Perspectives in Economics
Lecture 6
3
Interdependence and the
Gains from Trade
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N. Gregory Mankiw
E
conomics
Essentials of
Sixth Edition
In 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?
Interdependence
Every day
you rely on
many people
from around
the world,
most of whom
you’ve never met,
to provide you
with the goods
and services
you enjoy.
coffee from
Kenya
dress shirt
from China
cell phone
from Taiwan
hair gel from
Cleveland, OH
Interdependence
One of the Ten Principles from Chapter 1:
Trade can make everyone better off.
We now learn why people—and nations—
choose to be interdependent,
Our Example
Two countries: the U.S. and Japan
Two goods: computers and wheat
One resource: labor, measured in hours
We will look at how much of both goods
each country produces and consumes
if the country chooses to be self-sufficient
if it trades with the other country
Production 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.
4,000
100
5,000
2,000
1,000
3,000
500
200 300 400
0
Computers
Wheat
(tons)
The U.S. PPF
The U.S. has enough labor
to produce 500 computers,
or 5000 tons of wheat,
or any combination along
the PPF.
4,000
100
5,000
2,000
1,000
3,000
500
200 300 400
0
Computers
Wheat
(tons)
The U.S. Without Trade
Suppose the U.S. uses half its labor
to produce each of the two goods.
Then it will produce and consume
250 computers and
A C T I V E L E A R N I N G
1
Derive Japan’s PPF
Use the following information to draw Japan’s 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.
Computers
Wheat
(tons)
2,000
1,000
0
Japan’s PPF
Japan has enough labor to
produce 240 computers,
or 1200 tons of wheat,
or any combination
Japan Without Trade
Computers
Wheat
(tons)
2,000
1,000
200
0
100
300
Suppose Japan uses half its labor to
produce each good.
Then it will produce and consume
120 computers and
600 tons of wheat.
Consumption With and Without Trade
Without trade,
U.S. consumers get 250 computers
and 2500 tons wheat.
Japanese consumers get 120 computers
and 600 tons wheat.
We will compare consumption without trade to
consumption with trade.
First, we need to see how much of each good is
A C T I V E L E A R N I N G
2
Production under trade
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 Japan’s PPF.
4,000
100
5,000
2,000
1,000
3,000
500
200 300 400
0
Computers
Wheat
(tons)
U.S. Production With Trade
Producing 3400 tons of wheat
requires 34,000 labor hours.
The remaining 16,000
labor hours are used to
produce 160 computers.
Japan’s Production With Trade
Producing 240 computers
requires all of Japan’s 30,000
labor hours.
Computers
Wheat
(tons)
2,000
1,000
200
0
100
300
So, Japan would produce
0 tons of wheat.
Exports & Imports
Exports
:
goods produced domestically and sold abroad
To export
means to sell domestically produced
goods abroad.
Imports
:
goods produced abroad and sold domestically
To import
means to purchase goods produced
in other countries.
A C T I V E L E A R N I N G
3
Consumption under trade
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.)
How 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 Japan’s PPF.
4,000
100
5,000
2,000
1,000
3,000
500
200 300 400
0
Computers
Wheat
(tons)
U.S. Consumption With Trade
2700
270
= amount
consumed
0
110
+ imported
700
0
– exported
3400
160
produced
wheat
computers
Japan’s Consumption With Trade
Computers
Wheat
(tons)
2,000
1,000
200
0
100
300
700
130
= amount
consumed
700
0
+ imported
0
110
– exported
0
240
produced
wheat
computers
Trade Makes Both Countries Better Off
200
2700
2500
wheat
20
270
250
computers
gains from
trade
consumption
with trade
consumption
without trade
U.S.
100
700
600
wheat
10
130
120
computers
gains from
trade
consumption
with trade
consumption
without trade
Japan
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21
Where 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.
Where 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?
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23
Two Measures of the Cost of a Good
Two 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
Opportunity Cost and
Comparative Advantage
Comparative 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 opportunity
cost of a computer in each country.
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25
Opportunity Cost and
Comparative Advantage
The opportunity cost of a computer is
10 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!
Comparative Advantage and Trade
Gains 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 world’s “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.
S U M M A R Y
•
Interdependence 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.
9
Application:
International Trade
PowerPoint
Premium
Slides by
Ron Cronovich
N. Gregory Mankiw
E
conomics
Essentials of
Sixth Edition
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
29
In this chapter,
look for the answers to these questions:
•
What determines how much of a good a country
will import or export?
•
Who benefits from trade? Who does trade
harm? Do the gains outweigh the losses?
•
If policymakers restrict imports, who benefits?
Who is harmed? Do the gains from restricting
imports outweigh the losses?
•
What are some common arguments for
restricting trade? Do they have merit?
Introduction
Recall from Chapter 3:
A country has a comparative advantage in a
good if it produces the good at lower opportunity
cost than other countries.
Countries can gain from trade if each exports the
goods in which it has a comparative advantage.
Now we apply the tools of welfare economics
to see where these gains come from and
The World Price and
Comparative Advantage
P
W
= the world price of a good,
the price that prevails in world markets
P
D
= domestic price without trade
If
P
D
<
P
W
,
country has comparative advantage in the good
under free trade, country exports the good
If
P
D
>
P
W
,
country does not have comparative advantage
The Small Economy Assumption
A small economy is a
price taker
in world markets:
Its actions have no effect on
P
W
.
Not always true
—
especially for the U.S.
—
but
simplifies the analysis without changing its lessons.
When a small economy engages in free trade,
P
W
is the only relevant price:
No seller would accept less than
P
W
, since
she could sell the good for
P
W
in world markets.
