Chapter 3 Interdependence and the Gains from Trade PDF

Summary

This chapter examines interdependence and the gains from trade in a global economy. It describes how individuals and nations benefit from trading goods and services. The concepts of absolute advantage and comparative advantage are explained, showing how specialization can increase overall production.

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Chapter 3...

Chapter 3 Interdependence and the Gains from Trade C onsider your typical day. You wake up in the morning and pour yourself juice from oranges grown in Florida and coffee from beans grown in Brazil. Over breakfast, you watch a news program broadcast from New York on your television made in China. You get dressed in clothes made of cotton grown in Georgia and sewn in factories in Thailand. You drive to class in a car made of parts manufactured in more than a dozen countries around the world. Then you open up your economics textbook written by an author living in Massachusetts, published by a company located in Ohio, and printed on paper made from trees grown in Oregon. Every day, you rely on many people, most of whom you have never met, to provide you with the goods and services that you enjoy. Such inter­ dependence is possible because people trade with one another. Those people providing you with goods and services are not acting out of generosity. Nor is some government agency directing them to satisfy your desires. Instead, 47 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 48 PART I INTRODUCTION people provide you and other consumers with the goods and services they pro­ duce because they get something in return. In subsequent chapters, we examine how an economy coordinates the activities of millions of people with varying tastes and abilities. As a starting point for this analysis, in this chapter we consider the reasons for economic interdependence. One of the Ten Principles of Economics highlighted in Chapter 1 is that trade can make everyone better off. We now examine this principle more closely. What ex­ actly do people gain when they trade with one another? Why do people choose to become interdependent? The answers to these questions are key to understanding the modern global economy. Most countries today import from abroad many of the goods and ser­ vices they consume, and they export to foreign customers many of the goods and services they produce. The analysis in this chapter explains interdependence not only among individuals but also among nations. As we will see, the gains from trade are much the same whether you are buying a haircut from your local barber or a T-shirt made by a worker on the other side of the globe. 3-1 A Parable for the Modern Economy To understand why people choose to depend on others for goods and services and how this choice improves their lives, let’s look at a simple economy. Imagine that there are two goods in the world: meat and potatoes. And there are two people in the world—a cattle rancher named Rose and a potato farmer named Frank—each of whom would like to eat both meat and potatoes. The gains from trade are most obvious if Rose can produce only meat and Frank can produce only potatoes. In one scenario, Frank and Rose could choose to have nothing to do with each other. But after several months of eating beef roasted, boiled, broiled, and grilled, Rose might decide that self-sufficiency is not all it’s cracked up to be. Frank, who has been eating potatoes mashed, fried, baked, and scalloped, would likely agree. It is easy to see that trade would allow them to enjoy greater variety: Each could then have a steak with a baked potato or a burger with fries. Although this scene illustrates most simply how everyone can benefit from trade, the gains would be similar if Frank and Rose were each capable of produc­ ing the other good, but only at great cost. Suppose, for example, that Rose is able to grow potatoes but her land is not very well suited for it. Similarly, suppose that Frank is able to raise cattle and produce meat but he is not very good at it. In this case, Frank and Rose can each benefit by specializing in what he or she does best and then trading with the other person. The gains from trade are less obvious, however, when one person is better at producing every good. For example, suppose that Rose is better at raising cattle and better at growing potatoes than Frank. In this case, should Rose choose to remain self-sufficient? Or is there still reason for her to trade with Frank? To answer this question, we need to look more closely at the factors that affect such a decision. 3-1a Production Possibilities Suppose that Frank and Rose 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 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 49 Panel (a) shows the production opportunities available to Frank the farmer and Rose the rancher. Panel (b) shows the combinations of meat and potatoes that Frank can produce. Figure 1 Panel (c) shows the combinations of meat and potatoes that Rose can produce. Both The Production Possibilities production possibilities frontiers are derived assuming that Frank and Rose each work Frontier 8 hours per day. If there is no trade, each person’s production possibilities frontier is also his or her consumption possibilities frontier. (a) Production Opportunities Minutes Needed to Amount Make 1 Ounce of: Produced in 8 Hours Meat Potatoes Meat Potatoes Frank the farmer 60 min/oz 15 min/oz 8 oz 32 oz Rose the rancher 20 min/oz 10 min/oz 24 oz 48 oz (b) Frank’s Production Possibilities Frontier (c) Rose’s Production Possibilities Frontier Meat (ounces) Meat (ounces) 24 If there is no trade, Rose chooses this production and If there is no trade, consumption. Frank chooses this 8 production and 12 B consumption. 