Lecture 2 -Interdependence and the Gains from Trade

1.

LECTURE II.
INTERDEPENDENCE AND THE
GAINS FROM TRADE

2.

THE PRODUCTION POSSIBILITIES FRONTIER
shows the combinations
of output that the
economy can possibly
produce given the
available factors of
production and the
available production
technology

3.

TRADE IS NOT A ZERO-SUM GAME
VS

4.

PRINCIPLE 5: TRADE CAN MAKE EVERYONE
BETTER OFF.
IS IT SO???

5.

A PARABLE FOR THE MODERN ECONOMY
o Let’s examine a simple
economy
o Imagine there are just two
people in Economy - Robinson
and Friday
o Imagine that there are only
two goods in their world: meat
and potatoes

6.

A PARABLE FOR THE MODERN ECONOMY
o Scenario 1: Robinson is
better at raising cattle and
Friday is better at growing
potatoes
o What is the benefit from
trade?

7.

A PARABLE FOR THE MODERN ECONOMY
o Robinson is better at raising
cattle and better at growing
potatoes
o Should he remain self-
sufficient?

8.

A PARABLE FOR THE MODERN ECONOMY
o Suppose both of them work
8 hours per day.
o During those 8 hours they
can:
o
o
o
grow potatoes,
raise cattle, or
Do combination of the two

9.

PRODUCTION OPPORTUNITIES
Minutes Needed to
Make 1 Ounce of
Amount Produced in 8
Hours
Friday
Meat
60 min/oz
Potatoes
15 min/oz
Meat
8 oz
Potatoes
32 oz
Robinson
20 min/oz
10 min/oz
24 oz
48 oz
Robinson is better at raising cattle and better at growing
potatoes - he has absolute advantage!

10.

FRIDAY’S PRODUCTION POSSIBILITIES
FRONTIER

11.

ROBINSON’S PRODUCTION POSSIBILITIES
FRONTIER

12.

WHICH PRINCIPLE OF ECONOMICS
ROBINSON AND FRIDAY ARE FACING WHEN
THEY CHOOSE BETWEEN PRODUCING
MEAT AND PRODUCING POTATOES?

13.

SPECIALIZATION AND TRADE
o What if they start to trade?
o Robinson offers Friday to
specialize on growing potatoes
o He offers the following plan

14.

Friday
Robinson
Meat
Potatoes
Meat
Potatoes
4
16
12
24
Production
0
32
18
12
Trade
Gets 5
Gives 15
Gives 5
Gets 15
Consumption
5
32-15 =
17
18-5=13
12+15=27
+1
+1
+1
+3
Without Trade:
Production and consumption
With Trade:
Gains From Trade
Increase in consumption

15.

FRIDAY’S PRODUCTION POSSIBILITIES FRONTIER

16.

ROBINSON’S PRODUCTION POSSIBILITIES FRONTIER

17.

Q: BEFORE FRIDAY AND ROBINSON ENGAGE
IN TRADE, EACH OF THEM
A. consumes at a point inside his
production possibilities frontier.
B. consumes at a point on his
production possibilities frontier.
C. consumes at a point outside
his production possibilities
frontier.
D. consumes the same amounts
of meat and potatoes as the
other.

18.

Q: AFTER FRIDAY AND ROBINSON ENGAGE
IN TRADE, EACH OF THEM
A. consumes at a point inside his
production possibilities frontier.
B. consumes at a point on his
production possibilities frontier.
C. consumes at a point outside
his production possibilities
frontier.
D. consumes the same amounts
of meat and potatoes as the
other.

19.

HOW DO YOU THINK WHY TRADE INCREASED
CONSUMPTION AND PRODUCTION FOR BOTH OF
THEM?

20.

COMPARATIVE ADVANTAGE: THE DRIVING
FORCE OF SPECIALIZATION
Absolute Advantage
The producer that requires a
smaller quantity of inputs to
produce a good is said to have an
absolute advantage in producing
that good.

21.

COMPARATIVE ADVANTAGE: THE DRIVING
FORCE OF SPECIALIZATION
Opportunity Cost of:
1 oz of meat
1 oz of potatoes
Friday
Robinson
4 oz of potatoes ¼ oz of meat
2 oz of potatoes ½ oz of meat

22.

COMPARATIVE ADVANTAGE: THE DRIVING
FORCE OF SPECIALIZATION
Comparative Advantage
The ability to produce a
good at a lower opportunity
cost than another producer

23.

COMPARATIVE ADVANTAGE AND TRADE
The gains from specialization and trade are based on
comparative advantage.
Trade can benefit everyone in society because it
allows people to specialize in the activities in which
they have a comparative advantage

24.

THE PRICE OF THE TRADE
What determines the price at which trade takes place?
How are the gains from trade shared between the trading
parties?

25.

THE PRICE OF THE TRADE
For both parties to gain from trade, the price at which they trade
must lie between their opportunity costs.

26.

Q: IN AN HOUR, MATEO CAN WASH 2 CARS OR MOW 1
LAWN, AND SOPHIA CAN WASH 3 CARS OR MOW 1 LAWN.
WHO HAS THE ABSOLUTE ADVANTAGE IN CAR WASHING,
AND WHO HAS THE ABSOLUTE ADVANTAGE IN LAWN
MOWING?
A.Mateo in washing, Sophia in mowing
B.Sophia in washing, Mateo in mowing
C.Mateo in washing, neither in mowing
D.Sophia in washing, neither in mowing