Chapter 6: Gains from Trade ECON 102 PDF

ECON 102 Principles of Macroeconomics WEI DAI AS S I S T ANT P ROF E S S OR DE P ART ME NT OF E CONOMI CS , P HI L OS OP HY AND P OL I T I CAL S CI E NCE UNI VE RS I T Y OF BRI T I S H COL UMBI A OKANAGAN CAMP US Chapter 6 1. Gains from Trade Comparative 2. Comparat...

ECON 102 Principles of Macroeconomics WEI DAI AS S I S T ANT P ROF E S S OR DE P ART ME NT OF E CONOMI CS , P HI L OS OP HY AND P OL I T I CAL S CI E NCE UNI VE RS I T Y OF BRI T I S H COL UMBI A OKANAGAN CAMP US Chapter 6 1. Gains from Trade Comparative 2. Comparative Advantage Advantage and 3. Prices Are Signals, Incentives, and Gains from Information Trade 4. How Managers Can Harness Market Forces Chapter 6 (1 of 5) 1. Gains from Trade Understand the role of 2. Comparative Advantage markets in reallocating resources to better uses: 3. Prices Are Signals, Incentives, and Ø Defining gains from trade Information 4. How Managers Can Harness Market Forces Key Definition (1 of 3) Diving into the Definition Gains from trade: The benefits that come Airbnb Example: You have an apartment in from reallocating resources, goods, and Toronto. You will be out of town for 2 weeks visiting friends elsewhere. services to better uses. Another person is visiting Toronto for a few days, The big pictures: and they want a place to stay. Ø You have some stuff. You rent your apartment to them via Airbnb. Ø Other people have other stuff. Ø They want some of your stuff more Ø For those few days, they want your apartment than you do, and you want some of more than you do, and you want money more their stuff more than they do. than your apartment (for those few days). Ø Swap! Ø Trade your apartment for money and you both Ø Now you are both better off! become better off. 4 Chapter 6 (2 of 5) Distinguish between absolute 1. Gains from Trade advantage and comparative advantage 2. Comparative Advantage Use comparative advantage 3. Prices Are Signals, Incentives, and to allocate tasks to those with Information the lowest opportunity cost 4. How Managers Can Harness Market Forces  Who should do what? How to allocate tasks Natalia and Ryan both work as accountants. They need to decide how to assign the work they are being asked to do: Ø Balance accounts Ø Process customer payments received Natalia can balance an account in 30 minutes and can process a customer payment in 10 minutes. Ryan can balance an account in 40 minutes and can process a customer payment in 10 minutes. How should they allocate the tasks? Let’s look at some terminology to help figure this out. 6  Key Definition (2 of 3) Diving into the Definition Comparative advantage: The ability to do a To figure out the comparative advantage… task at a lower opportunity cost. Compare: RECALL: The opportunity cost of something is Ø What can you produce if assigned one task what you gave up to get that thing. versus the other? Ø What can the other person produce if Ø Opportunity cost principle: “Or what?” assigned one task versus the other? We want to allocate each task to the lowest- Advantage: cost producer. If you give up relatively less to get a task Ø Allocate the task to the person with the done, then it’s more efficient for you to do that comparative advantage in that task. task. Ø Who gives up relatively less to get the job Ø You have the comparative advantage! done? 7  Key Definition (3 of 3) Diving into the Definition Absolute advantage: The ability to do a Ludwig van Beethoven Example: task using fewer inputs. Beethoven was one of the greatest Equivalent statements: hat example composers in classical music. You have an absolute advantage in hat- Ø He has an absolute advantage in making if… composing music. Ø you can make 10 hats using fewer inputs Ø Suppose he also has an absolute (e.g. time) than the other person. advantage in tuning pianos. Ø using the same inputs, you can But if Beethoven takes time away from produce more hats than the other composing music to tune pianos, he sacrifices person. something greatly valued by society (his music). Absolute advantage tells you who is best at a task, but NOT who should do the task. Ø Thus, you don’t assign Beethoven the task of tuning pianos. 