Notes on Interdependence and the Gains from Trade (Mankiw, Principles of Microeconomics, 10e)
3-1 A Parable for the Modern Economy
(Introductory idea) Interdependence and gains from trade arise when economies specialize and trade based on relative efficiencies.
Chapter Objectives (1 of 2)
By the end of this chapter, you should be able to:
Explain how the terms of trade can lead to gains.
Describe opportunity cost in the context of the production possibilities frontier.
Describe how the production possibilities frontier explains aggregate production.
Determine if an output level is exhibiting allocative or productive efficiency.
Explain how comparative advantage determines trade.
Describe absolute advantage in the context of trade.
Chapter Objectives (2 of 2)
Describe the factors that cause the production possibilities frontier to shift.
Determine whether a country will be an importer or exporter of a good if the country opens up to international trade.
Ask the Experts: Trade with China and the United States
A quote: trade with China makes most Americans better off because, among other advantages, they can buy goods that are made or assembled more cheaply in China.
Source: IGM Economic Experts Panel, June 19, 2012.
Economic Interdependence
Trade can make everyone better off – one of the Ten Principles of Economics.
We now examine this principle more closely.
Key questions:
What exactly do people gain when they trade with one another?
Why do people become interdependent?
A Simple Economy
Two goods: meat and potatoes.
Two people: Ruby (cattle rancher) and Frank (potato farmer).
Both would like to eat both meat and potatoes.
Production Possibilities
If Ruby produces only meat and Frank produces only potatoes, both gain from trade.
If both Ruby and Frank produce both meat and potatoes, both gain from specialization and trade.
Production possibilities frontier (PPF): various mixes of output that an economy can produce.
Figure 1: The Production Possibilities Frontier (1 of 2)
Panel (a) shows the production opportunities available to Frank the farmer and Ruby the rancher.
Figure 1: The Production Possibilities Frontier (2 of 2)
Panel (b) shows the combinations of meat and potatoes that Frank can produce.
Panel (c) shows the combinations of meat and potatoes that Ruby can produce.
Assumptions: Frank and Ruby each work 8 hours per day.
If there is no trade, their production possibilities frontiers are also their consumption possibilities frontiers.
Example 1: The U.S. PPF (1 of 3)
The U.S. PPF: The U.S. economy has 50{,}000 labor hours per month available for production.
Produces only two goods—airplanes and soybeans.
To produce 1 airplane requires 500 labor hours.
To produce 1 ton of soybeans requires 10 labor hours.
Example 1: The U.S. PPF (2 of 3)
Employment of Labor Hours vs Production:
A: Airplanes = 50{,}000; Soybeans = 0; Production = Airplanes = 100; Soybeans = 0
B: Airplanes = 40{,}000; Soybeans = 10{,}000; Production = Airplanes = 80; Soybeans = 1{,}000
C: Airplanes = 25{,}000; Soybeans = 25{,}000; Production = Airplanes = 50; Soybeans = 2{,}500
D: Airplanes = 10{,}000; Soybeans = 40{,}000; Production = Airplanes = 20; Soybeans = 4{,}000
E: Airplanes = 0; Soybeans = 50{,}000; Production = Airplanes = 0; Soybeans = 5{,}000
Example 1: The U.S. PPF (3 of 3)
The United States has enough labor to produce any combination along the PPF.
Suppose the United States uses half its labor to produce each of the two goods.
The U.S. production and consumption would be 50 airplanes and 2{,}500 tons of soybeans.
Active Learning 1: Japan’s PPF
Given:
Japan has 30{,}000 labor hours per month available for production.
Produces only two goods—airplanes and soybeans.
To produce 1 airplane requires 625 labor hours.
To produce 1 ton of soybeans requires 25 labor hours.
Graph should measure soybeans (tons) on the horizontal axis.
Active Learning 1: Answers
Japan has enough labor to produce any combination along the PPF.
Suppose Japan uses half its labor to produce each of the two goods.
Japan’s production and consumption would be 24 airplanes and 600 tons of soybeans.
Specialization and Trade
Frank specializes in growing potatoes; more time growing potatoes, less time raising cattle.
Ruby specializes in raising cattle; more time raising cattle, less time growing potatoes.
