Principles of Microeconomics: Trade and Comparative Advantage Lecture 2

INTERDEPENDENCE AND THE GAINS FROM TRADE

  • Proposition of Economics

    • Trade can make everyone better off.

    • Explains why people trade with their neighbors and nations.

    • Key Questions:

    • What do people gain from trade?

    • Why do people choose interdependence?

CONTENTS

  • Key Concepts Included:

    • Production possibility curve

    • Marginal cost as slope of Production possibilities frontier

    • Preferences and Marginal benefit

    • Allocative Efficiency

    • Absolute and Comparative Advantage

    • Gains from Trade

PRODUCTION POSSIBILITY CURVE

  • Scarcity of Production Inputs:

    • Types of Inputs: time, skilled workers, land, capital (tools, machines, computers, etc.).

    • Face a trade-off: dedicating resources to one area limits output in another.

    • Opportunity Cost: Additional resources for cars means sacrificing production of computers.

PRODUCTION POSSIBILITY CURVE EXAMPLES

  • Production Combinations in an Economy:

    • Goods: Corn and Soybeans.

    • Point A on Production Possibility Frontier: Full resource utilization (corn).

    • Producing more soybeans requires reallocating land from corn.

    • Points:

      • Feasible: Points on or within the frontier.

      • Unfeasible: Points outside the frontier.

  • Resource Movement Example:

    • Moving from Point A to Point B:

    • Resource movement from corn production to soybean yields.

    • Decrease in corn: 12 million tons to gain 3 million tons of soybeans.

    • Opportunity Cost Calculation:

      • Cost of producing 1 soybean = rac{12}{3} = 4 million tons of corn per million tons of soybeans.

MARGINAL COST

  • Increasing Marginal (Opportunity) Cost:

    • In moving from Point C to A, less reduction in corn is observed than from A to B.

    • As soybean production increases, land less productive is used first, leading to higher costs.

DECREASING MARGINAL BENEFIT

  • Marginal Benefit and Consumption:

    • First glass of water provides high enjoyment when thirsty; each subsequent glass provides less satisfaction.

    • Principle illustrates decreasing marginal benefit.

    • May reach a point of zero or negative benefit with excessive consumption.

OPTIMAL PRODUCTION

  • Cost-Benefit Principle:

    • A country should produce a good if the marginal cost is less than the marginal benefit.

    • Marginal costs are considered to be increasing while marginal benefits are decreasing.

    • Optimal production level identified at 30 tons of soybeans at equal marginal cost and benefit of $400 per ton.

TRADE

  • Production vs. Specialization and Trade:

    • Individuals can either produce all goods independently or specialize and trade.

    • Unique skills lead to higher collective output, where trade increases efficiency.

PARABLE OF A MODERN ECONOMY

  • Example Setup:

    • Goods: Meat and potatoes.

    • Participants: Cattle Rancher (Ruby) and Potato Farmer (Frank) who prefer variety.

  • Frank's Scenarios:

    • Capable of raising cattle but not efficiently; thrive at producing potatoes.

    • Ruby excels in both but faces land challenges with potatoes.

COMPARATIVE ADVANTAGE

  • Understanding Comparative Advantage:

    • Absolute Advantage: Comparing producers based on productivity.

    • Identifies producer needing fewer inputs for goods.

    • Opportunity Cost: Next best alternative sacrificed for production.

    • Comparative advantage assessed on opportunity costs rather than inputs.

OPPORTUNITY COST EXAMPLES

  • Frank's Production Costs:

    • Time taken for 1 kg of meat: 60 minutes.

    • In that time, can produce rac{60}{15} = 4 kg of potatoes.

    • Opportunity cost of 1 kg of meat = 4 kg of potatoes.

    • Ruby's Costs:

    • Takes 20 minutes per kg of meat, yielding an opportunity cost of 2 kg of potatoes.

GAINS FROM TRADE

  • Principle:

    • Countries gain by specializing in goods they have comparative advantages in and trading.

    • Mutual benefits arise from trade leading to overall improved consumption.

EFFICIENCY THROUGH SPECIALIZATION AND TRADE

  • Specialization Impact:

    • Ruby’s utilization of hours leads to an increased production pattern via specialization.

    • Result: Consumption boost benefits both through trade arrangements.

SUMMARY OF GAINS FROM TRADE

  • Situation without Trade:

    • Frank: 4 kg meat, 16 kg potatoes.

    • Ruby: 12 kg meat, 24 kg potatoes.

  • Situation with Trade:

    • Frank's production becomes 0 kg meat, 32 kg potatoes.

    • Ruby produces 18 kg meat, 12 kg potatoes.

  • Net Increase in Consumption:

    • Both see improvement in resource consumption after engagement in trade.

COMPARATIVE ADVANTAGE IN ACTION

  • Example Calculations:

    • Frank’s original production aids Ruby in enhancing her output alongside trading benefits both.

    • Each benefits from a decrease in opportunity costs relative to trade.

ECONOMIC APPLICATIONS OF COMPARATIVE ADVANTAGE

  • International Trade:

    • Imports: Goods/services produced abroad and sold domestically.

    • Exports: Goods/services produced domestically and sold abroad.

  • Japan vs. Canada:

    • Japan's opportunity cost of a car is 2 tonnes of food; Canada’s is 1/2 car for 1 tonne.

    • Trading results in enhanced production capacities for both countries.