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Gains From Trade Antu Panini Murshid
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 2
Today’s Agenda
Gains from specialization and trade Absolute and comparative
advantage Ricardian model
3
Why Trade? Individuals and countries specialize in
production and trade with each other in order to address problems created by scarcity
Patterns in production and trade are based on differences in opportunity costs
Individuals or countries typically specialize in what they are good at
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 4
A Parable of a Modern Economy… Imagine that there are…
…only two goods—apples and bread …only two people—Jean and Joe
In a given day… …Jean can either pick 5 buckets of
apples or bake 10 loaves of bread …Joe can either pick 12 buckets of
apples or bake 6 loaves of bread
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 5
Production Opportunities
Production per DayApples Bread
Jean 5 buckets or 10 loavesJoe 12 buckets or 6 loaves
6
Jean and Joe’s Production Possibilities
Apples (buckets)
Bread (loaves)
5
100
12
6
Jean’s PPF… Joe’s PPF…
Joe
Jean
7
Consumption Possibilities Under Self-Sufficiency
Apples (buckets)
Bread (loaves)
5
10
12
6
If Jean and Joe are self-sufficient, the production possibilities frontier is also the consumption possibilities frontier
Jean’s consumption possibilities set is…
Joe’s consumption possibilities set is…
Joe
Jean
0
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 8
Self-Sufficiency
Production per DayApples Bread
Jean 2.5 buckets & 5 loavesJoe 6 buckets & 3 loavesEconomy 8.5 buckets & 8 loaves
They each devote half a day to each activity
9
Self-Sufficiency Using PPFs
Apples(buckets)
Bread(loaves)
5
100
If Jean and Joe devote 50% of their time to each activity then…
…Jean can produce…Jean
5
5 loaves of bread and 2.5
buckets of apples
2.5
10
Self-Sufficiency Using PPFs
Apples(buckets)
Bread(loaves)
0
12
6
…Joe can produce…
Joe
3
6
3 loaves of bread and 6 buckets of
apples
11
Self-Sufficiency Using PPFs
Apples(buckets)
Bread(loaves)
0
Jean and Joe combined are producing…
(3,6)
(5,2.5)
Economy8.5
8
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 12
Specialization and Trade Suppose…
…Jean specializes in baking bread …Joe specializes in picking apples
Economy-wide output is now 10 loaves of bread 12 buckets of apples
Jean trades 4 loaves of bread for 4 buckets of apples Jean has 6 loaves of bread and 4 buckets of
apples Joe has 4 loaves of bread and 8 buckets of
apples
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 13
Gains From Trade
Gains from TradeApples Bread
Jean +1.5 buckets +1 loafJoe +2 buckets +1loafEconomy +3.5 buckets +2 loaves
14
Trade and Self-Sufficiency Compared Using PPFs
Apples(buckets)
Bread(loaves)
5
100
12
6
Self-Sufficiency… Jean 5 loaves of
bread & 2.5 buckets of apples
Joe has 3 loaves of bread & 6 buckets of apples
Economy: 8 loaves of bread, 8.5 buckets of apples
Joe’s PPF
Jean’s PPF
53
6
2.5
8.5
8
Economy
Jean’s bundle before trade
Joe’s bundle before trade
15
Trade and Self-Sufficiency Compared Using PPFs
Apples(buckets)
Bread(loaves)
100
12
6
Trade… Jean has 6 loaves
of bread & 4 buckets of apples
Joe has 4 loaves of bread and 8 buckets of apples
Economy: 10 loaves of bread, 12 buckets of apples
4
Jean’s bundle after
trade
4
Joe’s bundle after trade8
Economyafter trade
16
Trade and Self-Sufficiency Compared Using PPFs
Apples(buckets)
Bread(loaves)
0 6
Jean is better off after trade…
…so is Joe
4
Jean’s bundle after
trade
4
Joe’s bundle
after trade8
Jean’s bundle before trade
Joe’s bundle before trade
2.5
53
6
17
Consumption Opportunities After Trade
After Trade… Jean consumes a
bundle which lies outside her production possibilities set
So does JoeJean’s bundle
Joe’s bundleApples (buckets)
Bread (loaves)
0
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 18
Who Should Specialize in What?
