Economic Principles: Interdependence and Gains from Trade PDF

# Part I Introduction ## Agency Directing Them To Satisy Your Desires - People provide goods and services in return for something. - Millions of people with different preferences live in economies. - The chapter will explore the origins of economic interdependence. - One of the ten principles of e...

# Part I Introduction ## Agency Directing Them To Satisy Your Desires - People provide goods and services in return for something. - Millions of people with different preferences live in economies. - The chapter will explore the origins of economic interdependence. - One of the ten principles of economics is that trade makes everyone better off. - People benefit from trade. ## Interdependence - Countries import and export goods and services from all around the world. - This chapter will explain the interdependence among nations and individuals. ## A Parable For The Modern Economy - Let's imagine a world where there are only two goods (meat and potatoes) and two people (Ruby and Frank). - Ruby is a cattle rancher and Frank is a potato farmer. - Both Ruby and Frank would like to eat a diet of both meat and potatoes. - The gains from trade are clearest if Ruby can only produce meat and Frank can only produce potatoes. - After several months, Ruby and Frank might choose to trade because it's easy to see that they can both enjoy greater variety in their diet. ## Production Possibilities - Frank can produce one ounce of potatoes in 15 minutes and an ounce of meat in 60 minutes. - Ruby can produce an ounce of potatoes in 10 minutes and an ounce of meat in 20 minutes. - Panel (b) of Figure 1 shows the various combinations of meat and potatoes Frank can produce. - Panel (c) of Figure 1 shows the various combinations of meat and potatoes Ruby can produce. - If there is no trade, each person's production possibilities frontier is also his or her consumption possibilities frontier. ## Specialization and Trade - Ruby suggests that Frank should specialize in producing potatoes and devote all of his time to farming potatoes. - Frank can produce 32 ounces of potatoes if he works 8 hours a day. - Ruby suggests that she will give Frank 5 ounces of meat in return for 15 ounces of potatoes. - Frank would prefer to get 17 ounces of potatoes and 5 ounces of meat, instead of 16 ounces of potatoes and 4 ounces of meat. - Ruby suggests that she will produce 18 ounces of meat and 12 ounces of potatoes, then trade 5 ounces of meat for 15 ounces of potatoes, which will allow her to eat 13 ounces of meat and 27 ounces of potatoes. - They both can benefit from specialization and trade. - By specializing in what they do best, they each can produce more meat and potatoes without working any more hours. ## Comparative Advantage - Ruby is better at producing meat and potatoes. - The puzzle: How can Frank ever specialize in doing what he does best if he doesn't seem to do anything best? - Ruby's explanation is correct, but it poses a puzzle. - The answer lies in the concept of comparative advantage. ## Absolute Advantage - Economists define absolute advantage when comparing the productivity of one person, firm, or nation to another. - The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in that good. - Ruby has an absolute advantage over Frank because it requires less time for her to produce either meat or potatoes. - Ruby needs only 20 minutes to produce one ounce of meat, and Frank needs 60 minutes to produce one ounce of meat. - Ruby only needs 10 minutes to produce one ounce of potatoes, and Frank needs 15 minutes. ## Opportunity Cost and Comparative Advantage - Opportunity cost is what must be given up to obtain some item. - Ruby can produce one ounce of meat in 20 minutes, and she can produce one ounce of potatoes in 10 minutes. - The opportunity cost of one ounce of potatoes is 1/2 ounce of meat for Ruby. - Frank can produce one ounce of potatoes in 15 minutes, and it takes 60 minutes to produce one ounce of meat. - The opportunity cost of one ounce of potatoes is 1/4 ounce of meat for Frank. - The producer who gives up less of other goods to produce Good X has the smaller opportunity cost of producing Good X. - Therefore, Frank has a lower opportunity cost of producing potatoes, and Ruby has a lower opportunity cost of producing meat. ## Comparative Advantage and Trade - The gains from specialization and trade are based on comparative advantage, not absolute advantage. - When each person specializes in the good in which he or she has the comparative advantage, total production in the economy rises. - In the example, Frank spends more time growing potatoes, and Ruby spends more time producing meat. - As a result, the total production of potatoes rises and the total production of meat rises. ## The Price Of The Trade - The principle of comparative advantage establishes that there are gains from specialization and trade. - The price must lie between each person's opportunity costs. - The price at which Frank and Ruby agreed to trade (3 ounces of potatoes for each ounce of meat) is between their respective opportunity costs. - The price need not be exactly halfway between, but it must be somewhere between each person's opportunity cost. ## The Legacy Of Adam Smith And David Ricardo - Adam Smith argued that it is a maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. - David Ricardo further developed the principle of comparative advantage. ## Applications of Comparative Advantage - Should LeBron James mow his own lawn? - LeBron may be good at mowing his own lawn, but his opportunity cost for spending two hours mowing his lawn is much higher than Kaitlyn's opportunity cost for mowing his lawn. - Kaitlyn is a better choice to mow LeBron's lawn. - Should the United States Trade with Other Countries? - We can apply the comparative advantage principle to the trade between nations. - The US is better at producing food than Japan, and Japan is better at producing cars. - The US and Japan can benefit from trade by specializing in the production of food and cars, respectively. - International trade allows all countries to achieve greater prosperity. ## Conclusion - Free societies coordinate the diverse activities of all the people involved in their economies through the market forces of supply and demand. - Trade allows all countries to achieve greater prosperity. - As in the example of Frank and Ruby, each person might have a comparative advantage in producing different goods. - By specializing in what they do best, nations can increase their overall wealth.