Trade example: 5 oz of meat for 15 oz of potatoes.
Figure 2: How Trade Expands the Set of Consumption Opportunities (1 of 2)
The proposed trade offers Frank and Ruby a combination of meat and potatoes that would be impossible without trade.
Panel (a): Frank consumes at point A* rather than point A.
Panel (b): Ruby consumes at point B* rather than point B.
Conclusion: Trade allows each to consume more meat and more potatoes.
Figure 2: How Trade Expands the Set of Consumption Opportunities (2 of 2)
Trade allows each to consume more meat and more potatoes.
Active Learning 2: Production Under Trade
We continue Example 1 and Active Learning 1, but now the two countries choose different production points.
The United States produces 3{,}500 tons of soybeans. How many airplanes can the United States produce with the remaining resources? Draw this point on the U.S. PPF.
Japan produces 48 airplanes. How many tons of soybeans can Japan produce with the remaining resources? Draw this point on Japan’s PPF.
Active Learning 2: Answers
(Answer key provided in the slides, not reproduced here.)
Active Learning 3: Consumption Under Trade
The two countries can trade: 22 airplanes for 880 tons of soybeans.
The United States exports 880 tons of soybeans and imports 22 airplanes.
How much of each good is consumed in the United States? Plot this combination on the U.S. PPF.
Japan exports 22 airplanes and imports 880 tons of soybeans.
How much of each good is consumed in Japan? Plot this combination on Japan’s PPF.
Active Learning 3: Answers
(Answer key provided in the slides, not reproduced here.)
3-2 Comparative Advantage: The Driving Force of Specialization
Absolute Advantage
Absolute advantage* is the ability to produce a good using fewer inputs than another producer.
Example:
To produce 1 oz of meat: Ruby needs 20 minutes; Frank needs 60 minutes.
To produce 1 oz of potatoes: Ruby needs 10 minutes; Frank needs 15 minutes.
Ruby has an absolute advantage in producing both meat and potatoes because she requires less time than Frank to produce a unit of either good.
*Words accompanied by an asterisk are key terms from the chapter.
Opportunity Cost and Comparative Advantage
Opportunity cost* is whatever must be given up to obtain some item.
Ruby: 10 min to grow 1 oz of potatoes, 20 min to produce 1 oz of meat.
Opportunity cost of producing 1 oz of potatoes is 1/2 oz of meat.
Frank: 15 min to grow 1 oz of potatoes, 60 min to produce 1 oz of meat.
Opportunity cost of producing 1 oz of potatoes is 1/4 oz of meat.
*Words accompanied by an asterisk are key terms from the chapter.
Table 1: The Opportunity Cost of Meat and Potatoes
Opportunity Cost of 1 oz of Meat
Frank the farmer: 4 oz potatoes
Ruby the rancher: 2 oz potatoes
Opportunity Cost of 1 oz of Potatoes
Frank the farmer: 1/4 oz meat
Ruby the rancher: 1/2 oz meat
Comparative Advantage (1 of 2)
Comparative advantage* is the ability to produce a good at a lower opportunity cost than another producer.
One person can have an absolute advantage in both goods.
Cannot have a comparative advantage in both goods.
*Words accompanied by an asterisk are key terms from the chapter.
Comparative Advantage (2 of 2)
The opportunity cost of one good is the inverse of the opportunity cost of the other good.
For different opportunity costs, one person has comparative advantage in one good and the other person has comparative advantage in the other good.
Comparative Advantage and Trade
Gains from specialization and trade are driven by comparative advantage.
Total production in the economy rises with specialization and trade.
Gains from trade are reflected in the implicit prices that trading partners pay each other.
Trade can benefit everyone because it allows people to specialize in activities in which they have a comparative advantage.
The Price of the Trade
For both parties to gain from trade, the price at which they trade must lie between their opportunity costs.
3-3 Applications of Comparative Advantage
Should Naomi Osaka Mow Her Own Lawn?
In 2 hours, Osaka can mow her lawn, or film a TV commercial, earn $30{,}000.
In 4 hours, Hari can mow Osaka's lawn, or work at McDonald’s, earn $50.
Gains from trade: As long as Osaka pays Hari more than $50 and less than $30{,}000, both are better off.
