2010 South-Western, a part of Cengage Learning, all rights reservedC H A P T E R2010 updateInterdependence and the Gains from TradeEconomicsP R I N C I P L E S O FP R I N C I P L E S O FN. Gregory MankiwPremium PowerPoint Slides by Ron Cronovich3In this chapter, look for the answers to these questions: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?1InterdependenceEvery day you rely on many people from around the world, most of whom youve never met, to provide you with the goods and services you enjoy.coffee from Kenyadress shirt from Chinacell phone from Taiwanhair gel from Cleveland, OHINTERDEPENDENCE AND THE GAINS FROM TRADE3InterdependenceOne of the Ten Principles from Chapter 1:Trade can make everyone better off.We now learn why people and nations choose to be interdependent, and how they can gain from trade. INTERDEPENDENCE AND THE GAINS FROM TRADE4Our ExampleTwo countries: the U.S. and JapanTwo goods: computers and wheatOne resource: labor, measured in hours We will look at how much of both goods each country produces and consumesif the country chooses to be self-sufficientif it trades with the other countryINTERDEPENDENCE AND THE GAINS FROM TRADE5Production 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. INTERDEPENDENCE AND THE GAINS FROM TRADE64,0001005,0002,0001,0003,0005002003004000ComputersWheat (tons)The U.S. PPFThe U.S. has enough labor to produce 500 computers,or 5000 tons of wheat,or any combination along the PPF.INTERDEPENDENCE AND THE GAINS FROM TRADE74,0001005,0002,0001,0003,0005002003004000ComputersWheat (tons)The U.S. Without TradeSuppose the U.S. uses half its labor to produce each of the two goods. Then it will produce and consume250 computers and2500 tons of wheat.Use the following information to draw Japans PPF.Japan has 30,000 hours of labor available for production, per month.Producing one computer requires 125 hours of labor. Producing one ton of wheat requires 25 hours of labor.Your graph should measure computers on the horizontal axis. A C T I V E L E A R N I N G A C T I V E L E A R N I N G 1 1 Derive Japans PPF8INTERDEPENDENCE AND THE GAINS FROM TRADE9ComputersWheat (tons)2,0001,0002000100300Japans PPFJapan has enough labor to produce 240 computers,or 1200 tons of wheat,or any combination along the PPF.INTERDEPENDENCE AND THE GAINS FROM TRADE10Japan Without TradeComputersWheat (tons)2,0001,0002000100300Suppose Japan uses half its labor to produce each good. Then it will produce and consume120 computers and600 tons of wheat.INTERDEPENDENCE AND THE GAINS FROM TRADE11Consumption With and Without TradeWithout trade, U.S. consumers get 250 computers and 2500 tons wheat.Japanese consumers get 120 computersand 600 tons wheat.We will compare consumption without trade to consumption with trade. First, we need to see how much of each good is produced and traded by the two countries. 1.Suppose the U.S. produces 3400 tons of wheat. How many computers would the U.S. be able to produce with its remaining labor? Draw the point representing this combination of computers and wheat on the U.S. PPF.2.Suppose Japan produces 240 computers. How many tons of wheat would Japan be able to produce with its remaining labor? Draw this point on Japans PPF.A C T I V E L E A R N I N G A C T I V E L E A R N I N G 2 2 Production under trade12INTERDEPENDENCE AND THE GAINS FROM TRADE134,0001005,0002,0001,0003,0005002003004000ComputersWheat (tons)U.S. Production With TradeProducing 3400 tons of wheat requires 34,000 labor hours. The remaining 16,000 labor hours are used to produce 160 computers. INTERDEPENDENCE AND THE GAINS FROM TRADE14Japans Production With TradeProducing 240 computers requires all of Japans 30,000 labor hours.ComputersWheat (tons)2,0001,0002000100300So, Japan would produce 0 tons of wheat. INTERDEPENDENCE AND THE GAINS FROM TRADE15 Basic International Trade TermsExports: goods produced domestically and sold abroadTo export means to sell domestically produced goods abroad.Imports: goods produced abroad and sold domesticallyTo import means to purchase goods produced in other countries. A C T I V E L E A R N I N G A C T I V E L E A R N I N G 3 3 Consumption under trade16How much of each good is consumed in the U.S.? Plot this combination on the U.S. PPF. How much of each good is consumed in Japan? Plot this combination on Japans PPF. Suppose the U.S. exports 700 tons of wheat to Japan, and imports 110 computers from Japan.