INTERDEPENDENCE AND THE GAINS FROM TRADE

Transcription

1 3 INTERDEPENDENCE AND THE GAINS FROM TRADE LEARNING OBJECTIVES: By the end of this chapter, students should understand: how everyone can benefit when people trade with one another. the meaning of absolute advantage and comparative advantage. how comparative advantage explains the gains from trade. how to apply the theory of comparative advantage to everyday life and national policy. KEY POINTS: 1. Each person consumes goods and services produced by many other people both in our country and around the world. Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods.. There are two ways to compare the ability of two people in producing a good. The person who can produce the goods with a smaller quantity of inputs is said to have an absolute advantage in producing the good. The person who has the smaller opportunity cost of producing the good is said to have a comparative advantage. The gains from trade are based on comparative advantage, not absolute advantage. 3. Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage. 4. The principle of comparative advantage applies to countries as well as people. Economists use the principle of comparative advantage to advocate free trade among countries. CHAPTER OUTLINE: I. A Parable for the Modern Economy A. Example: two goods meat and potatoes and two people a cattle rancher and a potato farmer (both of whom like to consume both potatoes and meat). 1. The gains from trade are obvious if the farmer can only grow potatoes and the rancher can only raise cattle.

2 . The gains from trade are also fairly obvious if, instead, the farmer can raise cattle as well as grow potatoes, but he is not good at it and the rancher can grow potatoes in addition to raising cattle, but her land is not well suited for it. 3. The gains from trade are not as clear if either the farmer or the rancher is better at producing both potatoes and meat. B. Production Possibilities 1. The farmer and rancher both work 40 hours per week and can use this time to grow potatoes, raise cattle, or both.. Table 3-1 shows the amount of time each takes to produce 1 pound of either good: Hours Needed to Make 1 Pound Amount Produced in 40 Hours Meat Potatoes Meat Potatoes Farmer 0 hours/lb. 10 hours/lb. 40/0 = lbs. 40/40 = 4 lbs. Rancher 1 hour/lb. 8 hours/lb. 40/1 = 40 lbs. 40/8 = 5 lbs. 3. The production possibilities can also be graphed. a. These production possibilities frontiers are drawn linearly instead of being bowed out. This assumes that the farmer s and the rancher s technology for producing meat and potatoes allows them to switch between producing one good and the other at a constant rate. b. As we saw in Chapter, these production possibilities frontiers represent the principles of tradeoffs and opportunity costs.

3 4. We will assume that the two divide their time equally between raising cattle and growing potatoes. Meat Meat 40 Farmer Rancher 0 B 1 A 4 Potatoes 5 Potatoes C. Specialization and Trade a. The farmer produces (and consumes) at point A - pounds of potatoes and 1 pound of meat. b. The rancher produces (and consumes) at point B - ½ pounds of potatoes and 0 pounds of meat. 1. Suppose the rancher suggests that the farmer specialize in the production of potatoes and then trade with the rancher for meat. a. The rancher will spend 4 hours a week producing meat (4 pounds) and 16 hours a week growing potatoes ( pounds). b. The farmer will spend 40 hours a week growing potatoes (4 pounds). c. The rancher will trade 3 pounds of meat for a pound of potatoes.

4 Meat Meat Farmer Rancher 40 3 A* 1 0 B B* 1 A 3 4 Potatoes 3 5 Potatoes. End results: a. The rancher produces 4 pounds of meat and trades 3 leaving him with 1 pounds of meat. He also grows pounds of potatoes and receives 1 pound in the trade, leaving him with 3 pounds of potatoes. b. The farmer produces 4 pounds of potatoes and trades 1 leaving him with 3 pounds. He also receives 3 pounds of meat in the trade with the rancher. 3. In both cases, they are able to consume quantities of potatoes and meat after the trade that they could not reach before the trade. II. The Principle of Comparative Advantage A. Absolute Advantage 1. Definition of Absolute Advantage: the comparison among producers of a good according to their productivity.. The rancher has an absolute advantage in the production of both potatoes and meat. B. Opportunity Cost and Comparative Advantage 1. Definition of Opportunity Cost: whatever must be given up to obtain some item. a. For the rancher, the opportunity cost of producing a pound of potatoes is 8 pounds of meat (because it takes 8 hours to produce 1 pound of potatoes).

5 b. For the farmer, the opportunity cost of producing 1 pound of potatoes is only ½ pound of meat (because it takes 10 hours to produce 1 pound of potatoes). c. The opportunity cost of producing 1 pound of meat is the inverse of producing 1 pound of potatoes.. Definition of Comparative Advantage: the comparison among producers of a good according to their opportunity cost. a. The farmer has a lower opportunity cost of producing potatoes and therefore has a comparative advantage in the production of potatoes. b. The rancher has a lower opportunity cost of producing meat and therefore has a comparative advantage in the production of meat. 3. Because the opportunity cost of producing one good is the inverse of the opportunity cost of producing the other, it is impossible for a person to have a comparative advantage in the production of both goods. C. Comparative Advantage and Trade 1. When specialization in a good occurs (assuming there is a comparative advantage), total output will grow.. As long as the opportunity cost of producing the goods differs across the two individuals, both can gain from specialization and trade. a. The rancher buys a pound of potatoes for 3 pounds of meat. This is lower than the rancher s opportunity cost of 8 pounds of meat and is therefore beneficial to the rancher. b. The farmer buys 3 pounds of meat with one pound of potatoes. This implies that the price of each pound of meat is 1/3 pound of potatoes, which is lower than the farmer s opportunity cost of pounds of potatoes. Thus, trade also benefits the farmer. III. FYI: The Legacy of Adam Smith and David Ricardo A. In Adam Smith s 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, he writes of the ability of producers to benefit through specialization and trade. B. In David Ricardo s 1817 book Principles of Political Economy and Taxation, Ricardo develops the theory of comparative advantage and argues against restrictions on free trade. C. The benefits of free trade are one issue that is generally agreed upon by economists, and the theories and arguments developed by these two gentlemen 00 years ago are still used today.

6 IV. Applications of Comparative Advantage A. Should Tiger Woods Mow His Own Lawn? 1. Given Wood s athleticism, it is entirely possible that he could mow his lawn faster than most men.. This implies that he has an absolute advantage. 3. However, if the opportunity cost of his time is $10,000 (his pay to film a commercial for Nike), it is likely that someone else will have a comparative advantage in mowing his lawn. 4. Both he and the person hired will be better off as long as he pays the individual more than the individual s opportunity cost and less than $10,000. B. Should the United States Trade with Other Countries? 1. Just as individuals can benefit from specialization and trade, so can the populations of different countries.. Definition of Imports: goods produced abroad and sold domestically. 3. Definition of Exports: goods produced domestically and sold abroad. 4. The principle of comparative advantage suggests that each good should be produced by the country with a comparative advantage in producing that good (smaller opportunity cost). 5. Through specialization and trade, countries can have more of all goods to consume. C. In the News: Who Has a Comparative Advantage in Producing Lamb? 1. A tariff is a tax on an imported product, used to lower the quantity of specific imports.. This is an opinion column from The Wall Street Journal on the use of tariffs in the lamb industry.