Gains from trade
Why do we trade?
Different countries can make different goods for cheaper
Uneven distribution of natural resources, labour , and capital tech around the world
Different goods need different resources
Specialisation and then trade is good because consumption goes up
Introduction to Comparative Advantage
Focus on the principle of comparative advantage, gains from trade, and how trade benefits both countries.
Example used: Two countries (Zambia and Malawi) producing two products (maize and meat).
Acknowledgment of simplicity but effectiveness in illustrating key economic principles.
Production Capabilities of Countries
Zambia's Production:
Can produce either 30 units of maize or 30 units of meat.
Possible linear combinations of maize and meat.
Malawi's Production:
Can produce 20 units of meat or 10 units of maize.
Also possible linear combinations of the two products.
Production Possibility Frontier (PPF)
Graphical representation of production capabilities of Zambia and Malawi.
Zambia's PPF is less steep and further from the origin, indicating it can produce more of both products relative to Malawi.
Assumption made that resources are equally suited for producing maize and meat, leading to constant opportunity costs.
Standard of Living Comparison
Zambia has a higher standard of living because it can produce more of both products compared to Malawi.
Absolute Advantage:
Zambia has absolute advantage in both maize and meat production.
It can produce more of both than Malawi.
Opportunity Costs and Specialization
Zambia's Opportunity Cost:
1 unit of maize = 1 unit of meat.
Malawi's Opportunity Cost:
1 unit of maize = 2 units of meat.
Conclusion:
Maize is relatively more expensive in Malawi, while it is cheaper in Zambia.
Zambia should specialize in maize production and Malawi in meat production due to their respective comparative advantages.
Gains from Trade
Both countries can benefit from specialising in a in the product where they have a comparative advantage.
Zambia Specialization: Produces and exports maize.
Malawi Specialization: Produces and exports meat.
By trading, In total Zambia and Malawi can consume more than they would be able to without trade- Specialising means you put all your resources towards making one product so your making more of that product (consumption goes up in the product even after export bcz all resources were put towards making that product) . You then also get imports to the value of more than you could make by yourself.
Trading Ratio and World Output Before Trade
Before trade, Zambia produces:
18 units of maize and 12 units of meat.
Before trade, Malawi produces:
8 units of maize and 4 units of meat.
Total world output without trade:
Maize = 26 units; Meat = 16 units.
Specialization and Trade Benefits
Zambia's Specialization Output:
30 units of maize and 0 units of meat.
Malawi's Specialization Output:
0 units of maize and 20 units of meat.
Post-specialization, world output increases:
Maize = 30 units; Meat = 20 units.
Trade example:
Zambia gives 10 units of maize for 15 units of meat from Malawi.
Each country's consumption patterns improve post-trade.
Gains from Trade Comparison
Zambia Gains:
2 additional units of maize, 3 additional units of meat.
Malawi Gains:
2 additional units of maize, 1 additional unit of meat.
World overall gain after trade: 4 units of maize and 4 units of meat.
Understanding Opportunity Costs
Importance of understanding opportunity costs to determine specialization.
Opportunity cost impacts whether trade is beneficial or not.
International Terms of Trade
Countries need to establish terms of trade to trade profitably.
The proposed exchange ratio (1 maize = 1.5 meat) should provide mutual benefits.
Mutual Benefits from Trade
If the exchange ratio is unfavorable, it may not be beneficial for either country (e.g., Zambia won't trade for less than 1 unit of meat for 1 unit of maize).
Optimal trade must exceed domestic opportunity costs for both countries to benefit.
Conclusion on Trade and Specialization
Trade and specialization allow countries to consume more than they could in isolation.
Effective negotiation of terms of trade is crucial in maximizing benefits from trade.
Reasons for Trade:
Different countries produce goods more efficiently due to factors like resource availability and technological capabilities.
Specialization in production leads to better allocation of resources across countries.
Comparative Advantage:
Trade benefits both countries when they specialize based on comparative advantage.
Example: Zambia can produce more maize and meat compared to Malawi.
Production Capabilities:
Zambia can produce 30 units each of maize and meat.
Malawi can produce 20 units of meat or 10 units of maize.
Production Possibility Frontier (PPF):
Zambia’s PPF is less steep, showing higher production capacity for both goods.
Standard of Living:
Zambia has a higher living standard due to greater production capabilities.
Zambia exhibits absolute advantage in both goods.
Opportunity Costs:
Zambia’s opportunity cost is 1 unit of maize for 1 unit of meat.
Malawi’s opportunity cost is 1 unit of maize for 2 units of meat.
Gains from Trade:
Both countries benefit from specializing where they have a comparative advantage.
Zambia specializes in maize, while Malawi specializes in meat, leading to increased total output.
Trading Ratio and World Output:
Before trade, combined output is 26 units of maize and 16 units of meat.
After specialization, total output increases to 30 maize and 20 meat.
Post-Trade Consumption Gains:
Zambia can trade for 15 units of meat in exchange for 10 units of maize, enhancing consumption for both countries.
Conclusion:
Effective specialization and favorable terms of trade are essential for maximizing benefits from trade, leading to a higher overall consumption than in isolation.
Reasons for Trade:
Different countries produce goods more efficiently due to factors like resource availability and technological capabilities.
Specialization in production leads to better allocation of resources across countries.
Comparative Advantage:
Trade benefits both countries when they specialize based on comparative advantage.
Example: Zambia can produce more maize and meat compared to Malawi.
Production Capabilities:
Zambia can produce 30 units each of maize and meat.
Malawi can produce 20 units of meat or 10 units of maize.
Production Possibility Frontier (PPF):
Zambia’s PPF is less steep, showing higher production capacity for both goods.
Standard of Living:
Zambia has a higher living standard due to greater production capabilities.
Zambia exhibits absolute advantage in both goods.
Opportunity Costs:
Zambia’s opportunity cost is 1 unit of maize for 1 unit of meat.
Malawi’s opportunity cost is 1 unit of maize for 2 units of meat.
Gains from Trade:
Both countries benefit from specializing where they have a comparative advantage.
Zambia specializes in maize, while Malawi specializes in meat, leading to increased total output.
Trading Ratio and World Output:
Before trade, combined output is 26 units of maize and 16 units of meat.
After specialization, total output increases to 30 maize and 20 meat.
Post-Trade Consumption Gains:
Zambia can trade for 15 units of meat in exchange for 10 units of maize, enhancing consumption for both countries.
Conclusion:
Effective specialization and favorable terms of trade are essential for maximizing benefits from trade, leading to a higher overall consumption than in isolation.