econ202, maclachlan, spring 20051 interdependence & gains from trade week 2

ECON202, Maclachlan, Spring 2005 1

Interdependence & Gains from Trade

Week 2

ECON202, Maclachlan, Spring 2005 2

Principle #5

Trade can make everyone better off.

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What’s the alternative to trade?

David Thoreau

at Walden Pond.

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Autarky

A policy of national self-sufficiency and nonreliance on imports or economic aid.

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Mercantilism

A country should aim to run trade surpluses and increase its monetary assets.

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Adam Smith (1723-1790)

Critic of mercantilism.

Countries should specialize and trade.

Specialize where there’s an ABSOLUTE ADVANTAGE

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ABSOLUTE ADVANTAGE

A region has an absolute advantage if it takes fewer resources to produce a good there than elsewhere.

Coffee in Columbia.

Computer software in Silicon Valley.

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David Ricardo (1772-1823)

Theory of comparative advantage.

Even without an absolute advantage a region can trade to the benefit of all parties.

Table 1 The Production Opportunities of the Farmer and Rancher

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Figure 1a The Production Possibilities Frontier

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Figure 1b The Production Possibilities Frontier

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Rancher’s Deal for Farmer

• Farmer stops producing meat and specializes in potatoes. In a week he can produce …

• 32 oz of potatoes.• Farmer sells 15 oz to Rancher for 5 oz of

meat. Farmer ends up with …• 32 - 15 = 17 oz of potatoes and 5 oz of

meat. Farmer is better off.

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Rancher’s Plan

• Spend 6 hrs producing 18 oz of meat.

• Sell 5 oz and keep 13 oz of meat.

• Spend 2 hrs producing 12 oz of potatoes.

• Total potato consumption 15 oz + 12 oz = 27 oz.

• Total consumption: 13 oz of meat and 27 oz of potatoes.

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Figure 2a How Trade Expands the Set of Consumption Opportunities

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Figure 2b How Trade Expands the Set of Consumption Opportunities

Table 2 The Gains from Trade: A Summary

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How to determine comparative advantage

Look for that good or service for which the OPPORTUNITY COST is lowest.

The opportunity cost is the cost of producing in terms of an alternative good.

Table 3 The Opportunity Cost of Meat and Potatoes

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