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Chapter 3 Interdependence and The Gains From Trade A Parable for the Modern Economy Farmer Rancher Production opportunities o Farmer can produce 1 oz of meat in 60 min o Farmer can produce 1 oz of potatoes in 15 min o Rancher can produce 1 oz of meat in 20 min o Rancher can produce 1 oz of potatoes in 10 min Production possibilities frontier shows the various mixes of output that an economy can produce illustrates that ppl face tradeoffs Combinations of meat potatoes that the farmer can produce his production possibilities frontier o 32 oz potatoes no meat o 8 oz meat no potatoes o Divide time in half 4 oz of meat 16 oz of potatoes Combinations of meat potatoes that the rancher can produce his production possibilities frontier o 48 oz of potatoes no meat o 24 oz meat no potatoes o Divide time in half 24 oz potatoes 12 oz meat Production possibilities frontier consumption possibilities frontier if both the rancher and farmer decide to be self sufficient Specialization and trade o Farmer produces only potatoes 32 oz a day and rancher spends 6 hours raising cattle 18 oz of meat and 2 hours growing potatoes 12 oz of potatoes o Farmer gives 15 oz of potatoes to the rancher and the rancher will o Both farmer and rancher benefit b c trade allows them to specialize in o Farmer now has 5 oz of meat instead of 4 oz and 17 oz of potatoes o Rancher now has 13 oz of meat instead of 12 oz and 27 oz of potatoes give him 5 oz of meat what they do best instead of 16 oz instead of 24 oz Comparative Advantage The Driving Force of Specialization Absolute advantage the ability to produce a good using fewer inputs than another producer compare productivity of one person firm or nation to that of another In our example time is the only input rancher has an absolute advantage in both producing potatoes and meat b c it takes him less time to produce 1 unit of each good Opportunity cost what we give up to get an item Farmer and rancher spend 8 hours a day working o Time producing potatoes takes away time from producing meat o Ranchers opportunity cost 10 min to produce 1 oz of potatoes 20 min to produce 1 oz of meat Spend 10 min producing 1 oz of potatoes takes away 10 min from producing 1 oz of meat therefore in the remaining 10 min for making meat he can make oz of meat Opportunity cost of producing 1 oz of potatoes is oz of meat o Farmers opportunity cost 15 min to produce 1 oz of potatoes 60 min to produce 1 oz of meat Spend 15 min producing 1 oz of potatoes takes away 15 min from producing 1 oz of meat therefore in the remaining 45 min for making meat he can make oz of meat 1 Opportunity cost of producing 1 oz of potatoes is oz of meat o Opportunity cost of meat is the inverse of opportunity cost of potatoes 1 oz of potatoes cost the rancher oz of meat 1 oz of meat costs the rancher 2 oz s of potatoes 1 oz of potatoes cost the farmer oz of meat 1 oz of meat cost the farmer 4 oz s of potatoes o Comparative advantage the ability to produce a good at a lower opportunity cost than another producer The producer who gives up less of other goods to produce good X has the smaller opportunity cost of producing good X Farmer has comparative advantage in producing potatoes b c 1 oz of potatoes cost the farmer oz of meat where it costs the rancher Rancher has comparative advantage in producing meat b c 1 oz of meat cost the rancher 2 oz s of potatoes where it costs the farmer 4 oz s of potatoes o Impossible for one person to have a comparative advantage in both goods Gains from specialization trade are based on comparative advantage when each person specializes in what they have a comparative advantage in the total production in the economy rises this increase in the size of the economic pie can be used to make everyone better off The farmer and rancher get more potatoes and meat for the same amount of time input and they get good prices Moral of the story trade can benefit everyone in society bc it allows ppl to specialize in activities in which they have a comparative advantage For both parties to gain form trade the price at which they trade must lie between the two opportunity costs o Farmer and rancher agreed to trade at a rate of 3 oz of potatoes for 1 oz of meat o Farmers opportunity cost 4oz of potatoes per 1 oz of meat o Ranchers opportunity cost 3oz of potatoes per 1 oz of meat o Mutually advantageous trade rancher wants to sell meat to buy potatoes and farmer wants to sell potatoes to buy meat Applications of Comparative Advantage Comparative advantage explains interdependence and the gain from trade Tom Brady should he mow his lawn bc he can do it fast or play football o In 2 hours mow his lawn or film a commercial make 20 000 o In 4 hours his neighbor could mow his lawn or work at McDonalds for 40 o Brady has absolute advantage bc he can mow the lawn in a shorter input of time but his opportunity cost of mowing the lawn is 20 000 while his neighbors opportunity cost is only 40 so neighbor has the comparative advantage in mowing lawns Should the US trade with other countries o Imports goods produced abroad and sold domestically o Exports goods produced domestically and sold abroad o US Japan and food cars o US worker and Japanese worker can produce 1 car per month o US worker produces 2 tons of food per month but Japanese worker only produces 1 ton of food per month o Japan has a comparative advantage in producing cars b c the opportunity cost of 1 car in the US is 2 tons of food where it is only 1 ton of food in Japan export cars to US o US has a comparative advantage in producing food b c the opportunity cost of 1 car in Japan is 1 ton of food where it is only a ton of food in US export food to Japan o International trade can make some individuals worse off even while it makes the country as a whole better off


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UMD ECON 200 - Chapter 3: Interdependence and The Gains From Trade

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