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Trade and Comparative Advantage

by: Tim Ford

Trade and Comparative Advantage ECON 21000

Marketplace > Purdue University > ECON 21000 > Trade and Comparative Advantage
Tim Ford
GPA 3.3
Principles Of Economics
Benjamin Van Kammen

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Discussing the benefits of trade between specific parties. For now, this is not taking into account money, rather its just benefitting from one another's skills and specialization.
Principles Of Economics
Benjamin Van Kammen
Class Notes
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This 16 page Class Notes was uploaded by Tim Ford on Friday September 18, 2015. The Class Notes belongs to ECON 21000 at Purdue University taught by Benjamin Van Kammen in Summer 2015. Since its upload, it has received 40 views.


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Date Created: 09/18/15
Trade and Comparative Advantage PRINCIPLES OF ECONOMICS ECON 210 BEN VAN KAIVIIVIEN PHD The incentive to trade holding the aggregate quantity of goods constant The economy is populated by individuals that want various goods Each individual values each unit of each good differently Voluntary trade enables goods to flow from individuals that value them less to individuals that value them more We have no reason to expect the initial allocation of goods to be optimal ie based on maximizing the aggregate value of the goods Trade allows individuals to compare the goods they have to goods available from others in terms of value Value is in terms of what each individual would be willing to give up in order to get them When two individuals observe a double coincidence of wants they will voluntarily trade with each partner receiving something he values more in exchange for something he values less The posttrade allocation is an improvement in terms of the values the individuals place on the goods they own Example professional sports There seem to be at least 2 distinct reasons sports franchises trade players Different objectives On July 22 2013 the Chicago Cubs traded their best starting pitcher Matt Garza to the Texas Rangers for prospects Justin Grimm Mike Olt and CJ Edwards At the time the Cubs were narrowly ahead of the Milwaukee Brewers for last place in the NL Central and the Rangers were trailing the Oakland A s by 3 games in the AL West With the Cubs effectively out of contention for the playoffs yet again Garza s arm was of relatively little use to the Cubs because of their vanishingly small chance of making the playoffs and Garza s expiring contract after which he would be a free agent The Rangers however wanted as much pitching talent as they could get in order to improve their chances of a World Series and were willing to part with promising young players who would theoretically help the Cubs win in a future season when they have a better shot at playoff success Both teams got what they wanted by exchanging Garza for the prospects Example continued Redundancy of goods On November 20 2013 the Rangers and Detroit Tigers both contending teams exchanged first baseman Prince Fielder and second baseman Ian Kinsler This trade was motivated by a common objective of winning in 2014 But the Tigers had too many players suited to playing 1St base and no good options at 239 The Rangers by contrast had phenomenal 2nol base prospect Jurickson Profar in addition to Kinsler After the trade both teams had formidable right sides of their infields Fielder and Profar in Texas and Kinsler and Miguel Cabrera in Detroit Specialization Trade is both more valuable and more important when individuals specialize Specialization increases both the aggregate quantity of goods and the imbalance of their allocation mbalance Specialization means that each individual devotes more of his resources to producing one or a small number of goodlsl Contrast this with self sufficiency in which he devotes a small fraction to each of many goods he wants The result is that each specialist has a lot of what he specializes in but little or none of the other goods at least in the absence of trade Sometimes this condition without trade is also called autarchy More of the goods each individual wants must now be procured by trade Specialization continued ncreased productivity Why would people specialize if the only result is an increased reliance on trade Because a specialist can produce more goods per unit of input than someone who divides his inputs among many productions For concreteness think of the input as the individual s tr e f a person specializes say that he spends 4 times as much time producing this good than before As long as he produces more than 4 times as much of the good he reaps gains from specialization This is a very old principle in economics It s actually the first sentence in the unofficial first modern economics book Adam Smith s The Wealth of Nations quotThe greatest improvements in the productive powers of labour and the greater