8  Returning to the accounting example Recall: Natalia can balance an account Productivity: How long does it take to… in 30 minutes and can process a customer payment in 10 Process a customer minutes. Balance an account payment Ryan needs 40 minutes to Natalia 30 minutes 10 minutes balance an account, and can process a customer payment in 10 minutes. Ryan 40 minutes 10 minutes 9  Recipe to assess comparative advantage 1. Write out how long each task takes each person (see the table on the right). Productivity: How long does it take to… 2. Convert this table into a Process a customer measure of opportunity cost. Balance an account payment 3. Evaluate! Who can produce each good at the lowest Natalia 30 minutes 10 minutes opportunity cost? This process identifies who has the Ryan 40 minutes 10 minutes comparative advantage in each task! 10  Step 2: Opportunity cost conversion (1 of 4) Productivity: How long does it take to… To start the conversion process… Balance an Process a account customer payment Ø What is Natalia’s opportunity cost of balancing an account? Natalia 30 minutes 10 minutes Opportunity cost of a task = Ryan 40 minutes 10 minutes Natalia’s opportunity cost of balancing an account = = processing three customer payments Interpretation: To balance an account, Natalia gives up processing three customer payments. 11  Step 2: Opportunity cost conversion (3 of 4) Productivity: How long does it take to… You try! Finish converting the productivity Balance an Process a table into a table measuring the opportunity account customer payment cost of each task for each person. Natalia 30 minutes 10 minutes Opportunity Cost: Ryan 40 minutes 10 minutes What does each person forgo to… Balance an Process a account customer payment 3 customer 1/3rd a balanced Opportunity cost of a task = Natalia payments account 4 customer 1/4th a balanced Ryan payments account 12  Step 2: Opportunity cost conversion (4 of 4) Interpreting Results: To balance an account, Opportunity Cost: Ø Natalia gives up processing three What does each person forgo to… customer payments. Ø Ryan gives up processing four Balance an Process a account customer payment customer payments. 3 customer 1/3 a balanced Natalia To process a customer payment, payments account 4 customer 1/4 a balanced Ø Natalia gives up 1/3 a balanced Ryan payments account account. Ø Ryan gives up 1/4 a balanced account. 13  Step 3: Evaluate comparative Who has the comparative advantage in advantage balancing accounts? Ø Hint: Who has the lower opportunity cost for Opportunity Cost: balancing accounts? What does each person forgo to… Natalia! She gives up relatively fewer customer payments to balance an account Balance an Process a (3 is less than 4). account customer payment Who has the comparative advantage in 3 customer 1/3 a balanced Natalia payments account processing customer payments? 4 customer 1/4 a balanced Ø Hint: Who has the lower opportunity cost for Ryan payments account processing customer payments? Ryan! He gives up relatively less of a balanced account to process a customer payment (1/4 is less than 1/3). 14  Everyone has a comparative advantage! Even though Ryan is not better than Natalia at either task, Ryan can still contribute! Ø It’s better to assign Ryan some task than nothing at all. Ryan can make the biggest contribution if he is assigned the task that he is least bad at relative to Natalia. Ø The task for which Ryan has a comparative advantage. Take-away: Everyone has a comparative advantage in something (even if they don’t have an absolute advantage in anything), and that is what they should focus on doing! 15  Specialization and gains from trade Simply rearranging who does what allows you to produce more stuff with the same inputs! How? à Specialization: focusing on specific tasks Each person specializes in the task in which they have a comparative advantage! Ø This ensures each task is being done at the lowest opportunity cost. Let’s look at how specialization and gains from trade work out in our example! 16  If Natalia and Ryan each reallocate 120 minutes of their day toward the task in which they have a comparative advantage (and 120 minutes less to the other task)… Gains from trade due to comparative advantage Balance an account Process a customer payment 120 more minutes on balancing 120 fewer minutes on processing customer Natalia accounts payments à 4 more balanced accounts à 12 fewer customer payments processed 120 fewer minutes on balancing 120 more minutes on processing customer Ryan accounts payments à 3 fewer balanced accounts à12 more customer payments processed Total 1 more balanced account overall Just as many customer payments processed. 