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Chapter 3 (Interdependence and Gains From Trade)

This document discusses concepts related to comparative advantage and gains from trade. It provides definitions of absolute advantage and comparative advantage, and explains that comparative advantage, as developed by Ricardo, is a more useful concept for understanding gains from trade. Countries benefit from specializing in and trading goods that they have a comparative rather than absolute advantage in producing. Examples are provided to illustrate opportunity costs and how comparative advantage applies to individual countries. The document concludes by stating that patterns of trade are consistent with comparative advantage principles if countries export goods they have an advantage in and import goods they have a disadvantage in.

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Md Fahim Islam Antur 1931900643
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106 views5 pages

Chapter 3 (Interdependence and Gains From Trade)

This document discusses concepts related to comparative advantage and gains from trade. It provides definitions of absolute advantage and comparative advantage, and explains that comparative advantage, as developed by Ricardo, is a more useful concept for understanding gains from trade. Countries benefit from specializing in and trading goods that they have a comparative rather than absolute advantage in producing. Examples are provided to illustrate opportunity costs and how comparative advantage applies to individual countries. The document concludes by stating that patterns of trade are consistent with comparative advantage principles if countries export goods they have an advantage in and import goods they have a disadvantage in.

Uploaded by

Md Fahim Islam Antur 1931900643
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter 3: Interdependence and the Gains from Trade

Importance of exchange in Economics


In modern economy we are dependent on each other
This expands our consumption possibilities and increases the quality of goods that we
consume, this happens because we can afford to have specialists on every narrowly defined
work, topic.
Specialization and trade
Absolute advantage: the ability to produce a good using fewer inputs than another producer
Comparative advantage the ability to produce a good at a lower opportunity cost than another
producer
Don’t Confuse Absolute Advantage and Comparative Advantage
First, make sure you know the definitions:
• Absolute advantage. The ability of an individual, a firm, or a country to produce more of a
good or service than competitors, using the same amount of resources. In our example, your
neighbor has an absolute advantage over you in both picking apples and picking cherries.
• Comparative advantage. The ability of an individual, a firm, or a country to produce a
good or service at a lower opportunity cost than competitors. In our example, your neighbor
has a comparative advantage in picking cherries, but you have a comparative advantage in
picking apples.
In Adam Smith's 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations,
he writes of the ability of producers to benefit through specialization and trade.
In David Ricardo's 1817 book Principles of Political Economy and Taxation, Ricardo
develops the theory of comparative advantage and argues against restrictions on free trade.
The benefits of free trade are an issue that is generally agreed upon by most economists, and
the theories and arguments developed by these two individuals 200 years ago are still used
today.
The Price of the Trade
For both parties to gain from trade, the price at which they trade must lie between the two
opportunity costs.
Should Tom Brady Mow His Own Lawn?
Should the United States Trade with Other Countries?
Why trade is not always good
Problem 1: Maria can read 20 pages of economics in an hour. She can also read 50 pages of
sociology in an hour. She spends 5 hours per day studying.
a. Draw Maria’s production possibilities frontier for reading economics and sociology.
b. What is Maria’s opportunity cost of reading 100 pages of sociology?
See Figure 2. If Maria spends all five hours studying economics, she can read 100 pages, so
that is the vertical intercept of the production possibilities frontier. If she spends all five hours
studying sociology, she can read 250 pages, so that is the horizontal intercept. The
opportunity costs are constant, so the production possibilities frontier is a straight line.
It takes Maria two hours to read 100 pages of sociology. In that time, she could read 40 pages
of economics. So the opportunity cost of 100 pages of sociology is 40 pages of economics.
Problem 2: American and Japanese workers can each produce 4 cars a year. An American
worker can produce 10 tons of grain a year, whereas a Japanese worker can produce 5 tons of
grain a year. To keep things simple, assume that each country has 100 million workers.
a. For this situation, construct a table analogous to the table in Figure 1.

b. Graph the production possibilities frontier of the American and Japanese economies.
See Figure 3. With 100 million workers and four cars per worker, if either economy were
devoted completely to cars, it could make 400 million cars. Because a U.S. worker can
produce 10 tons of grain, if the United States produced only grain it would produce 1,000
million tons. Because a Japanese worker can produce 5 tons of grain, if Japan produced only
grain it would produce 500 million tons. These are the intercepts of the production
possibilities frontiers shown in the figure. Note that because the trade-off between cars and
grain is constant for both countries, the production possibilities frontiers are straight lines.
c. For the United States, what is the opportunity cost of a car? Of grain? For Japan, what is
the opportunity cost of a car? Of grain? Put this information in a table analogous to Table 1.
Because a U.S. worker produces either four cars or ten tons of grain, the opportunity cost of
one car is two and one-half tons of grain, which is ten divided by four. Because a Japanese
worker produces either four cars or five tons of grain, the opportunity cost of one car is one
and one-fourth tons of grain, which is five divided by four. Similarly, the U.S. opportunity
cost of one ton of grain is2/5 car (4 divided by 10) and the Japanese opportunity cost of one
ton of grain is 4/5 car (4 divided by 5). This results in the following table:

d. Which country has an absolute advantage in producing cars? In producing grain?


Neither country has an absolute advantage in producing cars, because they are equally
productive (the same output per worker); the United States has an absolute advantage in
producing grain, because it is more productive (greater output per worker).
e. Which country has a comparative advantage in producing cars? In producing grain?
Japan has a comparative advantage in producing cars, because it has a lower opportunity cost
in terms of grain given up. The United States has a comparative advantage in producing
grain, because it has a lower opportunity cost in terms of cars given up.
f. Without trade, half of each country’s workers produce cars and half produce grain. What
quantities of cars and grain does each country produce?
With half the workers in each country producing each of the goods, the United States would
produce 200 million cars (50 million workers times 4 cars each) and 500 million tons of grain
(50 million workers times 10 tons each). Japan would produce 200 million cars (50 million
workers times 4 cars each) and 250 million tons of grain (50 million workers times 5 tons
each).
Problem 10: The United States exports corn and aircraft to the rest of the world, and it
imports oil and clothing from the rest of the world. Do you think this pattern of trade is
consistent with the principle of comparative advantage? Why or why not?
This pattern of trade is consistent with the principle of comparative advantage. If the United
States exports corn and aircraft, it must have a comparative advantage in the production of
these goods. Because it imports oil and clothing, the United States must have a comparative
disadvantage in the production of these items.

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