chapter 3 exchange and markets. consider your typical day –you wake up to an alarm clock made in...
TRANSCRIPT
Chapter 3Exchange and
Markets
Consider your typical day–You wake up to an alarm clock made in
Korea.–You pour yourself orange juice made
from Florida oranges and coffee from beans grown in Brazil.
–You put on some clothes made of cotton grown in Georgia and sewn in factories in Thailand.
–You drive to class in a car made of parts manufactured in a half-dozen different countries.
. . . and you haven’t been up for more than two hours yet!
Interdependence and the Gains from Trade
How do we satisfy our wants and needs in a global economy? – We can be economically self-sufficient.– We can specialize and trade
with others, leading to economic interdependence.
Interdependence and the Gains from Trade
Why is interdependence the norm?– Interdependence occurs because people
are better off when they specialize and trade with others.
What determines the pattern of production and trade? – Patterns of production and trade are
based upon differences in opportunity costs.
Adam SmithIn his 1776 book An Inquiry
into the Nature and Causes of the Wealth of Nations, Adam Smith performed a detailed analysis of trade and economic interdependence.
The Legacy of Adam Smith
Adam Smith1723 -1790
Adam Smith believed that specialization and trade should be based on absolute advantage.
Absolute Advantage
Absolute Advantage
The comparison among producers of a good according to their productivity.– The producer that requires a smaller
quantity of inputs to produce a good is said to have an absolute advantage in producing that good.
Minutes needed to make one
Boxes of
cookies
cake
Emily 40 30
Julia 20 60
• Who has an absolute
advantage in making
cookies?
• Julia
Example
Minutes needed to make one
Boxes of
cookies
cake
Emily 40 30
Julia 20 60
• Who has an absolute
advantage in making cake?
• Emily
Example
Pattern of specialization and trade
According to Adam Smith specialization and trade should be based on absolute advantage:
– Emily should specialize in making cakes.
– Julia should specialize in making cookies.
Minutes needed to make one
Box of cookies
cake
Emily 40 30
Julia 20 60
Amount produced in 8 hrs
Box of cookies
cake
Emily
Julia
Production PossibilitiesAssuming for simplicity that time is the only resource and that each has a total of 8 hours of work
Minutes needed to make one
Box of cookies
cake
Emily 40 30
Julia 20 60
Amount produced in 8 hrs
Box of cookies
cake
Emily 12 16
Julia 24 8
Production PossibilitiesAssuming for simplicity that time is the only resource and that each has a total of 8 hours of work
Julia’s Production Possibilities Frontier
cookies
4
12
8
24
A
0
cakes
If there is no trade, Julia chooses this production and consumption.
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Emily’s Production Possibilities Frontier
cookies
8
6
A
0
cakes
If there is no trade, Emily chooses this production and consumption.
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12
16
After Trade
Specialization and Trade results in more total output. Both are better off
Boxes of Cookies
Cakes
Total output before trade
12+6=18 4+8=12
Total output after trade
24 16
Problems
What if one person has an absolute advantage in making both goods, will there be gains from specialization and trade?
According to Adam Smith: there will be no gains from specialization and trade.
David RicardoIn his 1816 book Principles of
Political Economy and Taxation, David Ricardo developed the principle of comparative advantage as we know it today.
The Legacy of David Ricardo
David Ricardo1772-1823
Comparative Advantage
According to Ricardo specialization and trade should be based on comparative advantage.
Even if one person is better at making all goods, there are still gains from trade.
Example Consider an
economy with two people: Fred and Kate.
Two goods: coconut and fish.
Fred’s maximum output in a day if he produces only
Coconuts Fish
2 6
Kate’s maximum output in a day if she produces only
Coconuts Fish
1 1
Clearly, Fred is better at making both goods
Fred’s PPC
Fred’s maximum output in a day if he
produces only
Coconuts Fish
2 6
Fish
4
24
12
36
A
0
If there is no trade, assume Fred chooses this production and consumption.
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Assume that he works 6 days a week, we can
construct his PPC as follows
Coconuts
Kate’s PPC
Kate’s maximum output in a day if she produces only
Coconuts Fish
1 1
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Assume that she works 6 days a week, we can
construct her PPC as follows
1
5
B
0
Coconuts
6
6
If there is no trade, Assume Kate chooses this production and consumption.
Fish
Opportunity Cost and Comparative Advantage
Opportunity cost is what must be given up to obtain some item.
The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good.
Who has the comparative advantage in the production of each good?
? ?
The Opportunity CostFred’s maximum output in a
day if he produces only
Coconuts Fish
2 6
Kate’s maximum output in a day if she produces only
Coconuts Fish
1 1
• What is the opportunity cost of one coconut for
Fred?• 3 Fish
• What is the opportunity cost of one coconut for
Kate?• 1 Fish
• Who has a comparative advantage in Coconut?• Kate
The Opportunity CostFred’s maximum output in a
day if he produces only
Coconuts Fish
2 6
Kate’s maximum output in a day if she produces only
Coconuts Fish
1 1
• What is the opportunity cost of one fish for Fred?
• 1/3 coconut
• What is the opportunity cost of one fish for Kate?
• 1 coconut
• Who has a comparative advantage in fish?• Fred
You can calculate the opportunity cost using the PPF. The opportunity cost of – the x-axis good = the slope of the PPF.– the y-axis good equals 1/ the slope of
the PPF.
Rule: Opportunity cost and slope.
The opportunity costs
The Opportunity cost of
Coconut Fish
Fred 3 fish 1/3 coconut
Kate 1 fish 1 coconut
Who produces coconut cheaper?
Who produces fish cheaper?
Kate has a comparative advantage in coconut
Fred has a comparative advantage in fish.
Fred produces fish.
Kate produces coconuts.
Specialization and Trade
Suppose instead Kate and Fred decide to specialize and trade…– Both would be better off if they
specialize in producing the product they are more suited to produce, and then trade with each other.
Specialization and Trade
After specialization, they agreed to trade.
The terms of trade: 1 fish for ½ coconut.
Fred gives Kate 10 fish for 5 coconuts
Who will benefit from trade?
How Trade Expands the Set of Consumption Opportunities
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Fish
4
24
5
26
12
36
A
A*
0
Coconuts
Fred’s Production and consumption
Fred’s consumption with trade
Fred’s production with trade
Fred gives Kate 10 fish for 5 coconuts.
How Trade Expands the Set of Consumption Opportunities
Copyright©2003 Southwestern/Thomson Learning
Kate gives Fred 5 coconuts for 10 fish.
Fish
1
5 10
B
0
Kate’s Consumption and Production’
6
6
B*
Kate’s consumption with trade
Coconuts
Kate’s productionWith trade
Consumption and Production without trade
Gains from Trade
Coconut Fish
Fred 1 2
Kate 0 5
Total 1 7
Comparative Advantage and Trade
Benefits of Trade
– Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage.
Comparative Advantage and Trade
Comparative advantage and differences in opportunity costs are the basis for specialized production and trade.
Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade.
APPLICATIONS OF COMPARATIVE ADVANTAGE
Should the United States trade with other countries? Each country has many citizens with
different interests. International trade can make some individuals worse off, even as it makes the country as a whole better off. – Imports—goods produced abroad and sold
domestically– Exports—goods produced domestically and sold
abroad