copyright © 2004 south-western/thomson learning mod 4 interdependence and the gains from trade
TRANSCRIPT
Copyright © 2004 South-Western/Thomson Learning
ModMod44
Interdependence and the Gains from Trade
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Interdependence and the Gains from Trade
• Remember:
Economics is the study of how societies produce and distribute scarce goods & resources in an attempt to satisfy the wants and needs of its members.
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Interdependence and the Gains from Trade
• How do we satisfy our wants and needs in an economy? • We can be economically self-sufficient
OR• We can specialize and trade
with others, leading to economic interdependence.
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The Caveman Simulation
F Farmer Food
T Tailor Clothing
B Builder Shelter
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The Caveman Simulation, V. 2.0
Producer Food Shelter Food/Shelter
Skilled 400 400 100/300
Unskilled 300 100 75/75
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Interdependence and the Gains from Trade
• Individuals and nations rely on specialized production and exchange as a way to address problems caused by scarcity.
• But this gives rise to two questions:• Why is interdependence the norm?• What determines production and trade?
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Interdependence and the Gains from Trade
• Why is interdependence the norm?• Because people are better off when they specialize
and trade with others—Caveman Simulation
• What determines the pattern of production and trade? • Differences in opportunity costs.
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Comp Adv Wksht
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The Farmer and the Rancher: A Classic Example of Absolute and Comparative
Advantage• Imagine . . .
• only two goods: potatoes and meat• only two people: a potato farmer and a cattle
rancher
• What should each produce?
• Why should they trade?
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Production Possibilities (amt produced/40 hrs)
Meat Potatoes
Farmer 2 lbs 4 lbs
Rancher 40 lbs 5 lbs
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The Rancher has an absolute advantage in the production of both meat and potatoes—he can produce more of each in the same
amount of time
Absolute Advantage
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TWO Production Possibilities
Self-Sufficiency
• By ignoring each other:• Each consumes what they each produce.• The production possibilities frontier limits their
consumption• Without trade, economic gains are diminished.
The Production Possibilities Curve
Potatoes (lbs)
1
2
2
4
A
0
Meat (lbs)
The Farmer’s PPC’
If there is no trade, the farmer chooses this production and consumption level, so he can have some of both.
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The Production Possibilities Curve
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Potatoes (lbs)
20
2.5
B
0
Meat (lbs)
’
5
40 If there is no trade, the rancher chooses this production and consumption level, so he can have some of both.
The Rancher’s PPC
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TWO Production Possibilities
Trade
• By Specializing and Trade:• Each would be better off if they specialized in
producing the product they are more suited to produce, and then trade with each other.
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The Farmer and the Rancher
So, what should they each produce?
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THE PRINCIPLE OF COMPARATIVE ADVANTAGE• The producer who has the lower opportunity
cost of producing a good is said to have a comparative advantage in producing that good.
• Compares producers of a good according to their opportunity cost.• Whatever must be given up to obtain some item
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Steps to Figuring Opp Cost for Comp Adv Problems
1. Set up your Matrix as per the model
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Matrix Model
Producer Item: Item:
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Figuring Opportunity Cost of Meat and Potatoes (amt produced/40 hrs)
Meat Potatoes
Farmer 2 lbs 4 lbs
Rancher 40 lbs 5 lbs
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Steps to Figuring Opp Cost for Comp Adv
2. Determine whether it is an Output or Input problem
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Figuring Opportunity Cost of Meat and Potatoes (amt produced/40 hrs)
Meat Potatoes
Farmer 2 lbs 4 lbs
Rancher 40 lbs 5 lbs
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Steps to Figuring Opp Cost for Comp Adv
3. Create ratios for Opportunity Cost Analysis
a) Create ratios horizontally for each Producer
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Figuring Opportunity Cost of Meat and Potatoes (amt produced/40 hrs)
Meat Potatoes
Farmer 2 lbs 4 lbs
Rancher 40 lbs 5 lbs
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Steps to Figuring Opp Cost for Comp Adv
3. Create ratios for Opportunity Cost Analysis
a) Create ratios horizontally for each Producer
b) Output Problem—use Outside value over inside value first, then the reciprocal
c) Input Problem—use Inside value over outside value first, then the reciprocal
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Figuring Opportunity Cost of Meat and Potatoes (amt produced/40 hrs)
Meat Potatoes
Farmer 2 lbs 4 lbs
Rancher 40 lbs 5 lbs
4/2 2/4
5/40 40/5
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Steps to Figuring Opp Cost for Comp Adv
d) Compare ratios vertically for each Item/Good
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Figuring Opportunity Cost of Meat and Potatoes (amt produced/40 hrs)
Meat Potatoes
Farmer 2 lbs 4 lbs
Rancher 40 lbs 5 lbs
4/2 2/4
5/40 40/5
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Points to Remember using Matrices
5. Lowest Opp. Cost for each good determines producer
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Figuring Opportunity Cost of Meat and Potatoes (amt produced/40 hrs)
Meat Potatoes
Farmer 2 lbs 4 lbs
Rancher 40 lbs 5 lbs
4/2 2/4
5/40 40/5
Which is smaller? Which is smaller?