17  Gains from trade due to comparative advantage What we saw à the same inputs lead to more output! How? à reallocation in accordance with comparative advantage! In other words, we rearranged who did what in a smart way. Ø Reallocate from the person with high opportunity cost to person with low opportunity cost. Ø This is more efficient! à minimizes the resources used for each task. Examples: Ø At the dentist office, the hygienist cleans teeth and takes X-rays, which frees up the dentist to do more complicated procedures. Ø Toyota cars are designed and headquartered in Japan, but the largest Toyota car manufacturing facility is in Georgetown, Kentucky. Ø Can you think of more examples? 18  Should the best drummer play the drums? It’s been reported that when John Lennon was asked, “Is Ringo Starr the best drummer in the world?” he responded that “he’s not the best drummer in the Beatles!” It maybe true—Paul McCartney was also a superb drummer. But if McCartney played the drums, then he would not have played bass guitar, which is too high a price to pay. The Beatles assigned tasks in accordance with comparative advantage—thinking about the opportunity costs! 19  Concept Check: Comparative Advantage The table shows Imani’s and Laura’s opportunity costs for making scarves and hats. Who has the comparative advantage in the production of hats? Opportunity Cost: Answer: Laura What does each person forgo to… Explanation: Laura has the lower make a scarf make a hat opportunity cost for hats. Laura gives up relatively fewer Imani 1 hat 2 scarves scarves to make a hat: Laura 3 hats 1.5 scarves 1.5 is less than 2 20  Markets facilitate gains from trade Markets offer the opportunity to specialize according to comparative advantage: Ø You specialize in one task and get paid for doing that task. Ø Other people specialize in other tasks. Ø Then everyone trades, generating economic surplus! Example: You are good with numbers and become an accountant. You use part of your paycheck for… Ø car repairs; meal-prep services (think HelloFresh); cleaning services (think Roomba), etc. Ø Markets allow you to trade tasks! Ø you spend less time doing tasks which you are not relatively good at (where your opportunity cost is high) and more time elsewhere J 21  Comparative advantage drives international trade We trade with foreigners for the same reason we trade with locals. Ø You produce what you are relatively good at producing and buy everything else from others. Ø “Others” might be your neighbour or “others” might live in a different country. The gains from trade created by comparative advantage are the reason for international trade. Ø National borders are irrelevant to the central idea that there are gains from trade! Ø The only difference is that with international trade, goods are called imports and exports. Ø Trade is simply about minimizing opportunity costs. 22  Trading across the borders of Dan’s lawn (1 of 2) When Dan was a boy, his parents gave him an allowance for doing the yardwork. Dan quickly took on the yardwork of neighbouring houses for pay. After high school, he kept up the yardwork gig while he trained to become a plumber. However, once he started his own successful plumbing business, it no longer made sense for him to do his own yardwork. Ø It was time he could use to do plumbing projects for which he was well paid. Ø Dan hired a local teenager, Karla, to do the yardwork. Both Dan and Karla were made better off from this trade: Ø Dan paid Karla less than what he made from his time working, so Dan is financially better off. Ø Karla was paid better than other part-time jobs, and this job has more flexibility with hours. 23  Trading across the borders of Dan’s lawn (2 of 2) Now think of Dan’s property as its own country called the Republic of Danrovia. Critics of international trade will say international trade wrought havoc on Danrovia. Ø The thriving traditional yardwork sector of Danrovia has collapsed. Ø Destroyed by an influx of cheap labour from the Kingdom of Karla. Ø Danrovia now has a HUGE trade deficit with Karla. Ø Dan pays Karla every weekend, but Karla buys nothing from Dan. What the critics overlooked: 1. Dan’s business has grown even stronger thanks to specialization and trade. 2. Dan gets to consume more—he gets the nice yard AND whatever else he can now buy thanks to the extra money he earned from taking on the extra plumbing jobs (instead of yardwork). 24  Key take-aways: Comparative advantage Comparative Advantage Ø The person with the lowest opportunity cost should produce that good. Ø Reallocate resources to their better uses. Ø Allocate tasks based off comparative advantage NOT absolute advantage. Gains from Trade Ø Same inputs lead to more outputs. Ø Reallocating based off comparative advantage creates gains from trade. Specialize and Trade Ø You should specialize in producing the good for which you have a comparative advantage. Ø Buy everything else from others, either locally or globally. 