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International Trade

Why do people – and nations – choose to be economically interdependent?

How can trade make everyone better off?

What is absolute advantage? What is comparative advantage? How are these concepts similar? How are they different?

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…the market value of all final goods &

services produced within a country

in a given period of time.

Gross Domestic Product (GDP) is…

usually a year or a quarter (3 months).

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The Components of GDP Recall: GDP is total spending.

We can break total spending down into four components:

• Consumption (C)

• Investment (I)

• Government Purchases (G)

• Net Exports (NX)

These components add up to GDP (denoted Y):

Y = C + I + G + NX

Y = C + I + G + NX

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Consumption (C)

is total spending by households on goods and services.

Note:

• For renters, consumption includes their rent payments.

• For homeowners, consumption includes the imputed rental value of their house, NOT the purchase price or the mortgage payments!!!

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Investment (I)

is total spending on goods that will be used in the future to produce more goods.

includes spending on

• capital equipment (e.g. machines, tools)

• structures (factories, office buildings, houses)

• inventories (goods produced but not yet sold)

Note: “Investment”“Investment” does not

mean the purchase of financial

assets like stocks and bonds.

Note: “Investment”“Investment” does not

mean the purchase of financial

assets like stocks and bonds.

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Government Purchases (G)

include all spending on the goods and services purchased by government at the federal, state, and local levels.

exclude transfer payments, such as Social Security or Unemployment Insurance benefits. These payments represent transfers of income, not purchases of goods or services produced.

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Net Exports (NX)

NX = exports – imports

Exports represent foreign spending on the economy’s goods & services.

Imports are the portions of C, I, and G that are spent on goods and services produced abroad.

Adding up all the components of GDP gives:

Y = C + I + G + NX

Y = C + I + G + NX

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U.S. GDP and its components, 2004

–2,063

7,432

6,559

28,009

$39,938

per capita

–5.2

18.6

16.4

70.1

100.0

% of GDP

–606

2,184

1,927

8,230

$11,735

billions

NX

G

I

C

Y

Interdependence

Every day you rely on

many people from around the world,

most of whom you do not know,

to provide you with the goods and services

you enjoy.

coffee from Kenya

dress shirt from China

cell phone from Taiwan

hair gel from Cleveland, OH

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Interdependence

This session examines one of the Principles of Economics :

Trade can make everyone better off.

In this session, we will learn why people – and nations – choose to be interdependent, and how they gain from trade.

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Our example

Two countries: the U.S. and Japan

Two goods: computers and wheat

One resource: labor, measured in hours

First, we will look at how much each country produces and consumes if it chooses to be self-sufficient.

Then, we will allow the countries to trade with each other.

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Production Possibilities in the U.S.

The U.S. has 50,000 hours of labor available for production, per month.

Producing one computer requires 100 hours of labor.

Producing one ton of wheat requires 10 hours of labor.

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4,000

100

5,000

2,000

1,000

3,000

500200 300 4000

Computers

Wheat (tons)

The U.S. PPF

The U.S. has enough labor to produce 500 computers,or 5000 tons of wheat,or any combination along the PPF.

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4,000

100

5,000

2,000

1,000

3,000

500200 300 4000

Computers

Wheat (tons)

The U.S. without trade

Suppose the U.S. uses half its labor to produce each of the two goods.

Then it will produce and consume250 computers and

2500 tons of wheat.

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Production Possibilities in Japan

Japan produces 3,200 tons of wheat and 400 computers.

They choose to consume at mid-point.

Use this information to draw Japan’s PPF. Use this information to draw Japan’s PPF. Measure computers on the horizontal axis. Measure computers on the horizontal axis.

Start now. Start now.

Use this information to draw Japan’s PPF. Use this information to draw Japan’s PPF. Measure computers on the horizontal axis. Measure computers on the horizontal axis.

Start now. Start now.

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Computers

Wheat (tons)

2,000

1,000

2000

100 300

Japan’s PPF

Japan has enough labor to produce 400 computers,

or 3200 tons of wheat,

or any combination along the PPF.

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4,000

100

5,000

2,000

1,000

3,000

500200 300 4000

Computers

Wheat (tons)

U.S. production with trade

Producing 3400 tons of wheat requires 34,000 labor hours.

The remaining 16,000 labor hours are used to produce 160 computers.

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Computers

Wheat (tons)

2,000

1,000

2000

100 300

Japan’s production with trade

3,200 wheat to 400 computers

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Trade: Exports and Imports Exports: goods produced domestically and

sold abroad.

Imports: goods produced abroad and sold domestically.

US specializes in wheat, Japan in computers

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Where do these gains come from?

Absolute advantage is the ability to produce a good using fewer inputs that another producer.

In our example, the U.S. has an absolute advantage in the production of wheat: producing a ton of wheat uses 10 labor hours in the U.S. vs. 25 in Japan.

If each country has an absolute advantage in one good and specializes in that good, then both countries can gain from trade.

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Where do these gains come from?

Which country has an absolute advantage in computers?

Producing one computer requires 125 labor hours in Japan, but only 100 in the U.S.

The U.S. has an absolute advantage in both goods!

So why does Japan specialize in computers? Why do both countries gain from trade?

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Two measures of the cost of a good

Two countries can gain from trade when each specializes in the good it produces at lowest cost.

Absolute advantage measures the cost of a good in terms of the inputs required to produce it.

Recall there’s another way to measure cost: opportunity cost.

In our example, the opportunity cost of a computer is the amount of wheat that could be produced using the labor needed to produce one computer.

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Opportunity cost and comparative advantage

Comparative advantage is the ability to produce a good at a lower opportunity cost than another producer.

Which country has the comparative advantage in computers?

To answer this, we must determine the opportunity cost of a computer in both countries.

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Comparative Advantage and Trade

Differences in opportunity cost and comparative advantage create the gains from trade.

When each country specializes in the good(s) in which it has a comparative advantage, total production in all countries is higher, the world’s “economic pie” is bigger, and all countries can gain from trade.

The same applies to individual producers (like the farmer and the rancher) specializing in different goods and trading with each other.

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Unanswered questions…. We made a lot of assumptions about the

quantities of each good that each country produces, trades, and consumes, and the price at which the countries trade wheat for computers.

In the real world, these quantities and prices would be determined by the preferences of consumers and the technology and resources in both countries.

For now, though, our goal was only to see that trade, indeed, can make everyone better off.

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SESSION SUMMARY Interdependence and trade allow everyone to

enjoy a greater quantity and variety of goods & services.

Comparative advantage means being able to produce a good at a lower opportunity cost. Absolute advantage means being able to produce a good with fewer inputs.

When people – or countries – specialize in the goods in which they have a comparative advantage, the economic “pie” grows and trade can make everyone better off.