1 The Fundamentals of Trade Capitol Hill Campus May 21, 2010 copies of this presentation can be found at

2 There are two countries. West East

3 In each country, there are 10 workers. West East

4 The workers make RED stuff and BLUE stuff. West East

5 The workers eat the RED stuff and BLUE stuff. West East

6 Happiness = (RED stuff eaten) (BLUE stuff eaten) 126

7 0 0

8 In West, a single worker can produce 2 RED stuff or 1 BLUE stuff West or

9 In East, a single worker can produce 1 RED stuff or 2 BLUE stuff East or

10 You must decide how many workers to allocate to the production of RED stuff and how many to allocate to the production of BLUE stuff. Your goal is to attain the most happiness for your country.

11 Example (using West): Suppose you choose to assign 2 Workers to RED production and 8 Workers to BLUE production Production of RedProduction of BlueUnits of RedUnits of BlueUnits of RedUnits of Blue Labor Allocation (must total 10)ProductionImports (negative = exports) Units of RedUnits of Blue Consumption (production plus imports) Happiness (red consumed x blue consumed) or

12 Example (using West): Production of RedProduction of BlueUnits of RedUnits of BlueUnits of RedUnits of Blue Labor Allocation (must total 10)ProductionImports (negative = exports) Units of RedUnits of Blue Consumption (production plus imports) Happiness (red consumed x blue consumed) Suppose you choose to assign 3 Workers to RED production and 7 Workers to BLUE production or

13 Example (using East): Production of RedProduction of BlueUnits of RedUnits of BlueUnits of RedUnits of Blue Labor Allocation (must total 10)ProductionImports (negative = exports) Units of RedUnits of Blue Consumption (production plus imports) Happiness (red consumed x blue consumed) Suppose you choose to assign 3 Workers to RED production and 7 Workers to BLUE production or

14 Round 1: Autarky Allocate 10 workers to maximize your country’s happiness. or

15 Round 1: Autarky

16 Now, you may produce, exchange, then consume. West East

17 Example (using East): Production of RedProduction of BlueUnits of RedUnits of BlueUnits of RedUnits of Blue Labor Allocation (must total 10)ProductionImports (negative = exports) Units of RedUnits of Blue Consumption (production plus imports) Happiness (red consumed x blue consumed) 10-8 Suppose you choose to assign 3 Workers to RED production and 7 Workers to BLUE production. or Then, West agrees to trade you 10 RED in exchange for 8 BLUE.

18 Round 2: Trade Allocate 10 workers then trade (if you want) to maximize your country’s happiness. or

19 Round 2: Trade

20 West has an absolute advantage in the production of RED stuff.  In West, 1 unit of RED costs 1/2 worker.  In East, 1 unit of RED costs 1 worker. East has an absolute advantage in the production of BLUE stuff.  In West, 1 unit of BLUE costs 1 worker.  In East, 1 unit of BLUE costs 1/2 worker.

21 What if West is a lesser developed country such that East has an absolute advantage in the production of both RED and BLUE?

22 In West, a single worker can produce 2 RED stuff or 1 BLUE stuff West or

23 In East, a single worker can produce 3 RED stuff or 6 BLUE stuff East or

24 Round 3: Autarky (two worlds) Allocate 10 workers to maximize your country’s happiness. or

25 Round 3: Autarky (two worlds)

26 East has an absolute advantage in the production of RED stuff.  In West, 1 unit of RED costs 1/2 worker.  In East, 1 unit of RED costs 1/3 worker. East has an absolute advantage in the production of BLUE stuff.  In West, 1 unit of BLUE costs 1 worker.  In East, 1 unit of BLUE costs 1/6 worker.

27 Round 4: Trade (two worlds) Allocate 10 workers then trade (if you want) to maximize your country’s happiness. or

28 Round 4: Trade (two worlds)

29 Round 4: Trade (two worlds)

30 Are we thinking about the problem correctly? When you choose to produce more RED stuff, what do you give up? When you choose to produce more BLUE stuff, what do you give up? A country doesn’t give up workers when it produces stuff. It gives up the other stuff it could be producing instead.  The opportunity cost of BLUE stuff isn’t a worker.  The opportunity cost of BLUE stuff is RED stuff!

31 How many RED stuff does West have to give up to produce 1 more unit of BLUE stuff?  In West, the cost of 1 BLUE stuff is 2 RED stuff. or

32 How many RED stuff does West have to give up to produce 1 more unit of BLUE stuff?  In West, the cost of 1 BLUE stuff is 2 RED stuff. How many BLUE stuff does West have to give up to produce 1 more unit of RED stuff?  In West, the cost of 1 RED stuff is 1/2 of a BLUE stuff. or

33 How many RED stuff does East have to give up to produce 1 more unit of BLUE stuff? or  In East, the cost of 1 BLUE stuff is 1/2 RED stuff.  In East, the cost of 1 RED stuff is 2 BLUE stuff.