25 Chapter 6 (3 of 5) Understand the role that prices 1. Gains from Trade play in coordinating economic activity: 2. Comparative Advantage Ø Prices as signals 3. Prices Are Signals, Incentives, and Ø Prices as incentives Information Ø Prices as a bundle of 4. How Managers Can Harness Market information Forces  1. Prices are signals, incentives, and information Prices guide nearly every decision we make, helping to organize and coordinate economic activity. Let’s start by looking at prices as signals! The price is a signal to potential suppliers about how much buyers value a good (like quinoa!), revealing their marginal benefit. The price is a signal to potential buyers about how expensive it is for sellers to produce more of a product, revealing the seller’s marginal cost. 27  2. Prices as incentives A high price is an incentive for... Ø sellers to produce more à new profit opportunities! Ø buyers to buy less à consider switching to an alternative (if available). Ø strangers to coordinate à buying and selling plans end up balancing out. 3. A price aggregates information Prediction markets: Markets whose payoffs are linked to whether an uncertain event occurs. Ø The process of buying and selling aggregates information about the event. Ø Sports-betting example: The quarterback gets injured, and this information is reflected in the decline of that teams’ odds in the sports-betting market. 28 Chapter 6 (4 of 5) 1. Gains from Trade Harness market forces in your own life! 2. Comparative Advantage Ø Internal markets 3. Prices Are Signals, Incentives, and Information Ø Knowledge problem 4. How Managers Can Harness Market Forces  Harnessing the power of market forces After World War II, a natural experiment was set in motion when Korea was divided into two. North Korea was aligned with the Soviet Union, which established a centrally planned economy. Government officials decided who made what, who got what, and how much was made. South Korea was aligned with the United States, which established a market economy. All economic activity was dictated by market forces. Today, the average income of a South Korean citizen is 20 times that of North Korean: $43,000 versus $1,700. 30  Internal markets allocate resources (1 of 2) Internal markets: Markets within a company to buy and sell scarce resources. Knowledge problem: When knowledge needed to make a good decision is not available to the decision maker. Feeding America Example: Feeding America is the largest network of food banks in the United States. Ø solicits donations from large companies like Walmart or Kraft Ø allocates that food to 210 regional food banks around the country But how do you best distribute the donated food? Ø No single person knows the marginal benefit of each food item for all 210 food banks (i.e., they have a knowledge problem). 31  Internal markets allocate resources (2 of 2) Feeding America Example Continued: The creation of internal markets is the solution to the knowledge problem! Ø Each of the 210 food banks issues an artificial currency (issued by Feeding America). Ø Food banks bid for each truckload of food in an internal eBay-style auction. Ø It worked beautifully! Each regional food bank knows its own marginal benefit and bids accordingly. Ø forces of supply and demand allocated the donated food Ø does NOT rely on a centralized decision maker to make all allocation decisions Planet Money ep 665, “The Free Food Market”: https://www.npr.org/sections/money/2019/09/11/565736836/episode-665-the-free-food-market 32  Other examples of internal markets Google Ø Issue: How to allocate processing time, disk space, and memory across various product teams. Ø Is the Gmail, YouTube, or Chrome team more deserving of these resources? Ø Solution: Time and resources were allocated using internal markets! Ø Different product teams could compete to buy the space they needed. Business Schools and Law Schools Ø Issue: How to allocate the limited seats among students for very popular classes. Ø Solution: Internal markets! Each student is given some amount of fake money that they can use to buy and sell spots in popular classes. The more you want a spot, the more you will bid. 33 Chapter 6 (5 of 5) 1. The benefits of reallocating 1. Gains from Trade resources to better uses 2. Allocate resources based on 2. Comparative Advantage comparative advantage—the lowest opportunity cost 3. Prices Are Signals, Incentives, and 3. Prices coordinate economic Information activity 4. Market forces help allocate 4. How Managers Can Harness Market scarce resources effectively Forces