Chapter 3 Interdependence and the Gains from Trade
Chapter 3 Interdependence and the Gains from Trade Econ 202 - 01
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This 2 page Class Notes was uploaded by Roger D. on Friday April 8, 2016. The Class Notes belongs to Econ 202 - 01 at University of North Dakota taught by Kwan Yong Lee in Spring 2016. Since its upload, it has received 14 views. For similar materials see Principles Of Macroeconomics in Economcs at University of North Dakota.
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Date Created: 04/08/16
Econ 202 ~ Chapter 3 ~ Interdependence and the Gains from Trade Parable for the Modern Economy Each person consumes goods and services produced by many other people both in the United States and around the world. Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services. People benefit by trading because of specialization which leads to gains for everyone. Gains in trade come from comparative advantage Trade makes everyone better off because it allows people to specialize in those productive activities in which they are better at and thus have a comparative advantage in. A closed country can only consume what it produces: No bananas or coffee for Americans without trade. Gains are less obvious when one person has an absolute advantage in both items to be traded. The PPF (production possibilities frontier) shows the various “mixes” of output an economy can produce. The Production Opportunities table with the PPF graphs illustrate the combinations (ratios, mixes) of two products (services) by individuals, firms or countries The PPF is also referred to as the consumption possibilities frontier (CPF) which shows various mixes of consumption pairs. Comparative Advantage: The Driving Force of Specialization There are two (2) ways to compare the cost and ability of two people to produce a particular good: (1) The person who can produce the good with the smaller quantity of inputs (resources; such as, time & labor, land, natural, capital) is said to have an Absolute Advantage in producing the good. (2) The person who has the smaller opportunity cost (less of the other item is given up or forgone) in order to produce a particular good is said to have a Comparative Advantage. The gains from trade are based on the comparative advantage, NOT the absolute advantage. Absolute Advantage ~ is the ability to produce a particular good using fewer inputs (amount of resources) than another producer; such as, a country, state, firm or person. It measures the cost of a good in regards to inputs (resources) needed (required) to produce it. Absolute Advantage is NOT necessary for comparative advantages. A person, firm, country can have an absolute advantage in both items; however, it’s impossible for one person, firm or country to have comparative advantages in both items. The country, firm or person with the higher output production per amount of a given resource has an absolute advantage for that item or product. When less resources are used, this indicates an absolute advantage. (Example: 60 minutes per oz. of meat vs 20 minutes per oz. of meat; yields 8 oz. of meat in 8 hours versus 24 oz. of meat in 8 hours). The Opportunity Cost ~ is whatever or something which must be given up (forgone) in order to obtain or produce a particular item or a different (larger, smaller) amount of that desired final item. Lower opportunity cost indicates less of another item has to be given up for a desired item. When two different producers have different opportunity costs, then they will benefit via trade. The opportunity cost of a given item, by a particular producer, has an inverse relationship to its “tied, shared” counter-part item on its producer’s PPF. One (compared) item will have a higher opportunity cost and the other item will have a lower opportunity cost which are inverses (reciprocals) of each other; such as, 4 and 1/4. The producer who gives up less of Good Y to produce Good X has a smaller opportunity cost to produce Good X and has the comparative advantage. (Example: 1 oz. of meat is “Frank’s” opportunity cost to produce 4 oz. of potatoes or ¼ oz. of meat per ounce of potatoes.) Comparative Advantage ~ is the ability to produce a good at a lower opportunity cost than another producer. Gains from trade are measured via the comparative advantage and occur because of differences in opportunity costs. It measures the cost of a good via the amount produced given the amount of available resources. It is a factor of production via opportunity costs: (Amount finally produced per given resource ~ time in 8 hours) Comparative Adv. Meat Potatoes Comparative Adv. Frank 4 (32/8) 8 oz. 32 oz. 1/4 (8/32) Rose 2 (48/24) 24 oz. 48 oz. 1/2 (24/48) Applications of Comparative Advantage The principle of comparative advantage applies to countries as well as to people. Economists use the principle of comparative advantage to advocate free trade amongst countries. Imports ~ are goods produced abroad and sold domestically Exports ~ are goods produced domestically and sold abroad
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