Why should… …Jean specialize in making bread? …and Joe specialize in picking apples?
Because Jean is relatively better at making bread…
…and Joe is relatively better at picking apples
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 19
Comparative Advantage
Can we be precise in what we mean by “relatively better”?
Comparative advantage… A producer has a comparative
advantage in a good, if he/she can produce it at a lower opportunity cost than his/her competitor
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 20
Costs of Production
Production per DayApples Bread
Jean 5 buckets or 10 loavesJoe 12 buckets or 6 loaves
Opportunity CostApples Bread
Jean 2 loaves 1/2 bucketJoe 1/2 loaf 2 buckets
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 21
Principle of Comparative Advantage For trade to be beneficial, producers
should specialize in their comparative advantage
Whenever trading partners have differing opportunity costs, they can benefit form trade
Jean has a comparative advantage in bread
Joe has a comparative advantage in apples
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 22
David Ricardo and Adam Smith David Ricardo formalized the principle
of comparative advantage in Principles of Political Economy and Taxation
Earlier Adam Smith had developed the concept of absolute advantage in the Wealth of Nations
This formed the early logic behind the notion that trade could be beneficial
However, the principle of comparative advantage is more general, but also less intuitive
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 23
Absolute Advantage and Trade To have an absolute advantage in the
production of a good means being able to produce that good more efficiently than one’s competitors
In his Wealth of Nations, Adam Smith suggested that individuals/countries should specialize in their absolute advantage
This is exactly what Jean and Joe did… …since Jean has an absolute advantage in
bread ..and Joe has an absolute advantage in apples
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 24
Comparative Advantage and Absolute Advantage
If an individual has an absolute advantage in the production of some good, must he/she also have a comparative advantage in that good, and vice versa?
No!
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 25
A More Complex Parable… Consider our economy with two
inhabitants—Jean and Joe—and two goods—apples and bread…
Suppose that in a given day… …Jean can either pick 5 buckets of
apples or bake 10 loaves of bread …Joe can either pick 12 buckets of
apples or bake 12 loaves of bread
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 26
Costs of Production
Production per DayApples Bread
Jean 5 buckets or 10 loavesJoe 12 buckets or 12 loaves
Opportunity CostApples Bread
Jean 2 loaves 1/2 bucketJoe 1 loaf 1 bucket
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 27
Self Sufficiency
Devoting Half a Day to Each ActivityApples Bread
Jean 2.5 buckets & 5 loavesJoe 6 buckets & 6 loavesEconomy 8.5 buckets & 11 loaves
They each devote half a day to each activity
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 28
After Specialization
After Specializing*Apples Bread
Jean 0 buckets & 10 loavesJoe 10 buckets & 2 loavesEconomy 10 buckets & 12 loaves
Jean specializes completely in breadJoe devotes most of his time to picking apples
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 29
After Trade
After TradeApples Bread
Jean 4 buckets & 5 loavesJoe 6 buckets & 7 loavesEconomy 10 buckets & 12 loaves
Jean trades 5 loaves for 4 buckets of applesJean is better off by 1.5 buckets of applesJoe is better off by 1 loaf of bread
30
Quantity ofComputersProduced
Quantity ofCars Produced
3,000
0 1,000
Relative Slopes of PPFs:Trade Opportunities
PPF Country A
PPF Country B
750
1,500
Country A’s PPF is steeper and
everywhere above country B’s PPF. Should the two
countries trade?
31
Relative Slopes of PPFs:Trade Opportunities
Country A’s PPF is steeper and
everywhere above country B’s PPF. Should the two
countries trade?
Position of the PPFs doesn’t matter…
…all that matters is that the slopes are different
So long as that is true, trade will be beneficial
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 32
Predictions of the Ricardian Model
Trade occurs due to differences in production technology
Even a technologically inferior country can benefit from free trade
04/20/23Antu Panini Murshid--
Principles of Macroeconomics 33
Summary Specialization and trade allows consumption
outside of production possibilities A country/individual has an absolute
advantage in the production of a good if they are more efficient at producing that good
Comparative advantage is measured by opportunity costs (not monetary costs or resource costs)
The Ricardian model states that for trade to be beneficial countries should specialize in their comparative advantage