cost and trade Suppose the opportunity cost of an ounce of meat is 3 ounces of potatoes for both famer and rancher Will they trade? No. Trade would be pointless in this case. Opportunity Costs Meat Potatoes Farmer 3 Rancher By the way, can you fill in the blank cells in the table? 1/3 1/3 CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Opportunity cost and trade Now will they trade? Yes! Rancher will offer to sell meat to farmer at a price between 2 and 4 ounces of potatoes per ounce of meat Farmer will gladly accept Both farmer and rancher will be better off Opportunity Costs Meat Potatoes Farmer 4 Rancher 2 Again, can you fill in the blank cells in the table? 4 1/4 2 1/2 CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Opportunity cost and trade Therefore, we have just seen that opportunity cost is key to understanding virtually every aspect of trade If opportunity costs are equal, there will be no trade If opportunity costs are different, there will be trade The price at which the trading occurs will be somewhere between the two traders’ opportunity costs The person with the lower opportunity cost of meat will be the meat seller (exporter) and potato buyer This person is said to have a comparative advantage in meat production The person with the higher opportunity cost of meat will be the meat buyer (importer) and potato seller CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Opportunity cost and trade Trade makes people specialize in the production of the good they have a comparative advantage in Rancher has a comparative advantage in producing meat. Trade gives the rancher the incentive to expand meat production for sale (export) to the farmer That is, trade gives the rancher the incentive to specialize in what he does best Opportunity Costs Meat Potatoes Farmer 4 ¼ Rancher 2 ½ 4 ½ 2 ¼ CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE Opportunity costs We have just seen that opportunity costs are key to trade What makes opportunity costs vary from person to person or from country to country? One answer is technology: different people may have different technologies CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Production Technologies of the Farmer and Rancher These technology numbers can be used to calculate opportunity costs CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Opportunity Costs of Farmer 1 ounce of meat → 60 minutes → 4 ounces of potatoes. Therefore, Farmer’s opportunity cost of 1 ounce of meat is 4 ounces of potatoes. Table 1 Opportunity Costs Meat Potatoes Farmer 4 Rancher

Opportunity Costs of Farmer 1 ounce of potatoes → 15 minutes → 1/4 ounces of meat. Therefore, Farmer’s opportunity cost of 1 ounce of potatoes is 1/4 ounces of meat. Table 1 Opportunity Costs Meat Potatoes Farmer 4 ¼ Rancher

Opportunity Costs of Rancher 1 ounce of meat → 20 minutes → 2 ounces of potatoes. Therefore, Rancher’s opportunity cost of 1 ounce of meat is 2 ounces of potatoes. Table 1 Opportunity Costs Meat Potatoes Farmer 4 ¼ Rancher 2

Opportunity Costs of Rancher 1 ounce of potatoes → 10 minutes → 1/2 ounces of meat. Therefore, Rancher ’s opportunity cost of 1 ounce of potatoes is 1/2 ounces of meat. Table 1 Opportunity Costs Meat Potatoes Farmer 4 ¼ Rancher 2 ½

Opportunity Costs and Comparative Advantage It follows that, Farmer has a comparative advantage in potatoes and Rancher has a comparative advantage in meat. Table 1 Opportunity Costs Meat Potatoes Farmer 4 ¼ Rancher 2 ½

Technological differences are an important reason why we trade To sum up, we have so far seen that Trade happens if and only if opportunity costs vary from person to person (or from country to country) Differences in technological abilities can lead to differences in opportunity costs CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Differences Make Trade Useful Had the opportunity costs of Farmer and Rancher been equal, the proof of the Theory of Comparative Advantage would not have worked. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

But Differences Can’t be the Whole Story Why is Canada our main trade partner despite being so similar to the US? CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Other Reasons Why Trade Is Good for Us Trade allows us to fully utilize the benefits of bulk production by allowing each country’s production to be sold everywhere. Trade intensifies competition and squeezes out inefficient production. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Exercise: calculation of opportunity costs from technology We have seen how opportunity costs can be calculated from the 2nd and 3rd columns (blue border) of the technology table below But can you do it using the 4th and 5th columns (brown border) instead? Table 1 Opportunity Costs Meat Potatoes Farmer Rancher

Graphing production possibilities CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Rancher’s Production Possibilities: Further Details Time Spent on Production of… Amount Produced Meat Potatoes 8 48 2 6 36 4 12 24 18 CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Figure 1 The Rancher’s Production Possibilities Frontier (b) The Rancher ’ s Production Possibilities Frontier Meat (ounces) 48 24 Amount Produced Meat Potatoes 48 6 36 12 24 18 If there is no trade, the rancher might choose this production and consumption. 12 18 C 12 24 B 36 6 Potatoes (ounces) CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

