ECON 103 Principles of Microeconomics - 2024/25 PDF

Principles of Microeconomics ECON 103 – 2024/25 Dr. Hussain Muhammad 1  CH 3: Interdependence and the Gains from Trade Understanding Interdependence Interdependence occurs when individuals, firms, or nations rely o...

Principles of Microeconomics ECON 103 – 2024/25 Dr. Hussain Muhammad 1  CH 3: Interdependence and the Gains from Trade Understanding Interdependence Interdependence occurs when individuals, firms, or nations rely on each other for goods and services. In a globalized economy, no country is self-sufficient; all countries trade to obtain what they cannot efficiently produce themselves. Example: The UAE is highly dependent on global markets for importing food, technology, and machinery. In return, it exports oil, petrochemicals, tourism services, etc. This interdependence is critical for economic growth and improving living standards. 2  CH 3: Interdependence and the Gains from Trade Understanding Interdependence Every day you hair gel from rely on many Cleveland, OH people from around the cell phone world, most of from Taiwan whom you’ve never met, to dress shirt provide you from China with the goods and services, you coffee from enjoy. Kenya 3  CH 3: Interdependence and the Gains from Trade Gains from trade Gains from trade occur because it allows countries and individuals to specialize in what they do best, thereby increasing overall production and consumption. Comparative advantage plays a key role in driving trade benefits, as nations can focus on producing goods at a lower opportunity cost. Example: The UAE, with its large oil reserves, specializes in oil extraction and exports it globally, while importing technology and manufactured goods from countries that produce them more efficiently. 4  CH 3: Interdependence and the Gains from Trade Example: Trade between China and the United States “Trade with China makes most Americans better off because, among other advantages, they can buy goods that are made or assembled more cheaply in China.” 5  CH 3: Interdependence and the Gains from Trade Example Two people: A potato farmer and a cattle rancher Two goods: Potatoes and meat One resource: Labor, measured in hours What should each person produce? Why should these people trade? 6  CH 3: Interdependence and the Gains from Trade Production Possibilities Frontier (PPF) of the Farmer and the Rancher PPF is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology. PPF is used to illustrate some basic economic ideas. Suppose that the farmer and the rancher each work 8 hours per day and can devote this time to growing potatoes, raising cattle, or a combination of the two. The table in Figure 1 shows the amount of time each person requires to produce 1 ounce of each good. The farmer can produce an ounce of potatoes in 15 minutes and an ounce of meat in 60 minutes. The rancher, who is more productive in both activities, can produce an ounce of potatoes in 10 minutes and an ounce of meat in 20 minutes. The last two columns in the table show the amounts of meat or potatoes the farmer and rancher can produce if they work an 8-hour day producing only that good. 7  CH 3: Interdependence and the Gains from Trade Production Possibilities Frontier (PPF) of the Farmer and the Rancher 8  CH 3: Interdependence and the Gains from Trade (a) The Farmer’s PPF graph Meat (ounces) If there is no trade, the farmer chooses 8 this production and consumption. 4 A 0 16 32 Potatoes (ounces) 9  CH 3: Interdependence and the Gains from Trade Explanation of Graph (a) Graph (a) illustrates the amount of meat and potatoes that the farmer can produce. If the farmer devotes all 8 hours of his time to potatoes, he produces 32 ounces of potatoes (measured on the horizontal axis) and no meat. If he devotes all his time to meat, he produces 8 ounces of meat (measured on the vertical axis) and no potatoes. If the farmer divides his time equally between the two activities, spending 4 hours on each, he produces 16 ounces of potatoes and 4 ounces of meat. The graph shows these three possible outcomes and all others in between. 10  CH 3: Interdependence and the Gains from Trade (b) The Rancher’s PPF graph Meat (ounces) 24 If there is no trade, the rancher chooses this production and consumption. 12 B 0 24 48 Potatoes (ounces) 11  CH 3: Interdependence and the Gains from Trade Explanation of Graph (b) Graph (b) shows the production possibilities frontier for the rancher. If the rancher devotes all 8 hours of her time to potatoes, she produces 48 ounces of potatoes and no meat. If she devotes all her time to meat, she produces 24 ounces of meat and no potatoes. If the rancher divides her time equally, spending 4 hours on each activity, she produces 24 ounces of potatoes and 12 ounces of meat. Once again, the production possibilities frontier shows all the possible outcomes. 