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Interdependence And The Gains From Trade

Trade can make everyone better off

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Revisiting how people interact

Trade can make every one better off. Markets are a good way to organize economic

activity Governments can sometimes improve market

outcomes People provide you with goods and services

they produce because they get something in return (recall the operation of Smith’s “Invisible hand”)

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Demonstration of gains from trade

There are two goods in the economy: Meat Oranges

There are two producers in the economy: USA New Zealand

Gains from trade are obvious if each of them produces only one type of good the second good can be produced only at a

great cost

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Demonstration of gains from trade

The gains from trade are less obvious when one person/country is better at producing both goods. Is it better to remain self-sufficient?

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Demonstration of gains from tradeUSA and New Zealand

Country Quantity (kg) produced in 1 hr

Quantity (kg) produced in 8 hrs

Meat Oranges Meat Oranges

USA 3 3 24 24

NZ 24 6 192 48

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Demonstration of gains from trade

The PPF shows all the production possibilities that each of the countries can produce

In the absence of trade (self-sufficiency) the PPF becomes the consumption possibilities frontier.

With trade, both the countries can produce more of one commodity and consume more of both commodities

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Demonstration of gains from trade

Meat

Oranges

PPF

Why is the PPF a straight line instead of being concave? Is it something to do with technology?

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Demonstration of gains from tradeWith out trade With trade

Production & Consumption

Production Trade Consumption Gains

USA 12 kg Meat &12 kg Oranges

0 kg Meat & 24 kg Oranges*

Gets 14 kg Meat for 7 kg Oranges

14 kg Meat & 17 kg Oranges

2 kg Meat & 5 kg Oranges

NZ 96 kg Meat & 24 kg Oranges

120 kg Meat & 18 kg Oranges**

Gives 14 kg Meat for 7 kg Oranges

106 kg Meat & 25 kg Oranges

10 kg Meat &1 kg Oranges

*All 8 hours are spent on production of oranges

**5 hours are spent on meat production and 3 hours on production of oranges

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Interdependence and the gains from trade

Principle of absolute advantage compares producers of a good according to their productivity

Principle of comparative advantage compares producers of a good according to their opportunity cost

With trade, both countries can produce more of one commodity and consume more of both commodities (founded upon principle of comparative advantage)

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Demonstration of principle of comparative advantage The producer with a lower opportunity cost of

producing a good has a comparative advantage in producing that good and should specialize in the production of that good.

Country Opportunity Cost of oranges in terms of meat

Opportunity Cost of meat in terms of oranges

USA 1 1

NZ 4 1/4

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Interdependence and the gains from trade

It is impossible for a producer to have a comparative advantage in the production of both the goods. Why?

If two producers have different opportunity costs they gain from trade as the price of the good they buy is less than their opportunity cost for that good

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Interdependence and the gains from trade

To summarize: Comparative advantage Specialization

Economic well-being Increase in production

Gains from trade

Trade

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Applications of comparative advantage: International trade

Countries: Canada and Japan

Commodities: Food and Cars

Food

CarsCars

Food

Canada's PPF

Japan's PPF

1

2

1

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Applications of comparative advantage: International trade

Who should export cars? Who should import food? Why should Canada and Japan trade?

Try to figure out on your own! If not, look into your textbook.