part of the skill dexterity and judgment with which it is anywhere directed or applied seem to have been the effects of the division of labor page 3 Adam Smith s pin example Smith proceeds with his famous example of pin production concluding that 3 factors explain the gains from specialization Learning by doing The increase of dexterity in every particular workman I Less time lost in transitions between tasks The incentive to adopt labour augmenting technology the costs of which would not be justified by someone undertaking the production part time The gains from specialization are limited by the capacity of individuals to trade though It doesn t do much good if specialists are constrained by consuming only what they produce They lose out considerably on variety and have severely imbalanced consumption The incentive to specialize is lost if you can t trade your output for other goods you want Side point The double coincidence of wants is another limitation but one that can be resolved easily with a medium of exchange ie money Comparative advantage Specialization gets even better The gains from specialization are magnified if individuals can choose what to specialize in Contrast this with the method in Family Guy episode 23 quotDa Boom by which occupations are randomly chosen without considering comparative advantage This is precisely what they should consider when choosing specializations the production they can perform with the lowest opportunity cost Productivity increases even more because people produce the things that they are relatively good at Example A popular way of illustrating this is by specifying unit labor requirements for 2 goods and 2 individuals Each person can divide his time between producing either good and the amount of time required to produce 1 unit can vary across individuals and goods Eg Produces 1 Bookcase in Produces 1 Quilt in Stan 3 hours 6 hours Oliver 6 hours 24 hours Example continued Opp Cost of 1 Bookcase Opp Cost of 1 Quilt Stan 12 Quilt 2 Bookcases Oliver Quilt 4 Bookcases Their opportunity costs are what they forego by producing one good n this example Stan has a comparative advantage at making quilts and Oliver has a comparative advantage at bookcases Oliver has a comparative advantage even though Stan has absolute advantage in both goods But since Stan can t specialize in both goods Oliver will specialize in the one in which his absolute advantage is smaller Example continued iQ ms M Specializing according to comparative advantage allows trade to give them both more of at least 1 good compared to autarchy This can be shown graphically using a Production Possibilities Frontier For Stan and B k Oliver they would look like this i i i 3 6 t 8 6 f4 1397 Assume each has 48 hours to produce goods iQuilts Stan This is the set of all combinations of output for each person given the constraint of 48 hours Slope 12 I I I I I BooIkcasIes 1 2 339 4 s 6 7 8 9 1390 1391 1392 1393 1394 1395 1396 1397 139839 Example continued ndividuals can reach points beyond their PPFs by specializing and trading Both will be willing to trade as long as the terms of trade offer an improvement compared to their own opportunity costs Stan begins with 8 quilts and O bookcases Oliver begins with 8 bookcases and O quilts As long as Stan must give up less than 1 quilt per 2 bookcases he will trade voluntarily And as long as Oliver gets more than 1 quilt per 4 bookcases he will trade voluntarily too So if the terms of trading quilts for bookcases x is between 1lt lt1 4 x 2 both parties will gain from trade with production according to comparative advantage Example concluded Consider an initial allocation in which Stan produces and consumes 6 quilts and 4 bookcases per week Oliver produces 1 12 quilt and 2 bookcases per week If instead Stan specializes by producing 8 quilts and the terms of trade are 1 quilt per 3 bookcases he can trade 1 12 per quilt per week in exchange for E 3 45 bookcases per week Now Stan has 6 12 quilts and 4 12 bookcases Oliver has 1 12 quilts and 3 12 bookcases These combinations were both previously unattainable without trading Conclusion Specialization according to comparative advantage generalizes to trade across international borders As in the preceding example higher consumption is associated with the more productive trading partner ie wages are determined by productivity This issue will be examined in greater detail later in the semester Family Guy Comparative Advantage Brian Ah excuse me Mr Mayor We have an outsider who wishes to join our community Peter Welcome to my fair city If you want to become a citizen you have to get a job Man Well before the disaster I was a physician Cleveland That39s terrific We need a doctor Peter We sure do Let39s hope you get it Now pick a job out of the hat Ah quotVillage idiotquot That39s a good one On Tuesdays you get to wave your penis at traffic Congratulations Back Why Do Not Own One of These Back


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