Should the United States Trade with Other Countries? (1 of 4)
Imports* are goods produced abroad and sold domestically.
Exports* are goods produced domestically and sold abroad.
*Words accompanied by an asterisk are key terms from the chapter.
Should the United States Trade with Other Countries? (2 of 4)
United States and Japan: each produces food and cars.
One American worker, in one month, can produce one car or 2 tons of food.
One Japanese worker, in one month, can produce one car or 1 ton of food.
Should the United States Trade with Other Countries? (3 of 4)
Opportunity cost of a car: 2 tons of food in the United States, 1 ton of food in Japan.
Japan has a comparative advantage in producing cars.
Opportunity cost of a ton of food: 1 car in Japan, 1/2 car in the United States.
The United States has a comparative advantage in producing food.
Should the United States Trade with Other Countries? (4 of 4)
Principle of comparative advantage: Each good should be produced by the country with the smaller opportunity cost of producing that good.
Japan should produce more cars than it wants for its own use and export some to the United States.
The United States should produce more food than it wants to consume and export some to Japan.
Through specialization and trade, both countries have more food and more cars.
3-4 Conclusion
Recaps the key idea: the principle of comparative advantage shows that trade can make everyone better off, but raises questions about coordination and allocation.
Conclusion
The principle of comparative advantage shows that trade can make everyone better off.
How is it possible? How do free societies coordinate the diverse activities of all the people involved in their economies? What ensures that goods and services get from those who should be producing them to those who should be consuming them?
Most economies allocate resources using the market forces of supply and demand.
Ask the Experts: Trade between China and the United States - B
A statement: Some Americans who work in the production of competing goods, such as clothing and furniture, are made worse off by trade with China.
Source: IGM Economic Experts Panel, June 19, 2012.
Think-Pair-Share Activity
Debated scenario: a tariff on imports of steel, debating who is better off and the real-world implications of import restrictions.
Questions:
Will the United States be better off if we limit steel imports? Explain.
Will anyone in the United States be better off if we limit steel imports? Explain.
In the real world, does every person in the country gain when restrictions on imports are reduced? Explain.
Self-Assessment
What exactly do people gain when they trade with one another?
Compared to a roommate, are there activities in which you have an absolute advantage? A comparative advantage?
Summary
Review the objectives for the chapter and how the ideas of PPF, opportunity cost, absolute and comparative advantage, and gains from trade connect to real-world trade and policy decisions.
Link to Objectives
(Refer to the slide link to the objectives in the original presentation.)
3-1 A Parable for the Modern Economy
(Introductory idea) Interdependence and gains from trade arise when economies specialize in producing goods and services where they have a relative efficiency or lower opportunity cost. This specialization leads to increased overall production and allows individuals and countries to consume beyond their individual production capabilities.
Chapter Objectives (1 of 2)
By the end of this chapter, you should be able to:
Explain how the terms of trade, which are the rates at which one good can be exchanged for another, can lead to mutual gains for trading partners.
Describe opportunity cost as the value of the next best alternative given up, in the context of decisions made along the production possibilities frontier (PPF).
Describe how the production possibilities frontier illustrates the maximum possible output combinations of two goods an economy can produce given its resources and technology, thereby explaining aggregate production limits.
Determine if an output level is exhibiting allocative efficiency (producing the mix of goods most desired by society) or productive efficiency (producing goods at the lowest possible cost, i.e., on the PPF).
Explain how comparative advantage, the ability to produce a good at a lower opportunity cost, determines the patterns of international trade and specialization.
Describe absolute advantage, the ability to produce a good using fewer inputs (e.g., labor hours) than another producer, in the context of trade.
Chapter Objectives (2 of 2)
Describe the factors that cause the production possibilities frontier to shift, such as changes in technology or resource availability, indicating economic growth or contraction.
Determine whether a country will be an importer (buying goods from abroad) or an exporter (selling goods abroad) of a good if the country opens up to international trade, based on its comparative advantage.
Ask the Experts: Trade with China and the United States
A quote: trade with China makes most Americans better off because, among other advantages (such as lower prices for consumer goods, greater variety of products, and access to efficiently produced goods), they can buy goods that are made or assembled more cheaply in China.