No buyer would pay more than
P
W
, since
A Country That Exports Soybeans
Without trade,
P
D
= $4
Q
= 500
P
W
= $6
Under free trade,
domestic
consumers
demand 300
domestic producers
supply 750
exports = 450
P
Q
D
S
$6
$4
500
300
Soybeans
exports
750
A Country That Exports Soybeans
Without trade,
CS = A + B
PS = C
Total surplus
= A + B + C
With trade,
CS = A
PS = B + C + D
Total surplus
= A + B + C + D
P
Q
D
S
$6
$4
Soybeans
exports
A
B
D
C
gains
from trade
total surplus
producer surplus
consumer surplus
direction of trade
rises
falls
rises
imports
P
D
>
P
W
rises
rises
falls
exports
P
D
<
P
W
Summary: The Welfare Effects of Trade
Whether a good is imported or exported,
trade creates winners and losers.
Other Benefits of International Trade
Consumers enjoy increased variety of goods.
Producers sell to a larger market, may achieve
lower costs by producing on a larger scale.
Competition from abroad may reduce market
power of domestic firms, which would increase
total welfare.
Trade enhances the flow of ideas, facilitates the
spread of technology around the world.
Then Why All the Opposition to Trade?
Recall one of the Ten Principles from Chapter 1:
Trade can make everyone better off.
The winners from trade could compensate the losers
and still be better off.
Yet, such compensation rarely occurs.
The losses are often highly concentrated among
a small group of people, who feel them acutely.
The gains are often spread thinly over many people,
who may not see how trade benefits them.
Hence, the losers have more incentive to organize
and lobby for restrictions on trade.
Tariff: An Example of a Trade Restriction
Tariff
: a tax on imports
Example: Cotton shirts
P
W
= $20
Tariff:
T
= $10/shirt
Consumers must pay $30 for an imported shirt.
So, domestic producers can charge $30 per shirt.
In general, the price facing domestic buyers &
$30
Analysis of a Tariff on Cotton Shirts
P
W
= $20
Free trade:
buyers demand 80
sellers supply 25
imports = 55
T
= $10/shirt
price rises to $30
buyers demand 70
sellers supply 40
imports = 30
P
Q
D
S
$20
25
Cotton shirts
40
70 80
imports
imports
$30
Analysis of a Tariff on Cotton Shirts
Free trade
CS = A + B + C
+ D + E + F
PS = G
Total surplus = A + B
+ C + D + E + F + G
Tariff
CS = A + B
PS = C + G
Revenue = E
Total surplus = A + B
+ C + E + G
P
Q
D
S
$20
25
Cotton shirts
40
A
B
D
E
G
F
C
70 80
deadweight
$30
Analysis of a Tariff on Cotton Shirts
D = deadweight loss
from the
overproduction
of shirts
F = deadweight loss
from the
under-consumption
of shirts
P
Q
D
S
$20
25
Cotton shirts
40
A
B
D
E
G
F
C
70 80
deadweight
Import Quotas:
Another Way to Restrict Trade
An
import quota
is a quantitative limit on imports
of a good.
Mostly has the same effects as a tariff:
Raises price, reduces quantity of imports.
Reduces buyers’ welfare.
Increases sellers’ welfare.
A tariff creates revenue for the govt. A quota
creates profits for the foreign producers of the
imported goods, who can sell them at higher price.
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43
Arguments for Restricting Trade
1. The jobs argument
Trade destroys jobs in industries that compete
with imports.
Economists’ response:
Look at the data to see whether rising imports
cause rising unemployment…
U.S. Imports & Unemployment,
Decade averages, 1961–2010
0%
2%
4%
6%
8%
10%
12%
14%
16%
-
-
-
-
-
Imports
(% of GDP)
Unemployment
(% of labor force)
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45
Arguments for Restricting Trade
1. The jobs argument
Trade destroys jobs in the industries that compete
against imports.
Economists’ response:
Total unemployment does not rise as imports rise,
because job losses from imports are offset by
job gains in export industries.
Even if
all
goods could be produced more cheaply
abroad, the country need only have a
comparative
advantage to have a viable export
industry and to gain from trade.
Arguments for Restricting Trade
2. The national security argument
An industry vital to national security should be
protected from foreign competition, to prevent
dependence on imports that could be disrupted
during wartime.
Economists’ response:
Fine, as long as we base policy on true security
needs.
But producers may exaggerate their own
importance to national security to obtain
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47
Arguments for Restricting Trade
3. The infant-industry argument
A new industry argues for temporary protection
until it is mature and can compete with foreign
firms.
Economists’ response:
Difficult for govt to determine which industries
will eventually be able to compete and whether
benefits of establishing these industries exceed
cost to consumers of restricting imports.
Besides, if a firm will be profitable in the long run,
it should be willing to incur temporary losses.
Arguments for Restricting Trade
4. The unfair-competition argument
Producers argue their competitors in another
country have an unfair advantage,
e.g. due to govt subsidies.
Economists’ response:
Great! Then we can import extra-cheap products
subsidized by the other country’s taxpayers.
The gains to our consumers will exceed the
losses to our producers.
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49
Arguments for Restricting Trade
5. The protection-as-bargaining-chip argument
Example: The U.S. can threaten to limit imports
of French wine unless France lifts their quotas
on American beef.
Economists’ response:
Suppose France refuses. Then the U.S. must
choose between two bad options:
A)
Restrict imports from France, which reduces
welfare in the U.S.
B)
Don’t restrict imports, which reduces U.S.
credibility.
Trade Agreements
A country can liberalize trade with
unilateral reductions in trade restrictions
multilateral agreements with other nations
Examples of trade agreements:
North American Free Trade Agreement
(NAFTA), 1993
General Agreement on Tariffs and Trade
(GATT), ongoing
World Trade Organization (WTO), est. 1995,
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