Chapter 3

1. Chapter 3 Interdependence and the Gains from Trade 2002 by Nelson, a division of Thomson Canada Limited

2. In this chapter you will… • Consider how everyone can benefit when people trade with another country. • Learn the meaning of absolute advantage and comparative advantage. • See how comparative advantage explains the gains from trade. • Apply the theory of comparative advantage to everyday life and national policy.

3. Interdependence and the Gains from Trade • Consider your typical day: • You pour yourself orange juice made from Florida oranges and coffee from beans grown in Brazil. • You put on some clothes made of cotton grown in Georgia and sewn in factories in Thailand. • You watch the morning news broadcast from New York on your TV made in Japan.

4. Interdependence and the Gains from Trade • Consider your typical day (more): • You drive to class in a car made of parts manufactured in a half-dozen different countries. • Then you open your economics textbook written by authors living in Massachusetts, Alberta, and Quebec, published by a company located in Ontario, and printed from paper made from trees grown in New Brunswick.

5. Interdependence and the Gains from Trade • Economicsstudies how society produces and distributes goods and services so that wants and needs are satisfied. • Trade can make everyone better off.

6. Interdependence and the Gains from Trade • 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.

7. Interdependence and the Gains from 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?

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

9. A PARABLE FOR MODERN ECONOMY • Imagine that there are… … two goods in the world: • Potatoes • Meat … and two people in the world: • Potato farmer • Cattle rancher • What should each produce? • Why should they trade?

10. 1 1 8 8 8 2 64 16 Table 3-1: the Production Opportunities of the Farmer and the Rancher • Note that based on the Productivity Table above the Rancher is more productive in producing both of the products. • Yet, we will see that both the Rancher and the Farmer can gain from trade ... Amount produced in 1 Hour (in Kg) Amount produced in 8 Hours (in Kg) Meat Potatoes Meat Potatoes Farmer Rancher

11. 8 A 4 4 8 Figure 3-1(A): The Farmer’s Production Possibilities Frontier Meat (kilograms) Derived from Table 3-1 by working 8 hours a day 0 Potatoes (kilograms)

12. 64 B 32 8 16 Figure 3-1(B): The Rancher’s Production Possibilities Frontier Meat (kilograms) Derived from Table 3-1 by working 8 hours a day 0 Potatoes (kilograms)

13. Specialization and Trade • The Farmer and the Rancher Specialize and Trade • Each would be better off if they specialized in producing the product they are more suited to produce, and then trade with each other. The farmer should produce potatoes. The rancher should produce meat. They should trade

14. 8 A* Consumption with trade 6 A Consumption without trade 4 4 5 8 Figure 3-2 (A): How Trade Increases the Framer’s Consumption Meat (kilograms) 0 Potatoes (kilograms)

15. 64 Consumption with trade B* 34 Consumption without trade 9 16 Figure 3-2 (B): How Trade Increases the Rancher’s Consumption Meat (kilograms) 32 B 0 8 Potatoes (kilograms)

16. THE PRINCIPLE OF COMPARATIVE ADVANTAGE • Differences in the costs of production determine the following: • Who should produce what? • How much should be traded for each product? Who can produce potatoes at a lower cost? The farmer or the rancher!

17. THE PRINCIPLE OF COMPARATIVE ADVANTAGE • Measuring differences in costs of production: • Number of hours required to produce a standardized unit of output. • One pound of potatoes • Opportunity Cost: Whatever must be given up to obtain some item.

18. 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

19. Table 3-3: The Opportunity Cost of Meat and Potatoes • Who has the Absolute Advantage in each product? • Rancher, in both products! • Yet, we have seen that both the Rancher and the Farmer can gain from trade? Opportunity Cost of 1 Kg of Meat (in terms of potatoes given up) Potatoes (in terms of meat given up) 1 Farmer 1 1/4 Rancher 4

20. Opportunity Cost and Comparative Advantage • The comparison among 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.

21. Opportunity Cost and 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.

22. Comparative Advantage and Trade • Based on the earlier Productivity Table (Table 3-3 - Slide 19)… • The Rancher’s opportunity cost of 1 Kg of potatoes is 4 Kg of meat, whereas the Farmer’s opportunity cost of a Kg of potatoes is 1 Kg of meat. • The Rancher’s opportunity cost of 1 Kg of meat is only 1/4 Kg of potatoes, while the Farmer’s opportunity cost of 1 Kg of meat is only 1 Kg of potatoes...

23. Comparative Advantage and Trade • The Rancher has the Comparative Advantage in producing Meat (lower opportunity cost). • The Farmer has the Comparative Advantage in producing Potatoes (lower opportunity cost)

24. Comparative Advantage and Trade • Comparative advantage and differences in opportunity costs are the basis for specialized production and trade. • Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade.

25. Comparative Advantage and Trade Moral of the Story: “Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage.”

26. APPLICATIONS OF COMPARATIVE ADVANTAGE • The principle of comparative advantage has many applications. Here are two examples: • Joe Sakic and his lawn. • Canada and other countries.

27. Should Joe Sakic Mow His Own Lawn? • Absolute Advantage. . . • Opportunity Costs. . . • Gains from trade. . .

28. Should Canada Trade with other Countries? • 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

29. Summary • 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 and services.

30. Summary • There are two ways to compare the ability of two people producing a good. • The person who can produce a good with a smaller quantity of inputs has an absolute advantage. • The person with a smaller opportunity cost has a comparative advantage.

31. Summary • The gains from trade are based on comparative advantage, not absolute advantage. • Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage. • The principle of comparative advantage applies to countries as well as people.

32. The End