Ch.3+Interdependence+and+the+Gains+from+Trade

In this chapter, we will discuss why and how trade can make everyone better off. In order to analyze this, let's start by setting up some stuff.

Let's say there are only two goods in the world: cars and meat. And there are only two countries in the world: Japan and America. It is obvious that both Japan and America are capable of making cars and meat.

=How?=

First, study this table.

According to this graph, Japan needs 4 hours to make a car while America needs 12 hours to make a car. We can conclude that Japan has the **absolute advantage** in the production of cars, because Japan's productivity is higher than that of America. Also, Japan need 2 hours to make 1 ounce of meat while America need 3 hours to do the same. Japan has the absolute advantage in the productions of both cars and meat.
 * ~  |||| ====**Hours needed to make 1 unit of:**==== |||| ====**Units produced in 1 day**==== ||
 * ~  || ====**Cars**==== || ====**Meat**==== || ====**Cars**==== || ====**Meat**==== ||
 * ====**Japan**==== || ====**4 hrs/car**==== || ====**2 hrs/oz**==== || ====**6 cars**==== || ====**12 oz**==== ||
 * ====**America**==== || ====**12 hrs/car**==== || ====**3 hrs/oz**==== || ====**2 cars**==== || ====**8 oz**==== ||

If Japan is better at producing both of the goods, should they engage in a trade?

Let's try comparing the two goods in a different way.

Study this table.

According to this table, if Japan makes 1 car, Japan can't make 2 oz of meat. If America makes 1 car, America can't make 4 oz of meat. Because Japan can make 1 car with cheaper opportunity cost, Japan is said to have **comparative advantage** over America in car production. On the other hand, if Japan makes 1 oz of meat, Japan can't make 1/2 of a car. If America makes 1 oz of meat, America can't make 1/4 of a car. America has the comparative advantage over Japan in the production of meat because America can produce meat with cheaper opportunity cost.
 * ~  |||| ====**Opportunity Cost of Producing:**==== ||
 * ~  || ====**1 car**==== || ====**1 oz of meat**==== ||
 * ====**Japan**==== || ====**2 oz of meat**==== || ====**1/2 car**==== ||
 * ====**America**==== || ====**4 oz of meat**==== || ====**1/4 car**==== ||

To put it in simple words, for Japan 1 car is worth 2 oz of meat. For America, 1 oz of meat is worth 1/4 of a car.

Now, do you think Japan and America should engage in a trade?

If Japan gave 1 car to America, Japan would want at least 2 oz of meat from America (for Japan, 1 car is worth 2 oz of meat). This will not make Japan happier because she receives what she paid for. But America is certainly happy because she receives 1 car for 2 oz of meat (opp. cost of 2 oz of meat is 1/2 of car for America).

If America gave 4 oz of meat, America would want at least 1 car from Japan (for America, 1 oz of meat is worth 1/4 of a car). In this case, America will not be happier because she receives what she paid for. But Japan is certainly happy because she gets 4 oz of meat for 1 car (opp. cost of 1 car is 2 oz of meat for Japan).

If we squeeze our brains a little more, we can find out a way to figure out a trade that would make both Japan and America happier.

If Japan wants more than 2 oz of meat from America for 1 car, and America will not pay more than 4 oz of meat for 1 car, America can give amount between 2 ~ 4 oz of meat for 1 car. This way, both Japan and America will be happier; Japan gets more than 2 oz of meat for a car while America pays less than 4 oz of meat for a car.

We usually want a whole number, so let's say for every car Japan gives America, America gives 3 oz of meat to Japan.

How can we prove that this trade ratio will make both Japan and America better off?

Let's say Japan only makes cars the whole day and America only meat the whole day.

Japan gives 2 cars to America, and America 6 oz of meat to Japan (trade ratio of 1 car: 3 oz of meat).
 * ~  |||| ====**In 1 day**==== ||
 * ~  || ====**Cars**==== || ====**Meat**==== ||
 * ====**Japan**==== || ====**6 cars**==== || ====**0 oz**==== ||
 * ====**America**==== || ====**0 cars**==== || ====**8 oz**==== ||

After trade...


 * ~  |||||| ====**In 1 day**==== ||
 * ~  || ====**Cars**==== || ====**Meat**==== ||
 * ====**Japan**==== || ====**4 cars**==== || ====**6 oz**==== ||
 * ====**America**==== || ====**2 cars**==== || ====**2 oz**==== ||

How many hours does Japan need to make 6 cars and 6 oz of meat? Making 4 cars will take 16 hours (4 hrs/car), and making 6 oz of meat will take 12 hours (2 hrs/oz). They add up to 28 hours. Wow! In one day with trade, Japan actually did a work of 28 hours! Japan is surely happy with this trade.

How many hours does America need to make 2 cars and 2 oz of meat? Making 2 cars will take 24 hours (12hrs/car), and making 2 oz of meat will take 6 hours (3 hrs/oz). They add up to 30 hours. Wow again! In one day with trade, America did a work of 30 hours! America is surely happy with this trade as well.

Like this, if we find the right trade ratio, trade CAN make everyone better off.

__**Key Concept**__
 * absolute advantage**: producing more effectively in actual quantity than another group does
 * opportunity cost**: something you have to give up to gain something
 * comparative** **advantage**: producing more effectively in relevance to opportunity costs than another group does
 * imports**: goods that are produced abroad and consumed domestically
 * exports**: goods that are produced domestically and consumed abroad

Questions & Answers