Gains from Trade - Indonesian
Zero Sum Game
A zero sum game is where one party's gain necessarily implies another party's loss. Poker is an example where the total money remains constant; if one player wins , another must lose .
Gains from Trade
Trade isn't zero-sum; both parties can benefit. This video explores why individuals, businesses, and countries engage in trade and when trade is beneficial.
Hypothetical Scenario: Two roommates, you and I, have to mow the grass and do homework. If I'm better at mowing and you're better at homework, specialization benefits both.
Even if you are better at both tasks, trade can still benefit both of us. This is counterintuitive due to the common zero-sum mentality.
The discussion will cover under what conditions trade is beneficial for all parties involved.
Model: Farmer and Rancher
Consider a farmer and a rancher producing meat and potatoes.
Production Possibilities Frontier (PPF):
In earlier discussions, the shape of the PPF (linear vs. bowed out) depended on the specialization of inputs.
Specialized inputs lead to a bowed-out PPF, indicating increasing costs.
Non-specialized inputs lead to a linear PPF, indicating constant costs.
For simplicity, assume time is the only input and is not specialized, resulting in linear PPFs.
Focus on the time required to produce meat and potatoes, not the intricacies of the production process.
Time Required for Production
The following table shows time in minutes needed to produce one ounce of meat or potatoes:
Farmer: 60 minutes/ounce of meat, 15 minutes/ounce of potatoes.
Rancher: 20 minutes/ounce of meat, 10 minutes/ounce of potatoes.
The rancher is more efficient at producing both goods.
Production in Eight Hours
Assume both work for eight hours. The table below shows the amount produced in that time.
Farmer: 8 ounces of meat, 32 ounces of potatoes.
Rancher: 24 ounces of meat, 48 ounces of potatoes.
The rancher produces more of both goods in the same amount of time.
No Trade Scenario
These production numbers represent the endpoints of each person's PPF.
Farmer's PPF: Potatoes on the horizontal axis, Meat on the vertical axis. Endpoints at 32 potatoes, 8 meat.
Rancher's PPF: Potatoes on the horizontal axis, Meat on the vertical axis. Endpoints at 48 potatoes, 24 meat.
Assume both spend half their time on each good (point A):
Farmer: 4 ounces of meat, 16 ounces of potatoes.
Rancher: 12 ounces of meat, 24 ounces of potatoes.
Without trade, these production points also represent consumption possibilities.
The PPF represents the consumption possibilities frontier; points beyond it are unattainable without trade.
Consuming more of one good requires consuming less of the other, illustrating opportunity cost.
Summary of Production and Consumption (No Trade)
Farmer: 4 ounces meat, 16 ounces potatoes.
Rancher: 12 ounces meat, 24 ounces potatoes.
Trade Scenario: Rancher's Plan
The rancher proposes a plan to change production and trade to benefit both.
Farmer specializes in potatoes (point B on the farmer's PPF).
Rancher produces 18 ounces of meat and 12 ounces of potatoes (point B on the rancher's PPF).
Trade: Farmer gives 15 ounces potatoes to the rancher for 5 ounces of meat.
Production With Trade:
Farmer: 0 meat, 32 potatoes.
Rancher: 18 meat, 12 potatoes.
Trade:
Farmer: +5 meat (from trade), -15 potatoes (traded away).
Rancher: -5 meat (traded away), +15 potatoes (from trade).
Consumption With Trade:
Farmer: 5 meat, 17 potatoes. (Point C, outside original PPF).
Rancher: 13 meat, 27 potatoes. (Point C, farther outside original PPF).
Gains From Trade:
Farmer: +1 meat, +1 potatoes.
Rancher: +1 meat, +3 potatoes.
World gains: +2 meat, +4 potatoes.
The economic pie increases; trade is not a zero-sum game.
Source of Gains From Trade
Trade allows specialization in what each does best.
However, in this example, the rancher is better at both tasks than the farmer.
The gains come from specializing in what each does relatively best.
Understanding "Doing Something Best"
Opportunity cost is key. It's not just time spent, but the alternative forgone.
Avoid focusing solely on minutes required; consider what else could be produced.
Absolute vs. Comparative Advantage
Absolute Advantage: Producing something faster or with fewer inputs.
The rancher has absolute advantage in both goods, producing more in the same time.
