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P R I N C I P L E S O F

P R I N C I P L E S O F. F O U R T H E D I T I O N. Interdependence and the Gains from Trade. 3. In this chapter, look for the answers to these questions:. Why do people – and nations – choose to be economically interdependent? How can trade make everyone better off?

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P R I N C I P L E S O F

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  1. P R I N C I P L E S O F FOURTH EDITION Interdependence and the Gains from Trade 3

  2. In this chapter, look for the answers to these questions: • Why do people – and nations – choose to be economically interdependent? • How can trade make everyone better off? • Exports: goods produced domestically, sold abroad • Imports: goods produced abroad, sold domestically • What is comparative and absolute advantage, and how does this affect gains from trading? • How do you divide household tasks? CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  3. Household living: cleaning up for a party..we have to clean kitchen & living roomwho should do what? • Exhausted roommate: clean living room (1 hour) or clean kitchen (3 hrs). • Me: clean living room (1/2 hr) or kitchen (1 hr). • Hint: what are the opportunity costs of cleaning the living room? • Roommate 1/3 kitchen cleaned • Me ½ kitchen cleaned • Solution? CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  4. Our Example 0 • Two countries: the U.S. and Japan • Two goods: computers and wheat • Labor is the only input (measured in hours): US. 50,000 hrs Japan 30,000 hrs. • We will look at how much of both goods each country produces and consumes • if the country chooses to be self-sufficient • if it trades with the other country CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  5. Production Possibilities in the U.S. 0 • The U.S. has 50,000 hours of labor available for production, per month. • Producing one computer requires 100 hours of labor. • Producing one ton of wheat requires 10 hours of labor. • Production Possibilities Frontier has slope: 10 wheat / 1 computer. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  6. Wheat (tons) 4,000 5,000 2,000 1,000 3,000 Computers 0 400 300 200 100 500 The U.S. Without Trade 0 U.S. resources 50,000 hours. U.S. Costs: 1 comp =100 hours, 1 wheat = 10 hours. Cost ratio of 10/1. Splitting its resources, it will produce and consume 250 computers and 2500 tons of wheat. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  7. ACTIVE LEARNING 1: Derive Japan’s PPF • Japan has 30,000 hours of labor available for production, per month. • Producing one computer requires 125 hours of labor. • Producing one ton of wheat requires 25 hours of labor. Use the following information to draw Japan’s PPF. Your graph should measure computers on the horizontal axis. 6

  8. Wheat (tons) 2,000 1,000 Computers 0 100 200 300 Japan Without Trade 0 Japan costs: 1 comp requires 125 hours, 1 wheat requires 25 hours. Cost ratio of 5/1. Note it could produce 240 computers or 1,200 wheat. Suppose Japan also splits its labor resources. Then it will produce and consume 120 computers and 600 tons of wheat. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  9. Consumption With and Without Trade 0 • Can nations do better with trade than without? It depends on Comparative advantage: the ability to produce a good at a lower opportunity cost than another producer. • Comparative advantage exists whenever relative costs differ, hence opportunity costs differ. • Nations will trade at a “terms of trade” ratio that will lie between the differences in the opportunity costs in each nation. • We shall see that absolute costs do not matter! CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  10. ACTIVE LEARNING 2: Production under trade • Given the relative costs in the two nations, who has comparative advantage in which good? • At what rate would the U.S. and Japan be willing to trade wheat for computers ? • Why is trading possible at a trading rate between 10/1 and 5/1? Which trading rate does each country prefer? • Suppose they negotiate to trade at 7.5/1, i.e 7.5 wheat = 1 computer. 9