4 A 0 16 32 0 24 48 Potatoes (ounces) Potatoes (ounces) Trade-offs in each good. Frank can produce an ounce of potatoes in 15 minutes and an ounce of economics refer to meat in 60 minutes. Rose, 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 exchanging one two columns in the table show the amounts of meat or potatoes Frank and Rose thing for another, can produce if they devote all 8 hours to producing only that good. Panel (b) of Figure 1 illustrates the amounts of meat and potatoes that Frank where choosing one can produce. If Frank 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 de­ option entails giving votes all his time to meat, he produces 8 ounces of meat (measured on the vertical up the opportunity axis) and no potatoes. If Frank divides his time equally between the two activities, spending 4 hours on each, he produces 16 ounces of potatoes and 4 ounces of to pursue an meat. The figure shows these three possible outcomes and all others in between. alternative option. This graph is Frank’s production possibilities frontier. As we discussed in Chapter 2, a production possibilities frontier shows the various mixes of output Trade-offs occur that an economy can produce. It illustrates one of the Ten Principles of Economics in Chapter 1: People face trade-offs. Here Frank faces a trade-off between producing when unlimited meat and producing potatoes. wants meet limited resources. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 50 PART I INTRODUCTION You may recall that the production possibilities frontier in Chapter 2 was drawn bowed out. In that case, the rate at which society could trade one good for the other depended on the amounts that were being produced. Here, how­ ever, Frank’s technology for producing meat and potatoes (as summarized in ­Figure 1) allows him to switch between the two goods at a constant rate. When­ ever Frank spends 1 hour less producing meat and 1 hour more producing pota­ toes, he reduces his output of meat by 1 ounce and raises his output of potatoes by 4 ounces—and this is true regardless of how much he is already producing. As a result, the production possibilities frontier is a straight line. Panel (c) of Figure 1 shows the production possibilities frontier for Rose. If Rose devotes all 8 hours of her time to potatoes, she produces 48 ounces of pota­ toes and no meat. If she devotes all her time to meat, she produces 24 ounces of meat and no potatoes. If Rose 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. If Frank and Rose choose to be self-sufficient rather than trade with each other, then each consumes exactly what he or she produces. In this case, the production possibilities frontier is also the consumption possibilities frontier. That is, without trade, Figure 1 shows the possible combinations of meat and potatoes that Frank and Rose can each produce and then consume. These production possibilities frontiers are useful in showing the trade-offs that Frank and Rose face, but they do not tell us what Frank and Rose will actually choose to do. To determine their choices, we need to know the tastes of Frank and Rose. Let’s suppose they choose the combinations identified by points A and B in Figure 1. Based on his production opportunities and food preferences, Frank de­ cides to produce and consume 16 ounces of potatoes and 4 ounces of meat, while Rose decides to produce and consume 24 ounces of potatoes and 12 ounces of meat. 3-1b Specialization and Trade After several years of eating combination B, Rose gets an idea and goes to talk to Frank: Rose: Frank, my friend, have I got a deal for you! I know how to improve life for both of us. I think you should stop producing meat altogether and devote all your time to growing potatoes. According to my calcu­ lations, if you work 8 hours a day growing potatoes, you’ll produce 32 ounces of potatoes. If you give me 15 of those 32 ounces, I’ll give you 5 ounces of meat in return. In the end, you’ll 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 you now get. If you go along with my plan, you’ll have more of both foods. [To illustrate her point, Rose shows Frank panel (a) of Figure 2.] Frank: (sounding skeptical) That seems like a good deal for me. But I don’t understand why you are offering it. If the deal is so good for me, it can’t be good for you too. Rose: Oh, but it is! Suppose I spend 6 hours a day raising cattle and 2 hours growing potatoes. Then I can produce 18 ounces of meat and 12 ounces of potatoes. After I give you 5 ounces of my meat in ex­ change for 15 ounces of your potatoes, I’ll 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 I now get. So I will also consume more of both foods than I do now. [She points out panel (b) of Figure 2.] Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 51 The proposed trade between Frank the farmer and Rose the rancher offers each of them a combination of meat and potatoes that would be impossible in the absence of trade. FIGURE 2 In panel (a), Frank gets to consume at point A* rather than point A. In panel (b), Rose gets How Trade Expands the Set of to consume at point B* rather than point B. Trade allows each to consume more meat and Consumption Opportunities more potatoes. (a) Frank’s Production and Consumption (b) Rose’s Production and Consumption Meat (ounces) Meat (ounces) Rose's 24 production with trade Rose's consumption 18 with trade Frank's consumption Frank's production 13 with trade B* Rose's 8 and consumption production and without trade B 12 consumption 5 A* without trade 4 A Frank's production with trade 0 32 0 12 24 27 48 16 17 Potatoes (ounces) Potatoes (ounces) (c) The Gains from Trade: A Summary Frank Rose Meat Potatoes Meat Potatoes Without Trade: Production and Consumption 4 oz 16 oz 12 oz 24 oz With Trade: Production 0 oz 32 oz 18 oz 12 oz Trade Gets 5 oz Gives 15 oz Gives 5 oz Gets 15 oz Consumption 5 oz 17 oz 13 oz 27 oz GAINS FROM TRADE: Increase in Consumption +1 oz +1 oz +1 oz +3 oz Frank: I don’t know.... This sounds too good to be true. Rose: It’s really not as complicated as it first seems. Here—I’ve summarized my proposal for you in a simple table. [Rose shows Frank a copy of the table at the bottom of Figure 2.] Frank: (after pausing to study the table) These calculations seem correct, but I am puzzled. How can this deal make us both better off? Rose: We can both benefit because trade allows each of us to specialize in doing what we do best. You will spend more time growing potatoes and less time raising cattle. I will spend more time raising cattle and less time growing potatoes. As a result of specialization and trade, each of us can consume more meat and more potatoes without ­working any more hours. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 52 PART I INTRODUCTION Quick Quiz Draw an example of a production possibilities frontier for Robinson Crusoe, a shipwrecked sailor who spends his time gathering coconuts and catching fish. Does this frontier limit Crusoe’s consumption of coconuts and fish if he lives by himself? Does he face the same limits if he can trade with natives on the island? 3-2 Comparative Advantage: The Driving Force of Specialization Rose’s explanation of the gains from trade, though correct, poses a puzzle: If Rose is better at both raising cattle and growing potatoes, how can Frank ever special­ ize in doing what he does best? Frank doesn’t seem to do anything best. To solve this puzzle, we need to look at the principle of comparative advantage. As a first step in developing this principle, consider the following question: In our example, who can produce potatoes at a lower cost—Frank or Rose? There are two possible answers, and in these two answers lie the solution to our puzzle and the key to understanding the gains from trade. 3-2a Absolute Advantage One way to answer the question about the cost of producing potatoes is to compare the inputs required by the two producers. Economists use the term absolute advantage ­absolute advantage when comparing the productivity of one person, firm, or na­ the ability to produce a tion to that of another. The producer that requires a smaller quantity of inputs to good using fewer inputs produce a good is said to have an absolute advantage in producing that good. than another producer In our example, time is the only input, so we can determine absolute advan­ tage by looking at how much time each type of production takes. Rose has an absolute advantage both in producing meat and in producing potatoes because she requires less time than Frank to produce a unit of either good. Rose needs to input only 20 minutes to produce an ounce of meat, whereas Frank needs 60 minutes. Similarly, Rose needs only 10 minutes to produce an ounce of potatoes, whereas Frank needs 15 minutes. Based on this information, we can conclude that Rose has the lower cost of producing potatoes, if we measure cost in terms of the quantity of inputs. 3-2b Opportunity Cost and Comparative Advantage There is another way to look at the cost of producing potatoes. Rather than com­ paring inputs required, we can compare opportunity costs. Recall from Chapter 1 opportunity cost that the opportunity cost of some item is what we give up to get that item. In whatever must be given our example, we assumed that Frank and Rose each spend 8 hours a day work­ up to obtain some item ing. Time spent producing potatoes, therefore, takes away from time available for producing meat. When reallocating time between the two goods, Rose and Frank give up units of one good to produce units of the other, thereby moving along the production possibilities frontier. The opportunity cost measures the trade-off be­ tween the two goods that each producer faces. Let’s first consider Rose’s opportunity cost. According to the table in panel (a) of Figure 1, producing 1 ounce of potatoes takes 10 minutes of work. When Rose spends those 10 minutes producing potatoes, she spends 10 minutes less Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 53 Table 1 Opportunity Cost of: The Opportunity Cost of Meat and 1 oz of Meat 1 oz of Potatoes Potatoes Frank the farmer 4 oz potatoes 1/4 oz meat Rose the rancher 2 oz potatoes 1/2 oz meat producing meat. Because Rose needs 20 minutes to produce 1 ounce of meat, 10 minutes of work would yield 1/2 ounce of meat. Hence, Rose’s opportunity cost O.C = wha of producing 1 ounce of potatoes is 1/2 ounce of meat. t Now consider Frank’s opportunity cost. Producing 1 ounce of potatoes takes him was given 15 minutes. Because he needs 60 minutes to produce 1 ounce of meat, 15 minutes up divided of work would yield 1/4 ounce of meat. Hence, Frank’s opportunity cost of 1 ounce of potatoes is 1/4 ounce of meat. by the gain Table 1 shows the opportunity costs of meat and potatoes for the two produc­ ers. Notice that the opportunity cost of meat is the inverse of the opportunity cost of potatoes. Because 1 ounce of potatoes costs Rose 1/2 ounce of meat, 1 ounce of meat costs Rose 2 ounces of potatoes. Similarly, because 1 