Source: IGM Economic Experts Panel, June 19, 2012.
Economic Interdependence
Trade can make everyone better off – one of the Ten Principles of Economics. This is because trade allows for specialization, leading to increased total output and enabling individuals and nations to consume a wider array of goods and services than they could produce on their own.
We now examine this principle more closely.
Key questions:
What exactly do people gain when they trade with one another? They gain access to a larger quantity and variety of goods and services at lower costs due to specialized production.
Why do people become interdependent? They become interdependent because specialization requires trade to acquire other goods and services they do not produce themselves, leading to mutual reliance and benefits.
A Simple Economy
To illustrate the principles of trade, consider a simplified economy with:
Two goods: meat and potatoes.
Two people: Ruby (cattle rancher) and Frank (potato farmer).
Both Ruby and Frank would like to eat both meat and potatoes, setting the stage for potential trade.
Production Possibilities
If Ruby produces only meat and Frank produces only potatoes, both gain from trade by obtaining the other good. However, even if both Ruby and Frank produce both meat and potatoes, they can still gain from specializing in the good they produce more efficiently and then trading.
The Production Possibilities Frontier (PPF)\ extbar: This is a graph that shows the various combinations of output (in this case, meat and potatoes) that an economy can possibly produce given the available resources (e.g., labor hours) and production technology. It illustrates scarcity, trade-offs, and opportunity costs.
Figure 1: The Production Possibilities Frontier (1 of 2)
Panel (a) shows the production opportunities available to Frank the farmer and Ruby the rancher, illustrating the maximum amounts of meat and potatoes each can produce individually.
Figure 1: The Production Possibilities Frontier (2 of 2)
Panel (b) shows the combinations of meat and potatoes that Frank can produce within his resource constraints.
Panel (c) shows the combinations of meat and potatoes that Ruby can produce within her resource constraints.
Assumptions: For simplicity, Frank and Ruby each work 8 hours per day, and their productivity rates are constant.
If there is no trade, their individual production possibilities frontiers are also their consumption possibilities frontiers, meaning they can only consume what they produce.
Example 1: The U.S. PPF (1 of 3)
Consider the U.S. PPF example: The U.S. economy has 50{,}000 labor hours per month available for production.
It produces only two goods—airplanes and soybeans.
To produce 1 airplane requires 500 labor hours.
To produce 1 ton of soybeans requires 10 labor hours.
Example 1: The U.S. PPF (2 of 3)
The maximum possible production levels can be calculated as follows:
Max Airplanes = 50{,}000 ext{ hours} / 500 ext{ hours/airplane} = 100 airplanes.
Max Soybeans = 50{,}000 ext{ hours} / 10 ext{ hours/ton} = 5{,}000 tons.
Employment of Labor Hours vs Production for various points on the PPF:
A: Airplanes labor = 50{,}000; Soybeans labor = 0; Production = Airplanes = 100 (50{,}000/500); Soybeans = 0
B: Airplanes labor = 40{,}000; Soybeans labor = 10{,}000; Production = Airplanes = 80 (40{,}000/500); Soybeans = 1{,}000 (10{,}000/10)
C: Airplanes labor = 25{,}000; Soybeans labor = 25{,}000; Production = Airplanes = 50 (25{,}000/500); Soybeans = 2{,}500 (25{,}000/10)
D: Airplanes labor = 10{,}000; Soybeans labor = 40{,}000; Production = Airplanes = 20 (10{,}000/500); Soybeans = 4{,}000 (40{,}000/10)
E: Airplanes labor = 0; Soybeans labor = 50{,}000; Production = Airplanes = 0; Soybeans = 5{,}000 (50{,}000/10)
Example 1: The U.S. PPF (3 of 3)
The United States has enough labor to produce any combination of airplanes and soybeans along its PPF, representing efficient utilization of its resources.
Suppose the United States uses half its labor to produce each of the two goods (e.g., 25{,}000 labor hours for airplanes and 25{,}000 for soybeans).
The U.S. production and consumption (without trade) would then be 50 airplanes and 2{,}500 tons of soybeans, corresponding to point C on the PPF.
Active Learning 1: Japan’s PPF
Given the following for Japan:
Japan has 30{,}000 labor hours per month available for production.