34 West has a relative advantage in the production of RED stuff.  In West, 1 unit of RED costs ½ unit of BLUE.  In East, 1 unit of RED costs 2 units of BLUE. = = East has a relative advantage in the production of BLUE stuff.  In West, 1 unit of BLUE costs 2 units of RED.  In East, 1 unit of BLUE costs ½ unit of RED. = =

35 What does RED stuff cost?  In West, 1 unit of RED equals ½ unit of BLUE.  In East, 1 unit of RED equals 2 units of BLUE. = = West will export RED if West can get more than ½ BLUE. East will import RED if East can pay less than 2 BLUE.

36 What does BLUE stuff cost?  In West, 1 unit of BLUE equals 2 units of RED.  In East, 1 unit of BLUE equals ½ unit of BLUE. = = West will import BLUE if West can pay less than 2 RED. East will export BLUE if East can get more than ½ RED.

37 Conclusions: 1.Trade is a positive sum relationship. 2.Exchanging goods and services is what’s important. Money is only a tool that facilitates the exchanging. 3.By definition, every country has a relative advantage in something. 4.Trade is the combination of exchange and specialization. Specialization is the directing of resources toward a country’s relative advantage.

38 Why is trade controversial? Practical On the whole, societies are better off with trade though some individuals are not. Philosophical There are differences of opinion as to the nature of trade.

39 Protectionist Assumption: Trade leads to a centralization of political power, decreased competition, exploitation, and the concentration of wealth. Free Trade Assumption: Trade leads to a decentralization of political power, increased competition, empowerment, and the dissemination of wealth.

40 Income Protectionist argument: Trade results in increased income for one country at the expense of reduced income for the other country. Free Trade argument: Trade results in increased incomes for both trading partners.

41 Source:International Financial Statistics, International Monetary Fund, December 2001 Greater per-capita trade is associated with greater per-capita income.

42 Income Distribution Protectionist argument: Trade results in an inequitable distribution of income. Free Trade argument: Trade is necessary for an equitable income distribution.

43 Source:International Financial Statistics, International Monetary Fund, December 2001, and Measuring Income Inequality: A New Database, Deininger, Klaus, and Lyn Squire, World Bank, 2002 Countries that engage in more trade have more equitable income distributions.

44 Source:International Financial Statistics, International Monetary Fund, December 2001, and Measuring Income Inequality: A New Database, Deininger, Klaus, and Lyn Squire, World Bank, 2002 Thailand Lithuania Fiji Ukraine Among the poorest countries, those that engage in more trade have more equitable income distributions.

45 Life Necessities Protectionist argument: Trade results in an exploitation of subsistence-level economies by technologically advanced economies. Free Trade argument: Trade benefits both technologically advanced and subsistence-level economies.

46 Greater per-capita trade is associated with greater caloric intake. recommended Source:International Financial Statistics, International Monetary Fund, December 2001, and World Development Indicators, World Bank, 2002

47 Exploitation of the Powerless Protectionist argument: Trade results in the exploitation of the less powerful by the more powerful. Free Trade argument: Trade empowers the less powerful.

48 Source:International Financial Statistics, International Monetary Fund, December 2001, and Human Development Report, United Nations Development Programme, 2002 GDI measures quality of life (longevity, education, literacy, income) for women relative to men. Greater per-capita trade is associated with greater gender equality.

49 Source: International Financial Statistics, International Monetary Fund, December 2001, and World Development Indicators, World Bank, 2002 Greater per-capita trade is associated with reduced child labor.

50 Source: International Financial Statistics, International Monetary Fund, December 2001, and World Development Indicators, World Bank, 2002 Even among middle-lower and lower income countries, greater per-capita trade is associated with reduced child labor.

51 Unemployment in the U.S. Protectionist argument: Trade costs America jobs. Free Trade argument: Trade creates jobs in the U.S. and abroad.

52 Source: Bureau of Labor Statistics, and Bureau of Economic Analysis Greater per-capita trade is associated with reduced unemployment. U.S. Unemployment Rate U.S. Trade On average, a 1 percentage point increase in trade is associated with a ½ percentage point reduction in unemployment.

53 Wages in the U.S. Protectionist argument: Trade reduces American wages. Free Trade argument: Trade improves real wages.

54 Source: Bureau of Labor Statistics, and Bureau of Economic Analysis Greater per-capita trade is associated with increased real wages. U.S. Trade U.S. Average Real Hourly Earnings (2000$) On average, a 1 percentage point increase in trade is associated with a $0.25 per hour increase in real wages.

55 If trade is such a good thing, why are some countries still poor despite ever expanding global trade?

56 Name two metrics that distinguish the first world from the third world.

57 If you hit a light bulb with a hammer, will you make a mess?

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60 The Fundamentals of Trade Capitol Hill Campus May 21, 2010 copies of this presentation can be found at

61 Since 1948, employment in Services industries has grown by 50% while employment in Manufacturing industries has declined by 50%. Source: Bureau of Labor Statistics (via

62 Source: Bureau of Labor Statistics (via While the number of American jobs in manufacturing has been declining, American production of industrial goods has been rising. This implies that American manufacturing is becoming more efficient as it produces ever more output using less labor.

63 Income Distribution for 1980 (in 2003$) Source: Statistical Abstract of the United States, U.S. Bureau of the Census, 2006, Table 673.

64 Source: Statistical Abstract of the United States, U.S. Bureau of the Census, 2006, Table 673. Income Distribution for 2003 (in 2003$)