GAINS FROM TRADEETP Economics 101

Lecturer: Jack Wu

RECALL

The production possibilities frontier is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology.

SHAPE OF PRODUCTION POSSIBILITIES FRONTIER Concave curve (bowed outward): The opportunity cost of producing one good

increases as the production of this good rises.

REASON:Some resources are better suited to the

production of this good than another good (and vice versa).

Straight line: The opportunity cost of producing one good is

constant as the production of this good rises.

NOW

Let’s use the “Production Possibilities Frontier” to analyze trade problems.

AUTARKY OR TRADE?

How do we satisfy our wants and needs in a global economy? We can be economically self-sufficient (Autarky). We can specialize and trade

with others, leading to economic interdependence.

CASE 1

only two goods: potatoes and meat only two people: a potato farmer and a cattle

rancher Each only works 8 hours/day

What should each produce? Why should they trade?

CASE 1 (CONTINUED)

Minutes needed to make 1 ounce of___________________________________ Meat Potatoes___________________________________Farmer 60min/oz 15min/ozRancher 20min/oz 10min/oz

CASE 1 (CONTINUED)

Amounts produced in 8 hours___________________________________ Meat Potatoes___________________________________Farmer 8 oz 32 ozRancher 24 oz 48 oz

THE FARMER’S PRODUCTION POSSIBILITIES FRONTIER

Potatoes (ounces)

8

320

Meat (ounces)

(a) The Farmer’ s Production Possibilities Frontier

THE RANCHER’S PRODUCTION POSSIBILITIES FRONTIER

Potatoes (ounces)0

Meat (ounces)

(b) The Rancher ’s Production Possibilities Frontier

48

24

OPPORTUNITY COST

Opportunity cost Whatever must be given up to obtain some item Measures the trade-off between the two goods

that each producer faces

OPPORTUNITY COSTS

1oz of meat 1oz of potatoes

Farmer 4 oz of potatoes ¼ oz of meat

Rancher 2 oz of potatoes ½ oz of meat

ABSOLUTE ADVANTAGE

The comparison among producers of a good according to their productivity—absolute advantage Describes the productivity of one person, firm, or

nation compared to that of another. The producer that requires a smaller quantity of

inputs to produce a good is said to have an absolute advantage in producing that good.

COMPARATIVE ADVANTAGE

Compares producers of a good according to their opportunity cost. Whatever must be given up to obtain some item

The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good.

APPLICATION

Should Tiger Woods mow his own lawn? Woods

Mow his lawn in 2 hours Film a TV commercial and earn $10,000 (2 hours)

QUICK QUIZ 1

Who has the absolute advantage? The farmer or the rancher?

Who has the comparative advantage? The farmer or the rancher?

SPECIALIZATION AND TRADE

Comparative advantage and differences in opportunity costs are the basis for specialized production and trade.

QUICK QUIZ 2

What should farmer produce (or specialize in)?

What should rancher produce (or specialize in)?

BENEFITS OF TRADE

Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade.

Benefits of Trade Trade can benefit everyone in a society because

it allows people to specialize in activities in which they have a comparative advantage.

SELF-SUFFICIENCY (AUTARKY)

By ignoring each other: Each consumes what they each produce. The production possibilities frontier is also the

consumption possibilities frontier. Without trade, economic gains are diminished.

SELF-SUFFICIENCY (AUTARKY)

Assume: Farmer spends 4 hours on meat and 4 hours on potatoes. Rancher spends 4 hours on meat and 4 hours on potatoes.

WITHOUT TRADE Production: Farmer produces 4 oz of meat

and 16 oz of potatoes. Rancher produces 12 oz of meat and 24 oz of potatoes.

Consumption: Farmer consumes 4 oz of meat and 16 oz of potatoes. Rancher consumes 12 oz of meat and 24 oz of potatoes.

THE FARMER’S PRODUCTION AND CONSUMPTION WITHOUT TRADE

Copyright©2003 Southwestern/Thomson Learning

Potatoes (ounces)

4

16

8

32

A

0

Meat (ounces)

(a) The Farmer’ s Production and Consumption

Farmer's production and consumption without trade

THE RANCHER’S PRODUCTION AND CONSUMPTION WITHOUT TRADE

Copyright © 2004 South-Western

Potatoes (ounces)

12

24

B

0

Meat (ounces)

(b) The Rancher’s Production and Consumption

48

24

Rancher's production and consumption without trade

PROPOSALS FOR SPECIALIZATION

Farmer devotes all his time to growing potatoes.

Rancher spends 6 hours a day raising cattle and 2 hours growing potatoes.

PRODUCTION WITH TRADE

Farmer’s production with trade: 0 oz of meat and 32 oz of potatoes

Rancher’s production with trade: 18 oz of meat and 12 oz of potatoes.

PROPOSAL FOR TRADE

The price of trade Must lie between the two opportunity costs

Trade deal: Farmer gives rancher 15 oz of potatoes, and rancher gives farmer 5 oz of meat in return.

Note: Price of Meat: 2~4 oz of potatoes Note: Price of Potatoes: 1/4 oz ~1/2 oz of

meat

HOW TRADE EXPANDS THE SET OF CONSUMPTION OPPORTUNITIES

28

The gains from trade: A summary

Farmer Rancher

Meat Potatoes Meat Potatoes

Without trade: Production and consumptionWith trade: Production Trade ConsumptionGAINS FROM TRADE: Increase in consumption

4 oz

0 ozGets 5 oz

5 oz

+1 oz

16 oz

32 ozGives 15 oz

17 oz

+1 oz

12 oz

18 ozGives 5 oz

13 oz

+1 oz

24 oz

12 ozGets 15 oz

27 oz

+3 oz

CONSUMPTION WITH TRADE

Farmer’s consumption with trade: 5 oz of meat and 17 oz of potatoes

Rancher’s consumption with trade: 13 oz of meat and 27 oz of potatoes.

HOW TRADE EXPANDS THE FARMER’S SET OF CONSUMPTION OPPORTUNITIES

Potatoes (ounces)

4

16

5

17

8

32

A

A*

0

Meat (ounces)

(a) The Farmer’ s Production and Consumption

Farmer's production and consumption without trade

Farmer's consumption with trade

Farmer's production with trade

HOW TRADE EXPANDS THE RANCHER’S SET OF CONSUMPTION OPPORTUNITIES

Potatoes (ounces)

12

24

13

27

B

0

Meat (ounces)

(b) The Rancher’s Production and Consumption

48

24

12

18

B*

Rancher's consumption with trade

Rancher's production with trade

Rancher's production and consumption without trade

INTERNATIONAL TRADE

Each country has many citizens with different interests. International trade can make some individuals worse off, even as it makes the country as a whole better off. Imports—goods produced abroad and sold

domestically

Exports—goods produced domestically and sold abroad

QUICK QUIZ 3

Martha and Stewart each spend 8 hours a day wallpapering and painting:

Hours needed to Do 1 Room Paint WallpaperMartha 2 hours/room 8 hours/roomStewart 4 hours/room 10 hours/room

QUICK QUIZ 4 Suppose that a worker in Cornland can grow

either 40 bushels of corn or 10 bushels of oats per year, and a worker in Oatland can grow either 20 bushels of corn or 5 bushels of oats per year. There are 20 workers in Cornland and 20 workers in Oatland. Which of the following statements is true?

a. Both countries could gain from trade with each other.

b. Neither country would gain from trade because Cornland has an absolute advantage in both goods.

c. Neither country would gain from trade because neither one has a comparative advantage.

d. Only Oatland could possibly gain from trade.