(So, Japan imports 700 tons wheat and exports 110 computers.)INTERDEPENDENCE AND THE GAINS FROM TRADE174,0001005,0002,0001,0003,0005002003004000ComputersWheat (tons)U.S. Consumption With Trade2700270= amount consumed0110+ imported7000 exported3400160producedwheatcomputersINTERDEPENDENCE AND THE GAINS FROM TRADE18Japans Consumption With TradeComputersWheat (tons)2,0001,0002000100300700130= amount consumed7000+ imported0110 exported0240producedwheatcomputersINTERDEPENDENCE AND THE GAINS FROM TRADE19Trade Makes Both Countries Better Off2002,7002,500wheat20270250computersgains from tradeconsumption with tradeconsumption without tradeU.S.100700600wheat10130120computersgains from tradeconsumption with tradeconsumption without tradeJapanINTERDEPENDENCE AND THE GAINS FROM TRADE20Where Do These Gains Come From?Absolute advantage: the ability to produce a good using fewer inputs than another producer The U.S. has an absolute advantage in 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. INTERDEPENDENCE AND THE GAINS FROM TRADE21Where 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?INTERDEPENDENCE AND THE GAINS FROM TRADE22Two Measures of the Cost of a GoodTwo 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: Another measure of cost is 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. INTERDEPENDENCE AND THE GAINS FROM TRADE23Opportunity Cost and Comparative AdvantageComparative advantage: 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, must determine the opp. cost of a computer in each country. INTERDEPENDENCE AND THE GAINS FROM TRADE24Opportunity Cost and Comparative AdvantageThe opp. cost of a computer is10 tons of wheat in the U.S., because producing one computer requires 100 labor hours, which instead could produce 10 tons of wheat.5 tons of wheat in Japan, because producing one computer requires 125 labor hours, which instead could produce 5 tons of wheat. So, Japan has a comparative advantage in computers. Lesson: Absolute advantage is not necessary for comparative advantage!INTERDEPENDENCE AND THE GAINS FROM TRADE25Comparative Advantage and TradeGains from trade arise from comparative advantage (differences in opportunity costs). When each country specializes in the good(s) in which it has a comparative advantage, total production in all countries is higher, the worlds “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. Argentina and Brazil each have 10,000 hours of labor per month. In Argentina,producing one pound coffee requires 2 hoursproducing one bottle wine requires 4 hoursIn Brazil,producing one pound coffee requires 1 hourproducing one bottle wine requires 5 hoursWhich country has an absolute advantage in the production of coffee? Which country has a comparative advantage in the production of wine?A C T I V E L E A R N I N G A C T I V E L E A R N I N G 4 4 Absolute & comparative advantage26Brazil has an absolute advantage in coffee:Producing a pound of coffee requires only one labor-hour in Brazil, but two in Argentina. Argentina has a comparative advantage in wine:Argentinas opp. cost of wine is two pounds of coffee, because the four labor-hours required to produce a bottle of wine could instead produce two pounds of coffee. Brazils opp. cost of wine is five pounds of coffee.A C T I V E L E A R N I N G A C T I V E L E A R N I N G 4 4 Answers27INTERDEPENDENCE AND THE GAINS FROM TRADE28Unanswered 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. We will begin to study this in the next chapter.For now, though, our goal was merely to see how trade can make everyone better off. CHAPTER SUMMARYInterdependence 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. 29