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Interdependence and the
Gains from Trade
Chapter 3
Dr. Katherine Sauer
Principles of Microeconomics
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In England, it takes 100 minutes to produce a bottle of
wine and 120 minutes to produce a bolt of cloth.
In Portugal, it takes 80 minutes to produce a bottle of
wine and 90 minutes to produce a bold of cloth.
Consider a 10 hour work day.
Complete the table with each countrys maximum
output of each good.
wine cloth
England
Portugal
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England:
If it devotes the entire 10 hours to wine, it can produce
600 / 100 = 6 bottles of wine
If it devotes the entire 10 hours to cloth, it can produce
600 / 120 = 5 bolts of cloth
wine cloth
England 6 5
Portugal
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Portugal:
If it devotes the entire 10 hours to wine, it can produce
600 / 80 = 7.5 bottles of wine
If it devotes the entire 10 hours to cloth, it can produce
600 / 90 = 6.67 bolts of cloth
wine cloth
England 6 5
Portugal 7.5 6.67
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wine cloth
England 6 5
Portugal 7.5 6.67
In 10 hours, Portugal can produce more wine.
Economists would say that Portugal has absolute
advantage in producing wine.
Absolute advantage is the ability to produce
- more of a good than another producer, with a
given amount of resourcesor
- the good at the lowestmonetarycost
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wine cloth
England 6 5Portugal 7.5 6.67
In 10 hours, Portugalcan produce more cloth, so wed
say it has absolute advantage in the production of cloth.
Given the information in the table above, plot eachnations PPF for wine and cloth.
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wine
cloth5
6
PPF
If England spent some of its time on each activity, itcould produce some of each good.
England
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Portugal
wine
cloth
PPF
6.67
7.5
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Suppose that Portugal chooses to produce 3 bottles of
wine and 4 bolds of cloth.
Confirm that this production takes 10 hours.
1 bottle of wine takes 80 minutes
3 bottles of wine takes (3)(80) = 240 minutes
1 bolt of cloth takes 90 minutes
4 bolts of cloth takes (4)(90) = 360 minutes
240 + 360 = 600 minutes / 60 minutes = 10 hours
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Illustrate eachs choice on their PPF.
England Portugal
wine
cloth
PPF
wine
cloth
PPF
5
6
6.67
7.5
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Suppose now the two decide to specialize in the
production of one good and trade with the other country.
What good should each specialize in?
Well look at opportunity cost to find out.
We dont have money in this example.
Englands total cost of one bottle of wine is the cloth
it forgoes making during that time.
Portugals opportunity cost of one bottle of wine is the
cloth it forgoes making during that time.
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Formula for calculating per-unit opportunity cost:
opportunity cost of
getting one unit of = amount of B sacrificed = ___ units of Bgood A amount of A gained
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Englands opportunity cost
of 1 bottle of wine=
loss of
gain of
5 cloth
6 wine = 0.83 cloth
Portugals opportunity cost
of 1 bottle of wine= loss ofgain of6.67 cloth7.5 wine = 0.89 cloth
England gives up fewer bolts of cloth while
producing wine.
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England gives up fewerbolts of cloth while making wine
than Portugal does.
England has a loweropportunity cost of making wine than
Portugal does.
Economists would say England has comparative
advantage in producing wine.
Comparative advantage is the ability to produce at the
lowest opportunity cost.
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Portugal gives up fewer bottles of wine while making
cloth.
Portugal has comparative advantage in making cloth.
Englands opportunity cost
of 1 bolt of cloth=
loss of
gain of
6 wine
5 cloth = 1.2 wine
Portugals opportunity cost
of 1 bolt of cloth= loss ofgain of7.5 wine6.67 cloth = 1.12 wine
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So what if they each specialized in the production of thegood that they had comparative advantage in and then
traded?
England would specialize in wine and Portugal wouldspecialize in cloth.
The two of them would need to negotiate a rate to trade
wine for cloth.
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The trade price
Englands cost of 1 bottle of wine is 0.83 bolts of cloth.
It would be willing topart with a bottle of wine for 0.83 ormore bolts of cloth.
- minimum price for a bottle of wine is 0.83 bolts of
cloth
Portugals cost of 1 bottle of wine is 0.89 bolts of cloth.
It would be willing topay0.89 or less bolts of cloth for 1
bottle of wine.
- maximum price for a bottle of wine is 0.89 bolts of
cloth
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The price of bottle of wine will be between0.83
and 0.89 bolts of cloth.
(typo!!!)
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The price of a bolt of cloth will be between 1/0.83 and1/0.89 bottles of wine.
1.20 to 1.12
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The trade price of good A will be between each partys
opportunity cost in terms of good B.
Suppose that they agree to a price of 1.15 bottles of wine
for 1 bolt of cloth. Plot each nations consumptionpossibilities on your original graphs.
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Englands consumption
- could keep all 6 bottles of wine for self
If it traded away all 6 bottles, how much cloth could itget?
1C
1.15W
= ?C
6W 5.21C
With specialization and trade,
England can end up with more
wine and cloth than if it did nottrade.
Trade makes England better off.
wine
cloth
5
6
PPF
5.21
CPF
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Portugals consumption
- could keep all 6.67 bolts of cloth
If it traded away all 6.67 bolts, how much wine could itget in return?
1C
1.15W
= 6.67
?W 7.67W
With specialization and trade,
Portugal can end up with more
cloth and wine than if it wereself-sufficient.
Trade makes Portugal better off.
wine
cloth
PPF
CPF
7.67
6.67
7.5
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In general with specialization and trade, both parties can
be made better off.
What do we mean by better off?
consumption possibilities > consumption possibilities
with trade with no trade
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Historical Economic Theory
Adam Smith (1776)An Inquiry Into the Nature and
Causes of the Wealth of Nations
~ never attempt to make at home what will cost
more to make than buy
- absolute advantage
David Ricardo (1817) Principles of Political Economy
and Taxation
~ developed the principle of comparative advantage
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Summary:
Absolute Advantage is the ability to produce more witha given amount of resources or to produce at the lowest
cost.
Comparative Advantage is the ability to produce at thelowest opportunity cost.
When countries specialize according to comparative
advantage, both can gain.
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On a half sheet of paper,
1. Note the concept that you find the most fuzzy.
2. Explain how your future career is an example of
specialization, interdependence, and the gains from trade
for you personally.