Chapter+3+-+Micro

 __**CHAPTER 3 – Interdependence and the Gains from Trade**__

__Key Terms:__ absolute advantage opportunity cost comparative advantage import export

Basically, this chapter talks about trade, and the benefits of trade. We trade with people all around the world. Think about it. Your clothes might be made in China. We eat vegetables/fruit from farms. The coffee that we drink might be imported from Ethiopia. How is it that we can trade, and use goods and services from all around the world?

Remember Chapter 1 and it’s 10 Principles? One of the principles was that trade makes everyone better off. And this chapter will study why and how trade makes everyone better off.


 * A Really Good Example**

You also remember the section about Economic Models in Chapter 2? They were supposed to be easy, simple, yet informative. So we will show you in this example the benefits of trade.

Let’s say in this world, there were only 2 people existing: a rancher and a farmer. They can only produce 2 products: meat and potatoes.

Remember, simplicity is the key.

Anyways, now is the time to use the Production Possibilities Graph that we learned in Chapter 2. Let’s say that the rancher and farmer each work 8 hours per day. They can either farm potatoes, raise cattle, or do a combination of both. Here's a chart of what a rancher and farmer could do with their time a

As you can see, the farmer can produce an ounce of potatoes in 15 minutes and an ounce of meat in 60 minutes. The rancher can produce an ounce of potatoes in 10 minutes and ounce of meat in 20 minutes. Here are their production possibility frontiers:



As you can see, the Rancher is more productive than the Farmer in both meat and potatoes.

And as you can also see, the production possibility frontiers are also straight lines, instead of a more curved shape. Why is this so? Becuase whenever someone, such as a farmer, devotes one hour less making something and devotes it to the other food, it's going to be true no matter what. For example, if a farmer decides to spend 1 hour less making meat and instead, decides to spend one more hour producing potatoes, his output of potatoes will increase by 4 ounces, and his output of meat will decrease by one pound. The diagram, in Chapter 2, showed the production possibility frontiers of thousands of people, who each have straight lines. But because each of the people don't have the same production possibility frontiers, it distorts and eventually becomes a straight line instead.

This is the part where we see how trade is better for both parties. Let's say that the farmer and rancher decide to trade.
 * TRADE**



As you can see, after they trade, their production goes //OUTSIDE// of their production possibility frontiers. WHY and HOW ON EARTH DOES THIS HAPPEN?

The rancher seemed to outproduce the farmer in both meat and potatoes. But how did they both have better outcomes.
 * Absolute Advantage/Opportunity Cost**

Let's look at a few vocabulary words: __absolute advantage__ - how much you use to produce a good So basically, the person that can produce more with less input/time, has the absolute advantage. So in our farmer/rancher example, we can say that the rancher has the absolute advantage in both meat and potatoes because he can make both in less time than the farmer. Becuase we don't really know what supplies the farmer or rancher used, we can use time to determine the absolute advantages of each.

__opportunity cost__ - thing that is given up to get another thing This came out in Chapter 1, but it's coming out again, because it's actually needed now.

The opportunity cost plays a huge role in trade. It has a direct link with the production possibilities frontier.

Let's look at the rancher's oppotunity cost. If you look back to Table 1 (below), it says that it takes 10 minutes for the rancher to produce one ounce of potatoes. But in that time, she can also produce 1/2 oz. of meat, because it takes 20 minute for the rancher to produce 1 oz. of meat. When you look at it that way, //the opportunity cost of 1 oz. of potatoes for the rancher is 1/2 oz. of meat.// Likewise, the rancher can spend 20 minutes to make one ounce of meat, or spend it instead to produce 2 ozs. of potatoes.



For the farmer, it's the same thing. It takes him 15 minutes to make one oz. of potatoes. He could spend that time making 1/4 oz. of meat. Or with the 60 minutes that it takes to produce 1 ounce of meat, he can produce 4 ozs. of potates. So, //the opportunity cost of 1 oz. of meat is 4 ounces of potatoes for the farmer.//

We can come up with this table as our conclusion for opportunity cost:



What else do you notice about the opportunity costs? the Two opportunity costs are inverses, or reciprocals of each other (ex:4/1 flipped around is 1/4).

I still haven't answered the question. Why and how does trade benefit everyone? The answer's coming up...


 * Comparative Advantage**

__comparative advantage__ - an instance when a person gives up less than another person to produce a good. So basically, the person who has a lower opportunity cost than another person to produce a good.

