Chapter+3+-+Interdependence+and+the+Gains+from+Trade

=**Chapter 3**. Without specialization with specialization  trade=  = =  http://taskmanagement.com/img/specialization.jpg

__**Vocabulary:**__

 * Absolute advantage**: Producing a good with “fewer inputs” such as time, than the other
 * Comparative advantage**: Producing a good, in which it has the “lower opportunity cost” than the other
 * Imports**: goods coming “in” to your country from abroad
 * Exports**: goods being “sent” abroad from your country


First, let’s look at the diagram below.

Both production possibilities frontiers show the combination of Good Y and Good S when there is **no** trade. As you can see, the diagram of PPF for Germany can produce 500 of Good Y and 750 of Good S, while the diagram of PPF for France shows that it can produce 850 of Good Y and 1000 of Good S when each divides its time equally.

 //-With Specialization-//
However, say **Germany** decides to **specialize** in making what they are good at. Then Germany will devote its time to produce only 1500 of Good S and stop producing the Good Y. Also, say **France** decides to specialize in what they are good at, which is Good Y. So France will devote its time to make more of Good Y than Good S, which will be 1500 of Good Y and 450 of Good S (Shown in the graph below). THIS PHOTO IS REPLACED. IT IS SUPPOSE TO HAVE A GRAPH. =//**...& Trade**// = By specializing, Germany and France can trade and have benefits. How? If you look at the chart below, You can see the amount of goods for each of the countries. Also, THIS PHOTO IS REPLACED. IT IS SUPPOSE TO BE A CHART

However, when Germany and France decides to trade by having France give 600 of Good Y to Germany and Germany give 710 of Good S to France, this makes both countries to benefit from each other. So when you compare the results of //without trade// and //with trade//, you can see that specialization & trade is more beneficial than //without// specialization & without trade. Therefore, **trade** allows each country to benefit and specialize in what they are good at.

 =//**Comparative Advantage: The driving Force of Specialization ** //= = = __ Absolute Advantage __ According to the definition of an **absolute advantage**, it is when good is produced by using fewer inputs than another producer. And one of the examples of “inputs” is time. Look at the chart below, The country that uses less of its time to make either the food or clothing is the Country A. In other words, Country A has an absolute advantage in making both Food and Clothing. Why? Because Country A makes 6 units of food while Country B makes 1 unit, and Country A makes 3 units of clothing while Country B makes 2. __ Opportunity ____ Cost & Comparative Advantage __ According to the definition, **comparative advantage** is when a good is produced at a lower opportunity cost than another. And yes, we know that opportunity cost is what we give up to get another item from the previous chapter. Also, we must take in consider that opportunity cost determines the comparative advantage, and that comparative advantage also determines and plays a big role in trading. So we can find out who has the comparative advantage by calculating the opportunity cost.

You might ask how these numbers came out, and this is how: As you can see from the chart above, Montana takes 6 hours to make one basket and 2 hours to make a birdhouse. And so, when Montana spends 6 hours producing a basket, it spends 2 hours less in producing a birdhouse. This means that Montana’s opportunity cost of producing a basket is 3 birdhouses. Another way to look at it is by numbers: Montana : 4 Baskets=12birdhouses 1 Basket= 3 birdhouses or 1 birdhouse=1/3basket This shows that opportunity cost of one basket is 3 birdhouses OR opportunity cost of one birdcage is 1/3 of baskets. . And by doing it in the same way, we can calculate the opportunity cost for other ones as well:

So let’s go back to the main point. To determine the comparative advantage, we have to see who has the lower opportunity cost. Thus in this chart, we can see that Missouri has the comparative advantage over basket and Montana has comparative advantage over birdhouse.

Now that we have learned what the comparative advantage is, watch the video below and organize thoughts ! media type="youtube" key="q-bRZdR68Uc" height="344" width="425" =//**Comparative Advantage and Trade **//= It is important to take in consider that absolute advantage does not determine whether two different parties will benefit from trade or not. What matters is the comparative advantage. Comparative advantage allows both parties to benefit from trading, and this is because each party will receive a good at a price that is lower than its opportunity cost of that good. Moreover, this explains why specialization in certain good will increase the productivity in economy. Although it has not mentioned in the previous example of Germany and France, both of the countries were able to benefit from specialization and trade by considering the comparative advantage. How? By calculating the opportunity cost for each of the goods, Because Germany has comparative advantage in Good S, they will decide to trade Good S with France. On the other hand, since France has comparative advantage in Good Y, they will decide to trade Good Y with Germany. But we might wonder at what price should they both trade in order for both parties to gain? And the answer would be: a price that lies between the two opportunity costs of a good. For example from the chart above, when trading one of Good Y, the price should lie between 3/2 of Good S< x <20/17 of Good S. So when France decided to give 600 of Good Y to Germany, the number of Good S that is given to France must lie between 705.8< x < 900. So as long as the price lies between the two opportunity costs and people trade and specialize in which they have a comparative advantage, everyone can benefit from trading.

//** Summary **//
Trade can make everyone better off through the comparative advantage based on the opportunity cost. However, the absolute advantage does not determine whether one would benefit from each other by trading; instead, it just tells us who would produce more than the other using fewer inputs. So, to understand all the basic concepts of the specialization, absolute advantage, comparative advantage, and trade, lets look at the video below: media type="youtube" key="MoQwNmdOLyc&hl=ko&fs=1" height="344" width="425" http://www.youtube.com/watch?v=MoQwNmdOLyc&feature=PlayList&p=30BA310DFDB3E15C&index=0&playnext=1

Again, even if one person has absolute advantage over two goods, he or she will have comparative advantage on only one good by specialization. So through specializing in producing for which one has comparative advantage, both person A and person B will benefit.

//1. Chaeri can make 10 chocolate and 5 candies a year and Dayeon can make 30 chocolate and 10 candies a year. //
a) Who has the absolute advantage in making chocolate? Candies?  b)  Who has the comparative advantage in making chocolate? Candies? c) If Chaeri and Dayeon were to trade with each other, which one would Chaeri trade away

a) Who has the comparative advantage in making computers? Cell phones?  b)  If two countries were to trade with each other, who would export computers? Cell phones? c)<span style="font-family: 'Times New Roman'; font-style: normal; font-variant: normal; font-weight: normal; font-size: 7pt; line-height: normal; font-size-adjust: none; font-stretch: normal;"> What is the range of prices that the two countries must trade at?

** Solution **
1. a) Dayeon has the absolute advantage in making both chocolate and cadies because in given time, a year, Dayeon makes more chocolate and more candies than Chaeri. b) Dayeon has the comparative advantage in chocolate and Chaeri has the comparative advantage in candies: c) If Chaeri and Dayeon were to trade, Chaeri would trade away candies because that is the one that Chaeri has the comparative advantage. Moreover, as it was mentioned previously, both could benefit in trading based on the comparative advantage.

2. a) Korea has comparative advantage in Cell phones and Japan has comparative advantage in computers. b) If both countries were to trade, Korea would export Cell phones and Japan would export computers c) The **range** would be: 1 Cell phone: ½ Computers< x < 8/15 Computers OR 1 Computer: 15/8 Cell phones< x < 2 Cell phones

Sources: http://www.ueh.edu.vn/uoe-iss/ts_chvnhl_2008/dconta2.gif http://tutor2u.net/quiz/economics/Diagrams/int_trade2.gif http://wps.prenhall.com/wps/media/objects/3386/3467867/trade_table.jpg http://www.veromind.com/silhoettes%20w%20World.jpg