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Unformatted text preview: Lecture 2: A Demonstration of Why Trade Is Critical to the Production of Wealth Critical Evolution of Economic Theory: Traditional idea: Mercantilism Traditional (protectionism) policy best (protectionism) Adam Smith (1776) explained the value of 1) the division of labor and 1) 2) specialization of labor 2) Adam Smith and the Pin Factory Adam Evolution of Thinking Evolution
Smith’s Pin Factory: One man can make one bad pin a day 10 men could make 48,000 pins a day 18 steps in production that exploits 18 economies of scale economies What prevents the world from being covered What in pins? in Next: David Ricardo (died 1823): Next: Comparative Advantage Comparative No Man Is an Island No
Crusoe stranded on island for several years. (Based on real story)
Presume Crusoe spends his Presume time making breadfruit bread (BB) time loaves and cups of coconut milk (CM). He has ability to produce these as seen on the production possibility curve. Maybe he eats a balanced diet of 25 CM and 5 BB a week.
BB 10 Crusoe’s weekly Production Possibility 5 0 25 50 CM Crusoe Meets Competent Friday Crusoe
Friday, living on other side of island, same resources, also Friday, makes BB and CM, but is more productive. Why? Both work hard every day. work
BB Friday also produces BB and CM. He eats a BB balanced diet of 45 CM balanced and 15 BB loaves. Then the two meet. 30 Friday’s weekly Production Possibility 15 0 45 90 CM Friday Is Better at Making Both Friday
Crusoe and Friday notice differences in how much of both Crusoe goods they can produce each week. Friday is better at making both – an absolute advantage. absolute BB BB 10 30 CM 50 90 Ratio 1/5 1/3 Note: these ratios are personal opportunity costs. Crusoe Friday Friday But: Who is the low cost producer of which good, compared But: to the other? Who has comparative advantage? comparative Poor Crusoe Trades with Rich Friday Poor
Noticing differences in costs of producing CM and BB, let Noticing us presume they agree to trade 5 BB for 20 CM at the end of the week. So Friday must make 5 more BB; Crusoe must make 20 more CM. Crusoe Assume this term of trade: 1 BB for 4 CM (5 BB for 20 CM) Who is the winner of this trade? Trade Creates Wealth Trade
BB BB Friday 20 15 Crusoe 6 5 1 25 45 50 CM 30 45 50 CM Crusoe has 6 BB and 25 CM Friday has 15 BB and 50 CM Trade Exploits Comparative Advantage Comparative
The process of voluntary trade makes both parties richer. No more effort was required – just specialization in the thing No one is relatively better at doing compared to the trading relatively partner. The less able, Crusoe, has something to offer the more able, Friday. more Adding thousands of goods and millions of people Adding complicates the math but not the outcome. complicates Trade creates wealth. There are no exceptions to this. Trade Trade also requires social cooperation. also Trade Among Nations Trade
Assume companies in Japan and in Mexico Assume make shirts and cars for their consumers. make Current production abilities are up to 5 million Current shirts per week in Mexico and up to 50,000 cars per week — given current resources in labor and capital. capital. Current production abilities are up to 4 million Current shirts per week in Japan and up to 100,000 cars per week — given current resources in labor and capital. capital. Creating New Wealth Creating
To have more cars, resources must be To taken from shirt production — opportunity cost. Resources are scarce. We cannot have everything. One person or one nation cannot be best at making everything. We trade goods for goods based at what we are best at doing. Specialization and division of labor follows. division Production Possibility: Mexico Production cars 50k 25k Current production — based on internal costs in Mexico and demands of consumers — results in 25,000 cars per week and 2.5 million shirts being produced and bought by consumers in Mexico each week. Domestic prices are not relevant for trade with foreigners, what matters are relative costs — 100 shirts for 1 car is the internal rate of trade. shirts 2.5m 5m o Production Possibility: Japan Production cars 100k 50k Current production — based on internal prices and demand in Japan — results in 50,000 cars and 2 million shirts per week being produced and bought in Japan. The internal rate of trade is 40 shirts for one car within Japan. What do Japan and Mexico have to offer each other? 2m 4m shirts Gains from Trade: Comparative Advantage Comparative
Internal rate of exchange in Mexico is 100/1 Internal shirts for cars. shirts Internal rate of exchange in Japan is 40/1 shirts Internal for cars. for Comparing these two producers: Comparing Who is the lower cost producer of cars? Who is the lower cost producer of shirts? Who Trade will occur somewhere between 100/1 and Trade 40/1. Bargaining. Let us assume 60/1. 40/1. Trade: Both Become Wealthier Trade:
New point of production Japan
cars 100k 50k
New point of production 0 2m 5m shirts 0 3m 4m shirts Mexico specializes in shirts — makes 5 million, sells 3 million to Japan. Japan specializes in cars — makes 100,000, sells 50,000 to Mexico for 3 million shirts. Both end up beyond their own production possibilities — trade allows people in both nations to have more of what they want. Is There a Problem? Is
Japan and Mexico both are wealthier due to trade. Citizens in both nations get more of what they Citizens want at lower cost. want Note: Trade is done by Yen and Peso, but that is Note: just for convenience — people want cars and shirts — not money. shirts Expand this to 100 nations and 10,000 goods. Expand The math is more complicated, but same wealth creation results. creation So why is there opposition to free trade? ...
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- Fall '07