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…so, the Rancher has a comparative advantage in the
production of meat, but the Farmer has a comparative
advantage in the production of potatoes.
Comparative Advantage and Trade
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Matrices for Comp Adv Calculations
Producer Item: Item:
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Caveman Simulation
Producer Item: Item:
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Hatfield’s and McCoy’s Problem
Producer Item: Item:
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Figuring Opportunity Cost of Corn and Cloth (1 unit/amt hours)
Corn Cloth
Hatfields 8 hrs 10 hrs
McCoys 15 hrs 12 hrs
8/10 10/8
15/12 12/15
Which is smaller? Which is smaller?
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Types of Input vs Output Problems
• INPUT Problems:• # of hours to produce 1 unit• # of acres to produce 1 unit• # of certain ingredients to produce 1 unit
• OUTPUT Problems:• Tons per acre• Miles per gallon• Words per minute• Apples per tree• ETC
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Sample Word Problem
• In Italy, an automobile can be produced by 8 workers in 1 day and a washing machine by 3 workers in 1 day. In the U.S., an automobile can be produced by 6 workers in 1 day, and a washing machine by 2 workers in 1 day.• Draw the matrix• Absolute Advantage in autos?• Absolute Advantage in washers?• Comp Adv in washers?• Comp Adv in autos?
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Bert and Betsy
• Another Classic example of looking at Opportunity Costs, Absolute and Comparative Advantage
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Household Chores (output/hr)
Dishwashing (Number of sink loads)
Sweeping (Number of trash loads)
Bert 1 1
Betsy 2 3
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Points to Remember using Matrices
1. Set up your Matrix as per the model
2. Determine whether it is an Output or Input problem
3. Create your ratios of Opportunity Cost
a) Create ratios horizontally for each Producer
b) Output Problem—use Outside value over inside value first, then the reciprocal
c) Input Problem—use Inside value over outside value first, then the reciprocal
d) Compare ratios vertically for each Item/Good
5. Lowest Opp. Cost for each good determines producer
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Other Comp Adv Methods
• Using PPC curves and reading them to create a matrix, or for slope and opportunity cost
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Here’s the Matrix
Producer Item: Timber
Item: Apples
Oregon40 10
Washington10 40
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Here’s the PPC
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Read the PPC
Slope calculations:• For Oregon
• Slope is 40/10 (4) for Apples• Slope is 10/40 (1/4) for Timber
• For Washington• Slope is 10/40 (1/4) for Apples• Slope is 40/10 (4) for Timber
So…Oregon will produce Timber and Washington will produce apples—40 each.
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Figuring Terms of Trade
• Once you have figured Opportunity Costs… and seen who has Comp Adv in what—the two parties would produce that good totally and then trade some of that good to get some of the other.
• They would want to trade to better themselves overall from when they were self-sufficient
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Figuring Terms of Trade
So…as long as the trading terms are set somewhere between their Opp. Costs, the two parties will be satisfied.
Their Opp. Costs were between ¼ and 4 timbers for each apple.
We can set trade at 1 timber for 1 apple.
Let’s have them trade 20 for 20.
Now, their consumption can be beyond where their PPC’s were with no trade.
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Figuring Terms of Trade
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Review
• The most efficient outcome/use of resources comes from production based on comparative advantage and then trading to get the different items.• Trade can benefit everyone in a society because it
allows people to specialize in activities in which they have a comparative advantage.
• Trade can benefit countries because it allows nations to specialize in activities in which they have a comparative advantage.
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What is the basis for Comp Adv differences?
• Between PEOPLE:• Temperament• Skills• Natural talents
• Between NATIONS:• Climate• Workforce skills• Natural Resources• Capital Stock
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Comp Advantage Trade Problems
• Find a Partner
• Get slates, markers, and Kleenex for erasers.
• Get Problem set cards from me
• Solve the comp advantage problem• Write Number of Problem• Listen for Instructions for method
• Show answers and Check
• Take home Germany/Poland wksht problem for practice