The Production Possibilities Frontier If either person increases his production of meat, his production of potatoes must decrease. See the table in the previous slide and the Production Possibilities Curve in Figure 1 When there is no trade, each person must consume what he produces. In that case, if either person increases his consumption of meat, his consumption of potatoes must decrease. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Farmer’s Production Possibilities Time spent on production of… Amount Produced Meat Potatoes 8 32 2 6 24 4 16 CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Figure 1 The Farmer’s Production Possibilities Frontier (a) The Farmer ’ s Production Possibilities Frontier Meat (ounces) Amount Produced Meat Potatoes 32 2 24 4 16 6 8 2. If the farmer wants more meat, he can go from A to B. If there is no trade, the farmer might choose this production and consumption. B 8 32 3. Gain 4 ounces of meat A 4 16 4. Lose 16 ounces of potatoes 8. Lose 4 ounces of meat C 5. The opportunity cost of 1 ounce of meat is, therefore, 4 ounces of potatoes. 7. Gain 16 ounces of potatoes Potatoes (ounces) 6. If the farmer wants more potatoes, he can go from A to C. 9. The opportunity cost of 1 ounce of potatoes is therefore ¼ ounces of meat

The Production Possibilities Frontier Can Shift (a) The Farmer ’ s Production Possibilities Frontier Meat (ounces) If more or better resources become available or if more advanced technology becomes available, the PPC will move outward. In that case it might be possible to produce more of both goods, as in the move from A to B. 8 32 B A 4 16 Potatoes (ounces) CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

More Meat and More Potatoes? It may be possible to increase one’s consumption of both meat and potatoes—as in the last slide—if… More resources or better resources become available, or Technology becomes more advanced, or Farmer and Rancher begin to trade CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

More Meat and More Potatoes? Trade can increase the overall production—and consumption—of both goods even if resources and technology remain unchanged. This is the miracle of trade. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

The Production Possibilities Frontier The production possibilities frontier is a graph that shows the combinations of output that the economy can produce, given the available factors (resources) of production and the available production technology. This and the next three slides are from Chapter 2. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 14

The Production Possibilities Frontier Quantity of Computers This PPF illustrates Increasing Opportunity Costs or Diminishing Returns: as production of a commodity increases, so does its opportunity cost From E to A, the opp. cost of a car is (3000 – 2200)/600 = 1.33 From A to B, the opp. cost of a car is (2200 – 2000)/(700 – 600) = 2 From B to F, the opp. cost of a car is 2000/(1000 – 700) = 6.67 Produced 3,000 E C A 2,200 600 B 700 2,000 1,000 300 D F Quantity of 1,000 Cars Produced

The Production Possibilities Frontier Concepts illustrated by the production possibilities frontier Efficiency Trade-offs Opportunity cost Economic growth CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 21

A Shift in the Production Possibilities Frontier Quantity of Computers Produced 4,000 Can trade alone take us from A to G? 3,000 1,000 2,300 650 G 2,200 600 A Quantity of CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE Cars Produced

Revisiting the theory of comparative advantage CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE Why Is Trade Good for Us? Trade benefits both the Farmer and the Rancher by enabling each person to do only what he is better suited to do. Imagine what it would be like if you were required to produce everything that you needed. The situation would be similarly awful for a country that either chose not to trade with other countries or was forced to end all trade with other countries. There are additional reasons why trade is good for us. Those reasons will be briefly discussed later. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Theory of Comparative Advantage The Theory of Comparative Advantage says that if each person specializes in producing what he or she has a comparative advantage in, then total production of every good can increase and, As a result, trade can benefit everybody. In our example, the theory says that if Farmer specializes in potatoes and Rancher specializes in meat, the total production of meat can be increased and the total production of potatoes can also be increased. As a result, if Rancher and Farmer then trade, they could both benefit. But is this theory true? CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Theory of Comparative Advantage—Proof Suppose Farmer increases his production of potatoes by 4 ounces. Then, according to Table 1, his production of meat must decrease by 1 ounce. Suppose Rancher increases his production of meat by 1.5 ounces. Then his production of potatoes must decrease by 3 ounces. Therefore, by making these two people specialize according to their comparative advantages, it is possible to increase the total output of meat by 0.5 ounces and of potatoes by 1 ounce. Table 1 Opportunity Costs Meat Potatoes Farmer 4 ¼ Rancher 2 ½

Wow! Change in Production Potatoes Meat Farmer +4 -1 Rancher -3 +1.5 We have just witnessed a miracle—the miracle of trade. For an individual, it is impossible to make more of one good without making less of some other good. But for the world as a whole, it is possible to produce more of all goods simultaneously if we embrace trade. Change in Production Potatoes Meat Farmer +4 -1 Rancher -3 +1.5 Total +1 +0.5

Applications Of Comparative Advantage Should Tiger Woods mow his own lawn? Should the United States trade with other countries? CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

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. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE Terms of Trade In showing how trade can make Farmer and Rancher better off, I worked out an example of how trade could occur. Specifically, I showed that if 1.25 ounces of meat are traded for 3.5 ounces of potatoes, both Farmer and Rancher would be better off. But will trade take place? And if it does, at what price will people trade? That’s the subject of the next chapter. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE