Trade and Gains from Trade

1. Trade and Gains from Trade

2. Main Concepts • You should know how to effectively use, define and numerically analyze the following: • Production Possibilities Table • Production Possibilities Frontier • Opportunity Cost • Scarcity • Productive Efficiency • Growth/Technology Change

3. Recall Gilligan’s Island • http://www.metacafe.com/watch/2315010/gilligans_island_opening_theme_in_color/ • There are 7 people stranded on the island: Gilligan, The Skipper, Maryanne, Ginger, Mr. and Mrs. Howell, and the Professor.

4. Production on the Island • Suppose on the Island they only produce 2 things: • Huts (from Palm Trees) • Radios (from coconuts) • Due to scarcity of goods and the current technology on the island, if everyone makes huts they can produce 60 huts in one month and implicitly no radios.

5. Production on the Island • Suppose the gang decides it is a good idea to make some radios. Who do they ask to stop making huts? • The Professor • Crew now makes 3 radios and 50 huts in a month • The opportunity cost of Professor making radios rather than huts is 10 huts. • Opportunity Cost- the highest valued, next best alternative that must be sacrificed to obtain something or to satisfy a want.

6. Production on the Island • What if they want more radios? Who should also make radios and not huts? • Who ever is next best at making radios relative to making huts – • Lets say that’s Maryanne • The Professor and Maryanne can produce 6 radios and everyone else can produce 41 huts in one month • The opportunity cost of Maryanne making radios is 9 huts.

7. Production on the Island • At this point we have three production possibilities for the crew: • They all make huts • All but Professor makes huts • All but Professor and Maryanne make huts • Let’s look at this information in a table

8. Production on the Island

9. Production on the Island • This is known as a Production Possibilities Table • PPT- a table that shows all of the combinations of goods and services that can be produced given the resources of society and the existing state of technology. • This table lets us know how much our island economy can produce.

10. Production on Island • Now let’s consider what would happen if one by one, the rest of the crew moved into radio production from hut production • Remember, the people who are best at making radios and not very good at making huts relatively should move out of hut production and into radio production first. • Let’s see the production possibilities..

11. Production on the Island

12. Production on the Island • The Production Possibilities Table can be represented graphically … • To do this we plot each production possibility from the previous table possibility. • The quantity of each good is measured on the X and Y axis.

13. Production on the Island Huts When we connect the points, we have a Production Possibilities Frontier/Curve. Notice the inverse relationship! This relationship is mostly linear for ease of numbers, this is not always the case! 60 50 41 32 23 15 7 3 6 9 12 15 18 20 Radios

14. Production on the Island • The production possibilities frontier is a graph that shows all combinations of goods and services that can be produced given the resources of society and the existing state of technology. • PPF follows the scarcity principal - given limited resources, having more of one good thing generally means having less of another.

15. Production on the Island Huts Outside Production Possibilities – Not possible with current resources. 60 50 41 32 Inside of Production Possibilities – Not all resources are used. 23 15 7 3 6 9 12 15 18 20 Radios

16. Trade • Suppose Gilligan’s Island gets in contact with the Swiss Family Robinson. • Knowing that trade can make everyone better off, the two island occupants decide to trade huts for radios • But who should produce what? How much should they trade? What should be the terms of trade?

17. Trade • Recall, points on the GI PPF (Production Possibilities Frontier) are -Notice GI (Gilligan’s Island) can produce either 60 huts a month or 20 radios a month. So the opportunity cost for 60 huts is 20 radios. -Reducing this number, 60 huts/20 radios = 3 huts/1 radio. -Suppose GI is currently making and consuming 15 huts and 15 radios.

18. Trade • Suppose the Production Possibilities Table for the Swiss Family Robinson is as follows: -Notice SFR can produce either 20 huts a month or 60 radios a month. So the opportunity cost for 20 huts is 60 radios. -Reducing this number, 20 huts/60 radios = 1 huts/3 radio. -Suppose SFR is currently making and consuming 15 huts and 15 radios.

