Interdependence and the gains from trade

In this chapter,
look for the answers to these questions:
Why do people – and nations – choose to be economically interdependent?
How can trade make everyone better off?
What is absolute advantage?
What is comparative advantage?
How are these concepts similar?
How are they different?

Interdependence
Every day
you rely on
many people
from around
the world,
most of whom
you’ve never met,
to provide you
with the goods
and services
you enjoy.

INTERDEPENDENCE AND THE GAINS FROM TRADE
Interdependence
One of the Ten Principles from Chapter 1:
Trade can make everyone better off.
We now learn why people – and nations – choose to be interdependent,
and how they can gain from trade.

INTERDEPENDENCE AND THE GAINS FROM TRADE
Our Example
Two countries: the U.S. and Japan
Two goods: computers and wheat
One resource: labor, measured in hours
We will look at how much of both goods
each country produces and consumes
if the country chooses to be self-sufficient
if it trades with the other country

INTERDEPENDENCE AND THE GAINS FROM TRADE
Production Possibilities in the U.S.
The U.S. has 50,000 hours of labor
available for production, per month.
Producing one computer
requires 100 hours of labor.
Producing one ton of wheat
requires 10 hours of labor.

INTERDEPENDENCE AND THE GAINS FROM TRADE
The U.S. PPF
or 5000 tons of wheat,
or any combination along the PPF.

INTERDEPENDENCE AND THE GAINS FROM TRADE
The U.S. Without Trade
Suppose the U.S. uses half its labor to produce each of the two goods.
Then it will produce and consume
250 computers and
2500 tons of wheat.

Use the following information to draw Japan’s PPF.
Japan has 30,000 hours of labor available for production, per month.
Producing one computer requires 125 hours of labor.
Producing one ton of wheat requires 25 hours of labor.
Your graph should measure computers on the horizontal axis.
A C T I V E L E A R N I N G 1
Derive Japan’s PPF

INTERDEPENDENCE AND THE GAINS FROM TRADE
Japan’s PPF
or 1200 tons of wheat,
or any combination along the PPF.

INTERDEPENDENCE AND THE GAINS FROM TRADE
Japan Without Trade
Suppose Japan uses half its labor to produce each good.
Then it will produce and consume
120 computers and
600 tons of wheat.

INTERDEPENDENCE AND THE GAINS FROM TRADE
Consumption With and Without Trade
Without trade,
U.S. consumers get 250 computers
and 2500 tons wheat.
Japanese consumers get 120 computers
and 600 tons wheat.
We will compare consumption without trade to consumption with trade.
First, we need to see how much of each good is produced and traded by the two countries.

1. Suppose the U.S. produces 3400 tons of wheat. How many computers would the U.S. be able to produce with its remaining labor? Draw the point representing this combination of computers and wheat on the U.S. PPF.
2. Suppose Japan produces 240 computers.
How many tons of wheat would Japan be able to produce with its remaining labor? Draw this point on Japan’s PPF.
A C T I V E L E A R N I N G 2
Production under trade

INTERDEPENDENCE AND THE GAINS FROM TRADE
U.S. Production With Trade
Producing 3400 tons of wheat requires 34,000 labor hours.
The remaining 16,000 labor hours are used to produce 160 computers.

INTERDEPENDENCE AND THE GAINS FROM TRADE
Japan’s Production With Trade
Producing 240 computers requires all of Japan’s 30,000 labor hours.
So, Japan would produce
0 tons of wheat.

INTERDEPENDENCE AND THE GAINS FROM TRADE
Basic international trade terms
Exports:
goods produced domestically and sold abroad
To export means to sell domestically produced goods abroad.
Imports:
goods produced abroad and sold domestically
To import means to purchase goods produced in other countries.

A C T I V E L E A R N I N G 3
Consumption under trade
How much of each good is consumed in the U.S.? Plot this combination on the U.S. PPF.
How much of each good is consumed in Japan? Plot this combination on Japan’s PPF.
Suppose the U.S. exports 700 tons of wheat to Japan, and imports 110 computers from Japan.
(So, Japan imports 700 tons wheat and exports 110 computers.)