It produces only two goods—airplanes and soybeans.
To produce 1 airplane requires 625 labor hours.
To produce 1 ton of soybeans requires 25 labor hours.
Graph should measure soybeans (tons) on the horizontal axis and airplanes on the vertical axis. The PPF would be a straight line connecting the maximum output for each good.
Max Airplanes = 30{,}000 / 625 = 48
Max Soybeans = 30{,}000 / 25 = 1{,}200
Active Learning 1: Answers
Japan has enough labor to produce any combination along its PPF, just like the U.S.
Suppose Japan uses half its labor (e.g., 15{,}000 hours) to produce each of the two goods.
Japan’s production and consumption (without trade) would be:
Airplanes: 15{,}000 ext{ hours} / 625 ext{ hours/airplane} = 24 airplanes.
Soybeans: 15{,}000 ext{ hours} / 25 ext{ hours/ton} = 600 tons of soybeans.
Specialization and Trade
To maximize gains, individuals (or countries) should specialize based on their comparative advantage.
In the case of Frank and Ruby:
Frank specializes in growing potatoes; he dedicates more time to growing potatoes and less time to raising cattle, focusing on what he does relatively better.
Ruby specializes in raising cattle; she dedicates more time to raising cattle and less time to growing potatoes, focusing on her relative strength.
Trade example: If Ruby and Frank agree to trade 5 oz of meat for 15 oz of potatoes, this trade ratio must be mutually beneficial, meaning it falls between their respective opportunity costs of production.
Figure 2: How Trade Expands the Set of Consumption Opportunities (1 of 2)
The proposed trade offers Frank and Ruby a combination of meat and potatoes that would be impossible to achieve without trade, pushing their consumption beyond their individual production possibilities frontiers.
Panel (a): Frank consumes at point A* (e.g., more of both goods) rather than point A (his no-trade production/consumption point).
Panel (b): Ruby consumes at point B* (e.g., more of both goods) rather than point B (her no-trade production/consumption point).
Conclusion: Trade allows each to consume more meat and more potatoes than they could produce independently.
Figure 2: How Trade Expands the Set of Consumption Opportunities (2 of 2)
This expansion means that the consumption possibilities frontier (CPF) lies outside the PPF when trade occurs, illustrating the gains from trade for both parties.
Active Learning 2: Production Under Trade
We continue Example 1 (U.S.) and Active Learning 1 (Japan), now with the two countries choosing different production points based on their potential for trade.
The United States produces 3{,}500 tons of soybeans. To produce this, the U.S. uses 3{,}500 ext{ tons} imes 10 ext{ hours/ton} = 35{,}000 labor hours. With the remaining resources (50{,}000 - 35{,}000 = 15{,}000 labor hours), the U.S. can produce 15{,}000 ext{ hours} / 500 ext{ hours/airplane} = 30 airplanes. This point would be plotted on the U.S. PPF.
Japan produces 48 airplanes. To produce this, Japan uses 48 ext{ airplanes} imes 625 ext{ hours/airplane} = 30{,}000 labor hours. With the remaining resources (30{,}000 - 30{,}000 = 0 labor hours), Japan can produce 0 tons of soybeans. This indicates Japan fully specializes in airplane production. This point would be plotted on Japan’s PPF.
Active Learning 2: Answers
(The previous detailed calculations are the answer key, explicitly provided here for more detail.)
U.S. production: 30 airplanes, 3{,}500 tons of soybeans.
Japan production: 48 airplanes, 0 tons of soybeans (full specialization).
Active Learning 3: Consumption Under Trade
The two countries can trade: 22 airplanes for 880 tons of soybeans. This terms of trade allows both countries to benefit.
The United States exports 880 tons of soybeans and imports 22 airplanes.
How much of each good is consumed in the United States? The U.S. produced 30 airplanes and 3{,}500 tons of soybeans. After exporting 880 tons of soybeans (3{,}500 - 880 = 2{,}620 ext{ tons}$) and importing 22 airplanes (30 + 22 = 52 ext{ airplanes}), the U.S. consumes 52 airplanes and 2{,}620 tons of soybeans. This combination would be plotted outside the U.S. PPF, on its Consumption Possibilities Frontier.