19. Thus the two PPFs are as follows: Trade Huts GI PPF 60 20 SFR PPF 20 60 Radios

20. Trade • Recall currently GI and SFR are producing (and consuming) 15 huts and 15 radios. • The total economy thus has 30 huts and 30 radios

21. Trade • Comparative Advantage – The advantage in the production of a product enjoyed by one country over another when that product can be produced at lower cost in terms of other goods than it could be in the other country. • GI has a comparative advantage in producing huts, to produce a hut, it costs 1/3 of a radio. For SFR to produce a hut, it costs 3 radios. • SFR has a comparative advantage in producing radios. To produce a radio, it costs 1/3 of a hut. For GI to produce a radio, it costs 3 huts.

22. Trade • Now suppose GI, who has the comparative advantage in huts only produces huts and SFR, who has the comparative advantage in radios only produced radios. • This is called specialization- the division of productive activities among persons and regions so that no one individual or one area is totally self-sufficient.

23. GI specializes in huts and produces 60 huts. SFR specializes in radios and produces 60 radios Trade Huts GI PPF 60 Current Consumption (15 huts, 15 Radios) each. (Just happens to be at the cross point.) 20 SFR PPF 20 60 Radios

24. Trade • Now suppose that GI and SFR trade • Terms of trade are 1 radio for 1 hut. • This means GI buys radios from SFR for less huts than the opportunity cost for GI to produce them (1 radio for 1 hut instead of 1 radio for 3 huts). • And, SFR buys huts from GI for less radios than the opportunity cost for SFR to produce them (1 hut for 1 radio instead of 1 hut for 3 radios).

25. Trade • Suppose GI trades SFR 30 huts for 30 radios. • Now, GI consumes their 30 remaining huts and the 30 radios they received from SFR. This is more than the 15 huts and 15 radios they consumed before trading. • SFR consumes their 30 remaining radios and the 30 huts they received from GI. This is more than the 15 huts and 15 radios they consumed before trading.

26. Trade • Note the consumption after trade, GI and SFR each have more Huts and Radios than their resources allowed them to have if they did not trade. • Ricardo’s Theory of Comparative Advantage – Specialization and free trade will benefit all trading partners, even those that may be absolutely more efficient producers.

27. Trade • Note, neither island had an absolute advantage. • Absolute Advantage – The advantage in the production of a product enjoyed by one country over another when it uses fewer resources to produce than the other country does.

28. Trade – Gillies and Swissies • Suppose there exists a tribe of natives on Gilligan’s Island called the Gillies. • Suppose there also exists a tribe of natives on Swiss Family Robinson’s island called the Swissies. • The two tribes both cut logs for fire and gather nuts for food.

29. Trade - Gillies and Swissies • Suppose the two tribes’ production information for cutting logs & gathering nuts is below:

30. Trade - Gillies and Swissies • Will it benefit the Gillies to trade with the Swissies? • YES!!!!!!!!!!!!!!! • Gillies opportunity cost to cut 10 logs is 5 barrels of nuts or the opportunity cost to cut 2 logs is 1 barrel of nuts. • Swissies opportunity cost to cut 6 logs is 2 barrels of nuts or the opportunity cost to cut 3 logs is 1 barrel of nuts.

31. Trade - Gillies and Swissies • Suppose the Gillies currently consume 6 logs and 2 barrels of nuts. • Suppose the Swissies currently consume 3 logs and 1 barrel of nuts. • So the total economy consumes 9 cut logs and 3 barrels of nuts.

32. Trade – Gillies and Swissies • The Production Possibility Frontiers are as follows: Logs Cut 10 Gillies PPF Gillies Current Consumption 6 Swissies PPF 3 Swissies Current Consumption 1 2 5 Barrels of Nuts Gathered

33. Trade - Gillies and Swissies • The Gillies have the comparative advantage in gathering barrels of nuts. It costs them 2 logs to gather a barrel of nuts. It costs the Swissies 3 logs to gather a barrel of nuts. • The Swissies have the comparative advantage in cutting logs. It costs them 1/3 of a barrel of nuts to cut one log. It costs the Gillies ½ of a barrel of nuts to cut one log.

34. Trade - Gillies and Swissies • Suppose the Swissies specialize in cutting logs. • The Gillies move along their production possibility curve and partially specialize. They produce 3 barrels of nuts and 4 cut logs. • The total economy thus has 3 barrels of nuts and 10 cut logs, and is better off with the specialization of the Swissies.

35. Trade - Gillies and Swissies • Suppose the Gillies and Swissies trade. Their terms of trade is 1 barrel of nuts for 2½ cut logs. • Both end up benefitting from the trade! • The Gillies and Swissies goods are tracked below: