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Why We Trade

Three benefits of trade1. Trade makes people better off when

preferences differ.2. Trade increases productivity through

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p y gspecialization and the division of knowledge.

3. Trade increases productivity through specialization according to comparative advantage.

Trade and Preferences

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Why We Trade

2. Specialization, Productivity, and the Division of KnowledgeModern economies require more knowledge than can exist in a single brain.

Specialization →↑ knowledge → ↑productivity

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Without trade, specialization is not possible.Trade connects all markets.Trade → ↑markets → ↑division of knowledge

Entrance of China, Eastern Europe, and Russia into world markets → ↑ stock of engineers, scientists → ↑ available knowledge

Click below for one of the authors’ TED talks….The "dismal science" truly shines in this optimistic talk, as economist Alex Tabarrok argues free trade and globalization are shaping our once-divided world into a community of idea-sharing more healthy, happy and prosperous than anyone's predictions. (14:37 minutes)

http://www.ted.com/talks/lang/eng/alex_tabarrok_foresees_economic_growth.html

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Why is Globalization Good?

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Reducing Trade Barriers in Berlin, 1989

Why We Trade

3. Comparative AdvantageA country has a comparative advantage comparative advantage in

producing goods for which it has the lowest opportunity cost.Allows both trading partners to benefit from trade.

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Allows both trading partners to benefit from trade. (Not to be confused with absolute absolute

advantageadvantage-The ability to produce the same good using fewer inputs than another producer.)

Just because the U.S. can produce more shoes than Indonesia per worker doesn’t mean it makes sense for the U.S. to make all its own shoes.

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Why Absolute Advantage Doesn’t MatterJust because a person or country can produce

more of a good than others doesn’t necessarily mean it can produce the good cheaper.

Even very productive countries gain when they import cheaper goods (instead of being self-sufficient)

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sufficient)

SEE THE SEE THE INVISIBLEINVISIBLE HANDHANDSEE THE SEE THE INVISIBLEINVISIBLE HANDHAND

Martha Stewart probably hires housecleaners…. Every hour she spends cleaning (instead of writing about how to keep a clean house) is an hour she doesn’t spend running her empire.

The Production Possibilities Frontier

We can use the PPF model to answer questions like:

How much can we produce?

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What will it cost us to change our mix of production?

The Production Possibilities Frontier

Suppose that there are just two goods, computers and shirts, and one input, (labor).

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The Production Possibilities Frontier

Assume that in Mexico, it takes 12 units of labor to make one computer and 2 units of labor to produce one shirt

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The Production Possibilities Frontier

Suppose that Mexico has 24 units of labor. It can produce 2 computers and 0 shirts… or 0 computers and 12 shirts

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The Production Possibilities Frontier

The PPF is about trade-offs.If Mexico wants to produce more shirts, it must produce fewer computers.Each computer “costs” 12 workers…. (Who could produce 6 shirts )

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(Who could produce 6 shirts.)So a computer “costs” 6 shirts in Mexico.

The Production Possibilities Frontier

AND…Each shirt “costs” 2 workers…. (Who could produce 1/6 of a computer.)So a shirt “costs” 1/6 of a computer in Mexico.

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1/6

The Production Possibilities FrontierMexico’s Production Possibilities Frontier

Production Possibilities

Computers Shirts2 0

6

5

4

The PPFThe PPF

Computers

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2 01 60 123

2

1

2 1210864 Shirts

The slope = the tradeoff (“cost”) of the x-axis good to the y-axis good(1/6= 1 shirt “costs” 6 computers)

Try it!Try it!

Erin has a choice between two activities: She can repair one transmission per hour or she can repair two fuel injectors per hour. What is the opportunity cost of repairing one fuel the opportunity cost of repairing one fuel injector?a) 1 transmissionb) ½ transmissionc) 2 transmissions

To next To next Try it! Try it!

Try it!Try it!

Deirdre has a choice between writing one more book this year or five more articles this year. What is the opportunity cost of writing half of a book this year in terms of writing half of a book this year, in terms of articles?a) 1/5 articleb) 1 articlec) 2.5 articlesd) 10 articles To next To next

Try it! Try it!

The Production Possibilities Frontier

Enter the U.S. with its own production and cost ratios.

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The Production Possibilities Frontier

Assume that in the U.S, there are 24 units of labor and it takes 1 unit of labor to produce either good.

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The Production Possibilities Frontier

Each shirt “costs” 1 workers…. (Who could produce 1 computer.)So a shirt “costs” 1 computer in the U.S.

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The Production Possibilities Frontier

U.S’s Production Possibilities FrontierComputers The PPFThe PPF

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Shirts

Comparative Advantage

Summary of costs: each country has a different opportunity cost for each good. Take a look at the opportunity costs for computers:

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Would there be benefit to trade? If so, who should produce what?Would there be benefit to trade? If so, who should produce what?

Comparative Advantage

U.S. and Mexico have the following PPFs

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Opportunity Costs

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A country has a comparative advantage in producing goods for which it has the lowest opportunity cost.

Mexico is the low-cost producer of shirts

The U.S. is the low-cost producer of computers

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Try it!Try it!

Which country has the absolute advantage in producing high-quality cars? Low-quality cars?

a) North has absolute advantage in bothb) South has absolute advantage in bothc) North: high-quality, South: low-qualityd) South: high-quality, North: low-quality To next To next

Try it! Try it!

Try it!Try it!

What is the opportunity cost of each high-quality car (HQ) in the South? (Hint: first translate from hours into units of the goods produced)

a) ½ of a low-quality (LQ) carb) 1 LQ carc) 2 LQ carsd) 1.5 LQ cars To next To next

Try it! Try it!

Try it!Try it!

What is the opportunity cost of each high-quality car (HQ) in the NORTH? (Hint: first translate from hours into units of the goods produced)

a) ½ of a low-quality (LQ) carb) 1 LQ carc) 2 LQ carsd) 1.5 LQ cars To next To next

Try it! Try it!

Try it!Try it!

Which country has the comparative advantage (CA) i hi h lit (HQ) ? I l lit (LQ) (CA) in high-quality (HQ) cars? In low-quality (LQ) cars?a) North has the CA in both HQ and LQ carsb) South has the CA in both HQ and LQ carsc) North has the CA in HQ cars; South has the CA

in LQ carsd) North has the CA in LQ cars; South has the CA in

HQ cars To next To next Try it! Try it!

Why We Trade

3. Comparative AdvantageWith No Trade—Suppose U.S. and Mexico allocate the same amount of labor (12 units) to the production of each good

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Total production will be 13 computers, 18 shirts.

Why We Trade

3. Comparative AdvantageSuppose Mexico completely specializes in

producing shirts and the U.S. moves 2 units of labor from producing shirts to computers

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computers.

Total production of the two goods is higher with specialization.

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The Economics of Trade

“Tariffs and import quotas usually reduce the general welfare of a society.”

% of American Economics Association members Agree 92%

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Disagree 6%

“The U.S. should eliminate remaining tariffs and other barriers to trade.”

% of AEA members Agree 88% Disagree 8%

SEE THE SEE THE INVISIBLEINVISIBLE HANDHANDSEE THE SEE THE INVISIBLEINVISIBLE HANDHAND

“It is the maxim of every prudent master of a family never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. ….If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage.” –Adam Smith

SEE THE SEE THE INVISIBLEINVISIBLE HANDHANDSEE THE SEE THE INVISIBLEINVISIBLE HANDHANDGlobalization is not new

Phoenicians: 1550 B.C. TradersRoman Empire: 753 B.C. Specialization and TradeCollapse of trade networks? 476 A.D. Collapse of trade networks? 476 A.D. “Dark Ages”Revitalized trade routes? 1300s “European Renaissance”

Periods of increased trade and the spread of ideas have been among the best for human progress.

Try it!Try it!Is there a Moral Dimension to Economic Growth?

Do you agree with Benjamin Friedman? When people feel they are getting ahead, are they more likely to protect and enhance our basic moral values like:like:– Opportunity for all?– Tolerance?– Improving fairness/equality?– Preserving democracy?

a) Yes, I agreeb) No, I do not agree

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