CHAPTER 3 - INTERDEPENDENCE AND THE GAINS FROM TRADE




interdependence.jpg


  • KEY TERMS

- comparative advantage
- absolute advantage
- imports
- exports
- opportunity cost



  • WHAT WE WILL LEARN

- what are absolute advantage and comparative advantage
- the difference between absolute advantage and comparative advantage
- how the two advantages relate to exports and imports in trade
- the purpose of restrictions in trade



  • INTRODUCTION


There are two gods.
God 1: I can create 4 dogs an hour, and 3 cats an hour
4dogs_8578.jpg3_cats.jpg

God 2: I can create 5 dogs an hour, and 4 cats an hour
my5dogs.jpg4cats1.jpg
SHOULD THEY TRADE??? In another words, SHOULD THEY SPECIALIZE IN CREATING one SPECIES?
Or are they better off with no trade?gar




  • TOPICS


COMPARATIVE ADVANTAGE: THE DRIVING FORCE OF SPECIALIZATION
· In order to decide in which area should a person specialize in, you must look at the comparative advantage
· Absolute Advantage
o The ability to produce a good using fewer inputs than another producer
· Opportunity Cost and Comparative Advantage
o Comparative advantage – describes the opportunity cost of two producers; it is the ability to produce a good at a lower opportunity cost than another producer.
o Unless two people have exactly the same opportunity cost, one person will have a comparative advantage in one good, and the other person will have a comparative advantage in the other good
· Comparative advantage and trade
o Gains from specialization and trade are based not on absolute advantage but on comparative advantage


EXAMPLE:
(Right click and "open link with new tab" so you can follow along the written explanation below as you listen)


Meat (oz)
Potatoes (oz)
Hanna
60 min./oz
15 min./oz
Lauren
20 min./oz
10 min./oz

In 8 hours:


Meat
Potatoes
Sarah
8 oz.
32 oz.
Lauren
24 oz.
48 oz.
Lauren has the absolute advantage in making meat and potatoes.


1 OZ. meat
1 oz. potatoes
Sarah
Costs 4 potatoes
Costs ¼ meat
Lauren
Costs 2 potatoes
Costs ½ meat
Lauren has comparative advantage for meat, but Sarah has comparative advantage to produce potatoes

Lauren: 24 oz. meat
0 oz. potatoes

Sarah: 0 oz. meat
32 oz. potatoes

Lauren wants at least 2 potatoes for 1 meat.
Sarah is willing to give up 4 or less potatoes for 1 oz. of meat

SO THE FAIR TRADE IS 3!
they trade 10 meat: 30 potatoes

AFTER TRADE:

Lauren - 14 oz. meat
30 oz. potato

Sarah - 10 oz. meat
2 oz. potato

go back to the first chart and you’ll see that they both benefit

AND THEREFORE, on the production possibility frontier, the impossible point can be reached


Steps:
Step 1: lock in a specific amount of resources (in this case, time – 8 hours)
Step 2: maximum amount of products possible with the amount of resources
Step 3: the costs per 1 unit (cost table gives the trade ratio)
Step 4: decide comparative advantage and trade ratio!




CONCLUSION

It's always good to trade. One should decide in which to specialize by comparing the comparative advantage. Restrictions in trade are needed sometimes though to protect domestic markets or the consumers.

QUIZ


1. Why is trade always beneficial?
2. Should you compare comparative advantage or absolute advantage when deciding on how to trade?
3. From the introduction, what would be the fair trade ratio?


SOURCE

http://www.treehugger.com/files/2009/02/heres_why-free-trade-absolutism-hinders-environmental-goals-compromise-will-help-planet-increase-jobs.php
http://api.ning.com/files/Bl28UjyYuJPKk4H7tsnwJGZrhNkIDBi*0xxpcY9JJoE_/interdependence.jpg