Interdependence and the Gains from Trade

Interdependence and the Gains from Trade

Overview of Economic Interdependence

  • Economic interdependence refers to the reliance of nations on each other for goods, services, and resources.

  • People and nations often choose interdependence to enhance their welfare and economic outcomes.

Key Questions Addressed

  • Why do individuals and nations opt for economic interdependence?

  • How does trade contribute to the overall improvement of economic welfare?

  • Definitions:

    • Absolute Advantage

    • Comparative Advantage

  • Comparison:

    • Similarities between absolute advantage and comparative advantage.

    • Differences between the two concepts.

Trade Example: The United States and China

  • Example highlights the benefits of trade between the U.S. and China.

    • Assertion: Trade with China positively impacts most Americans, allowing them access to cheaper goods produced or assembled in China.

Interdependence as a Principle

  • “Trade can make everyone better off” is a core principle from Chapter 1 of Mankiw’s text.

  • Provides rationale for why individuals and nations choose interdependence and analyze gains from trade.

Case Study: The U.S. and Canada

Assumptions Used in Analysis

  • Countries Chosen: United States and Canada.

  • Goods Available for Trade: Airplanes and soybeans.

  • Resource Limitation: Labor, quantified in hours.

  • Objective: Analyze production and consumption under two scenarios:

    1. Self-sufficient economy.

    2. Economies engaged in trade.

Example 1: Production Scenarios for the U.S.

  • Labor Hours Available: 50,000 hours/month.

  • Goods Produced: 100 airplanes and/or 5,000 tons of soybeans.

    • Resources Required:

    • 1 airplane needs 500 labor hours.

    • 1 ton of soybeans needs 10 labor hours.

Production Possibilities Frontier (PPF) for the U.S.

  • Graphical Representation: PPF

    • x-axis: Soybeans.

    • y-axis: Airplanes.

  • Combinations of Production:

    • Point A: 5,000 tons of soybeans (0 airplanes).

    • Point E: 100 airplanes (0 tons of soybeans).

    • Any point on the frontier indicates efficient production levels.

U.S. Production Without Trade

  • Scenario: U.S. splits labor equally:

    • Production Outcome: 50 airplanes and 2,500 tons of soybeans when labor is divided equally between both goods.

Example 2: Production Scenarios for Canada

  • Labor Hours Available: 30,000 hours/month.

  • **Goods Produced: ** 48 airplanes and/or 1,200 tons of soybeans.

    • Resource Requirements:

    • 1 airplane requires 625 labor hours.

    • 1 ton of soybeans requires 25 labor hours.

PPF for Canada

  • Graphical Representation: PPF

    • Points of Production:

    • Point A: 1,200 tons of soybeans (0 airplanes).

    • Point E: 48 airplanes (0 tons of soybeans).

Canada Production Without Trade

  • Labor divided equally leads to:

    • Production Outcome: 24 airplanes and 600 tons of soybeans.

Consumption Without Trade in Both Countries

  • U.S. Consumption: 50 airplanes and 2,500 tons of soybeans.

  • Canada Consumption: 24 airplanes and 600 tons of soybeans.

Example 2: Production Under Trade

  • Trade Scenario:

    • U.S. production: 3,500 tons of soybeans.

    • Canada production: 48 airplanes.

  • Questions to Resolve:

    • Production of airplanes in the U.S. after dedicating resources to soybeans?

    • Soybean production capabilities of Canada, given their focus on airplane production?

Production Calculations Post-Trade

Example 2A: U.S. Production Calculation

  • Producing 3,500 tons of soybeans uses:

    • 3,500 imes 10 = 35,000 labor hours.

    • Remaining labor for airplanes:

    • 50,000 - 35,000 = 15,000 labor hours.

    • Produces:

      • rac{15,000}{500} = 30 airplanes.

Example 2B: Canada’s Production Calculation

  • Producing 48 airplanes utilizes all of Canada’s resources:

    • Labor hours used:

    • 48 imes 625 = 30,000 labor hours.

  • Soybeans Produced: 0 tons.

Exports and Imports Defined

  • Imports: Products made abroad that are sold domestically.

  • Exports: Domestic products sold abroad.

Example 3: Consumption Under Trade

  • Trade specifics:

    • The U.S. exports 880 tons of soybeans and imports 22 airplanes.

    • Calculation of total consumption in both countries after trade.

Example 3A: U.S. Consumption with Trade

  • U.S. soybean and airplane consumption accounting for trade outcomes:

    • Total U.S. consumption after trade:

    • Soybeans = 2,620 tons (2,500 produced + 880 imported).

    • Airplanes = 52 (30 produced + 22 imported).

Example 3B: Canada’s Consumption with Trade

  • Canada’s consumption outcomes:

    • Soybeans = 880 tons (600 produced + 880 imported).

    • Airplanes = 26 (24 produced + 22 exported).

Gains from Trade: Comparative Advantage Results

  • U.S. Consumption Post-Trade: Shows consumption gains compared to pre-trade.

    • Soybeans: 2,620 (gain of 120).

    • Airplanes: 52 (gain of 2).

    • Illustrative Graph: Outcome comparison pre and post trade.

Understanding the Gains

Absolute Advantage Explained

  • Definition: Absolute advantage is defined as the capability to produce a good using fewer inputs than another producer.

  • Application in Example:

    • Soybeans:

    • U.S. (10 labor hours) vs. Canada (25 labor hours).

    • Airplanes:

    • U.S. (500 labor hours) vs. Canada (625 labor hours).

    • Conclusion: The U.S. holds absolute advantage in both goods.

Determining Specialization and Comparative Advantage

  • Rationale for why Canada specializes in airplanes, despite the U.S. having an absolute advantage.

    • Trade leads to specialization based on lowest production cost.

Opportunity Cost Criterion

  • Definition: The opportunity cost is the value of the best alternative forgone when a choice is made.

  • Example Calculation: Opportunity cost of one airplane relative to soybeans in the U.S. and Canada:

    • U.S.:

    • 1 ext{ airplane} = 50 ext{ tons of soybeans}

    • 1 ext{ ton of soybeans} = 0.02 ext{ airplanes}

    • Canada:

    • 1 ext{ airplane} = 25 ext{ tons of soybeans}

    • 1 ext{ ton of soybeans} = 0.04 ext{ airplanes}

Comparative Advantage Analysis

  • U.S. and Canada opportunity cost outcomes:

    • Comparative Advantage Identified:

    • U.S. in soybeans due to lower opportunity cost.

    • Canada in airplanes due to lower opportunity cost.

Gains from Comparative Advantage

  • The total gain from trade arises when countries specialize based on comparative advantage.

  • Trade leads to:

    • Higher total production worldwide.

    • Enhanced economic welfare across involved nations.

Trade Price and Terms

  • Trade Price Determination: Must lie between the respective opportunity costs.

  • In the example:

    • Trade terms of 22 ext{ airplanes} ext{ for } 880 ext{ tons of soybeans} give a trade price of:

    • rac{880}{22} = 40 ext{ tons of soybeans per airplane}.

    • This trade price is higher than Canada’s opportunity cost (25 tons) and lower than the U.S. opportunity cost (50 tons).