12  CH 3: Interdependence and the Gains from Trade Production and Consumption Without Trade 13  CH 3: Interdependence and the Gains from Trade Specialization and Trade Specialization occurs when countries focus on producing goods in which they have a comparative advantage. By specializing, countries increase productivity and efficiency, which results in more goods and services available at lower prices. 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. 14  CH 3: Interdependence and the Gains from Trade Specialization and Trade Suppose, the armer works 8 hours a day growing only potatoes, he’ll produce 32 ounces of potatoes. If he gives Rancher 15 of those 32 ounces of potatoes, The Rancher will give him 5 ounces of meat in return. In the end, the farmer will get to eat 17 ounces of potatoes and 5 ounces of meat every day, instead of the 16 ounces of potatoes and 4 ounces of meat he now gets. Suppose now Rancher spends 6 hours a day raising cattle and 2 hours growing potatoes. Then he can produce 18 ounces of meat in exchange for 15 ounces of your potatoes, he will end up with 13 ounces of meat and 27 ounces of potatoes, instead of the 12 ounces of meat and 24 ounces of potatoes that he now gets. They can both benefit because trade allows them to specialize in doing what they do best. The farmer will spend more time growing potatoes and less time raising cattle. The rancher will spend more time raising cattle and less time growing potatoes. As a result of specialization and trade, they can consume more meat and more potatoes without working any more hours. 15  CH 3: Interdependence and the Gains from Trade (c) The Farmer’s Production and Consumption graph Meat (ounces) Farmer's consumption with trade 8 Farmer's production and consumption 5 A* without trade 4 A Farmer's production with trade 0 32 Potatoes (ounces) 16 17 16  CH 3: Interdependence and the Gains from Trade (c) The Rancher’s Production and Consumption graph Meat (ounces) 24 Rancher's production with trade Rancher's consumption 18 with trade 13 B* Rancher's production and B 12 consumption without trade 0 12 24 27 48 Potatoes (ounces) 17  CH 3: Interdependence and the Gains from Trade Gains from Trade 18  CH 3: Interdependence and the Gains from Trade Absolute Advantage Absolute advantage is the ability to produce a good using fewer inputs than another producer. Absolute advantage looks at the efficiency of producing a single product. 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. 19  CH 3: Interdependence and the Gains from Trade Absolute Advantage Example: One real-world example of absolute advantage is in oil production. Nations in the Middle East including UAE compared to other countries, have an absolute advantage when it comes to producing oil. In oil-rich nations, businesses can use simple, inexpensive techniques to drill for the resource and get it in large quantities. Although absolute advantage is important, trade benefits arise more significantly from comparative advantage. 20  CH 3: Interdependence and the Gains from Trade Comparative Advantage and Opportunity Cost Comparative advantage means producing a good at a lower opportunity cost than another country. Comparative advantage is an economy's ability to produce particular goods or services at a lower opportunity cost than its trading partners. Opportunity cost is the cost of giving up one opportunity in order to take another one. The ‘next best alternative’ that must be given up comes with a cost. 21  CH 3: Interdependence and the Gains from Trade Comparative Advantage and Opportunity Cost Example: Let's assume that China has enough resources to produce either smartphones or computers such that China can produce either 10 computers or 10 smartphones. Computers generate a higher profit. The opportunity cost is the difference in value lost from producing a smartphone rather than a computer. If China earns $100 for a computer and $50 for a smartphone then the opportunity cost is $50. If China has to choose between producing computers over smartphones it will probably select computers because the chance of profit is higher. 22  CH 3: Interdependence and the Gains from Trade Comparative Advantage and Opportunity Cost Example in UAE Context:: Although the UAE may not have an absolute advantage in producing manufactured goods, it imports electronics from Japan, U.S., or China because these countries have a comparative advantage in producing these items at a lower cost. In return, the UAE exports its oil to those countries. 23  CH 3: Interdependence and the Gains from Trade Summary Each person consumes goods and services produced by many other people both in the country and around the world. Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services. 24  CH 3: Interdependence and the Gains from Trade Summary There are two ways to compare the ability of two people producing a good. The person who can produce a good with a smaller quantity of inputs has an absolute advantage. The person with a smaller opportunity cost has a comparative advantage. Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage. 25