eStudy.us copyright © 2010, All rights reserved Interdependence and the Gains from Trade

eStudy.us copyright © 2010, All rights reserved Two goods: Corn and Wheat Two counties: U.S.A. and Canada If U.S.A produces only corn and Canada produces only wheat – both gain from trade If both U.S.A. and Canada produce both corn and wheat – they still gain from specialization and trade

eStudy.us copyright © 2010, All rights reserved U.S.A. production possibilities frontier The left graph shows the combinations of corn and wheat that can be produced in the U.S.A. The right graph shows the combinations of corn and wheat that the can be produced in Canada. If there is no trade, each country’s production possibilities frontier is also the consumption possibilities frontier. Canada production possibilities frontier Wheat Corn A If there is no trade, then U.S.A. produces and consumes Wheat 0 Corn B If there is no trade, then Canada produces and consumes. Production Possibilities Frontier

eStudy.us copyright © 2010, All rights reserved Specialization and trade – U.S.A specializes in growing corn more land growing corn less land raising wheat – Canada specializes in growing wheat more land growing wheat less land growing corn

eStudy.us copyright © 2010, All rights reserved Comparative Advantage Absolute advantage producing a good using fewer inputs than another producer Opportunity cost – Whatever must be given up to obtain some item – Measures the trade-off between the two goods that each producer faces The opportunity cost of corn and wheat U.S.A.: 100 / 50 = 2 (opportunity cost of one bushel of wheat is two bushels of corn in the U.S.A.) Canada: 40 / 40 = 1 (opportunity cost of one bushel of wheat is one bushel of corn in Canada)

eStudy.us copyright © 2010, All rights reserved A country has a comparative advantage if opportunity cost is less than in other countries for a product A country – can have absolute advantage in both goods – can’t have comparative advantage in both goods Gains from specialization and trade – Based on comparative advantage – Total production in economy rises Increase in the size of the economic pie Everyone – better off Comparative Advantage

eStudy.us copyright © 2010, All rights reserved Gains from trade (expands consumption opportunities) With specialization and trade the world adds 10 corn and 10 wheat that can not be produced otherwise 60 Would without Trade Corn Wheat U.S.A. Canada World Would with Trade Corn Wheat U.S.A. Canada World 10040

eStudy.us copyright © 2010, All rights reserved Trade can benefit everyone in society – Allows people to specialize in activities The price of trade – Must lie between the two opportunity costs Principle of comparative advantage explains: – Interdependence – Gains from trade

eStudy.us copyright © 2010, All rights reserved Should Tiger Woods mow his own lawn? Tiger Woods or Michael Roberson – Tiger Woods can mow his lawn in 2 hours – Michael Roberson can mow Woods’s lawn in 4 hours – Film a TV commercial and earn $10,000 (2 hours) – Work at McDonald’s and earn $36 (4 hours) Tiger Woods has the absolute advantage, but Michael Roberson has the comparative advantage. Michael Robeson should mow Tiger’s yard

eStudy.us copyright © 2010, All rights reserved Should the U.S. trade with other countries? – Imports are goods produced abroad and sold domestically – Exports are goods produced domestically and sold abroad Principle of comparative advantage Good should be produced by the country with smaller opportunity cost of producing that good (Comparative advantage) Specialization and trade allow all countries greater prosperity