Chapter 3 Interdependence and the Gains From Trade

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Chapter 3 Interdependence and the Gains From
Trade

• Outline of Topics
• T1 A Parable for the modern economy
• T2 The principle of comparative advantage
• T3 Applications of comparative advantage

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• Every day you rely on many people from around the
  world, most of whom you do not know, to provide
  you with the goods and services that you enjoy.
• You wake up in the morning and you pour yourself
  juice from oranges grown in Florida and coffee
  from beans grown in Brazil. You get dressed in
  clothes made of cotton grown in Georgia and sewn
  in factories in Thailand. You drive to class in a
  car made of parts manufactured in more than a
  dozen countries around the world.
• Those people who provide you with goods and
  services are not acting out of generosity or
  concern for your welfare instead, they produce
  because they get something in return.

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• T1 A parable for the modern economy
• To understand why people choose to depend on
  others for goods and services and how this choice
  improves their lives, lets look at a simple
  economy.
• Imagine that there are two goods in the
  world-meat and potatoes.
• And there are two people in the world- a cattle
  rancher and a potato farmer-each of whom would
  like to eat both meat and potatoes.
• Suppose that the farmer and the rancher each work
  8 hours a day and can devote this time to growing
  potatoes, raising cattle or a combination of the
  two.
• See Table 3-1 on page 49

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• Table 3-1 shows
• the farmer can produce 1 kg of meat per hour or 1
  kg of potatoes per hour. If the farmer devotes
  all 8 hours of his time to potatoes, he produces
  8 kg of potatoes and no meat. If he devotes all
  of his time to meat, he produces 8 kg of meat and
  no potatoes. If the farmer divides his time
  equally between the two activities, spending 4
  hours on each, he produces 4 kg of potatoes and 4
  kg of meat.
• See Figure 3-1 on page 50

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• Panel (a) of Figure 3-1 is the farmers
  production possibilities frontier. It shows the
  combinations of meat and potatoes that the farmer
  can produce when he works 8 hours a day.
• The farmers technology for producing meat and
  potatoes allows him to switch between one good
  and the other at a constant rate. The PPF is a
  downward-sloping straight line with a slope of 1.

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• Table 3-1 shows
• The rancher, who is more productive in both
  activities, can produce 8 kg of meat per hour or
  2 kg of potatoes per hour. If the rancher devotes
  all 8 hours of his time to potatoes, he produces
  16 kg of potatoes and no meat. If he devotes all
  of his time to meat, he produces 64 kg of meat
  and no potatoes. If the farmer divides his time
  equally between the two activities, spending 4
  hours on each, he produces 8 kg of potatoes and
  32 kg of meat.
• See Figure 3-1 on page 50

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• Panel (b) of Figure 3-1 is the ranchers
  production possibilities frontier. It shows the
  combinations of meat and potatoes that the
  rancher can produce when he works 8 hours a day.
• The ranchers technology for producing meat and
  potatoes allows him to switch between one good
  and the other at a constant rate.
• The PPF is a downward-sloping straight line with
  a slope of 4.
• If the farmer and the rancher choose to be
  self-sufficient, rather than to trade with each
  other, then each consumes exactly what he or she
  produces. In this case, the PPF is also the
  consumption possibilities frontier.

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• We further assume that the farmer chooses point A
  and the rancher chooses point B in Figure 3-1
  the farmer produces and consume 4 kg of potatoes
  and 4 kg of meat, while the rancher produces and
  consumes 8 kg of potatoes and 32 kg of meat.
• Initial production consumption bundle without
  trade
• (4 p, 4 m) for the farmer
• (8 p, 32 m) for the rancher.
• Now assume the rancher proposes a trade deal to
  the farmer as follows
• The Farmer works 8 hours a day growing potatoes.
  So, the farmer produces 8kg potatoes and 0 kg
  meat.
• (8 p, 0 m)

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• The rancher works 5 hours a day producing meat
  and 3 hours a day producing potatoes. So,the
  rancher produces 40 kg of meat and 6 kg of
  potatoes.
• (6 p, 40 m)
• If the farmer give the rancher 3 kg of potatoes,
  the rancher will give the farmer 6 kg of meat in
  return.
• New consumption bundle with trade
• (5 p, 6 m) for the farmer
• (9 p, 34 m) for the rancher.
• See Figure 3-2 on page 51
• See Table 3-2 on page 52
• So, the farmer and the rancher can both benefit
  because trade allows each of them to specialize
  in doing what they do best. Each of them can
  consume both more meat and more potatoes without
  working any more hours.

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• T2 The principle of comparative advantage
• Puzzle If the rancher is better at both raising
  cattle and growing potatoes, how can the farmer
  ever specialize in doing what he does best? The
  farmer doesnt seem to do anything best. To solve
  this puzzle, we need to look at the principle of
  comparative advantage. To develop this principle,
  consider the following Question
• Who can produce potatoes at lower cost - the
  rancher or the farmer? There are two possible
  ways to answer.
• T 2.1 First Way Using Absolute Advantage
• Absolute Advantage the comparison among
  producers of a good according to their
  productivity

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• Economists use the term absolute advantage when
  comparing 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.
• We compare the inputs required by the two
  producers. The rancher needs only half hour to
  produce 1 kg of potatoes, whereas the farmer
  needs 1 hour. The rancher needs only 1/8 hour to
  produce 1 kg of meat, whereas the farmer needs 1
  hour.
• In our example, the rancher has an absolute
  advantage both in producing potatoes and in
  producing meat, because she requires less time
  than the farmer to produce a unit of either good.

