Lecture Notes: Normative vs Positive Economics and Bilateral Trade (Chapter 2)

Administrative announcements

  • Eye (i)Clicker policy: We have not started counting iClicker yet and will not count it until next week.
  • Labor Day schedule: Monday is Labor Day; the university is closed; the instructor will not be there.
  • Optional room work: You are welcome to hang out in the room, but please don’t make a mess.
  • Class status: There will be no formal class on Labor Day.
  • Assignments: Typically due on Monday at 11:59 PM, but due to Labor Day, the due date has been shifted to Wednesday.
  • MRU and homework updates:
    • First MRU and second MRU are mentioned; MRU 3 encountered technical difficulties and the link was unpublished temporarily.
    • Homework 1 is due; Homework 2 will be addressed today, with any unfinished parts possibly covered in a slide Wednesday.
    • Students can complete most of Homework 1 this weekend and get a large portion of Homework 2 done as well.
  • Signing in and participation: You should be working on getting signed in, but you may not yet have enough material to ask insightful questions.
  • Next week’s focus: Supply and demand; you’ll be able to ask more insightful questions about assignments and about what’s going on in the course.
  • Recap of the last class: We left off mid-chapter, with Chapter 2 and the big idea that we’ll explore next.

Big picture context and key concepts

  • Chapter 2 focuses on the power of trade (Big Idea 5): When there is trade, specialization occurs and, broadly, everyone can be better off.
  • Chapter 2 is tied to Chapter 1’s framework and to Chapter 21 (a brief detour on normative vs positive economics).

Positive economics vs normative economics (Chapter 21 context)

  • Positive economics: Testing hypotheses about how the world works; statements can be true or false and subject to evidence but do not require a value judgment.
    • Examples in the bilateral trade discussion will be about policy effects, who benefits, who hurts, etc.
    • Positive doesn’t have to be true at all times; it can be contested and revised through evidence and testing.
  • Normative economics: Involves value judgments about what ought to happen; depends on perspectives and goals; not easily aggregated into a single objective measure.
  • The instructor emphasizes that, when teaching the bilateral trade model or standard supply-and-demand models, the focus is on positive analysis: policy effects and outcomes. Normative questions come in later and are more subjective.

The power of trade (Big Idea 5)

  • Trade and specialization: By focusing resources on what they do best (comparative advantages), economies can produce more overall and improve welfare.
  • The lesson is not that wages alone drive trade; wages interact with productivity but do not determine the pattern of trade.
  • The historical framing includes Adam Smith (specialization of labor; early emphasis on absolute advantage) and David Ricardo (the shift to comparative advantage as the key driver of trade patterns).
  • The objective is to demonstrate that comparative advantage, not absolute advantage, explains trade patterns and welfare gains.

The bilateral trade model: setup and intuition

  • Objective: Introduce a simple economic model to illustrate how nations gain from trade via comparative advantage.
  • Core idea: Compare two countries trading two goods, using a simple frame to show how specialization and exchange can increase total production and improve consumption options for both countries.

Simple model choices (why “simple”)

  • The model uses two countries and two goods to keep math manageable while capturing the essential insight.
  • Countries: The United States (US) and Mexico.
  • Goods: Computers and shirts.
  • Labor endowments: Each country has 24 units of labor at its disposal, kept constant to isolate productivity differences.
  • Productivity differences are what generate differences in production capabilities and opening for trade.

Autarky vs trade (production possibilities and channels)

  • Production Possibility Frontier (PPF) idea: A country can produce a mix of goods up to its resource/productivity constraints; points on and inside the PPF are feasible; points outside are unattainable without trade.
  • In autarky (no trade), the US and Mexico have their own PPFs and produce a mix of computers and shirts that consumes locally.
  • The instructor sets up a simple numerical example to illustrate absolute vs comparative advantage and the gains from trade.

Two-country, two-good setup: US and Mexico

  • Goods and productivity (per unit of labor):
    • United States (US): 1 computer per 1 unit of labor; 1 shirt per 1 unit of labor.
    • Mexico: 2 labor units per shirt; 12 labor units per computer.
  • Labor endowment: Each country has 24 units of labor.
  • Autarky production (equal labor split as a baseline):
    • US: 12 computers and 12 shirts (12 labor to computers, 12 labor to shirts).
    • Mexico: 1 computer and 6 shirts (12 labor to computers gives 1 computer; 12 labor to shirts gives 6 shirts).
  • Autarky totals (world level, no trade):
    • Computers: $C_{ ext{total}}^{auto} = 12 + 1 = 13$.
    • Shirts: $S_{ ext{total}}^{auto} = 12 + 6 = 18$.
  • So, without trade, world output is 13 computers and 18 shirts.

Production Possibility Curves (PPFs)

  • US PPF (two goods, linear because 1 unit of labor yields 1 unit of either good):
    • Intercept points: (C,S) = (0,24) when all labor goes to shirts; (C,S) = (24,0) when all labor goes to computers.
    • General equation (with C on the y-axis and S on the x-axis): C = 24 - S.
  • Mexico PPF (different productivity):
    • Maximum computers: 2 (when all labor is allocated to computers).
    • Maximum shirts: 12 (when all labor is allocated to shirts).
    • Linear relation (with C on the x-axis or S on the y-axis; here we present S in terms of C): If C is on the x-axis and S on the y-axis, we have: S = 12 - 6C. (Equivalently, $12C + 2S = 24$ as a linear relationship in the original units.)
  • Key takeaway from the PPFs: A country can produce any combination on its curve or below it efficiently; cannot produce above its curve with given resources and tech.

