Copyright © 2004 South-Western/Thomson Learning Mod 4 Interdependence and the Gains from Trade

ModMod44

Interdependence and the Gains from Trade

• Remember:

Economics is the study of how societies produce and distribute scarce goods & resources in an attempt to satisfy the wants and needs of its members.

• How do we satisfy our wants and needs in an economy? • We can be economically self-sufficient

OR• We can specialize and trade

with others, leading to economic interdependence.

The Caveman Simulation

F Farmer Food

T Tailor Clothing

B Builder Shelter

The Caveman Simulation, V. 2.0

Producer Food Shelter Food/Shelter

Skilled 400 400 100/300

Unskilled 300 100 75/75

• Individuals and nations rely on specialized production and exchange as a way to address problems caused by scarcity.

• But this gives rise to two questions:• Why is interdependence the norm?• What determines production and trade?

• Why is interdependence the norm?• Because people are better off when they specialize

and trade with others—Caveman Simulation

• What determines the pattern of production and trade? • Differences in opportunity costs.

Comp Adv Wksht

The Farmer and the Rancher: A Classic Example of Absolute and Comparative

Advantage• Imagine . . .

• only two goods: potatoes and meat• only two people: a potato farmer and a cattle

rancher

• What should each produce?

• Why should they trade?

Production Possibilities (amt produced/40 hrs)

Meat Potatoes

Farmer 2 lbs 4 lbs

Rancher 40 lbs 5 lbs

The Rancher has an absolute advantage in the production of both meat and potatoes—he can produce more of each in the same

amount of time

Absolute Advantage

TWO Production Possibilities

Self-Sufficiency

• By ignoring each other:• Each consumes what they each produce.• The production possibilities frontier limits their

consumption• Without trade, economic gains are diminished.

The Production Possibilities Curve

Potatoes (lbs)

Meat (lbs)

The Farmer’s PPC’

If there is no trade, the farmer chooses this production and consumption level, so he can have some of both.

The Production Possibilities Curve

Potatoes (lbs)

Meat (lbs)

40 If there is no trade, the rancher chooses this production and consumption level, so he can have some of both.

The Rancher’s PPC

TWO Production Possibilities

• By Specializing and Trade:• Each would be better off if they specialized in

producing the product they are more suited to produce, and then trade with each other.

The Farmer and the Rancher

So, what should they each produce?

THE PRINCIPLE OF COMPARATIVE ADVANTAGE• The producer who has the lower opportunity

cost of producing a good is said to have a comparative advantage in producing that good.

• Compares producers of a good according to their opportunity cost.• Whatever must be given up to obtain some item

Steps to Figuring Opp Cost for Comp Adv Problems

1. Set up your Matrix as per the model

Matrix Model

Producer Item: Item:

Figuring Opportunity Cost of Meat and Potatoes (amt produced/40 hrs)

Meat Potatoes

Farmer 2 lbs 4 lbs

Steps to Figuring Opp Cost for Comp Adv

2. Determine whether it is an Output or Input problem

Meat Potatoes

Farmer 2 lbs 4 lbs

3. Create ratios for Opportunity Cost Analysis

a) Create ratios horizontally for each Producer

Meat Potatoes

Farmer 2 lbs 4 lbs

3. Create ratios for Opportunity Cost Analysis

b) Output Problem—use Outside value over inside value first, then the reciprocal

c) Input Problem—use Inside value over outside value first, then the reciprocal

Meat Potatoes

Farmer 2 lbs 4 lbs

4/2 2/4

5/40 40/5

d) Compare ratios vertically for each Item/Good

Meat Potatoes

Farmer 2 lbs 4 lbs

4/2 2/4

5/40 40/5

Points to Remember using Matrices

5. Lowest Opp. Cost for each good determines producer

Meat Potatoes

Farmer 2 lbs 4 lbs

4/2 2/4

5/40 40/5

Which is smaller? Which is smaller?

