Econ 102, Mankiw,Chapter 3, Interdependence and Gains from Trade (1).doc

Econ 102, Introduction to Microeconomics, Instructor: J. A. FreemanChapter 3, Interdependence and Gains From Trade I.A Parable of Modern Economy Voluntary trade (exchange) results in gains (or no losses) to all parties involved. See the Farmer and Rancher example in text. The distribution of the gains from trade can be unequal because it depends on the parties bargaining powerB.Comparative Advantage: The Driving Force of Specialization. Application of Comparative Advantage: International Trade Exchanges (Trade) among nations can benefit all nations involved. The distribution of the benefits from international trade may be unequal because it depends on nations supply conditions (technology, resource base, knowledge base, types of products, etc.) and demand conditions (income level, taste and preference, culture, etc) Although a nation as a whole gains from international trade, certain industries and workers within a nation may experience a decline in earnings and employment. Thus, international trade can affect the distribution of earnings and employment within a nation Most international trades are multilateral trade (trade among several nations) rather than bilateral trade (trade between two nations) It is therefore misleading to focus on trade imbalances between the U.S. and any particular nation (e.g., Japan or China). It is also misleading to focus on the imbalances in goods and services trade (the product market) between the U.S. and the rest of the world, without analyzing the effects of international trade on capital flows between the U.S. and the rest of the world (capital markets). ExamplesII.Comparative Advantage: A Basis of Trade (Background Material)Gains from Specialization and TradeA. Theories of Trade1.Mercantilism (17th and 18th) Belief that the quantity of precious metals (e.g., gold, silver etc.) determines a nations wealth. The goal of trading is to accumulate precious metals by restricting imports and encouraging exports. Trading is a zero-sum game. When someone gains, someone loses. Criticism of the Mercantilist Trade theory: Productive resources and the total output determines a nations wealth An accumulation of precious metals can lead to higher prices (inflation) since precious metals were also used as money. Trade is a positive sum gain. All parties can benefit from trade.2.Adam Smiths (1723-1790) Absolute AdvantageAdam Smiths brief biography Born in Kicarldy, Scotland, 1723. Education: M.A. University of Glasgow, 1740; Independent study at Oxford, Edinburgh and later at Kicarldy, Scotland. Jobs: Professor, University of Glasgow, Tutor for a Duke, and Commissioner of Customs. Publications: Theory of Moral Sentiments, 1759 An Inquiry into the Nature and Causes of the Wealth of Nations, 1776Adam Smiths Absolute Advantage trade Theory Gains from trade can occur if nations (individuals) specialize in the production of goods in which they have absolute advantage (i.e. they can produce more units than other nations or individuals).3.David Ricardos (1772-1823) Comparative AdvantageRicardos brief biography Born in London, 1772. Education: Never attended College. Got interested in economics after reading Smiths Wealth of Nations Jobs: Stockbroker, 1786-1815; Member of Parliament, 1819-1823 Major Publication: On the Principles of Political Economy and Taxation, 1817. Ricardos comparative advantage trade theory improved upon Smiths Absolute advantage to show that gains from trade can occur even if a nation (individual) has absolute advantage in the production of two (or more) products. Gains from specialization and trade can be realized if comparative advantage exists. A nation (or an individual) has comparative advantage in the production of a good if that good can be produced at lower opportunity cost (in terms of other goods).III. Absolute Advantage, Opportunity Cost and Principle of Comparative AdvantageA.Economists use the Production Possibilities Frontier (PPF) to illustrate the problem of scarcity and choice, and the gains from specialization and trade. The PPF shows the maximum combination of products that can be produced by a nation (region or individual) when it uses all of its resources and available technology efficiently The slope of the PPF measures the opportunity cost to a nation (region or individual) of producing one more unit of a product. That is, it measures the rate at which one product is given up to produce one more unit of the other product. The Principle of comparative advantage states that total output of a group of individuals, regions and nations will be greatest when individuals (nations) produce the products in which they have the lowest (smallest) opportunity cost of production The comparative advantage principle of trade implies that nations, regions, individuals will be better off if they produce products in which they have lower opportunity cost, and trade these products at a mutually acceptable rate with others for products in which they have higher opportunity cost. Example: See Exercise at the end of the notes. B.Comparative Advantage and Specialization Specialization increases productivity through division of labor, learning, and innovation Specialization is limited by the size of the market, and can lead to increased interdependence and boredom as well as decreased worker motivation and creativityC.Determinants of Comparative Advantage and TradeSupply Factors Determinants Natural EndowmentsAvailability of Productive resources Acquired EndowmentsInvestment in Capital base through savings Superior KnowledgeInvestments in training and educations (human capital), technology and researchDemand Factors Determinants Preferences and tastes, income levels, and cultural or social valuesD. Trade Among Nations The preceding exercise is a simplified version of trade among nations because it assumes a constant opportunity costs or a linear Production Possibilities Curves. As illustrated in Chapter 2, Production Possibilities Frontiers have increasing opportunity costs because a nations resources are not equally productive in the production of all goods. The benefits of trade based on comparative advantage still holds when one assume an increasing opportunity cost (i.e., concave PPF), although one would need to use additional tools (calculus) to demonstrate these benefits. Below are some of the modifications to the gains from trade based on comparative advantage when nations have increasing opportunity costs. Modifications Increasing Opportunity Costs or Concave Production Possibilities Frontier result in incomplete specialization. Each Nation will specialize more in the production and trade of products in which it has comparative advantage, but will not completely specialize. The Pre-trade Opportunity Cost (the point of the Production Possibilities Frontier before trade) depends on both supply factors (Natural resources, Capital, knowledge and technology, Education and training) and demand Factors (Income Levels, Preferences and Tastes) Thus, a nation like the U.S. may have an abundance of natural resources, capital, technology, and highly skilled labor force and still have a higher pre-trade opportunity cost of producing certain skilled-intensive or high tech products if U.S. residents have a higher demand for these products. That is, the U.S. can be at the steeper slope (higher opportunity) portion of its production possibilities curve before trade.Econ 102. Instructor: J. A. Freeman. Class Exercise Date:Name:Signature:1.The table below shows the weekly production possibility frontiers of Wheat and Cars for the U.S. and Canada.Number of Cars produced in a WeekNumber of Tons of Wheat produced in a Week U.S.1000100,000Canada50060,000a. Draw the Production possibilities Frontiers for Canada and U.S. Let Cars be on the horizontal (X) axis and Wheat on the vertical (Y) axis). Assume that the pre-trade consumption and production point for the U.S. is 500 cars and 50,000 tons of wheat, while the pre-trade consumption and production point for Canada is 250 cars and 30,000 tons of wheat. Label these points on each countrys PPF as point A.b. What is the opportunity cost of car production (in terms in tons of wheat) fo