principles of microeconomics & principles of macroeconomics: ch. 3 first canadian edition...

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Interdependence and Trade

Economics studies how society produces and distributes goods and services so that wants and needs are satisfied.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

How Do We Satisfy Our Wants and Needs?

We can be economically

Self-Sufficient.We can specialize

and trade with others leading to Economic Interdependence.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Interdependence & Trade

A general observation . . .– Individuals and nations rely on

specialized production and exchange as a way to address problems caused by scarcity.

This gives rise to two questions. . .–Why is interdependence the norm?

–What determines production & trade?

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Interdependence & Trade Why is interdependence the norm?

–Interdependence occurs because people are better off when they specialize and trade with others.

What determines the pattern of production & trade?

–Patterns of production and trade are based upon differences in opportunity costs.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Interdependence and Trade: “A Parable for the Modern Economy”

Imagine...

… only two goods (potatoes and meat)

… only two people (potato farmer and a cattle rancher)

What should each produce?

Why should they trade?

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Productivity Table Amount Produced In One Hour

(in Kilograms)Meat Potatoes

Farmer 1 Kg 1 Kg

Rancher 8 Kg 2 Kg

Note that based on the Productivity Tableabove the Rancher is more productive inproducing both of the products.

Yet, we will see that both the Rancher and the Farmer can gain from trade ...

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Product Possibility FrontiersBased on the Productivity Table above we can construct Productivity Possibility Frontiers assuming an 8 hour day as follows:

Mea

t in

Kg

Farmer

Potatoes in Kg

8

8

Mea

t in

Kg

Potatoes in Kg

Rancher64

16

PPF PPF

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

A World of Self-SufficiencyAssuming self sufficiency (no trade) the Farmer produces and consumes combination A, while the Rancher is at combination B:

Mea

t in

Kg

Farmer

Potatoes in Kg

8

8

Mea

t in

Kg

Potatoes in Kg

Rancher64

16

B32

8

A4

4

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Specialization and Trade

If the farmer and the rancher were to specialize in producing the product that they were best suited to produce, and then trade with each other, they would be better off.

–Farmer should produce potatoes.

–Rancher should produce meat.

–Farmer and Rancher should trade.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Specialization and TradeSuppose the Farmer specializes in Potatoes and the Rancher specializes in Meat. If the Farmer trades 5 Kg Potatoes for 10 Kg Meat:

Mea

t in

Kg

Farmer

Potatoes in Kg

8

8

Mea

t in

Kg

Potatoes in Kg

Rancher64

16

B48

4

A6

2

A*trade B*trade

3

10 54

5

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

The Principle of Comparative Advantage

What determines who should produce what? And how much should be traded for each product?

Differences in Costs of Production Who can produce products (e.g.

potato, meat) at a lower cost? There are two ways to measure...

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

The Principle of Comparative Advantage

Measuring differences in costs of production:–Hours required to produce a

standardized unit of output. One pound of potatoes

–Opportunity Cost - amount of one item sacrificed to obtain another.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Absolute Advantage

Describes the productivity of one person, firm, or nation to that of another.- The producer that requires a smaller

quantity of inputs to produce a good is said to have an absolute advantage in producing that good.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Productivity Table Amount Produced In One Hour

(in Kilograms)Meat Potatoes

Farmer 1 Kg 1 Kg

Rancher 8 Kg 2 Kg

Who has the Absolute Advantage in eachproduct?

Rancher, in both products. Yet, we have seen that both the Rancher

and the Farmer can gain from trade?

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Comparative Advantage

Compares producers of a good according to their opportunity cost.- The producer who has the smaller

opportunity cost of producing a good is said to have a comparative advantage in producing that good.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

The Principle of Comparative Advantage

Comparative advantage, which refers to differences in opportunity costs, is the basis for specialized production and trade.

Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade.

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Opportunity Cost Table Cost of 1 Kg of each product in real terms

1 Kg of Meat Costs 1 Kg of Potatoes costs

Farmer 1 Kg of Potatoes 1 Kg of Meat

Rancher .25 Kg of Potatoes 4 Kg of Meat

Based on the Productivity Table (earlier slide) you can use simple math to calculate the opportunity cost of 1 unit of each good.

The Rancher has the Comparative Advantage inproducing Meat (lower opportunity cost).

The Farmer has the Comparative Advantage inproducing Potatoes (lower opportunity cost).

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Applications of Comparative Advantage

Should Canada trade with Other Countries (e.g. Japan)?–Opportunity Costs

–Imports

–Exports

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Trade: Canada and Japan

Cars Cars

FoodCanada Japan

4

2

Food2

2

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Opportunity Cost: Sacrifice of Food Production for Car Production

Computing Opportunity Cost

Slope of PPF:

(0-4) ÷ (2-0) =

2 Units of food given

up to get 1 Unit of a car.Cars

Canada4

2

Food

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Opportunity Cost: Sacrifice of Food Production for Car Production

Computing Opportunity Cost

Slope of PPF:

(0-4) ÷ (2-0) =

? Units of food

given up to get 1 Unit of a car

Cars

Canada4

2

Food

1

?

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Opportunity Cost: Sacrifice of Food Production for Car Production

Computing Opportunity Cost

Slope of PPF:

(0-4) ÷ (2-0) =

2 Units of food

given up to get 1 Unit of a car

Cars

Canada4

2

Food

2

1

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Opportunity Cost: Sacrifice of Food Production for Car Production

Computing Opportunity Cost

Slope of PPF:

( 2 ) ÷ (2 ) =

1Unit of food given up to get 1

Unit of a car

Cars

Japan2

2

Food

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Trade: Canada and Japan

Cars Cars

FoodCanada Japan

4

2

Food2

2

2

1

1

1

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Cars Cars

Food Canada Japan4

2

Food2

2

2

1

1

1

Who should produce Cars?

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Cars Cars

Food Canada Japan4

2

Food2

2

2

1

1

1

Who should produce Food?

Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition

Interdependence: Canada & Japan

Interdependence and trade are desirable because they allow everyone to enjoy a

greater quantity and variety of goods and services. Founded upon the. . .

Principle of Comparative Advantage