CH 3 Interdependence and the Gains from Trade 09 13 2012 What exactly do people gain when they trade with one another Why do people choose to become interdependent Explains Interdependence not only among individuals but also among 9 13 2012 nations Role of exchange Both parties in a voluntary trade benefit Opportunity for mutually beneficial trade arises when individuals firms or countries own or desire different goods PPF graph combination of many goods an economy can produce w its current resources EXAMPLE 1 PPF with different countries and goods o Assume each country always chooses output levels that are on its PPF in both schedules point E represents the current level of production Let us look at what happens if each country changes its production by 100 airplanes If china moves from E to E1 decreasing airplane production by 100 10 000 more garments can be produced If the united states at the same time increases its airplane production by 100 from E to E2 it will produce only 1 000 fewer garments In the new situation the world production of airplanes is unchanged 100 300 200 200 but world production of garments has increased by 9 000 20 000 9 000 is 9 000 more than 10 000 10 000 BASIC TERMS FOR INTERNATIONAL TRADE Exports goods produced domestically and sold abroad o To export sell domestically produced goods abroad Imports goods produced abroad and sold domestically o To import to purchase goods in other countries EXAMPLE 2 consider a possible level of trade for the two countries The compare consumption w o trade to consumption w trade Suppose the US exports 100 airplanes to China and imports 5 500 garments from China China imports 100 airplanes from US and exports 5 500 garments to US US CONSUMPTION w TRADE AIRPLANES GARMENTS CHANGE IN OUTPUT 100 IMPORTED EXPORTED Gain from trade 0 0 100 BOTH COUNTRIES BENEFIT FROM TRADE Q Where Do the Gains Come From 1 000 5 500 0 4 500 Absolute Advantage when country A is able to produce a particular good using fewer resources than country B would need to produce the good Country A has an absolute advantage in producing the good If each country has an absolute advantage in one good and specializes in that good then both countries can gain from trade One way to measure the cost of a good is to figure out what inputs are required to produce it EXAMPLE 3 LABOR REQUIREMENTS FOR PRODUCTION PER CAMERA PER COMPUTER GERMANY USA 2 hrs 1 5 hrs 16 hrs 9 hrs USA has absolute advantage in producing cameras AND computers Sometimes one country is better at producing everything o Is trade possible between them o YES EX 4 The US increases computer production by 600 and exports to Germany Germany increases camera production by 4 000 and exports to US When the US increases computer production by 600 that uses up 9 hours 600 9 5400 hours 5400 hours less to produce cameras 5400 1 5 3600 cameras US CONSUMPTION WITH TRADE CHANGE IN OUTPUT IMPORTED EXPORTED 400 0 CAMERAS 3600 COMPUTERS 600 4000 0 0 600 o When Germany increases camera production by 4 000 that uses up 4000 2 hours 8000 hours o So computer production decreases by 8000 hours 16 hours per computers 500 computers Cameras Change in Output 4000 imported exported gain from trade 0 0 4000 500 600 0 100 o BOTH COUNTRIES benefit from this trade WHAT LED TO THE GAINS FROM TRADE From Germany s perspective o In the trade each computer costs 4000 600 that is approx 6 67 cameras o If it tried to produce those computers they would have to give up 8 cameras for each computer From US perspective o In the trade each camera costs 600 4000 that is approx 15 of a computer o If it tried to produce those cameras they would have to give up 1 6 17 of a computer for each camera o 17 15 so it is more cost effective to trade with Germany OPPORTUNITY COSTS GERMANY USA PER CAMERA 1 8 computer 1 6 computer PER COMPUTER 8 cameras 6 cameras The producer who has the smaller opportunity cost from producing a particular good is said to have a comparative advantage in producing that good ABSOLUTE AND COMPARATIVE ADVANTAGE Although one country might have an absolute advantage in producing every good another country can still have a comparative advantage in some good comparative advantage the ability to produce a good at a lower opportunity cost than another produce o Comparative advantage reflects the relative opportunity cost o 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 Gains from trade arise from comparative advantage o Difference in opp Cost lead to gains from trade o Specialization leads to gains even if one country has an absolute advantage in both goods David Ricardo British Economist established principle of comparative advantage in early 1800s Portugal had absolute advantage in producing both wool and wine but had a comparative advantage in producing wine and Britain had comparative advantage in producing wool Trade was beneficial to both countries The slope of the production possibilities frontier for china is 10 000 Slope of PPF for the US is 1 000 100 10 US has a comparative advantage in producing airplanes China has comparative advantage in producing textiles BACK TO USA 100 100 Trade can benefit everyone in society because it allows people to specialize in activities in which they have a comparative advantage Trade between individuals benefits every single person involved Trade between countries benefits each country but not the individuals that reside in each state may actually hurt harm people living in countries Why orgs resist trade 09 13 2012 3 2D The Price Of The Trade For both parties to gain from trade the price at which they trade must lie between the two opportunity costs Trade allows all countries to achieve greater prosperity Each person consumes goods and services produced by many other people both in the United States and around the world Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services There are two ways to compare the ability of two people in producing a good The person who can produce the good with the smaller quantity of inputs is said to have an absolute advantage in producing the good The person who has the smaller opportunity cost of producing the good is said to have a comparative advantage The gains from trade are based on comparative advantage not absolute advantage Trade
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