Interdependence and the Gains from Trade

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Interdependence and the Gains from Trade

• PRINCIPLE 5
• Trade Can Make Everyone Better Off!

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Superficial explanations for why there is trade

• Heterogeneity in the conditions of production
• decreasing costs
• differences in tastes

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The Principle of Comparative Advantage is the
deeper explanation for why there is
specialization and trade.
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A model of production showing the gains from
trade

• Assumptions
• Gilligan and the Professor live on nearby
  islands.
• Initially each is self sufficient.
• Two goods food and clothing
• Labor is the only input and technology is fixed.
• Each works 600 hours.
• Both are indifferent between the production
  activities

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• Gilligans PPF
• food clothing
• 0 600
• 150 300
• 200 200
• 300 0

• Professors PPF
• food clothing
• 0 200
• 75 100
• 100 66.67
• 150 0

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This model illustrates Principle 7 Standards of
living are determined by the productivity of
labor.
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• Gilligans PPF
• food clothing
• 0 600
• 150 300
• 200 200
• 300 0

• Gilligans opportunity cost
• of production
• clothing 1/2 unit of food per
• unit of clothing
• food 2 units of clothing per
• unit of food

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• The producer who can produce relatively more
  output using a given quantity of input(s) is said
  to have an absolute advantage.
• Equivalently, the producer having the absolute
  advantage can produce a given level of output
  using the smallest quantity of inputs.

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The producer who has the lowest opportunity cost
of production is said to have a comparative
advantage.
Gilligan has a comparative advantage in the
production of clothing. The Professor has a
comparative advantage in the production of food.
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• The concept of absolute advantage focuses on the
  relative abilities of producers to transform
  inputs into outputs.
• The concept of comparative advantage focuses on
  the relative abilities of producers to substitute
  one output into another output.

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• Insight
• Even if one producer has an absolute advantage in
  the production of every good, the producer cannot
  have a comparative advantage in the production of
  all goods.

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Example Gilligan initially produces and consumes
200 units of F and 200 units of C (point a). The
Professor only produces clothing and consumes the
200 units (point a).
a
a
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Gilligan, proposes that he specialize in the
production of clothing (produce less food) and
that the Professor specialize in the production
of food, in order for them to exploit their
comparative advantages.
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Gilligan proposes that he will give the professor
250 units of C in exchange for the Professor
giving Gilligan 150 units of F.
a
a
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Through specialization and trade, each
individuals, regions and countries can consume
more than it is able to produce.How can this be?

• Trade allows each producer to specialize in
  the production of that good for which he (it) has
  a comparative advantage (i.e., lower opportunity
  cost) and trade for desired units of other goods.

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250 units of C were exchanged for 150 units of F.

• 5/3 units of C was exchanged for each on unit of
  F.
• one unit of C was exchanged for 3/5 units of F.
• The terms of trade measure the number of units
  of one good that must be given up in exchange for
  each additional unit of the other.

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Terms of trade in example One unit of food can
be traded for 5/3 units of clothing. One unit of
clothing can be traded for 3/5ths of a unit of
food.
Gilligan His opportunity cost of producing a
unit of food is 2 clothing units. His
opportunity cost of trading for a unit of food is
5/3 units of clothing. Gilligan has an
incentive to obtain food through trade because it
is less costly.The Professor His
opportunity cost of producing a unit of clothing
is ¾ food units. His opportunity cost of
trading for a unit of clothing is 2/3 food
units. It is less costly for the Professor to
obtain clothing through trade.Note that trade
will be mutually beneficial for any of a range of
values for the terms of trade. Gilligan and the
Professor will find trade advantageous as long as
the terms of trade are between 2 units of
clothing per unit of food and 4/3 units of
clothing per unit of good or, equivalently,
between 1/2 and ¾ units of food per unit of
clothing.
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Suppose Gilligan is initially self sufficient,
producing and consuming the output combination at
a. He has the opportunity to trade F and C in
a barter market where the exchange rate is 5/3
units of C for each unit of F. Can he do better
than produce and consume at a.
Figure 2.a Gilligan
Opportunity cost of a unit of F in exchange 5/3
C Opportunity cost of a unit of F in production
2 C
a
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Suppose Gilligan is initially self sufficient,
producing and consuming the output combination at
a. He has the opportunity to trade F and C in
a barter market where the exchange rate is 5/3
units of C for each unit of F. Can he do better
than produce and consume at a.
C
Gilligans production possibilities
600
Opportunity cost of a unit of F in exchange 5/3
C Opportunity cost of a unit of F in production
2 C
500
400
300
Gilligans consumption possibilities with trade
200
a
100
50
100
150
200
250
300
360
F
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Specialization is beneficial when inputs are used
to produce the goods and services for which they
are relatively best suited (i.e., have a
comparative advantage or, equivalently,
relatively low opportunity cost). Such
specialization is required for there to be
production efficiency.
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