Chapter 3 (Interdependence and gains from trade) PDF

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The teacher is AFM Ataur Rahman...

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Chapter 3: Interdependence and the Gains from Trade Importance of exchange in Economics In modern economy we are dependent on each other This expands our consumption possibilities and increases the quality of goods that we consume, this happens because we can afford to have specialists on every narrowly defined work, topic. Specialization and trade

Absolute advantage: the ability to produce a good using fewer inputs than another producer Comparative advantage the ability to produce a good at a lower opportunity cost than another producer Don’t Confuse Absolute Advantage and Comparative Advantage First, make sure you know the definitions: • Absolute advantage. The ability of an individual, a firm, or a country to produce more of a good or service than competitors, using the same amount of resources. In our example, your neighbor has an absolute advantage over you in both picking apples and picking cherries. • Comparative advantage. The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors. In our example, your neighbor has a comparative advantage in picking cherries, but you have a comparative advantage in picking apples. In Adam Smith's 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, he writes of the ability of producers to benefit through specialization and trade. In David Ricardo's 1817 book Principles of Political Economy and Taxation, Ricardo develops the theory of comparative advantage and argues against restrictions on free trade. The benefits of free trade are an issue that is generally agreed upon by most economists, and the theories and arguments developed by these two individuals 200 years ago are still used today. The Price of the Trade For both parties to gain from trade, the price at which they trade must lie between the two opportunity costs. Should Tom Brady Mow His Own Lawn? Should the United States Trade with Other Countries? Why trade is not always good Problem 1: Maria can read 20 pages of economics in an hour. She can also read 50 pages of sociology in an hour. She spends 5 hours per day studying. a. Draw Maria’s production possibilities frontier for reading economics and sociology. b. What is Maria’s opportunity cost of reading 100 pages of sociology? See Figure 2. If Maria spends all five hours studying economics, she can read 100 pages, so that is the vertical intercept of the production possibilities frontier. If she spends all five hours studying sociology, she can read 250 pages, so that is the horizontal intercept. The opportunity costs are constant, so the production possibilities frontier is a straight line.

It takes Maria two hours to read 100 pages of sociology. In that time, she could read 40 pages of economics. So the opportunity cost of 100 pages of sociology is 40 pages of economics. Problem 2: American and Japanese workers can each produce 4 cars a year. An American worker can produce 10 tons of grain a year, whereas a Japanese worker can produce 5 tons of grain a year. To keep things simple, assume that each country has 100 million workers. a. For this situation, construct a table analogous to the table in Figure 1.

b. Graph the production possibilities frontier of the American and Japanese economies. See Figure 3. With 100 million workers and four cars per worker, if either economy were devoted completely to cars, it could make 400 million cars. Because a U.S. worker can produce 10 tons of grain, if the United States produced only grain it would produce 1,000 million tons. Because a Japanese worker can produce 5 tons of grain, if Japan produced only grain it would produce 500 million tons. These are the intercepts of the production possibilities frontiers shown in the figure. Note that because the trade-off between cars and grain is constant for both countries, the production possibilities frontiers are straight lines.

c. For the United States, what is the opportunity cost of a car? Of grain? For Japan, what is the opportunity cost of a car? Of grain? Put this information in a table analogous to Table 1. Because a U.S. worker produces either four cars or ten tons of grain, the opportunity cost of one car is two and one-half tons of grain, which is ten divided by four. Because a Japanese worker produces either four cars or five tons of grain, the opportunity cost of one car is one and one-fourth tons of grain, which is five divided by four. Similarly, the U.S. opportunity cost of one ton of grain is2/5 car (4 divided by 10) and the Japanese opportunity cost of one ton of grain is 4/5 car (4 divided by 5). This results in the following table:

d. Which country has an absolute advantage in producing cars? In producing grain? Neither country has an absolute advantage in producing cars, because they are equally productive (the same output per worker); the United States has an absolute advantage in producing grain, because it is more productive (greater output per worker). e. Which country has a comparative advantage in producing cars? In producing grain? Japan has a comparative advantage in producing cars, because it has a lower opportunity cost in terms of grain given up. The United States has a comparative advantage in producing grain, because it has a lower opportunity cost in terms of cars given up. f. Without trade, half of each country’s workers produce cars and half produce grain. What quantities of cars and grain does each country produce? With half the workers in each country producing each of the goods, the United States would produce 200 million cars (50 million workers times 4 cars each) and 500 million tons of grain (50 million workers times 10 tons each). Japan would produce 200 million cars (50 million workers times 4 cars each) and 250 million tons of grain (50 million workers times 5 tons each). Problem 10: The United States exports corn and aircraft to the rest of the world, and it imports oil and clothing from the rest of the world. Do you think this pattern of trade is consistent with the principle of comparative advantage? Why or why not? This pattern of trade is consistent with the principle of comparative advantage. If the United

States exports corn and aircraft, it must have a comparative advantage in the production of these goods. Because it imports oil and clothing, the United States must have a comparative disadvantage in the production of these items....