Interdependence and the Gains from Trade

The Role of Economists

  • The IGM (Initiative on Global Markets) explores economists' views on vital policy issues via their U.S. and European Economic Experts Panels.

Trade Between China and the United States

  • 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."

  • Economists' Consensus:

    • 0% disagree

    • 100% agree

    • 0% uncertain

Review of Economic Principles

How People Make Decisions

Principle 1: People face trade-offs.

Principle 2: The cost of something is what you give up to get it.

Principle 3: Rational people think at the margin.

Principle 4: People respond to incentives.

How People Interact

Principle 5: Trade can make everyone better off.

Principle 6: Markets are usually a good way to organize economic activity.

Principle 7: Governments can sometimes improve market outcomes.

How the Economy as a Whole Works

Principle 8: A country’s standard of living depends on its ability to produce goods and services.

Principle 9: Prices rise when the government prints too much money.

Principle 10: Society faces a short-run trade-off between inflation and unemployment.

Interdependence

  • Rely on many people from around the world, most of whom you’ve never met, to provide you with the goods and services you enjoy.

  • Evidence of interdependence:

    • People and nations choose to be interdependent.

    • They can gain from trade.

Example: U.S. and Japan Trade Dynamics

Assumptions and Determination of how much both goods each country produces and consumes:

  • Two countries: the U.S. and Japan.

  • Two goods: airplanes and soybeans.

  • One resource: labor, measured in hours.

  • If the country chooses to be self-sufficient

  • If it trades with the other country

U.S. Economy Data

  • Labor hours available for production: 50,000 hours/month.

  • Production requirements:

    • 1 airplane requires 500 labor hours

    • 1 ton of soybeans requires 10 labor hours

Building the U.S. Production Possibility Frontier (PPF)


  • Combinations of airplane and soybean production:

    — fix this

    Labor Hours

    Airplanes

    Soybeans (tons)


    50,000

    100

    0


    40,000

    80

    1,000


    25,000

    50

    2,500


    10,000

    20

    4,000


    0

    0

    5,000

    PPF Summary for the U.S.

    • Maximum production capabilities:

      • 100 airplanes OR 5,000 tons of soybeans OR any combination along the PPF.

    U.S. without Trade

    • If self-sufficient and using half its labor for each good:

      • 50 airplanes and 2,500 tons of soybeans produced and consumed.

    Building Japan’s PPF

    —add here

    Japan Economy Data

    • Labor hours available for production: 30,000 hours/month.

    • Production requirements:

      • 1 airplane = 625 labor hours

      • 1 ton of soybeans = 25 labor hours

    PPF Summary for Japan

    • Maximum production capabilities:

      • 48 airplanes OR 1,200 tons of soybeans OR any combination along the PPF.

    Japan without Trade

    • If self-sufficient and using half its labor for each good:

      • 24 airplanes and 600 tons of soybeans produced and consumed.

    Consumption With or Without Trade

    • U.S. consumption without trade: 50 airplanes and 2,500 tons of soybeans.

    • Japan consumption without trade: 24 airplanes and 600 tons of soybeans.

    • Need to analyze production and trading scenarios for gains.

    Production Under Trade

    Producing for Trade

    A. U.S. produces 3,500 tons of soybeans.

    • Remaining resources for airplanes:

      • Produce: 3,500 imes 10 = 35,000 labor hours for soybeans.

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

      • Airplanes produced: 15,000 ig/ 500 = 30 airplanes.

    B. Japan produces 48 airplanes.

    • Remaining resources for soybeans:

      • Therefore produce $0$ tons of soybeans.

    Import and Export Definitions

    • Imports: Goods produced abroad and sold domestically.

    • Exports: Goods produced domestically and sold abroad.

    Consumption Under Trade

    • Trade example: 22 airplanes traded for 880 tons of soybeans.

    U.S. Consumption Calculation

    • Exports: 880 tons of soybeans.

    • Imports: 22 airplanes.

    • Consumption in U.S.: 52 airplanes (30 produced + 22 imported) and 2,620 tons of soybeans.

    Japan Consumption Calculation

    • Exports: 22 airplanes.

    • Imports: 880 tons of soybeans.

    • Consumption in Japan: 26 airplanes (48 produced - 22 exported) and 880 tons of soybeans.

    Trade Outcomes Summary

    U.S. Consumption without Trade

    U.S. Consumption with Trade

    Airplanes

    50

    52

    Soybeans

    2500

    2620

    Japan Consumption without Trade

    Japan Consumption with Trade

    ---

    -------------------------------

    -----------------------------

    Airplanes

    24

    26

    Soybeans

    600

    880

    What is Absolute Advantage?

    • Absolute Advantage: The ability to produce a good using fewer inputs than another producer.

    Absolute Advantage Examples

    U.S. Economy

    • Absolute advantage in airplanes:

      • 1 airplane = 500 labor hours in the U.S. vs. 625 in Japan.

    • Absolute advantage in soybeans:

      • 1 ton of soybeans = 10 labor hours in the U.S. vs. 25 in Japan.

    Comparative Advantage

    • Comparative Advantage: The ability to produce a good at a lower opportunity cost than another producer; reflects relative opportunity cost.

    • Gains from trade arise when countries specialize based on comparative advantage.

    • Economic principle: Each good should be produced by the individual or nation that has the smaller opportunity cost.

    Opportunity Cost Calculations

    U.S. Opportunity Costs

    • For 1 airplane: Producing 1 airplane uses 500 labor hours, thus 500 ig/ 10 = 50 tons of soybeans.

    • Opportunity cost of 1 airplane = 50 tons of soybeans.

    • Opportunity cost of 1 ton of soybeans = 10 ig/ 500 = 0.02 airplanes.

    Japan Opportunity Costs

    • For 1 airplane: Producing 1 airplane uses 625 labor hours, thus 625 ig/ 25 = 25 tons of soybeans.

    • Opportunity cost of 1 airplane = 25 tons of soybeans.

    • Opportunity cost of 1 ton of soybeans = 25 ig/ 625 = 0.04 airplanes.

    Comparative Advantage Summary

    • Absolute advantage: U.S. in both goods.

    • Comparative advantage in airplanes: Japan (because 25 tons is less than 50 tons for U.S.).

    • Comparative advantage in soybeans: The U.S. (because 0.02 airplanes is less than 0.04 airplanes for Japan).

    Gains from Trade

    • Arise from comparative advantage, where each country specializes and total production increases, enlarging the economic "pie" for all to gain from trade.

    Trade Price Dynamics

    • Price of trade must lie between the opportunity costs of each country.

    • Example: 22 airplanes traded for 880 tons of soybeans, where the trade price of 1 airplane = 40 tons of soybeans lies between 25 tons (Japan's opportunity cost) and 50 tons (U.S.'s opportunity cost).

    Economists’ Views on Trade

    U.S.-China Trade Insights

    • Economists agree that trade with China makes most Americans better off, with 100% consensus.

    • Trade's negative impact on some American workers is acknowledged with 96% agreeing that certain jobs may suffer due to competition.

    Final Summary of Chapter

    • Interdependence and trade are desirable; they allow everyone to enjoy a greater quantity and variety of goods and services.

    • Comparative advantage: being able to produce a good at a lower opportunity cost.

    • Absolute advantage: being able to produce a good with fewer inputs.

    • Gains from trade are fundamentally based on comparative advantage, not absolute advantage.

    • Trade enhances specialization according to comparative advantage, applicable to countries and individuals, advocating for free trade as a beneficial practice.