Chapter 3: Interdependence and the Gains from Trade PDF

Chapter 3: Interdependence and the Gains from Trade Shuo Xu September 13, 2024 1/23 Introduction I Interdependence in the global economy. I How individuals, firms, and countries specia...

Chapter 3: Interdependence and the Gains from Trade Shuo Xu September 13, 2024 1/23 Introduction I Interdependence in the global economy. I How individuals, firms, and countries specialize and trade. I The theory of comparative advantage. 2/23 A Parable for the Modern Economy I The idea of production possibilities. I Example of two goods: Meat and Potatoes. I Different production capabilities of two producers: The Rancher and The Farmer. 3/23 Production Possibilities Frontier (PPF) I The PPF illustrates the combinations of output that an economy can possibly produce. I It shows trade-offs and opportunity costs. 4/23 Specialization and Trade I Specialization based on comparative advantage allows more efficient production. I Trade enables consumption beyond the PPF. I Example: The Rancher specializes in meat, the Farmer specializes in potatoes. 5/23 Quick Quiz Before Frank and Ruby engage in trade, each consumes I a. at a point inside his or her production possibilities frontier. I b. at a point on his or her production possibilities frontier. I c. at a point outside his or her production possibilities frontier. I d. the same amounts of meat and potatoes as the other. 6/23 Quick Quiz After Frank and Ruby trade, each of them consumes I a. at a point inside his or her production possibilities frontier. I b. at a point on his or her production possibilities frontier. I c. at a point outside his or her production possibilities frontier. I d. the same amounts of meat and potatoes as the other. 7/23 Comparative Advantage: The Driving Force of Specialization I Absolute vs. Comparative Advantage. I Opportunity cost as the key to understanding comparative advantage. Example: The Rancher’s opportunity cost of producing potatoes is lower than the Farmer’s. 8/23 Absolute Advantage I A producer has an absolute advantage if they can produce more of a good than another producer. I Example: Rancher has an absolute advantage in both meat and potatoes, but still benefits from trade due to comparative advantage. 9/23 Opportunity Cost and Comparative Advantage I Opportunity cost is what is given up to produce one more unit of a good. I Comparative advantage focuses on who has the lower opportunity cost. 10/23 Quick Quiz Question: What is the difference between absolute and comparative advantage? 1. Absolute advantage refers to being able to produce more with fewer inputs. 2. Comparative advantage refers to producing at a lower opportunity cost. 11/23 The Price of the Trade I The price of the trade must lie between the opportunity costs of the trading partners. I Example: Rancher trades meat for potatoes at a mutually beneficial price. 12/23 Quick Quiz Question: If the Rancher trades 3 pounds of meat for 10 pounds of potatoes, is this trade beneficial for both? I Yes, as long as the trade price is between the opportunity costs of both parties. 13/23 Quick Quiz In an hour, Mateo can wash 2 cars or mow 1 lawn, and Sophia can wash 3 cars or mow 1 lawn. Who has the absolute advantage in car washing, and who has it in lawn mowing? I a. Mateo in washing, Sophia in mowing I b. Sophia in washing, Mateo in mowing I c. Mateo in washing, neither in mowing I d. Sophia in washing, neither in mowing 14/23 Quick Quiz Between Mateo and Sophia, who has the comparative advantage in car washing, and who has it in lawn mowing? I a. Mateo in washing, Sophia in mowing I b. Sophia in washing, Mateo in mowing I c. Mateo in washing, neither in mowing I d. Sophia in washing, neither in mowing 15/23 Quick Quiz When Mateo and Sophia produce efficiently and make a mutually beneficial trade based on comparative advantage, I a. Mateo mows more, and Sophia washes more. I b. Mateo washes more, and Sophia mows more. I c. Mateo and Sophia both wash more. I d. Mateo and Sophia both mow more. 16/23 Applications of Comparative Advantage I Should Naomi Osaka mow her own lawn? I Should the U.S. trade with other countries? I Specialization and gains from trade apply in various real-life scenarios. 17/23 Should Naomi Osaka Mow Her Own Lawn? I Even if Naomi Osaka can mow faster than anyone else, her opportunity cost is higher because she can earn more playing tennis. I It’s better to hire someone to mow the lawn, and she focuses on tennis. 18/23 Should the U.S. Trade with Other Countries? I Yes! The U.S. has a comparative advantage in some goods and should specialize and trade. I Trade benefits all parties involved through efficient allocation of resources. I Goods produced abroad and sold domestically are imports. I Those produced domestically and sold abroad are exports. 19/23 Trade between China and the U.S. 20/23 Quick Quiz Question: Why should countries specialize in the goods they have a comparative advantage in? I Countries can consume more by specializing in producing goods with lower opportunity costs and trading for other goods. 21/23 Conclusion I Comparative advantage is the key to understanding trade. I Specialization allows countries to consume beyond their PPF. I Trade makes everyone better off. 22/23 Recap of Key Concepts I Production Possibilities Frontier I Comparative Advantage I Absolute Advantage I Opportunity Cost I Benefits of Trade 23/23