Chapter 3: Interdependence and The Gains From TradeA Parable for the Modern Economy - Farmer & Rancher - Production opportunitieso Farmer can produce 1 oz of meat in 60 mino Farmer can produce 1 oz of potatoes in 15 mino Rancher can produce 1 oz of meat in 20 mino 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 meato 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 meato 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 give him 5 oz of meat o Both farmer and rancher benefit b/c trade allows them to specialize inwhat they do besto Farmer now has 5 oz of meat instead of 4 oz and 17 oz of potatoes instead of 16 ozo Rancher now has 13 oz of meat instead of 12 oz and 27 oz of potatoes instead of 24 ozComparative 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 workingo 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 ofmeat 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 ½ oz of meat Opportunity cost of producing 1 oz of potatoes is ½ oz of meato Farmers opportunity cost 15 min to produce 1 oz of potatoes & 60 min to produce 1 oz ofmeat 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 ¾ oz of meat (1- ¾ = ¼) Opportunity cost of producing 1 oz of potatoes is ¼ oz of meat o Opportunity cost of meat is the inverse of opportunity cost of potatoes 1 oz of potatoes cost the rancher ½ oz of meat, 1 oz of meat costs the rancher 2 oz’s of potatoes 1 oz of potatoes cost the farmer ¼ 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 ¼ oz of meat where it costs therancher ½ Rancher has comparative advantage in producing meat b/c 1 oz of meat cost the rancher 2 oz’s of potatoes where it costs thefarmer 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; wheneach 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 meato 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 $20,000o In 4 hours: his neighbor could mow his lawn or work at McDonalds for $40o 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 domesticallyo Exports: goods produced domestically and sold abroad o US & Japan and food & cars o US worker and Japanese worker can produce 1 car per montho US worker produces 2 tons of food per month but Japanese worker only produces 1 ton of food per montho 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 USo 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 ½ a ton of food in US >> export food to Japano International trade can make some individuals worse off even while it makes the country as a whole better
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