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Lecture 9: A Demonstration of Why Trade Is Critical to the Production of Wealth

Lecture 9: A Demonstration of Why Trade Is Critical to the Production of Wealth. Evolution of Economic Theory: Adam Smith (1776) explained the value of 1) the division of labor and 2) specialization of labor Pin factory example David Ricardo later explained: comparative advantage.

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Lecture 9: A Demonstration of Why Trade Is Critical to the Production of Wealth

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  1. Lecture 9: A Demonstration of Why Trade Is Critical to the Production of Wealth Evolution of Economic Theory: Adam Smith (1776) explained the value of 1) the division of labor and 2) specialization of labor Pin factory example David Ricardo later explained: comparative advantage

  2. No Man Is an Island Crusoe stranded on island for several years. Based on real story. Presume Crusoe spends most time making breadfruit bread (BB) loaves and cups of coconut milk (CM) (weekly output). He has ability to produce these shown on production possibility curve. Maybe he eats a balanced diet of 25 CM and 5 BB. BB Crusoe’s Production Possibility 10 5 CM 0 25 50

  3. Crusoe Meets Competent Friday Friday, living on other side of island, same resources, also makes BB and CM, but is much more productive. Why? Both work hard all day long. Friday also produces BB and CM all week Long. He eats a Balanced diet of 45 CM And 15 BB loaves. Then the two meet. BB Friday’s Production Possibility 30 15 CM 0 45 90

  4. Friday Is Better at Making Both Crusoe and Friday notice differences in how much of both goods they can produce each week. Friday is better at making both – an absolute advantage. BB CM Ratio Crusoe 10 50 1/5 Friday 30 90 1/3 But: Who is the low cost producer of what, compared to the other? Who has comparative advantage?

  5. Poor Crusoe Trades with Friday Noticing relative differences in costs of producing CM and BB, let us presume they agree to trade 5 BB for 20 CM at the end of the week. So Friday must make more BB; Crusoe must make more CM. Assume this term of trade: 1 BB for 4 CM Who is the winner of this trade?

  6. Trade Creates Wealth Exchange occurs: Crusoe has 6 BB and 25 CM Friday has 15 BB and 50 CM BB BB Crusoe Friday 6 5 20 15 CM CM 30 45 50 25 45

  7. Trade Exploits Comparative Advantage The process of voluntary trade makes both parties to the trade richer. No more effort was required – just specialization in the thing one is relatively better at doing compared to the trading partner. The less able, Crusoe, has something to offer the more able, Friday. Adding thousands of goods and millions of people complicates the math but not the outcome. Trade creates wealth and requires social cooperation.

  8. Trade Among Nations Has Same Wealth Creating Effect • Assume companies in Japan and in Mexico make shirts and cars for their consumers. • Current production abilities are up to 5 million shirts per week in Mexico and up to 50,000 cars per week — given current resources in labor and capital. • Current production abilities are up to 4 million shirts per week in Japan and up to 100,000 cars per week — given current resources in labor and capital. • To have more cars, resources must be taken from shirt production — opportunity cost.

  9. Production Possibilities Mexico Current production — based on internal prices in Mexico and demands of consumers — results in 25,000 cars per week and 2.5 million shirts being produced and bought by consumers in Mexico each week. Domestic prices are not relevant for trade, what matters are relative costs — 100 shirts for 1 car is the internal rate of trade. cars 50k 25k o 2.5m 5m shirts

  10. Production Possibilities Japan Current production — based on internal prices and demand in Japan — results in 50,000 cars and 2 million shirts per week being produced and bought in Japan. The internal rate of trade is 40 shirts for one car within Japan. What do Japan and Mexico have to offer each other? cars 100k 50k 2m 4m shirts

  11. Gains from Trade: Comparative Advantage • Internal rate of exchange in Mexico is 100/1 shirts for cars. • Internal rarte of exchange in Japan is 40/1 shirts for cars. • Comparing these two producers, who is the lower cost producer of cars? Who is the lower cost producer of shirts? • Trade will occur somewhere between 100/1 and 40/1. Let us assume 60/1.

  12. Trade: Both Become Wealthier Mexico Japan New point of production cars cars New point of production 100k 50k 50k 0 3m shirts 4m 0 2m 5m shirts Mexico specializes in shirts — makes 5 million, sells 3 million to Japan. Japan specializes in cars — makes 100,000, sells 50,000 to Mexico for 3 million shirts. Both end up outside of their own production possibilities — trade allows people in both nations to have more of what they want.

  13. So Why Is There a Problem? • Japan and Mexico both become wealthier due to free trade. • Citizens in both nations get more of what they want at the new prices available to them. • Note: Trade is done by Yen and Peso, but that is just for convenience — people want cars and shirts — not money. • Expand this to 100 nations and 10,000 goods as people seek what they want. The math is more complicated, but same wealth creating results. • So why is there opposition to free trade?

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