Goals

1. Lecture Notes: Econ 203 Introductory MicroeconomicsLecture/Chapter 3: Interdependence/gains from tradeM. Cary LeaheyManhattan CollegeFall 2012

2. Goals • Why do people/nations choose to be interdependent • How does trade make everyone better off • Absolute versus comparative advantage • Definitions • Similarities/differences

3. Interdependence • One of 10 principles – trade makes everyone better off • Explain by example using the production possibilities frontier (PPF); • Simplifying assumptions: • Two nations • Two goods • One resource: labor which is more variable than capital

4. The U.S. PPF Wheat (tons) The U.S. has enough labor to produce500 computers, 4,000 5,000 2,000 1,000 3,000 Computers 0 400 300 200 500 100 0 or 5000 tons of wheat, or any combination along the PPF. 4

5. The U.S. Without Trade Wheat (tons) 4,000 5,000 2,000 1,000 3,000 Computers 0 300 200 500 100 400 0 Suppose the U.S. uses half its labor to produce each of the two goods. Then it will produce and consume 250 computers and 2500 tons of wheat. 5

6. Japan’s PPF Japan has enough labor to produce 240 computers, Wheat (tons) 2,000 1,000 Computers 0 100 200 300 0 or 1200 tons of wheat, or any combination along the PPF. 6

7. Japan Without Trade Wheat (tons) 2,000 1,000 Computers 0 100 200 300 0 Suppose Japan uses half its labor to produce each good. Then it will produce and consume 120 computers and 600 tons of wheat. 7

8. 0 Consumption With and Without Trade • Without trade, • U.S. consumers get 250 computers and 2500 tons wheat. • Japanese consumers get 120 computersand 600 tons wheat. • We will compare consumption without trade to consumption with trade. • First, we need to see how much of each good is produced and traded by the two countries.

9. Production under trade 1. Suppose the U.S. produces 3400 tons of wheat. How many computers would the U.S. be able to produce with its remaining labor? Draw the point representing this combination of computers and wheat on the U.S. PPF. 2. Suppose Japan produces 240 computers. How many tons of wheat would Japan be able to produce with its remaining labor? Draw this point on Japan’s PPF.

10. U.S. Production With Trade Wheat (tons) 4,000 5,000 2,000 1,000 3,000 Computers 0 300 200 500 100 400 0 Producing 3400 tons of wheat requires 34,000 labor hours. The remaining 16,000 labor hours are used to produce 160 computers. 10

11. Japan’s Production With Trade Wheat (tons) 2,000 1,000 Computers 0 100 200 300 0 Producing 240 computers requires all of Japan’s 30,000 labor hours. So, Japan would produce 0 tons of wheat. 11

12. Consumption under trade Suppose the U.S. exports 700 tons of wheat to Japan, and imports 110 computers from Japan. (So, Japan imports 700 tons wheat and exports 110 computers.) • How much of each good is consumed in the U.S.? Plot this combination on the U.S. PPF. • How much of each good is consumed in Japan? Plot this combination on Japan’s PPF.

13. U.S. Consumption With Trade Wheat (tons) computers wheat produced 160 3400 + imported 110 0 – exported 0 700 = amount consumed 270 2700 1,000 5,000 3,000 2,000 4,000 Computers 0 100 400 300 200 500 0 13

14. Japan’s Consumption With Trade computers wheat Wheat (tons) produced 240 0 + imported 0 700 – exported 110 0 2,000 = amount consumed 130 700 1,000 Computers 0 100 200 300 0 14

15. Trade Makes Both Countries Better Off computers 250 270 20 wheat 2500 2700 200 Japan consumption without trade consumption with trade gains from trade computers 120 130 10 wheat 600 700 100 0 U.S. consumption without trade consumption with trade gains from trade 15

16. Gains from trade • What happens: • Trade separates consumption from production as consumption is above the PPF • Trade acts like technological progress, shifting up the PPF • Where do the gains come from? • Absolute advantage – the ability of one nation to produce a good with fewer resources • US has absolute advantage in wheat: 1 ton of what = 10 hours versus 25 in Japan • US has absolute advantage in computers: one computer = 100 hours in US versus 125 in Japan

17. Why do both countries gain from trade: comparative advantage • While Japan is worse in producing both goods it has a relative advantage in producing computers. The opportunity cost of producing computers is relatively lower • Opportunity cost of one computer • In US 10 tons of wheat • In Japan it is 5 tons of wheat

18. Summary • Interdependence allows everyone to be better off, breaking down the tie between domestic production and domestic consumption • Comparative advantage means being able to produce a good at a lower opportunity cost • Absolute advantage means being able to produce a good with fewer inputs. • Absolute advantage is not needed for comparative advantage.