Interdependence and Trade

1. Interdependence and Trade Economics studies how society produces and distributes goods and services so that wants and needs are satisfied.

2. How Do We Satisfy Our Wants and Needs? • We can be economically Self-Sufficient. • We can specialize and trade with others leading to Economic Interdependence.

3. Interdependence & Trade • A general observation . . . • Individuals and nations rely on specialized production and exchange as a way to address problems caused by scarcity. • This gives rise to two questions. . . • Why is interdependence the norm? • What determines production & trade?

4. Interdependence & Trade • Why is interdependence the norm? • Interdependence occurs because people are better off when they specialize and trade with others. • What determines the pattern of production & trade? • Patterns of production and trade are based upon differences in opportunity costs.

5. Interdependence and Trade: “A Parable for the Modern Economy” Imagine... … only two goods (potatoes and meat) … only two people (potato farmer and a cattle rancher) What should each produce? Why should they trade?

6. Productivity Table • Note that based on the Productivity Tableabove the Rancher is more productive inproducing both of the products. • Yet, we will see that both the Rancher and the Farmer can gain from trade ...

7. Product Possibility Frontiers Based on the Productivity Table above we can construct Productivity Possibility Frontiers assuming an 8 hour day as follows: Rancher Farmer 64 PPF PPF 8 Meat in Kg Meat in Kg 8 16 Potatoes in Kg Potatoes in Kg

8. A World of Self-Sufficiency Assuming self sufficiency (no trade) the Farmer produces and consumes combination A, while the Rancher is at combination B: Rancher Farmer 64 8 B Meat in Kg Meat in Kg 32 A 4 8 4 8 16 Potatoes in Kg Potatoes in Kg

9. Specialization and Trade • If the farmer and the rancher were to specialize in producingthe product that they were best suited to produce, and then tradewith each other, they would be better off. • Farmer should produce potatoes. • Rancher should produce meat. • Farmer and Rancher should trade.

10. Specialization and Trade Suppose the Farmer specializes in Potatoes and the Rancher specializes in Meat. If the Farmer trades 5 Kg Potatoes for 10 Kg Meat: Rancher Farmer 64 A*trade 54 B*trade 10 48 B 8 Meat in Kg Meat in Kg 6 A 5 4 2 3 8 16 Potatoes in Kg Potatoes in Kg

11. The Principle of Comparative Advantage • What determines who should produce what? And how much should be traded for each product? Differences in Costs of Production • Who can produce products (e.g. potato, meat) at a lower cost? • There are two ways to measure...

12. The Principle of Comparative Advantage • Measuring differences in costs of production: • Hours required to produce a standardized unit of output. • One pound of potatoes • Opportunity Cost - amount of one item sacrificed to obtain another.

13. Absolute Advantage • Describes the productivity of one person, firm, or nation 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.

14. Productivity Table • Who has the Absolute Advantage in eachproduct? • Rancher, in both products. • Yet, we have seen that both the Rancher and the Farmer can gain from trade?

15. Comparative Advantage • Compares producers of a good according to their opportunity cost. - The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good.

16. The Principle of Comparative Advantage • Comparative advantage, which refers to differences in opportunitycosts, is the basis for specialized production and trade. • Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade.

17. Opportunity Cost Table • Based on the Productivity Table (earlier slide) you can use simple math to calculate the opportunity cost of 1 unit of each good. • The Rancher has the Comparative Advantage inproducing Meat (lower opportunity cost). • The Farmer has the Comparative Advantage inproducing Potatoes (lower opportunity cost).

18. Applications of Comparative Advantage • Should Canada trade with Other Countries (e.g. Japan)? • Opportunity Costs • Imports • Exports

19. Trade: Canada and Japan Food Food Canada Japan 4 2 2 2 Cars Cars

20. Opportunity Cost: Sacrifice of Food Production for Car Production Food Canada Computing Opportunity Cost Slope of PPF: (0-4) ÷ (2-0) = 2Units of food given up to get 1Unit of a car. 4 2 Cars

21. Opportunity Cost: Sacrifice of Food Production for Car Production Food Canada Computing Opportunity Cost Slope of PPF: (0-4) ÷ (2-0) = ? Units of food given up to get 1 Unit of a car 4 ? 1 2 Cars

22. Opportunity Cost: Sacrifice of Food Production for Car Production Food Canada Computing Opportunity Cost Slope of PPF: (0-4) ÷ (2-0) = 2 Units of food given up to get 1 Unit of a car 4 2 1 2 Cars

23. Opportunity Cost: Sacrifice of Food Production for Car Production Food Japan Computing Opportunity Cost Slope of PPF: ( 2 ) ÷ (2 ) = 1Unit of food given up to get 1 Unit of a car 2 2 Cars

24. Trade: Canada and Japan Food Food Canada Japan 4 2 2 1 1 1 2 2 Cars Cars

25. Who should produce Cars? Food Food Canada Japan 4 2 2 1 1 1 2 2 Cars Cars

26. Who should produce Food? Food Food Canada Japan 4 2 2 1 1 1 2 2 Cars Cars

27. Interdependence: Canada & Japan Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services. Founded upon the. . . Principle of Comparative Advantage