ounce of potatoes costs Frank 1/4 ounce of meat, 1 ounce of meat costs Frank 4 ounces of potatoes. Economists use the term comparative advantage when describing the opportu­ comparative advantage nity costs faced by two producers. The producer who gives up less of other goods the ability to produce to produce Good X has the smaller opportunity cost of producing Good X and is a good at a lower said to have a comparative advantage in producing it. In our example, Frank has opportunity cost than a lower opportunity cost of producing potatoes than Rose: An ounce of potatoes another producer costs Frank only 1/4 ounce of meat, but it costs Rose 1/2 ounce of meat. Conversely, Rose has a lower opportunity cost of producing meat than Frank: An ounce of meat costs Rose 2 ounces of potatoes, but it costs Frank 4 ounces of potatoes. Thus, Frank has a comparative advantage in growing potatoes, and Rose has a comparative advantage in producing meat. Although it is possible for one person to have an absolute advantage in both goods (as Rose does in our example), it is impossible for one person to have a comparative advantage in both goods. Because the opportunity cost of one good is the inverse of the opportunity cost of the other, if a person’s opportunity cost of one good is relatively high, the opportunity cost of the other good must be rela­ tively low. Comparative advantage reflects the relative opportunity cost. Unless two people have the same opportunity cost, one person will have a comparative advantage in one good, and the other person will have a comparative advantage in the other good. 3-2c Comparative Advantage and Trade The gains from specialization and trade are based not on absolute advantage but on comparative advantage. When each person specializes in producing the good for which he or she has a comparative advantage, total production in the economy rises. This increase in the size of the economic pie can be used to make everyone better off. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 54 PART I INTRODUCTION In our example, Frank spends more time growing potatoes, and Rose spends more time producing meat. As a result, the total production of potatoes rises from 40 to 44 ounces, and the total production of meat rises from 16 to 18 ounces. Frank and Rose share the benefits of this increased production. We can also look at the gains from trade in terms of the price that each party pays the other. Because Frank and Rose have different opportunity costs, they can both get a bargain. That is, each of them benefits from trade by obtaining a good at a price that is lower than his or her opportunity cost of that good. Consider the proposed deal from Frank’s viewpoint. Frank receives 5 ounces of meat in exchange for 15 ounces of potatoes. In other words, Frank buys each ounce of meat for a price of 3 ounces of potatoes. This price of meat is lower than his opportunity cost for an ounce of meat, which is 4 ounces of potatoes. Thus, Frank benefits from the deal because he gets to buy meat at a good price. Now consider the deal from Rose’s viewpoint. Rose buys 15 ounces of potatoes for a price of 5 ounces of meat. That is, the price of potatoes is 1/3 ounce of meat. This price of potatoes is lower than her opportunity cost of an ounce of potatoes, which is 1/2 ounce of meat. Rose benefits because she gets to buy potatoes at a good price. The story of Rose the rancher and Frank the farmer has a simple moral, which should now be clear: Trade can benefit everyone in society because it allows people to specialize in activities in which they have a comparative advantage. 3-2d The Price of the Trade The principle of comparative advantage establishes that there are gains from specialization and trade, but it raises a couple of related questions: What deter­ mines the price at which trade takes place? How are the gains from trade shared ­between the trading parties? The precise answer to these questions is beyond the scope of this chapter, but we can state one general rule: For both parties to gain from trade, the price at which they trade must lie between the two opportunity costs. In our example, Frank and Rose agreed to trade at a rate of 3 ounces of potatoes for each ounce of meat. This price is between Rose’s opportunity cost (2 ounces of potatoes per ounce of meat) and Frank’s opportunity cost (4 ounces of potatoes per ounce of meat). The price need not be exactly in the middle for both parties to gain, but it must be somewhere between 2 and 4. To see why the price has to be in this range, consider what would happen if it were not. If the price of meat were below 2 ounces of potatoes, both Frank and Rose would want to buy meat, because the price would be below each of their opportunity costs. Similarly, if the price of meat were above 4 ounces of potatoes, both would want to sell meat, because the price would be above their opportunity costs. But there are only two members of this economy. They cannot both be buyers of meat, nor can they both be sellers. Someone has to take the other side of the deal. A mutually advantageous trade can be struck at a price between 2 and 4. In this price range, Rose wants to sell meat to buy potatoes, and Frank wants to sell pota­ toes to buy meat. Each party can buy a good at a price that is lower than his or her opportunity cost. In the end, each person specializes in the good for which he or she has a comparative advantage and is, as a result, better off. Quick Quiz Robinson Crusoe can gather 10 coconuts or catch 1 fish per hour. His friend Friday can gather 30 coconuts or catch 2 fish per hour. What is Crusoe’s opportunity cost of catching 1 fish? What is Friday’s? Who has an absolute advantage in catching fish? Who has a comparative advantage in catching fish? Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 55 FYI The Legacy of Adam Smith and David Ricardo E conomists have long understood the gains from trade. Here is how the great economist Adam Smith put the argument: Smith’s book inspired David Ricardo, a million- aire stockbroker, to become It is a maxim of every prudent master of a family, never to attempt an economist. In his 1817 book Prin- to make at home what it will cost him more to make than to buy. The ciples of Political Economy and Taxation, Ricardo tailor does not attempt to make his own shoes, but buys them of the developed the principle of comparative advantage as we know it today. shoemaker. The shoemaker does not attempt to make his own clothes He considered an example with two goods (wine and cloth) and two coun- but employs a tailor. The farmer attempts to make neither the one tries (England and Portugal). He showed that both countries can gain nor the other, but employs those different artificers. All of them find by opening up trade and specializing based on comparative advantage. it for their interest to employ their Ricardo’s theory is the starting point of modern international whole industry in a way in which economics, but his defense of free trade was not a mere academic they have some advantage over their exercise. Ricardo put his beliefs to work as a member of the British neighbors, and to purchase with a Parliament, where he opposed the Corn Laws, which restricted the part of its produce, or what is the import of grain. same thing, with the price of part The conclusions of Adam Smith and David Ricardo on the gains of it, whatever else they have occa- from trade have held up well over time. Although economists often sion for. Bettmann/CORBIS disagree on questions of policy, they are united in their support of free This quotation is from Smith’s 1776 trade. Moreover, the central argument for free trade has not changed book An Inquiry into the ­Nature and much in the past two centuries. Even though the field of economics has Causes of the Wealth of ­Nations, which broadened its scope and refined its theories since the time of Smith David Ricardo was a landmark in the analysis of and Ricardo, economists’ opposition to trade restrictions is still based trade and economic interdependence. largely on the principle of comparative advantage. 3-3 Applications of Comparative Advantage The principle of comparative advantage explains interdependence and the gains from trade. Because interdependence is so prevalent in the modern world, the principle of comparative advantage has many applications. Here are two exam­ ples, one fanciful and one of great practical importance. 3-3a Should Tom Brady Mow His Own Lawn? Tom Brady spends a lot of time running around on grass. One of the most tal­ © Cliff Welch/Icon SMI/Corbis ented football players of all time, he can throw a pass with a speed and accuracy that most casual athletes can only dream of. Most likely, he is talented at other physical activities as well. For example, let’s imagine that Brady can mow his lawn faster than anyone else. But just because he can mow his lawn fast, does this mean he should? To answer this question, we can use the concepts of opportunity cost and com­ parative advantage. Let’s say that Brady can mow his lawn in 2 hours. In that “They did a nice job mowing same 2 hours, he could film a television commercial and earn $20,000. By contrast, this grass.” Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 56 PART I INTRODUCTION In the News Economics within a Marriage An economist argues that you shouldn’t always unload the dishwasher just because you’re better than your partner at it. You’re Dividing the dishwasher, I’d often find he had run it “full” Chores Wrong with one pot and eight forks. After we had a kid, we had more to do and By Emily Oster less time to do it in. It seemed like it was time efficient for the best cook and dishwasher for some reassignments. But, of course, I was to do all the cooking and dishwashing. The N o one likes doing chores. In happiness surveys, housework is ranked down there with commuting as activities that people en- still better at doing both things. Did that mean I should do them both? I could have appealed to the principle of fair- economic principle at play here is increasing marginal cost. Basically, people get worse when they are tired. When I teach my students joy the least. Maybe that’s why figuring out ness: We should each do half. I could have ap- at the University of Chicago this principle, I who does which chores usually prompts, at pealed to feminism—surveys show that women explain it in the context of managing their best, tense discussion in a household and, at more often than not get the short end of the employees. Imagine you have a good employee worst, outright fighting. chore stick. In time-use data, women do about and a not-so-good one. Should you make the If everyone is good at something differ- 44 minutes more housework than men (2 hours good employee do literally everything? ent, assigning chores is easy. If your part- and 11 minutes versus 1 hour and 27 minutes). Usually, the answer is no. Why not? It’s ner is great at grocery shopping and you are Men outwork women only in the areas of “lawn” likely that the not-so-good employee is better great at the laundry, you’re set. But this isn’t and “exterior maintenance.” I could have sug- at 9 a.m. after a full night