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• T 2.2 Second Way Using Opportunity cost and
  comparative advantage
• Recall from Chapter 1 that the opportunity cost
  of some item is what we give up to get that item
• comparative advantage the comparison among
  producers of a good according to their
  opportunity cost
• Lets first consider the farmers opportunity
  cost. Producing 1 kg of potatoes takes him 1 hour
  of work. When the farmer spends that hour
  producing potatoes, he spends 1 hour less
  producing meat. Since he produces 1 kg of meat
  per hour, he produces 1 kg of meat less for every
  extra 1 kg of potatoes he produces.The farmers
  PPF reflects this opportunity cost. The
  downward-sloping PPF has a slope equal to 1.

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• Now consider the ranchers opportunity cost.
  Every hour she spends producing potatoes instead
  of meat, she produces 2 kg more potatoes and 8 kg
  less meat. So every half-hour she spends
  producing potatoes, she produces 1 kg more
  potatoes and 4 kg less meat. Hence, the ranchers
  opportunity cost of 1 kg of potatoes is 4 kg of
  meat. Hence, the ranchers opportunity cost of 1
  kg of potatoes is 4 kg of meat. The ranchers PPF
  reflects this opportunity cost by having a slope
  equal to 4.
• Economists use the term comparative advantage
  when describing the opportunity cost of two
  producers.

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• The producer who has the smaller opportunity cost
  of producing a good is said to have a comparative
  advantage in producing that good.
• See Table 3-3
• From Table 3-3, the farmer has a lower
  opportunity cost of producing potatoes than the
  rancher ( 1 kg vs. 4 kg of meat). The rancher has
  a lower opportunity cost of producing meat than
  the farmer ( 1/4 kg vs. 1 kg of potatoes).
• Thus, the farmer has a comparative advantage in
  growing potatoes, and the rancher has a
  comparative advantage in producing meat.
• Notice that it would be impossible for the same
  person to have a comparative advantage in both
  goods.

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• Because the opportunity cost of one good is the
  inverse of the opportunity cost of the other,if a
  persons opportunity cost of one good is
  relatively high, his or her opportunity cost of
  the other good must be relatively low.
  Comparative advantage reflects the relative
  opportunity cost.
• Unless two people have exactly the same
  opportunity cost, one person will have a
  comparative advantage in one good, and the other
  person will have a comparative advantage in the
  other good.
• T 2.3 Comparative advantage and trade
• Differences in opportunity cost and comparative
  advantage create the gains from trade.
• When each person specializes in producing the
  good for which he or she has a comparative
  advantage,

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• total production in the economy rises, and this
  increase in the size of the economy pie can be
  used to make everyone better off.
• Quick Quiz ( page 55)
• Robinson Crusoe can gather 10 coconuts or catch 1
  fish per hour. His friend Friday can gather 30
  coconuts or catch 2 fish per hour.
• What is Crusoes opportunity cost of catching 1
  fish? What is Fridays?
• Who has an absolute advantage in catching fish?
• Who has a comparative advantage in catching fish?

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• T3 Applications of Comparative Advantage
• T 3.1 Should Joe Sakic mow his own lawn?
• Joe Sakic is a great NHL hockey player. Lets say
  that Sakic can mow his lawn in 2 hours. In that
  same 2 hours, he could film a television
  commercial for hockey skates and earn 10,000. By
  contrast, Jennifer,the girl next door, can mow
  Sakics lawn in 4 hours. In that same 4 hours,
  she could work at McDonalds and earn 20.
• Sakics opportunity cost of mowing the lawn is
  10,000, and Jennifers opportunity cot is 20.
• Sakic has an absolute advantage in mowing lawns
  because he can do the work in less time.

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• Yet Jennifer has a comparative advantage in
  mowing lawns because she has the lower
  opportunity cost.
• The gains from trade in this example are
  tremendous.
• Rather than mowing his own lawn, Sakic should
  make the commercial and hire Jennifer to mow the
  lawn. As long as he pays her more than 20 and
  less than 10,000, both of them are better off.

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• T 3.2 Should Canada trade with other countries
• Imports goods and services that are produced
  abroad and sold domestically
• Exports goods and services that are produced
  domestically and sold abroad.
• Suppose there are two countries Canada and Japan
• there are two goods food and cars
• Assume
• A Canadian worker and a Japanese worker can each
  produce 1 car per month.
• A Canadian worker can produce 2 tones of food per
  month, whereas a Japanese worker can produce only
  1 tone of food per month.

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• Japan has a comparative advantage in producing
  cars because the opportunity cost of a car is 2
  tones of food in Canada but only 1 tone of food
  in Japan. Japan should produce more cars than it
  wants for its own use and export some of them to
  Canada
• Canada has a comparative advantage in producing
  food because the opportunity cost of a tone of
  food is 1 car in Japan but only ½ car in Canada.
  Canada should produce more food than it wants to
  consume and export some of it to Japan.
• Through specialization and trade, both countries
  can have more food and more cars.