Japan exports 22 airplanes and imports 880 tons of soybeans.
How much of each good is consumed in Japan? Japan produced 48 airplanes and 0 tons of soybeans. After exporting 22 airplanes (48 - 22 = 26 ext{ airplanes}$) and importing 880 tons of soybeans (0 + 880 = 880 ext{ tons}), Japan consumes 26 airplanes and 880 tons of soybeans. This combination would also be plotted outside Japan’s PPF.
Active Learning 3: Answers
(The previous detailed calculations are the answer key, explicitly provided here for more detail.)
U.S. consumption: 52 airplanes, 2{,}620 tons of soybeans.
Japan consumption: 26 airplanes, 880 tons of soybeans.
3-2 Comparative Advantage: The Driving Force of Specialization
Absolute Advantage
Absolute advantage* is the ability to produce a good using fewer inputs (such as time, labor, or resources) than another producer.
Example: Using Ruby and Frank's production times:
To produce 1 oz of meat: Ruby needs 20 minutes; Frank needs 60 minutes.
To produce 1 oz of potatoes: Ruby needs 10 minutes; Frank needs 15 minutes.
Ruby has an absolute advantage in producing both meat and potatoes because she requires less time (fewer inputs) than Frank to produce a unit of either good. This means she is generally more productive in both activities.
*Words accompanied by an asterisk are key terms from the chapter.
Opportunity Cost and Comparative Advantage
Opportunity cost* is whatever must be given up to obtain some item; it's the value of the next best alternative forgone.
Calculating opportunity costs for Ruby:
Ruby: 10 min to grow 1 oz of potatoes, 20 min to produce 1 oz of meat.
Opportunity cost of producing 1 oz of potatoes = rac{10 ext{ min (potatoes)}}{20 ext{ min (meat)}} = rac{1}{2} oz of meat. (To get 1 oz potatoes, Ruby must give up 1/2 oz meat).
Opportunity cost of producing 1 oz of meat = rac{20 ext{ min (meat)}}{10 ext{ min (potatoes)}} = 2 oz of potatoes. (To get 1 oz meat, Ruby must give up 2 oz potatoes).
Calculating opportunity costs for Frank:
Frank: 15 min to grow 1 oz of potatoes, 60 min to produce 1 oz of meat.
Opportunity cost of producing 1 oz of potatoes = rac{15 ext{ min (potatoes)}}{60 ext{ min (meat)}} = rac{1}{4} oz of meat. (To get 1 oz potatoes, Frank must give up 1/4 oz meat).
Opportunity cost of producing 1 oz of meat = rac{60 ext{ min (meat)}}{15 ext{ min (potatoes)}} = 4 oz of potatoes. (To get 1 oz meat, Frank must give up 4 oz potatoes).
*Words accompanied by an asterisk are key terms from the chapter.
Table 1: The Opportunity Cost of Meat and Potatoes
This table summarizes the calculated opportunity costs:
Opportunity Cost of 1 oz of Meat | Opportunity Cost of 1 oz of Potatoes | |
|---|---|---|
Frank the farmer | 4 oz potatoes | rac{1}{4} oz meat |
Ruby the rancher | 2 oz potatoes | rac{1}{2} oz meat |
Comparative Advantage (1 of 2)
Comparative advantage* is the ability to produce a good at a lower opportunity cost than another producer. This is the fundamental basis for beneficial trade.
It is possible for one person (like Ruby) to have an absolute advantage in producing both goods (being more productive in everything).
However, one person cannot have a comparative advantage in both goods. This is because the opportunity cost of one good is the inverse of the opportunity cost of the other; if you have a lower opportunity cost for one, you must have a higher opportunity cost for the other.
*Words accompanied by an asterisk are key terms from the chapter.
Comparative Advantage (2 of 2)
The opportunity cost of one good is always the inverse of the opportunity cost of the other good for a given producer. For example, if Frank's opportunity cost of 1 oz of potatoes is rac{1}{4} oz of meat, then his opportunity cost of 1 oz of meat must be 4 oz of potatoes.
Because of these inverse relationships, if two producers have different opportunity costs for producing two goods, one person will inevitably have a comparative advantage in one good, and the other person will have a comparative advantage in the other good. This ensures a basis for mutually beneficial specialization and trade.
