Thomson 2007 SouthWestern
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 watch the morning news broadcast from New York on your TV made in Japan. 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!
2007 Thomson South-Western
Interdependence and the Gains from Trade
Remember, economics is the study of how societies produce and distribute goods in an attempt to satisfy the wants and needs of their members.
2007 Thomson South-Western
Interdependence and the Gains from Trade
We can be economically self-sufficient. We can specialize and trade with others, leading to economic interdependence.
How do we satisfy our wants and needs in a global economy?
2007 Thomson South-Western
Interdependence and the Gains from Trade
Individuals and nations rely on specialized production and exchange as a way to address problems caused by scarcity. But this gives rise to two questions:
Why is interdependence the norm? What determines production and trade?
2007 Thomson South-Western
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.
2007 Thomson South-Western
A PARABLE FOR THE MODERN ECONOMY Imagine an economic system with only two goods, potatoes and meat and only two people, a potato farmer and a cattle rancher
What should each person produce? Why should these people trade?
2007 Thomson South-Western
2007 Thomson South-Western
Production Possibilities Suppose the farmer and rancher decide not to engage in trade:
Each consumes only what he or she can produce alone. The production possibilities frontier is also the consumption possibilities frontier. Without trade, economic gains are diminished.
2007 Thomson South-Western
Figure 1 The Production Possibilities Frontier
(a) The Farmer' s Production Possibilities Frontier Meat (ounces)
8
If there is no trade, the farmer chooses this production and consumption.
4
A
0
16
32
Potatoes (ounces)
Copyright2003 Southwestern/Thomson Learning
2007 Thomson South-Western
Figure 1 The Production Possibilities Curve
(b) The Rancher 's Production Possibilities Frontier Meat (ounces) 24 If there is no trade, the rancher chooses this production and consumption.
12
B
0
24
48 Potatoes (ounces)
2007 Thomson South-Western
Copyright2003 Southwestern/Thomson Learning
Production and Consumption Without Trade
2007 Thomson South-Western
Specialization and Trade Suppose instead the farmer and the rancher 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.
The farmer should produce potatoes. The rancher should produce meat.
2007 Thomson South-Western
Figure 2 How Trade Expands the Set of Consumption Opportunities
(a) The Farmer' s Production and Consumption Meat (ounces)
8
Farmer's consumption with trade
5 4
A* A
Farmer's production and consumption without trade Farmer's production with trade 32 Potatoes (ounces)
0 16 17
2007 Thomson South-Western
Copyright2003 Southwestern/Thomson Learning
Figure 2 How Trade Expands the Set of Consumption Opportunities
(b) The Rancher's Production and Consumption Meat (ounces) 24 Rancher's production with trade
18 13 B
Rancher's consumption with trade B*
12
Rancher's production and consumption without trade
0
12
24 27
48 Potatoes (ounces)
2007 Thomson South-Western
Copyright 2004 South-Western
COMPARATIVE ADVANTAGE
Differences in the costs of production determine the following:
Who should produce what? How much should be traded for each product?
2007 Thomson South-Western
COMPARATIVE ADVANTAGE
Two ways to measure differences in costs of production:
The number of hours required to produce unit a of output (for example, one pound of potatoes). The opportunity cost of sacrificing one good for another.
2007 Thomson South-Western
Absolute Advantage The comparison among producers of a good according to their productivity.
Describes the productivity of one person, firm, or nation compared to that of another. The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good.
2007 Thomson South-Western
Absolute Advantage The Rancher needs only 10 minutes to produce an ounce of potatoes, whereas the Farmer needs 15 minutes. The Rancher needs only 20 minutes to produce an ounce of meat, whereas the Farmer needs 60 minutes. The Rancher has an absolute advantage in the production of both meat and potatoes.
2007 Thomson South-Western
Opportunity Cost and Comparative Advantage Compares producers of a good according to their opportunity cost, that 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?
?
?
2007 Thomson South-Western
Comparative Advantage and Trade Potato costs...
The Rancher's opportunity cost of an ounce of potatoes is an ounce of meat. The Farmer's opportunity cost of an ounce of potatoes is an ounce of meat.
Meat costs...
The Rancher's opportunity cost of a pound of meat is only 4 ounces of potatoes. The Farmer's opportunity cost of an ounce of meat is only 2 ounces of potatoes...
2007 Thomson South-Western
Comparative Advantage and Trade
...so, the Rancher has a comparative advantage in the production of meat but the Farmer has a comparative advantage in the production of potatoes.
2007 Thomson South-Western
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.
2007 Thomson South-Western
Gains from Trade
2007 Thomson South-Western
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.
2007 Thomson South-Western
FYI--The Legacy of Adam Smith and David Ricardo Adam Smith
In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith perform...