Ch 3: Interdependence and Gains from Trade

1. Ch 3: Interdependence and Gains from Trade • Intro: --Satisfy your wants by: self sufficiency or specialize and trade • --You rely on others around the world every day for the things you need and want. • --Those that provide it are NOT acting out of generosity or kindness. They provide goods and services in order to get something in return . • -- 1/10 Principles of Economics: Trade can make everyone better off • --What exactly do people gain from trade? Why do people choose to become interdependent?

2. Parable for the Modern Economy • Simple Economic Example • 2 Producers Rancher = Meat and Farmer= Potatoes • -- if each could only produce the one good, then trade is quite obvious • --Specialization: if rancher can grow potatoes, but not efficiently and… • if farmer can raise cattle and produce meat but not efficiently…….then…… • Trade is beneficial if both stick to their specialty • But what if the Rancher is better at raising cattle AND growing potatoes,……shouldn’t he choose to be self sufficient?

3. Production Possibilities Read along and study Table 3-1 and Figure 3-1 ----------------------------------------------------------------------- • Farmer 20 hours = 1lb meat 10 hours = 1lb potatoes • Rancher 1 hour = 1lb meat 8 hours = 1lb potatoes ------------------------------------------------------------------------ • Farmer 40 hours = 2lb meat or 4lb potatoes • Rancher 40 hours = 40lb meat or 5lb potatoes ------------------------------------------------------------------------ • Key Ideas • Production possibilities frontier • (also the consumption possibilities frontier if they remain self sufficient and do not trade) • principle of tradeoffs

4. Prod. Poss. Frontier = linear not bowed b/c…… • Constant opportunity costs …..technology allows them to switch from one good to another at a constant rate • But ……What will they choose? ……. Need to know their TASTES …….see pt. A + B in Fig 3-1

5. What will they choose? • Specialization and Trade • Read and study Fig 3-2 and Table 3-2 • What are the big ideas???? • Free Trade and Specialization • Increased productivity, choices, increased standard of living • #1 Quick Quiz pg. 52 -

6. coconuts Can achieve greater combination of goods if specializes and trades Limited to the frontier – by himself fish

7. Comparative Advantage First define Absolute Advantage – Requires smaller amount of inputs Farmer 20 hours = 1lb meat 10 hours = 1lb potatoes Rancher 1 hour = 1lb meat 8 hours = 1lb potatoes ----------------------------------------------------------------- Farmer 40 hours = 2lb meat or 4lb potatoes Rancher 40 hours = 40lb meat or 5lb potatoes

8. Rancher has absolute advantage in both • Opportunity Cost and Comparative Advantage • Opportunity cost – what is given up • Read along and study table 3-3

9. Farmer 20 hours = 1lb meat 10 hours = 1lb potatoes If farmer wants 1lb meat, his O.C. = 2lb potatoes If farmer wants 1lb potatoes, his O.C. = ½ lb meat ====================================== • Rancher 1 hour = 1lb meat 8 hours = 1lb potatoes If Rancher wants 1lb meat, his O.C. = 1/8 lb potatoes If Rancher wants 1lb potatoes, his O.C. = 8lb of meat ======================================= • Define Comparative advantage- • The producer who gives up less of Y in order to produce X is said to have the comparative advantage in producing X • Farmer = comp. advantage for potatoes Rancher = comp. advantage for meat

10. Impossible for same person to have a comp. advantage for both goods, b/c the opp. Cost of Y is the inverse of the opp. cost of X • Comparative Advantage and Trade • When you specialize in producing X (with a comparative advantage) , total production in the economy rises • As long as two people have different opp. costs, each can benefit from trade by obtaining a good at a price lower than his opp. cost of that good. • #2 Quick Quiz pg. 55 draw and show all work

11. 10 coconuts/hr • Crusoe • Friday 1 fish / hr 30 coconuts/hr 2 fish/hr

12. Crusoe’s OC of 1 fish 10 coconuts/hr = 10 coconuts 1 fish/hr • Friday’s OC of 1 fish 30 coconuts/hr = 15 coconuts 2 fish/hr Absolute advantage for fish? Friday (2 / hr vs. 1 / hr) • Absolute advantage for coconuts? Friday (30/ hr vs. 10/ hr) • Comparative advantage for fish? Crusoe- he has a lower OC of catching 1 fish (he only gives up 10 coconuts vs. 15 ) He should specialize in catching fish and trade for coconuts --Continue on next slide • ***HELPFUL HINT*** given two goods ( X , Y ) – when finding the o.c. of X – always put X as the denominator

13. Crusoe’s OC of 1 coconut 1 fish/hr = 1/10 of fish 10 coconuts/hr • Friday’s OC of 1 coconut 2 fish/hr = 1/15 of fish 30 coconuts/hr • Comparative advantage for coconuts? Friday has the lower OC of gathering coconuts (he only gives up 1/15 of fish vs. 1/10) He should specialize in gathering coconuts and trade for fish