  11. Two Measures of the Cost of a Good 0 • Absolute advantage measures the cost of a good in terms of the inputs required to produce it. • Recall: Another measure of cost is opportunity cost – what is foregone if one good is produced. In this instance, what is foregone if someone makes a computer is the wheat it could otherwise produce. ** Opportunity cost is the key to comparative advantage and the gains from trade. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  12. Absolute Costs vs. Opportunity Costs** lowest opp costs creates Comp. Adv. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  13. Wheat (tons) 2,000 1,000 Computers 0 100 200 300 Japan’s Outcome With Trade (Produces only computers, trades for wheat!) 0 CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  14. Wheat (tons) 4,000 5,000 2,000 1,000 3,000 Computers 0 100 500 200 300 400 U.S. Outcome With Trade (Produces both, sells wheat for some computers) 0 CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  15. Trade Makes Both Countries Better Off 0 CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  16. Where Do These Gains Come From? 0 • Absolute advantage (the ability to produce a good using fewer inputs than another producer)? NO! • The U.S. has an absolute advantage in the production of wheat: producing a ton of wheat uses 10 labor hours in the U.S. vs. 25 labor hours in Japan. • It also has an absolute advantage in producing computers: a computer uses 100 hours in the U.S. and 125 hours in Japan. YET, both nations gain from trading. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  17. Opportunity Cost and Comparative Advantage 0 • Opportunity cost, what is foregone if a good is produced, underlies the determination of comparative advantage. • The opportunity cost of a computer is • 10 tons of wheat in the U.S., because producing one computer requires 100 labor hours, which instead could produce 10 tons of wheat. • 5 tons of wheat in Japan, because producing one computer requires 125 labor hours, which instead could produce 5 tons of wheat. • So, Japan has a comparative advantage in computers. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  18. Another example CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  19. Questions for the example • Opportunity cost of a quilt for Helen is … • Opportunity cost of a quilt for Carolyn is … • Opportunity cost of a dress for Helen is … • Helen has a comparative advantage in ….. and Carolyn has a comparative advantage in …… CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  20. Summary of Chapter 3: Comparative Advantage and Trade 0 • Differences in opportunity cost and comparative advantage create the gains from trade. These exist anytime relative production costs differ in the two countries – implying different opportunity costs. • When each country specializes in the good(s) in which it has a comparative advantage, total production and consumption in all countries is higher and all countries can gain from trade. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  21. In Ch. 9 on International Trade, look for the answers to these questions: • Who benefits and who loses from trade? Do the gains outweigh the losses? • If policymakers restrict imports, what are the benefits, costs and net effects? • What are the common arguments for restricting trade? Do they have merit? • Resolving trade disputes. Who is the absolute authority among nations? CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  22. Describing the Trade Model with Prices. • Countries gain from trade if each exports the goods in which it has a comparative advantage. We describe trade in terms of world and domestic prices: PW = the world price of a good PD = domestic price without trade If PD < PW, a country exports the good. If PD > PW, a country imports the good. We assume all nations are price takers in the world market. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  23. P S exports $6 $4 D Q 300 750 500 A Country That Exports Soybeans Without trade,PD = $4Q = 500 PW = $6 Under free trade, • domestic consumers demand 300 • domestic producers supply 750 • exports = 450 Soybeans CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  24. P S exports $6 gains from trade D Q A Country That Exports Soybeans: economic welfare analysis. Without trade, CS = A + B PS = C Total surplus = A + B + C With trade, CS = A PS = B + C + D Total surplus = A + B + C + D Soybeans A D B $4 C CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  25. P S $3000 $1500 D Q 200 600 400 ACTIVE LEARNING 1: Analysis of trade Without trade,PD = $3000, Q = 400 In world markets, PW = $1500 Under free trade, how many TVs will the country import or export? Identify CS, PS, and total surplus without trade, and with trade. Plasma TVs CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 24

  26. P S $3000 $1500 D Q 200 600 400 ACTIVE LEARNING 1: Analysis of trade Without trade,PD = $3000, Q = 400 In world markets, PW = $1500 Under free trade, how many TVs will the country import or export? Identify CS, PS, and total surplus without trade, and with trade. Plasma TVs CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 25

  27. P S gains from trade $1500 imports D Q ACTIVE LEARNING 1: Answers. A welfare analysis Without trade, CS = A PS = B + C Total surplus = A + B + C With trade, CS = A + B + D PS = C Total surplus = A + B + C + D Plasma TVs A $3000 B D C CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 26

  28. Summary: The Welfare Effects of Trade PD < PW PD > PW exports imports falls rises rises falls rises rises direction of trade consumer surplus producer surplus total surplus Whether a good is imported or exported, trade creates winners and losers. But the gains exceed the losses. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

  29. Other Benefits of International Trade • Consumers enjoy increased variety of goods. • Producers sell to a larger market and may achieve lower costs through economies of scale. • Competition from abroad may reduce market power of some firms at home, which would increase total welfare. • Trade enhances the flow of ideas, facilitates the spread of technology around the world. • Wealth created abroad fosters better ‘trading partners’. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

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