So if we look back at that table of opportunity costs, we can see that //the farmer has the comparative advantage in potatoes because he only gives up 1/4 oz. of meat while the rancher gives up 1/2 oz.//

And vice-versa. The rancher has the comparative advantage in meat because he only gives up 2 oz. of potatoes to produce 1 oz. of meat, while the farmer produces 4 oz. of potatoes.

Because opportunity costs work on reciprocals, everyone should have a comparative advantage in something, unless the production of both sides. Even if one side has the absolute advantage in both goods, as we have here, //the most important factor in determining trade is not the absolute advantage, but the comparative advantage.//
 * RESULT**

The reason why we can go above and beyond our production possibility frontiers is because, through comparative advantages, we can all specialize in what we are better in.

But how much should we trade? How much should each side trade so that both sides would benefit?

Let's go back to our farmer/rancher example.

The farmer has the comparative advantage in potatoes. So for every 1 oz. of potatoes, he should receive between 1/4 oz. of meat up to 1/2 oz. of meat from the rancher. Why? Think about it. If he received less than 1/4 oz. of meat, such as 1/10 oz. of meat, the rancher would be happy. But the farmer wouldn't. Why? Because then he wouldn't need to trade. He can make 1/4 oz. of meat by himself, so trading for that amount or less wouldn't benefit him. Likewise, he shouldn't receive more than 1/2 oz. of meat, because then the rancher would be cheated. The rancher can produce 1/2 of. of meat by himself with 1 oz. of potatoes. So he shouldn't give more than 1/2 oz. of meat, because then he wouldn't need to trade.

The point is that the amount to trade should come //BETWEEN// the two opportunity costs.


 * SUMMARY**

- trade should help both sides - trade is not based on comparative advantage, not absolute advantage - every business __must__ have a comparative advantage in something because comparative advantage works in reciprocals - businesses must trade between two opportunity costs

__Questions__ 1. Define: comparative advantage absolute advantage opportunity cost //(3 points)//

2. //Application:// Michael Jordan can clean his house in 3 hours. Alternatively, he can go and get filmed in a commercial for 20,000 dollars. His next door neighbor, Peter, can clean his house in 6 hours. He would earn 100 dollars from his 6 hours. But if he weren't to clean Michael's house, he would work at In-N-Out for 50 dollars in 6 hours. What should Michael do, and why? //(6 points)//

3. Why does comparative advantage matter more than absolute advantage when it comes down to trading? //(2 points)//

4. An **import** is a good produced abroad and sold domestically. Conversely, an **export** is a good produced domestically and sold abroad in another country. There are two countries, USA and UK, that are involved in a trade. They produce Hamburgers and PS3s. A US worker and UK worker can produce 1 PS3 per month. But, a US worker can produce 2 lbs. of Burgers per month, while the UK worker can only produce 1 lb. Who should trade to whom? And for how much? (If US should trade PS3s to UK, how many hamburgers should the US receive for 1 PS3? and vice versa) //(8 points)//

Answers: 1. __comparative advantage__ - an instance when a person gives up less than another person to produce a good. So basically, the person who has a lower opportunity cost than another person to produce a good. __absolute advantage__ - how much you use to produce a good __opportunity cost__ - thing that is given up to get another thing

2. Michael Jordan should go for the commercial. His opportunity cost of cleaning his house is 20,000 dollars. Peter's opportunity cost of working at In-N-Out and not cleaning Michael's house is 50 dollars. Although Michael has the absolute advantage in cleaning his house, Peter has the opportunity cost because he gives up less dollars. As a result, as long as Michael pays Peter more than 50 dollars, and less than 20,000 dollars, both sides are benefiting.

3. The comparative advantage matters the most because it indicates to each side the good that each country should specialize in.

4. The Opportunity cost for US: 1 PS3 = 2 lbs. of burgers. 1 lb. of burgers = 1/2 PS3 Opportunity cost of UK: 1 PS3 = 1 lb. burgers. 1 lb. burgers = 1 PS3. As a result, the US has the comparative advantage in burgers, and Uk in PS3s.

The US should give up 1 lb. of burgers for more than 1/2 PS3s, but less than 1 PS3. Because for any more or any less, both of these countries wouldn't need to trade, because they would benefit more by making PS3s and burgers by themselves.

The UK shoul give up 1 PS3 for at least 1 lb. of burgers, but less than 2 lbs. of burgers. Because if the US gave less than 1 PS3, if would be bad for UK because they can just make the 1 lb. of burgers by themselves for a better cost. But less than 2 lbs. of burgers, becuase it wouldn't benefit USA.