Comparative Advantage: Having a lower opportunity cost of production.
Requires determining the cost of producing one good in terms of the other.
Rancher's Perspective:
It takes 10 minutes to produce an ounce of potatoes.
That's 10 minutes that can't be used to produce meat.
In 10 minutes, the rancher could produce 1/2 ounce of meat.
Opportunity cost of 1 ounce of potatoes for the rancher is 1/2 ounce of meat.
This aligns with the PPF's slope, where the slope indicates the opportunity cost of the good on the horizontal axis.
Farmer's Perspective:
The slope of the farmer's PPF is 8/32 = 1/4.
Opportunity cost of 1 ounce of potatoes for the farmer is 1/4 ounce of meat.
The farmer has the lower opportunity cost for production of potatoes.
Opportunity Cost Table
Essential for solving these problems.
Potatoes: Farmer: 1/4 meat, Rancher: 1/2 meat. (Farmer has lower opportunity cost).
Meat: Farmer: 4 potatoes, Rancher: 2 potatoes. (Rancher has lower opportunity cost).
The farmer has the comparative advantage in potatoes; the rancher in meat.
One person cannot have the comparative advantage in both goods. It's always divided.
Gains from Trade (Revisited)
Trade allows specialization based on comparative advantage (lower opportunity cost).
Determining the Range of Prices for Trade
The question is where the trade opportunity came from.
Price Implied by the Trade
Farmer's perspective: 5 ounces of meat for 15 ounces of potatoes.
Each ounce of meat costs 3 ounces of potatoes.
This is beneficial because it falls between the farmer's (4 potatoes) and rancher's (2 potatoes) opportunity costs.
The rancher sells meat for 3 potatoes, more than their cost of 2 potatoes.
Any price between 2 and 4 potatoes per ounce of meat would create gains from trade.
Infinitely many prices exist within this range.
Rancher's Perspective
Rancher received 15 ounces of potatoes for 5 ounces of meat.
Each ounce of potatoes cost 1/3 ounce of meat.
This aligns with the 1/4 to 1/2 range in the previous table.
Problem Solving
A problem should be solved methodically
Example: US and Mexico
Consider two countries: The US and Mexico.
Two goods: food and computers.
US: If the US produces only food, it can produce 400 units. If the US produces only computers, it can produce 100 computers.
Mexico: If Mexico produces only food, it can produce 300 units. If Mexico produces only computers, it can produce 20 computers.
Production Possibilities Frontiers (PPFs)
Draw PPFs for both countries with food on the horizontal axis and computers on the vertical axis.
Numbers are simply the endpoints.
We are going to assume as before that the inputs used to produce are not specialized
So they are linear, even though food and computers in reality are specialized
Analyzing Absolute Advantage:
The US has the absolute advantage in both goods, producing more food and computers if specializing in either.
Opportunity Cost Table: Create to Compare Comparative Advantages
One Unit Food: The US has an opportunity cost to produce 1 unit of food equal to = Slope: 100/400 = .25 computers. The cost of 1 unit of food in Mexico is 20/300 = .06 computers. Mexico has lower cost to produce food.
One Unit Computer: The US has a cost of 4 food where Mexico gives up 15 food. The US has the comparative advantage in computer production.
Specialization and Trade
Based on comparative advantage:
Mexico will specialize completely in food production
The US will specialize completely in computer production
Exports and Imports:
Mexico will export food
The US will export computers
Total production with trade will show that only Mexico produces food at 300 where only the US has potential to produce 100 computers, showing how absolute advantage is not what creates gains from trade as brain tries to make you think about more
Range of Prices for computers
What would be price to make both agree to trade? What price and how to get the answer is
Solving these questions
Any price in between countries to agree to trade: 4 and 15 units of any single product
** Ex: 1 computer with any number in between the product unit, as in, one computer to 9.3 units of food would imply gains from trade
Real World Prices:
Trade might be negotiated based on each persons negotiating ability or skill, but there can always be trades that create benefits
We can use this to write an example of a homework problem where you may need to identify a a trade of 7 or 20 computers
Regarding the production with trade: The farmer specializes in potatoes, so they allocate all their resources to potato production, resulting in 0 meat. The rancher produces both meat and potatoes but shifts production to produce 18 ounces of meat and 12 ounces of potatoes as part of the trade arrangement.