Principles of Macroeconomics - Interdependence and the Gains from Trade

Chapter 3: Interdependence and the Gains from Trade

Chapter Objectives

• By the end of this chapter, you should be able to answer:

  • Why do people – and nations – choose to be economically interdependent?

  • How can trade make everyone better off?

  • What is absolute advantage?

  • What is comparative advantage?

  • How are these concepts similar?

  • How are they different?

3-1 A Parable for the Modern Economy

Interdependence

• Economic interdependence is critical in modern trade.

• People rely on goods and services from regions they may never visit, illustrated by examples:

  • Coffee from Kenya

  • Dress shirts from China

  • Cell phones from Taiwan

  • Hair gel from Cleveland, OH

Economic Interdependence

• Key Principle: "Trade can make everyone better off."

• This principle draws close examination regarding:

  • The individual gains from trade.

  • Reasons for economic interdependence.

Ask the Experts: Trade between China and the United States

• A perspective from IGM Economic Experts Panel, June 19, 2012:

  • "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."

Example: The U.S. and Japan

Scenario Setup

• Countries: The U.S. and Japan

• Goods: Computers and wheat

• Resource: Labor (measured in hours)

• Examination of production and consumption:

  • If countries are self-sufficient vs. if they engage in trade.

Production Possibilities in the U.S.

• Labor availability: 50,000 hours/month

1. Production time required:

   • 1 computer: requires 100 hours

   • 1 ton of wheat: requires 10 hours

• Maximum outputs based on labor:

  • 500 computers (using all labor)

  • 5,000 tons of wheat (using all labor)

The U.S. Production Possibilities Frontier (PPF)

• Production capabilities plotted on the PPF, with combinations possible:

  • Producing 250 computers and 2,500 tons of wheat with half labor used for each good.

Active Learning 1: Japan’s PPF

Information for Graphing Japan’s PPF

• Labor availability: 30,000 hours/month

1. Production time required:

   • 1 computer: requires 125 hours

   • 1 ton of wheat: requires 25 hours

• Maximum outputs:

  • 240 computers

  • 1,200 tons of wheat

Japan Without Trade

• Domestic consumption levels if Japan uses half its labor:

  • Produces 120 computers and 600 tons of wheat.

Consumption With and Without Trade

• U.S. consumption without trade: 250 computers, 2,500 tons of wheat.

• Japanese consumption without trade: 120 computers, 600 tons of wheat.

• Analysis of consumption without trade vs. consumption with trade focuses on production and trade dynamics.

Active Learning 2: Production Under Trade

1. If U.S. produces 3,400 tons of wheat:

   • Remaining labor dedicated to producing 160 computers.

2. If Japan produces 240 computers:

   • Labor constraints imply 0 tons of wheat produced.

Exports and Imports

• Imports: Goods produced abroad and sold domestically.

• Exports: Goods produced domestically and sold abroad.

Active Learning 3: Consumption Under Trade

• Scenario: U.S. exports 700 tons of wheat and imports 110 computers from Japan.

  • Determine consumption in both countries post-trade and plot data on respective PPFs.

3-2 Comparative Advantage: The Driving Force of Specialization

Absolute Advantage

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

1. The U.S. absolute advantage in wheat:

   • 10 labor hours vs. 25 hours (Japan).

2. The U.S. absolute advantage in computers:

   • 100 labor hours (U.S.) vs. 125 hours (Japan).

Understanding Gains from Trade

• Although the U.S. has absolute advantages in both goods, Japan specializes in computers due to different opportunity costs.

• Trade gains arise when countries specialize in goods produced with lower production costs.

Opportunity Cost and Comparative Advantage

• Opportunity Cost: The loss of potential gain from other alternatives when one alternative is chosen.

• For goods:

  • Computers:

  • U.S. opportunity cost: 10 tons of wheat per computer (100 labor hours).

  • Japan opportunity cost: 5 tons of wheat per computer (125 labor hours).

Comparative Advantage

• Definition: The ability to produce a good at a lower opportunity cost than another producer.

• Principle of Comparative Advantage: Each good should be produced by the individual with the lower opportunity cost.

3-3 Applications of Comparative Advantage

Example Scenario: Argentina vs. Brazil

• Argentina (Labor) Consumption:

  • 1 lb. coffee: 2 hours

  • 1 bottle wine: 4 hours

• Brazil (Labor) Consumption:

  • 1 lb. coffee: 1 hour

  • 1 bottle wine: 5 hours

  • Result: Brazil has an absolute advantage in coffee; Argentina has a comparative advantage in wine.

Gains from Trade - Naomi Osaka Scenario

• Osaka’s potential earnings from commercial work compared to mowing her lawn demonstrate comparative advantage in action.

• The conditions for mutually beneficial trade between Osaka and Hari.

Should the United States Trade with Other Countries?

• Comparative advantage applied to U.S.-Japan trade:

  • U.S. workers can produce:

    • 1 car or 2 tons of food (1 month)

  • Japanese workers can produce:

    • 1 car or 1 ton of food (1 month)

• Findings: Japan has a comparative advantage in cars, while the U.S. in food.

3-4 Conclusion

• The principle of comparative advantage asserts that trade can make everyone better off:

  • Addresses fundamental questions about resource allocation and market forces of supply and demand.

• Conditions of trade must be such that both parties see gains, emphasizing the importance of economic interdependence.

Ethical and Practical Implications

• Trade Impact: Different stakeholders may experience varying impacts from trade agreements, as highlighted by expert opinions on U.S.-China relations, showing complex interaction between advantages and disadvantage.