INTERDEPENDENCE AND THE GAINS FROM TRADE
U.S. Consumption With Trade

INTERDEPENDENCE AND THE GAINS FROM TRADE
Japan’s Consumption With Trade

INTERDEPENDENCE AND THE GAINS FROM TRADE
Trade Makes Both Countries Better Off
gains from trade
consumption with trade
consumption without trade
U.S.

INTERDEPENDENCE AND THE GAINS FROM TRADE
Where Do These Gains Come From?
Absolute advantage: the ability to produce a good using fewer inputs than another producer
The U.S. has an absolute advantage in wheat:
producing a ton of wheat uses 10 labor hours
in the U.S. vs. 25 in Japan.
If each country has an absolute advantage
in one good and specializes in that good,
then both countries can gain from trade.

INTERDEPENDENCE AND THE GAINS FROM TRADE
Where Do These Gains Come From?
Which country has an absolute advantage in computers?
Producing one computer requires
125 labor hours in Japan,
but only 100 in the U.S.
The U.S. has an absolute advantage in both goods!
So why does Japan specialize in computers? Why do both countries gain from trade?

INTERDEPENDENCE AND THE GAINS FROM TRADE
Two Measures of the Cost of a Good
Two countries can gain from trade when each specializes in the good it produces at lowest cost.
Absolute advantage measures the cost of a good in terms of the inputs required to produce it.
Recall:
Another measure of cost is opportunity cost.
In our example, the opportunity cost of a computer is the amount of wheat that could be produced using the labor needed to produce one computer.

INTERDEPENDENCE AND THE GAINS FROM TRADE
Opportunity Cost and
Comparative Advantage
Comparative advantage: the ability to produce
a good at a lower opportunity cost than another producer
Which country has the comparative advantage in computers?
To answer this, must determine the opp. cost of
a computer in each country.

INTERDEPENDENCE AND THE GAINS FROM TRADE
Opportunity Cost and
Comparative Advantage
The opp. cost of a computer is
10 tons of wheat in the U.S., because producing one computer requires 100 labor hours,
which instead could produce 10 tons of wheat.
5 tons of wheat in Japan, because producing one computer requires 125 labor hours,
which instead could produce 5 tons of wheat.
So, Japan has a comparative advantage in computers. Lesson: Absolute advantage is not necessary for comparative advantage!

INTERDEPENDENCE AND THE GAINS FROM TRADE
Comparative Advantage and Trade
Gains from trade arise from comparative advantage (differences in opportunity costs).
When each country specializes in the good(s)
in which it has a comparative advantage,
total production in all countries is higher,
the world’s “economic pie” is bigger,
and all countries can gain from trade.
The same applies to individual producers
(like the farmer and the rancher) specializing
in different goods and trading with each other.

Argentina and Brazil each have 10,000 hours of labor per month.
In Argentina,
producing one pound coffee requires 2 hours
producing one bottle wine requires 4 hours
In Brazil,
producing one pound coffee requires 1 hour
producing one bottle wine requires 5 hours
Which country has an absolute advantage in the production of coffee? Which country has a comparative advantage in the production of wine?
A C T I V E L E A R N I N G 4
Absolute & comparative advantage

Brazil has an absolute advantage in coffee:
Producing a pound of coffee requires only one
labor-hour in Brazil, but two in Argentina.
Argentina has a comparative advantage in wine:
Argentina’s opp. cost of wine is two pounds of coffee, because the four labor-hours required
to produce a bottle of wine could instead produce two pounds of coffee.
Brazil’s opp. cost of wine is five pounds of coffee.
A C T I V E L E A R N I N G 4
Answers

INTERDEPENDENCE AND THE GAINS FROM TRADE
Unanswered Questions….
We made a lot of assumptions about the quantities of each good that each country produces, trades, and consumes, and the price at which the countries trade wheat for computers.
In the real world, these quantities and prices would be determined by the preferences of consumers and the technology and resources in both countries.
We will begin to study this in the next chapter.
For now, though, our goal was merely to
see how trade can make everyone better off.