…so, the Rancher has a comparative advantage in the

production of meat, but the Farmer has a comparative

advantage in the production of potatoes.

Comparative Advantage and Trade

Matrices for Comp Adv Calculations

Caveman Simulation

Hatfield’s and McCoy’s Problem

Figuring Opportunity Cost of Corn and Cloth (1 unit/amt hours)

Corn Cloth

Hatfields 8 hrs 10 hrs

McCoys 15 hrs 12 hrs

8/10 10/8

15/12 12/15

Which is smaller? Which is smaller?

Types of Input vs Output Problems

• INPUT Problems:• # of hours to produce 1 unit• # of acres to produce 1 unit• # of certain ingredients to produce 1 unit

• OUTPUT Problems:• Tons per acre• Miles per gallon• Words per minute• Apples per tree• ETC

Sample Word Problem

• In Italy, an automobile can be produced by 8 workers in 1 day and a washing machine by 3 workers in 1 day. In the U.S., an automobile can be produced by 6 workers in 1 day, and a washing machine by 2 workers in 1 day.• Draw the matrix• Absolute Advantage in autos?• Absolute Advantage in washers?• Comp Adv in washers?• Comp Adv in autos?

Bert and Betsy

• Another Classic example of looking at Opportunity Costs, Absolute and Comparative Advantage

Household Chores (output/hr)

Dishwashing (Number of sink loads)

Sweeping (Number of trash loads)

Bert 1 1

Betsy 2 3

Points to Remember using Matrices

1. Set up your Matrix as per the model

2. Determine whether it is an Output or Input problem

3. Create your ratios of Opportunity Cost

b) Output Problem—use Outside value over inside value first, then the reciprocal

c) Input Problem—use Inside value over outside value first, then the reciprocal

d) Compare ratios vertically for each Item/Good

5. Lowest Opp. Cost for each good determines producer

Other Comp Adv Methods

• Using PPC curves and reading them to create a matrix, or for slope and opportunity cost

Here’s the Matrix

Producer Item: Timber

Item: Apples

Oregon40 10

Washington10 40

Here’s the PPC

Read the PPC

Slope calculations:• For Oregon

• Slope is 40/10 (4) for Apples• Slope is 10/40 (1/4) for Timber

• For Washington• Slope is 10/40 (1/4) for Apples• Slope is 40/10 (4) for Timber

So…Oregon will produce Timber and Washington will produce apples—40 each.

Figuring Terms of Trade

• Once you have figured Opportunity Costs… and seen who has Comp Adv in what—the two parties would produce that good totally and then trade some of that good to get some of the other.

• They would want to trade to better themselves overall from when they were self-sufficient

So…as long as the trading terms are set somewhere between their Opp. Costs, the two parties will be satisfied.

Their Opp. Costs were between ¼ and 4 timbers for each apple.

We can set trade at 1 timber for 1 apple.

Let’s have them trade 20 for 20.

Now, their consumption can be beyond where their PPC’s were with no trade.

Review

• The most efficient outcome/use of resources comes from production based on comparative advantage and then trading to get the different items.• Trade can benefit everyone in a society because it

allows people to specialize in activities in which they have a comparative advantage.

• Trade can benefit countries because it allows nations to specialize in activities in which they have a comparative advantage.

What is the basis for Comp Adv differences?

• Between PEOPLE:• Temperament• Skills• Natural talents

• Between NATIONS:• Climate• Workforce skills• Natural Resources• Capital Stock

Comp Advantage Trade Problems

• Find a Partner

• Get slates, markers, and Kleenex for erasers.

• Get Problem set cards from me

• Solve the comp advantage problem• Write Number of Problem• Listen for Instructions for method

• Show answers and Check

• Take home Germany/Poland wksht problem for practice

Copyright © 2004 South-Western/Thomson Learning Mod 4 Interdependence and the Gains from Trade

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