of sleep than the always—or even usually—the case. Often gested he do more chores to rectify this imbal- good employee is at 2 a.m. after a 17-hour one person is better at everything. (And let’s ance, to show our daughter, in the Free To Be You workday. So you want to give at least a few be honest, often that person is the woman.) and Me style, that Mom and Dad are equal and tasks to your worse guy. The same principle Better at the laundry, the grocery shopping, that housework is fun if we do it together! I could applies in your household. Yes, you (or your the cleaning, the cooking. But does that mean have simply smashed around the pans in the spouse) might be better at everything. But she should have to do everything? dishwasher while sighing loudly in the hopes he anyone doing the laundry at 4 a.m. is likely to Before my daughter was born, I both would notice and offer to do it himself. put the red towels in with the white T-shirts. cooked and did the dishes. It wasn’t a big deal, But luckily for me and my husband, I’m an Some task splitting is a good idea. How much it didn’t take too much time, and honestly I economist, so I have more effective tools than depends on how fast people’s skills decay. was a lot better at both than my husband. passive aggression. And some basic economic To “optimize” your family efficiency (every His cooking repertoire extended only to eggs principles provided the answer. We needed to economist’s ultimate goal—and yours, too), and chili, and when I left him in charge of the divide the chores because it is simply not you want to equalize effectiveness on the final Forrest Gump, the boy next door, can mow Brady’s lawn in 4 hours. In that same 4 hours, Gump could work at McDonald’s and earn $40. In this example, Brady has an absolute advantage in mowing lawns because he can do the work with a lower input of time. Yet because Brady’s opportunity cost of mowing the lawn is $20,000 and Gump’s opportunity cost is only $40, Gump has a comparative advantage in mowing lawns. The gains from trade in this example are tremendous. Rather than mowing his own lawn, Brady should make the commercial and hire Gump to mow the lawn. As long as Brady pays Gump more than $40 and less than $20,000, both of them are better off. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 57 task each person is doing. Your partner does comparative advantage. Economists usu- guideline for how to trade tasks in your the dishes, mows the lawn, and makes the ally talk about this in the context of trade. house. You want to assign each person the grocery list. You do the cooking, laundry, shop- Imagine Finland is better than Sweden at tasks on which he or she has a comparative ping, cleaning, and paying the bills. This may making both reindeer hats and snowshoes. advantage. It doesn’t matter that you have seem imbalanced, but when you look at it, you But they are much, much better at the hats an absolute advantage in everything. If you see that by the time your partner gets to the and only a little better at the snowshoes. are much, much better at the laundry and grocery-list task, he is wearing thin and start- The overall world production is maximized only a little better at cleaning the toilet, you ing to nod off. It’s all he can do to figure out when Finland makes hats and Sweden should do the laundry and have your spouse how much milk you need. In fact, he is just makes snowshoes. get out the scrub brush. Just explain that it’s about as good at that as you are when you get We say that Finland has an absolute efficient! around to paying the bills, even though that’s advantage in both things but a compara- In our case, it was easy. Other than us- your fifth task. tive advantage only in hats. This principle ing the grill—which I freely admit is the If you then made your partner also do the is part of the reason economists value free husband domain—I’m much, much bet- cleaning—so it was an even four and four— trade, but that’s for another column (and ter at ­c ooking. And I was only moderately the house would be a disaster, since he is al- probably another author). But it’s also a better at the dishes. So he got the job of ready exhausted by his third chore while you cleaning up after meals, even though his are still doing fine. This system may well end dishwasher loading habits had already up meaning one person does more, but it is un- come under scrutiny. The good news is likely to result in one person doing everything. another economic ­p rinciple I hadn’t even Once you’ve decided you need to divide up counted on was soon in play: learning by the chores in this way, how should you decide doing. As people do a task, they improve at who does what? One option would be randomly it. ­Eighteen months into this new arrange- assigning tasks; another would be having each ment the dishwasher is almost a work of person do some of everything. One spousal-ad- art: neat rows of dishes and everything vice website I read suggested you should divide carefully screened for “top-rack only” sta- Illustration by Robert Neubecker tasks based on which ones you like the best. tus. I, meanwhile, am ­f orbidden from get- None of these are quite right. (In the last case, ting near the dishwasher. ­Apparently, there how would anyone ever end up with the job of is a risk that I’ll “ruin it.” cleaning the bathroom?) To decide who does what, we need more Ms. Oster is a professor of economics at economics. Specifically, the principle of the University of ­Chicago. Source: Slate, November 21, 2012. The article is found in the link: http://www.slate.com/articles/double_x/doublex/2012/11/dividing_the_chores_who_should_cook_and_who_ should_clean.2.html 3-3b Should the United States Trade with Other Countries? imports Just as individuals can benefit from specialization and trade with one another, as goods produced abroad and Frank and Rose did, so can populations of people in different countries. Many sold domestically of the goods that Americans enjoy are produced abroad, and many of the goods produced in the United States are sold abroad. Goods produced abroad and sold exports domestically are called imports. Goods produced domestically and sold abroad goods produced domestically are called exports. and sold abroad Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 58 PART I INTRODUCTION To see how countries can benefit from trade, suppose there are two countries, the United States and Japan, and two goods, food and cars. Imagine that the two countries produce cars equally well: An American worker and a Japanese worker can each produce one car per month. By contrast, because the United States has more and better land, it is better at producing food: A U.S. worker can produce 2 tons of food per month, whereas a Japanese worker can produce only 1 ton of food per month. The principle of comparative advantage states that each good should be produced by the country that has the smaller opportunity cost of producing that good. Because the opportunity cost of a car is 2 tons of food in the United States but only 1 ton of food in Japan, Japan has a comparative advantage in producing cars. Japan should produce more cars than it wants for its own use and export some of them to the United States. Similarly, because the opportu­ nity cost of a ton of food is 1 car in Japan but only 1/2 car in the United States, the United States has a comparative advantage in producing food. The United States should produce more food than it wants to consume and export some to Japan. Through specialization and trade, both countries can have more food and more cars. In reality, of course, the issues involved in trade among nations are more com­ plex than this example suggests. Most important among these issues is that each country has many citizens with different interests. International trade can make some individuals worse off, even as it makes the country as a whole better off. When the United States exports food and imports cars, the impact on an ­American farmer is not the same as the impact on an American autoworker. Yet, contrary to the opinions sometimes voiced by politicians and pundits, international trade is not like war, in which some countries win and others lose. Trade allows all coun­ tries to achieve greater prosperity. Quick Quiz Suppose that a skilled brain surgeon also happens to be the world’s fastest typist. Should she do her own typing or hire a secretary? Explain. 3-4 Conclusion You should now understand more fully the benefits of living in an inter­ dependent economy. When Americans buy tube socks from China, when resi­ dents of Maine drink orange juice from Florida, and when a homeowner hires the kid next door to mow the lawn, the same economic forces are at work. The principle of comparative advantage shows that trade can make everyone better off. Having seen why interdependence is desirable, you might naturally ask how it is possible. How do free societies coordinate the diverse activities of all the people involved in their economies? What ensures that goods and services will get from those who should be producing them to those who should be con­ suming them? In a world with only two people, such as Rose the rancher and Frank the farmer, the answer is simple: These two people can bargain and al­ locate resources between themselves. In the real world with billions of people, the answer is less obvious. We take up this issue in Chapter 4, where we see that free societies allocate resources through the market forces of supply and demand. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 59 Summary Each person consumes goods and services produced advantage. The gains from trade are based on compara­ by many other people both in the United States and tive advantage, not absolute advantage. around the world. Interdependence and trade are de­ Trade makes everyone better off because it allows sirable because they allow everyone to enjoy a greater ­people to specialize in those activities in which they quantity and variety of goods and services. have a comparative advantage. There are two ways to compare the ability of two The principle of comparative advantage applies to ­people to produce a good. The person who can pro­ countries as well as to people. Economists use the prin­ duce the good with the smaller quantity of inputs ciple of comparative advantage to advocate free trade is said to have an absolute advantage in producing the among countries. good. The person who has the smaller opportunity cost of producing the good is said to have a comparative Key Concepts absolute advantage, p. 52 comparative advantage, p. 53 exports, p. 57 opportunity cost, p. 52 imports, p. 57 Questions for Review 1. Under what conditions is the production possibilities 5. If two parties trade based on comparative advantage frontier linear rather than bowed out? and both gain, in what range must the price of the 2. Explain how absolute advantage and comparative trade lie? advantage differ. 6. Why do economists oppose policies that restrict trade 3. Give an example in which one person has an absolute among nations? advantage in doing something but another person has a comparative advantage. 