Comparative Advantage and Trade
The significant gains from specialization and trade are fundamentally driven by comparative advantage, not absolute advantage.
When individuals or countries specialize in producing the goods for which they have a comparative advantage, total production in the economy rises, leading to a larger economic pie for everyone.
Gains from trade are reflected in the implicit prices that trading partners pay each other. These prices, or terms of trade, must fall between the opportunity costs of the two parties for both to benefit.
Trade can benefit everyone because it allows people to specialize in activities in which they have a comparative advantage, making the overall economy more efficient and expanding consumption possibilities.
The Price of the Trade
For both parties to gain from trade, the price at which they trade (the ratio of exchange of one good for another) must lie between their respective opportunity costs. If the price is outside this range, one party would be better off producing the good themselves instead of trading.
3-3 Applications of Comparative Advantage
Should Naomi Osaka Mow Her Own Lawn?
Scenario:
In 2 hours, professional tennis player Naomi Osaka can mow her lawn, or film a TV commercial and earn 30{,}000.
In 4 hours, Hari, a local landscaper, can mow Osaka's lawn, or work at McDonald’s and earn 50.
Analysis of Opportunity Costs:
Osaka's opportunity cost of mowing her lawn: 30{,}000 (the income she forgoes from filming a commercial).
Hari's opportunity cost of mowing Osaka's lawn: 50 (the income he forgoes from working at McDonald's).
Gains from trade: Hari has a much lower opportunity cost of mowing the lawn. As long as Osaka pays Hari more than 50 (so Hari is better off) but less than 30{,}000 (so Osaka is better off by paying someone else rather than doing it herself), both are better off. Osaka can use her time for higher-value activities while Hari earns more than his alternative.
Should the United States Trade with Other Countries? (1 of 4)
International trade involves:
Imports*: goods produced abroad (in other countries) and sold domestically (within a country).
Exports*: goods produced domestically (within a country) and sold abroad (to other countries).
*Words accompanied by an asterisk are key terms from the chapter.
Should the United States Trade with Other Countries? (2 of 4)
Let's consider a scenario involving the United States and Japan:
Each country produces two goods: food and cars.
Production rates:
One American worker, in one month, can produce one car or 2 tons of food.
One Japanese worker, in one month, can produce one car or 1 ton of food.
Should the United States Trade with Other Countries? (3 of 4)
Calculation of Opportunity Costs:
United States:
Opportunity cost of 1 car = 2 tons of food (to produce 1 car, 2 tons of food must be forgone).
Opportunity cost of 1 ton of food = rac{1}{2} car (to produce 1 ton of food, 1/2 car must be forgone).
Japan:
Opportunity cost of 1 car = 1 ton of food.
Opportunity cost of 1 ton of food = 1 car.
Comparative Advantage:
Japan has a comparative advantage in producing cars because its opportunity cost of a car (1 ton of food) is lower than that of the U.S. (2 tons of food).
The United States has a comparative advantage in producing food because its opportunity cost of a ton of food (1/2 car) is lower than that of Japan (1 car).
Should the United States Trade with Other Countries? (4 of 4)
Applying the principle of comparative advantage: Each good should be produced by the country with the smaller opportunity cost of producing that good.
Therefore, Japan should specialize in producing cars, producing more cars than it wants for its own use and exporting the surplus to the United States.
The United States should specialize in producing food, producing more food than it wants to consume and exporting some to Japan.
Through this specialization and trade, both countries end up with more food and more cars than they would have had if they tried to be self-sufficient, demonstrating the gains from trade.
3-4 Conclusion
Conclusion
The principle of comparative advantage convincingly shows that trade can make everyone better off by increasing overall production and expanding consumption opportunities.
However, this raises important questions: How is it possible for free societies to coordinate the diverse activities of all the people involved in their economies? What ensures that goods and services get from those who should be producing them (based on comparative advantage) to those who should be consuming them?
Most economies allocate resources and coordinate activities using the market forces of supply and demand, where prices act as signals to guide production and consumption decisions.