Opportunity costs (how to read the PPF slopes)

  • Mexico:
    • To produce an additional computer (move from 0 to 1 or 1 to 2 computers), they must reallocate labor from shirts to computers.
    • If they move to produce the second computer (i.e., go from 1 computer to 2), they give up 6 shirts (since 12 labor on computers vs 12 labor on shirts yields a drop from producing 12 shirts to 0 shirts? The simplified takeaway: 1 additional computer costs 6 shirts).
    • Therefore, OC$_{MX}$(C) = 6 shirts per computer.
    • Conversely, to produce an additional shirt, they must move labor from computers to shirts; the cost is 2/12 = 1/6 computer per shirt. OC$_{MX}$(S) = 1/6 computer per shirt.
  • United States:
    • To produce an additional computer, they give up 1 shirt (since 1 labor unit can produce either 1 computer or 1 shirt).
    • So OC$_{US}$(C) = 1 shirt per computer.
    • Conversely, to produce an additional shirt, they give up 1 computer; OC$_{US}$(S) = 1 computer per shirt.

Comparative advantage (the driver of trade patterns)

  • Comparative advantage is driven by relative opportunity costs, not sheer productivity totals (absolute advantage).
  • In this setup:
    • US absolute advantage: higher productivity in both goods (can produce more of each with the same labor). However, this does not determine trade direction.
    • US comparative advantage: lower opportunity cost in producing computers (OC${US}$(C) = 1 shirt per computer vs OC${MX}$(C) = 6 shirts per computer).
    • Mexico comparative advantage: lower opportunity cost in producing shirts (OC${MX}$(S) = 1/6 computer per shirt vs OC${US}$(S) = 1 computer per shirt).
  • Conclusion: US should specialize in computers; Mexico should specialize in shirts. With specialization, total world output can rise and consumption bundles can improve for both countries through trade.

What trade looks like in this simple model

  • Step 1: Specialize according to comparative advantage
    • US focuses on producing computers; Mexico focuses on producing shirts.
  • Step 2: Trade to obtain the other good
    • Some computers are traded for shirts at a price that lies between the two countries’ opportunity costs.
  • Step 3: Choose a terms of trade (price of one good in terms of the other)
    • A common illustration: set a price where one computer equals a certain number of shirts, p shirts per computer.
    • The price must lie between the two countries’ opportunity costs to be mutually beneficial:
    • If we denote p as the number of shirts per computer, the mutually beneficial range is:
    • OC{US}(C) < p < OC{MX}(C) \Rightarrow 1 < p < 6.
    • Example: p = 3 shirts per computer is a feasible rate that makes both sides better off.
  • After specialization and trade, consumption possibilities for both countries can exceed their autarky production possibilities, meaning both can consume more of both goods than under autarky, depending on the terms of trade and the allocation of trade.

Why money appears (and what it does here)

  • In this purely conceptual model, everything is in terms of goods (computers and shirts).
  • Money is not needed to demonstrate the core idea, but in real life, money provides a common measure and a convenient medium of exchange that makes trading easier and quantifies values more precisely. Here, money would serve as a unit of account and a medium of exchange, but the core insight does not rely on money.

Real-world relevance and caveats

  • The key insight: Trade increases total welfare when countries specialize according to comparative advantage.
  • Everyone has some comparative advantage in something; even if a country is worse at producing everything (absolute disadvantage in both goods), it can still gain from trade by specializing where its relative productivity is least bad.
  • The model abstracts away many real-world frictions (transportation costs, tariffs, non-constant opportunity costs, multiple goods, more than two countries). Yet it captures the core intuition behind why trade can make participants better off.
  • Illustrative anecdotes and cautionary notes from the lecture:
    • Adam Smith emphasized specialization, originally tied to absolute advantage; Ricardo later showed that comparative advantage is the key driver of trade, albeit absolute advantage can interact with wages and other factors.
    • A real-world tangent mentioned: Argentina’s Blackberry investment failed because it pursued a product with no competitive advantage in the marketplace, illustrating that misaligned specialization can backfire if the opportunity costs and market demand are not favorable.

Quick practice themes (iClicker-style intuition)

  • Conceptual: Use time or resource tradeoffs to derive opportunity costs and identify comparative advantages.
  • Example pattern: If one person can wash a load of dishes in 30 minutes and cook a meal in 60 minutes, then in 60 minutes they could wash 2 loads or cook 1 meal. The opportunity cost of a meal is 2 loads of dishes (and vice versa, the opportunity cost of a dish-load is 0.5 meals).
  • In a bilateral setup, identify which country should specialize in which good by comparing the opportunity costs: the country with the lower opportunity cost of producing a good should specialize in that good.
  • Consider a feasible terms-of-trade range: price the goods such that both sides benefit by trading at a rate between the two opportunity costs.

Summary of key takeaways

  • Normative vs positive economics: Positive economics analyzes how the world works; normative economics adds value judgments about how the world ought to be.
  • Trade and specialization: Trade, via comparative advantage, can make all trading partners better off by allowing each to specialize in what they do relatively best.
  • Absolute vs comparative advantage: Absolute advantage is about bigger or faster production; comparative advantage is about lower opportunity cost, which actually drives trade patterns.
  • Two-country, two-good model: A teaching tool that demonstrates how PPFs, opportunity costs, comparative advantage, and terms of trade lead to welfare gains through specialization and exchange.
  • Practical implications: The framework helps explain real-world trade flows and policy questions, while also highlighting the importance of evaluating opportunity costs and market conditions before committing to particular production specializations.