Introduction to Economic Institutions

Transcription

1 Introduction to Economic Institutions ECON 1500 Week 1 Lecture 2 30 August 1 / 15

2 Topics covered today who gains from trade PPF Comparative advantage - specialisation Case studies Reading: Mankiw, Chapter 3 2 / 15

3 Why are we interested in this? most countries today imports a large proportions of the goods they consume and export a large proportion of goods they produce who gains and who looses from this exchange? We will show how trade can make everyone better off 3 / 15

4 A model: Assumptions 2 goods: meat and potatoes 2 people: rancher and farmer both would like to eat both meat and potatoes if each produces only one good... if each produces both but is better at producing one good... what if one is better at producing both goods? both rancher and farmer work 8h a day and can devote their time either to growing potatoes or raising cattle or both the farmer can produce an ounce of potatoes in 15 minutes and an ounce of meat in 60 minutes the rancher is more productive and produces ounce of potatoes in 10 minutes and an ounce of meat in 20 minutes 4 / 15

5 A model: PPF note: here the slope of the PPF is constant both the farmer and the rancher technology allows them to switch between the two goods at constant rate without trade points A and B below can possibly describe what the farmer and the rancher will produce and consume 5 / 15

6 What happens when they are allowed to trade? farmer rancher Meat Potatoes Meat Potatoes Without trade Production & Consumption With trade Production Trade get 5 give 15 give 5 get 15 Consumption GAINS / 15

7 What happens when they are allowed to trade? 7 / 15

8 Comparative vs absolute advantage Absolute advantage: ability to produce goods using fewer inputs than another producer this refers simply to higher productivity of one person in the example above the rancher had an absolute advantage in producing both goods yet the gains from trade still exist how is this possible? Comparative advantage: the ability to produce a good at a lower opportunity cost than another producer instead of comparing costs of producing a good we can compare opportunity costs opportunity cost is whatever must be given up to obtain some item 8 / 15

9 Example opportunity costs of producing meat and potatoes the farmer can produce an ounce of potatoes in 15 minutes and an ounce of meat in 60 minutes the rancher is more productive and produces ounce of potatoes in 10 minutes and an ounce of meat in 20 minutes 1 oz of meat 1 oz of potatoes farmer 4 of of potatoes 1/4 oz of meat rancher 2 oz of potatoes 1/2 of of meat the producer who gives up less of other good to produce good x has the smaller opportunity cost of producing good x and has comparative advantage here: farmer has a lower opportunity cost of producing potatoes, rancher of meat 9 / 15

10 Gains from trade It is possible for for one person to have absolute advantage in producing both goods BUT not possible for one person to have a comparative advantage in producing both goods comparative advantage reflects relative opportunity costs gains from trade are based on comparative advantage if each person specialises in what she has comparative advantage in, total production increases, everyone can be better off 10 / 15

11 Price at which the goods would be traded each person benefits from trade by obtaining a good at a price that is lower than her opportunity cost of that good the trading price will be between the two opportunity costs what would happen if it was not? 1 oz of meat 1 oz of potatoes farmer 4 of of potatoes 1/4 oz of meat rancher 2 oz of potatoes 1/2 of of meat farmer rancher Meat Potatoes Meat Potatoes get 5 give 15 give 5 get 15 1 oz of meat at price of 3 oz of potatoes 1 oz of potatoes at price of 1/3 of meat 11 / 15

12 Exercise Suppose that... France produces 12 liters of wine and 4oz of cheese in 36h week Italy produces 2 liters of wine and 3oz of cheese in 36h week who has the comparative advantage in producing wine? cheese? how will these countries trade? 12 / 15

13 More explanation 13 / 15

14 Why is this relevant? Important to understand gains from trade especially within the context of the recent revival of protectionist trade policies and trade war with China china-trump-trade-war-tariffs If you are interested in the effects of tariffs on prices and outputs, you can see more in Mankiw, Chapter 9 keep in mind that trade brings gains to both economies, hence restricting it has the ability to limit those gains 14 / 15

15 Recap Terms I would like you to be familiar with at the end of this lecture absolute advantage opportunity cost comparative advantage 15 / 15