Slide 1Knowledge RecapSimple Trade ModelSimple Trade ModelSimple Trade ModelGains from TradeGains from TradeGains from TradeGains from TradePrice of TradeInternational Gains from TradeECON 203: Principles of MicroeconomicsClass 3: The Gains from Trade1Knowledge Recap•Economics is the study of how to allocate scarce resources to satisfy unlimited wants and needs.•Economic models use assumptions combined with economic concepts to simplify and explain reality.–Example: Production Possibilities Frontier (PPF).•In this class we focus on trade.–Introduce a simple model that shows how it can improve allocation of resources.2Simple Trade Model•Economic concepts.–Opportunity Cost: whatever must be given up to obtain a given good.–Absolute Advantage: the ability to produce a good using fewer inputs than another producer.–Comparative Advantage: the ability to produce a good at a lower opportunity cost than another producer. •Assumptions.–Two people, a farmer and a rancher.–Two goods, meat and potatoes.3Simple Trade Model•Amount produced in one day (8 hours).–Each person works 100 days per year.•Each person’s ability to produce different mixes of goods is given by the PPF.–Farmer can produce a maximum of 800 ounces of meat or 3,200 ounces of potatoes in one year.–Rancher can produce a maximum of 2,400 ounces of meat or 4,800 ounces of potatoes in one year.–Rancher has an absolute advantage in production of both meat and potatoes.4Meat PotatoesFarmer 8 oz 32 ozRancher 24 oz 48 ozSimple Trade Model•Amount produced in one day (8 hours).–Each person works 100 days per year.•With no trade, a person’s consumption equals his or her production.– Farmer chooses to produce and consume 300 ounces of meat and 2,000 ounces of potatoes.– Rancher chooses to produce and consume 900 ounces of meat and 3,000 ounces of potatoes.5Meat PotatoesFarmer 8 oz 32 ozRancher 24 oz 48 ozGains from Trade•Trade could benefit both the farmer and the rancher.– With trade, consumption of a person no longer has to equal his or her production.– Increasing total production increases total consumption. –To maximize total production and consumption, each person should specialize in producing the good for which he or she has a comparative advantage.6Gains from Trade•Amount produced in one day (8 hours).–Each person works 100 days per year.•Opportunity costs.–Farmer: 1 ounce of meat “costs” 4 ounces of potatoes; 1 ounce of potatoes “costs” ¼ ounces of meat.–Rancher: 1 ounce of meat “costs” 2 ounces of potatoes; 1 ounce of potatoes “costs” ½ ounces of meat.•Farmer has a comparative advantage in potatoes and rancher has a comparative advantage in meat.7Meat PotatoesFarmer 8 oz 32 ozRancher 24 oz 48 ozGains from Trade•With trade farmer will produce only potatoes and rancher will produce both.–Rancher chooses production to increase total production (and consumption) of both goods.No Trade•In 8 hours rancher can make 48 oz. potatoes, or 24 oz. meat.• In 1 hour rancher can make 6 oz. potatoes, or 3 oz. meat.8Consumption = ProductionMeat PotatoesFarmer 300 2,000Rancher 900 3,000Total 1,200 5,000Gains from Trade•Given higher total production, consumption of both goods is increased with trade.9No Trade TradePotatoes Meat Potatoes MeatFarmer 2,000 300 2,200 400Rancher 3,000 900 3,100 950Total 5,000 1,200 5,300 1,350Price of Trade•The price of trade can be given by the amount the amount of one good traded for the other.–In our example, the rancher traded 400 ounces of meat for 1,000 ounces of potatoes.– The price of an ounce of meat in this example is 2.5 potatoes. • The price of trade needs to be between the opportunity costs of both parties involved in trade.–Actual price given by bargaining power and relative value of the two goods.10International Gains from Trade•Same model can be applied to countries.–2 countries (U.S. and Japan); two goods (cars and food).–Both countries can produce 1 car per month, but U.S. can produce more food (2 tons vs. 1 ton per month).•Both countries can increase consumption by trade:–Japan: •No trade: production=consumption= 6 cars, 6 tons food.•With trade: production=12 cars; consumption=7 cars , 7.5 tons food.–U.S.:•No trade: production = consumption = 7 cars,10 tons food.•With trade: production = 3 cars, 18 tons food; consumption = 8 cars, 10.5 tons food.–Price of trade:•5 cars for 7.5 tons of food  1 car worth 1.5 tons