4. Is absolute advantage or comparative advantage more important for trade? Explain your reasoning using the example in your answer to Question 3. Quick Check Multiple Choice 1. In an hour, David can wash 2 cars or mow 1 lawn, 3. When two individuals produce efficiently and then and Ron can wash 3 cars or mow 1 lawn. Who has make a mutually beneficial trade based on compara­ the absolute advantage in car washing, and who tive advantage, has the absolute advantage in lawn mowing? a. they both obtain consumption outside their a. David in washing, Ron in mowing. ­production possibilities frontier. b. Ron in washing, David in mowing. b. they both obtain consumption inside their c. David in washing, neither in mowing. ­production possibilities frontier. d. Ron in washing, neither in mowing. c. one individual consumes inside her production 2. Once again, in an hour, David can wash 2 cars or mow possibilities frontier, while the other consumes 1 lawn, and Ron can wash 3 cars or mow 1 lawn. Who ­outside hers. has the comparative advantage in car washing, and d. each individual consumes a point on her own who has the comparative advantage in lawn mowing? ­production possibilities frontier. a. David in washing, Ron in mowing. 4. Which goods will a nation typically import? b. Ron in washing, David in mowing. a. those goods in which the nation has an absolute c. David in washing, neither in mowing. advantage d. Ron in washing, neither in mowing. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 60 PART I INTRODUCTION b. those goods in which the nation has a comparative c. Both nations will export shirts. advantage d. There are no gains from trade in this situation. c. those goods in which other nations have an 6. Mark can cook dinner in 30 minutes and wash the ­absolute advantage laundry in 20 minutes. His roommate takes half as d. those goods in which other nations have a long to do each task. How should the roommates ­comparative advantage ­allocate the work? 5. Suppose that in the United States, producing an air­ a. Mark should do more of the cooking based on his craft takes 10,000 hours of labor and producing a shirt comparative advantage. takes 2 hours of labor. In China, producing an aircraft b. Mark should do more of the washing based on his takes 40,000 hours of labor and producing a shirt takes comparative advantage. 4 hours of labor. What will these nations trade? c. Mark should do more of the washing based on his a. China will export aircraft, and the United States absolute advantage. will export shirts. d. There are no gains from trade in this situation. b. China will export shirts, and the United States will export aircraft. Problems and Applications 1. Maria can read 20 pages of economics in an hour. She brewing root beer. Pat takes 4 hours to brew a gallon can also read 50 pages of sociology in an hour. She of root beer and 2 hours to make a pizza. Kris takes spends 5 hours per day studying. 6 hours to brew a gallon of root beer and 4 hours to a. Draw Maria’s production possibilities frontier for make a pizza. reading economics and sociology. a. What is each roommate’s opportunity cost of mak­ b. What is Maria’s opportunity cost of reading 100 ing a pizza? Who has the absolute advantage in pages of sociology? making pizza? Who has the comparative advan­ 2. American and Japanese workers can each produce tage in making pizza? 4 cars a year. An American worker can produce 10 b. If Pat and Kris trade foods with each other, who tons of grain a year, whereas a Japanese worker can will trade away pizza in exchange for root beer? produce 5 tons of grain a year. To keep things simple, c. The price of pizza can be expressed in terms of gal­ assume that each country has 100 million workers. lons of root beer. What is the highest price at which a. For this situation, construct a table analogous to the pizza can be traded that would make both room­ table in Figure 1. mates better off? What is the lowest price? Explain. b. Graph the production possibilities frontiers for the 4. Suppose that there are 10 million workers in Canada American and Japanese economies. and that each of these workers can produce either 2 c. For the United States, what is the opportunity cost cars or 30 bushels of wheat in a year. of a car? Of grain? For Japan, what is the opportu­ a. What is the opportunity cost of producing a car in nity cost of a car? Of grain? Put this information in Canada? What is the opportunity cost of producing a table analogous to Table 1. a bushel of wheat in Canada? Explain the relation­ d. Which country has an absolute advantage in pro­ ship between the opportunity costs of the two ducing cars? In producing grain? goods. e. Which country has a comparative advantage in b. Draw Canada’s production possibilities frontier. producing cars? In producing grain? If Canada chooses to consume 10 million cars, f. Without trade, half of each country’s workers pro­ how much wheat can it consume without trade? duce cars and half produce grain. What quantities Label this point on the production possibilities of cars and grain does each country produce? frontier. g. Starting from a position without trade, give an c. Now suppose that the United States offers to buy example in which trade makes each country 10 million cars from Canada in exchange for 20 better off. bushels of wheat per car. If Canada continues to 3. Pat and Kris are roommates. They spend most of consume 10 million cars, how much wheat does their time studying (of course), but they leave some this deal allow Canada to consume? Label this point

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