Ask the Experts: Trade between China and the United States - B
A statement: Some Americans who work in the production of competing goods, such as clothing and furniture, are made worse off by trade with China. While trade benefits the overall economy, it can create job losses and economic disruption in specific domestic industries that face intense competition from efficient import producers, leading to concentrated costs for certain groups.
Source: IGM Economic Experts Panel, June 19, 2012.
Think-Pair-Share Activity
Debated scenario: a tariff on imports of steel, debating who is better off and the real-world implications of import restrictions.
Questions:
Will the United States be better off if we limit steel imports? Overall, no. While domestic steel producers might benefit from reduced competition and higher prices, steel-using industries (like auto manufacturers) would face higher input costs, potentially becoming less competitive themselves. Consumers would also face higher prices for goods made with steel. Overall economic efficiency would likely decrease.
Will anyone in the United States be better off if we limit steel imports? Yes, specific groups would benefit. Domestic steel producers would likely see increased sales and profits, and their workers might experience greater job security and potentially higher wages due to reduced foreign competition.
In the real world, does every person in the country gain when restrictions on imports are reduced? No. While a reduction in import restrictions (free trade) generally leads to overall economic gains by allowing specialization and lower prices for consumers, some individuals and industries that previously faced less competition may suffer. Workers in those industries might lose jobs or face wage reductions, requiring economic adjustments and potentially government assistance or retraining programs.
Self-Assessment
What exactly do people gain when they trade with one another? They gain the ability to consume more goods and services than they could produce on their own, often at lower costs, by specializing in what they do best and exchanging with others.
Compared to a roommate, are there activities in which you have an absolute advantage? A comparative advantage? (Consider your relative speeds/efficiencies in tasks like cooking, cleaning, studying, or earning income).
Summary
This chapter has reviewed the objectives by exploring how the ideas of the Production Possibilities Frontier (PPF), opportunity cost, absolute and comparative advantage, and the gains from trade connect to real-world trade patterns and policy decisions, emphasizing that comparative advantage is the key driver of beneficial specialization and trade.
Link to Objectives
(Refer to the slide link to the objectives in the original presentation to ensure
Absolute advantage: the ability to produce a good using fewer inputs than another producer.
Opportunity cost: whatever must be given up to obtain some item.
Comparative advantage: the ability to produce a good at a lower opportunity cost than another producer.
Imports: goods produced abroad and sold domestically.
Exports: goods produced domestically and sold abroad.
The Production Possibilities Frontier (PPF) is a graph that illustrates the various combinations of output that an economy can possibly produce, given its available resources and current production technology. It visually represents the limits of aggregate production, showing combinations of goods an economy can efficiently produce, as well as concepts like scarcity, trade-offs, and opportunity costs.
Specialization refers to the act of an individual, firm, or country focusing their productive efforts on a specific task, good, or service for which they have a particular efficiency or a lower opportunity cost (comparative advantage). By specializing, producers can increase their overall output, which then enables them to trade with others to acquire goods and services they do not produce themselves, leading to mutual gains and increased consumption possibilities for all parties involved.
The statement "Shahina should hire the assistant as long as she pays the assistant less than 25 per hour" is true due to the concept of opportunity cost.
Here's the breakdown:
Shahina's Opportunity Cost of Typing: Shahina can earn 100 per hour doing tax returns. In that same hour, she can type 10,000 characters into spreadsheets. This means her opportunity cost of spending one hour typing (and thus not doing tax returns) is 100.
Valuing the Assistant's Work: The assistant can type 2,500 characters per hour. This amount of typing would take Shahina rac{2,500 ext{ characters}}{10,000 ext{ characters/hour}} = rac{1}{4} of an hour.
Shahina's Opportunity Cost for the Assistant's Output: If Shahina were to do the 2,500 characters herself, she would spend rac{1}{4} of an hour. The income she would forgo during that rac{1}{4} hour of typing is rac{1}{4} imes 100 ext{ per hour} = 25. This is Shahina's opportunity cost of getting 2,500 characters typed.
Decision to Hire: Since it would cost Shahina 25 in forgone earnings to type 2,500 characters herself, she would be better off hiring an assistant to do the same task as long as the assistant's wage is less than her own opportunity cost of 25 per hour. If she pays less than 25$$, she saves money relative to doing it herself, allowing her to focus on higher-value tax return work.