Econ 101

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Econ 101

• Interdependence and the
• Gains from Trade

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Interdependence and Trade

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

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Interdependence and Trade

• This gives rise to two questions. . .
• Why is interdependence the norm?
• What determines production and trade?

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Why is interdependence the norm?

• Interdependence occurs because people are better
  off when they specialize and trade with others.

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What determines the pattern of production and
trade?

• Patterns of production and trade are based on
  differences in opportunity costs.

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A Simple Model
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A Simple Model

• Imagine a simple economy. . .
• . . . only two goods

• . . . only two countries
• Pagong tribe and Tagi tribe
• What should each produce?
• Why should they trade?

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A Simple Model Pagong and Tagi

• Hours needed to make 1 pound of
• Fish Coconuts
• Pagong 20 10
• Tagi 1 8
• Amount produced in 40 hours (in pounds)
• Pagong 2 4
• Tagi 40 5

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Self-Sufficiency
Hours needed to make 1 pound of
Fish Coconuts Pagong 20 10
10
Self-Sufficiency
Hours needed to make 1 pound of
Fish Coconuts 1
8
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Pagong and Tagi
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Pagong and Tagi Specialize and Trade

• Each would be better off if they specialize in
  producing the product that they are more suited
  to produce, and then trade with each other.
• ??The Pagong Tribe should produce more coconuts.
  
• ??The Tagi Tribe should produce more fish.

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Example of Production and Trade

• Pagong Produce 4 pounds of coconuts, no fish.
• Tagi Produce 24 pounds fish and 2 pounds
  coconuts
• Exchange rate 1 pounds coconuts for 3 pounds fish

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How Trade Expands Consumption Opportunities
Pagongs Production point
15
How Trade Expands Consumption Opportunities
Tagis production point
24
2
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The Gains From Trade
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Determination of Production and Trade Patterns

• Differences in the costs of production determine
  the following
• ??Who should produce what?
• ??How much should be traded for each product?

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Differences in Costs of Production

• There are two ways to measure differences in
  costs of production
• ? The number of hours required to produce a
  unit of output. (for example, one pound of
  coconuts)
• ? The opportunity cost of sacrificing one good
  for another.

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Absolute Advantage

• Describes the productivity of one person, firm,
  or nation to that of another.
• Tagi needs only 8 hours to produce a pound of
  coconuts, whereas the Pagong tribe needs 10 hours

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Absolute Advantage

• The producer that requires a smaller quantity of
  inputs to produce a good is said to have an
  absolute advantage in producing that good.

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Comparative Advantage

• Compares producers of a good according to their
  opportunity cost.

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Comparative Advantage

• The producer who has the smaller opportunity cost
  of producing a good is said to have a comparative
  advantage in producing that good.

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Specialization and Trade

• Who has the absolute advantage?
• ??The Pagong or the Tagi?Tagi has an absolute
  advantage in producing both goods
• Who has the comparative advantage?
• ??The Pagong or the Tagi?

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Comparative Advantage
Hours needed to make 1 pound of Fish Coconu
ts Pagong 20 10 Tagi 1 8 Amount produced
in 40 hours (in pounds) Pagong 2 4 Tagi 40 5
Pagong Producing 1 pound of coconuts takes 10
hours ? Pagong spends 10 hours less to produce
fish (1/2 pound). ? The Pagongs opportunity
cost of 1 pound of coconuts is 1/2 pounds of
fish.
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Comparative Advantage
Hours needed to make 1 pound of Fish Coconu
ts Pagong 20 10 Tagi 1 8 Amount produced
in 40 hours (in pounds) Pagong 2 4 Tagi 40 5
Tagi Producing 1 pound of coconuts takes 8 hours
? Tagi spends 8 hours less to produce fish? The
Tagis opportunity cost of 1 pound of coconuts is
8 pounds of fish
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Opportunity Cost (Graphical Representation)
The slope of the PPF is equal to 1/2
Slope rise / run
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Opportunity Cost (Graphical Representation)
The slope of the PPF is equal to 8
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Opportunity Cost

• Opportunity Cost of 1 pound of Fish (in
  terms of coconuts given up)
• Pagong 2
• Tagi 1/8Note Opportunity cost of fish is
  the inverse of the opportunity cost of coconuts

Opportunity Cost of 1 pound of Coconuts (in
terms of fish given up) Pagong 1/2 Tagi 8
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The Principle of Comparative Advantage

• Comparative advantage and differences in
  opportunity costs are the basis for specialized
  production and trade.
• Whenever potential trading parties have
  differences in opportunity costs, they can each
  benefit from trade.

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Benefit of Trade

• Trade can benefit everyone in a society because
  it allows people to specialize in activities in
  which they have a comparative advantage.

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Conclusion

• Interdependence and trade allow people to enjoy a
  greater quantity and variety of goods and
  services.

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Conclusion

• The person who can produce a good with a smaller
  quantity of inputs has an absolute advantage.
• The person with a smaller opportunity cost has a
  comparative advantage.
• The gains from trade are based on comparative
  advantage, not absolute advantage.

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Conclusion

• Comparative advantage applies to countries as
  well as to people.