WEEK 1 - Chapter 3: Interdependance and the Gains from Trade Flashcards
What is gains from trade?
. A fundamental insight from economics.
. Individuals, firms, countries gain from voluntary exchange of goods and services
. Gains from interdependence
. Restriction to trade are welfare reducing
The baker doesn’t sell you bread out of the goodness and kindness of her heart. The baker sells bread to you to make profit, THE BAKER GAINS and YOU GAIN from buying it from the baker.
In economics, gains from trade are the net benefits to economic agents from being allowed an increase in voluntary trading with each other.
What is absolute advantage?
The ability to produce a good using fewer inputs than another producer.
Economists use the term absolute advantage when comparing the productivity of one person, firm or nation with that of another.
The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good.
In our example, time is the only input, so we can determine absolute advantage by looking at how much time each type of production takes. Leonard has an absolute advantage both in laundry and cooking, because he requires less time than Sheldon to produce a unit of either good.
Leonard needs only three hours to do a basket of laundry, whereas Sheldon needs four hours. Similarly, Leonard needs only half an hour to cook a meal whereas Sheldon needs two hours. Based on this information, we can conclude that Leonard has a lower cost of doing laundry and a lower cost of cooking, if we measure cost in terms of the quantity of inputs.
Opportunity cost and comparative advantage.
Rather than comparing inputs required, we can compare the opportunity costs.
Recall from chapter 1 that the opportunity cost of some item is what we give up to get that item.
In our example, we assumed that Sheldon and Leonard each spend 12 hours a week on household tasks. Time spent doing laundry, therefore, takes away from time available for cooking.
When reallocating time between the two goods, Leonard and Sheldon give up units of one good to produce units of the other good, moving along their production possibility frontiers.
The opportunity cost measures the trade-off between the two goods that each faces.
Opportunity cost and comparative advantage example.
Table 3.3 shows the opportunity cost of cooking and laundry for Sheldon and Leonard. Notice that the opportunity cost of cooking is the inverse of the opportunity cost of laundry.
Because one clean basket of laundry costs Leonard six meals, one meal costs Leonard one-sixth of a basket of laundry. Similarly, because doing one basket of laundry costs Sheldon two meals, one meal costs Sheldon half a basket of laundry.
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What is comparative advantage?
The ability to produce a good at a lower opportunity cost than another producer.
Economists use the term comparative advantage when describing the opportunity cost of two producers. The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good.
In our example, Sheldon has a lower opportunity cost of laundry than Leonard (two versus six meals). Leonard has a lower opportunity cost of cooking than Sheldon (1/6 rather than 1⁄2 of a basket). Thus, Sheldon has a comparative advantage in laundry, and Leonard has a comparative advantage in cooking.
Absolute and comparative advantage.
Although it is possible for one person to have an absolute advantage in both goods (as Leonard does in our example), it is impossible for the same person to have a comparative advantage in both goods.
This is because the opportunity cost of one good is the inverse of the opportunity cost of the other; if a person’s opportunity cost of one good is relatively high, his opportunity cost of the other good must be relatively low. Comparative advantage reflects the relative opportunity cost.
Unless two people have exactly the same opportunity cost, one person will have a comparative advantage in one good and the other person will have a comparative advantage in the other good.
What creates gains from trade?
Differences in opportunity cost and comparative advantage create the gains from trade.
When each person specialises in producing the good for which he or she has a comparative advantage, total production in the economy rises.
This increase in the size of the economic pie can be used to make everyone better off.
What does the principle of comparative advantage explain?
The principle of comparative advantage explains interdependence and the gains from trade.
Because interdependence is so prevalent in the modern world, the principle of comparative advantage has many applications.
Example: should roger federer mow his own lawn?
Roger can probably mow his lawn faster than anyone else. But just because he can mow his lawn fast, does this mean he should?
To answer this question, we can use the concepts of opportunity cost and comparative advantage.
Let’s say that Roger can mow his lawn in two hours. In that same two hours, he could film a television commercial for sports shoes and earn $1000000. In contrast, Becky, the girl next door, can mow Roger’s lawn in four hours. In that same four hours, she could work at Coles supermarket and earn $40.
In this example, Roger’s opportunity cost of mowing the lawn is $1000000, and Becky’s opportunity cost is $40. Roger has an absolute advantage in mowing lawns because he can do the work in less time. Yet Becky has a comparative advantage in mowing lawns because she has the lower opportunity cost.
The gains from trade in this example are tremendous. Rather than mowing his own lawn, Roger should make the commercial and hire Becky to mow the lawn. As long as he pays her more than $40 and less than $1 000 000, both of them are better off.
Should a country trade with other countries?
Just as individuals can benefit from specialisation and trade with one another, so can populations of people in different countries.
Many of the goods that Australians enjoy are produced abroad and many of the goods produced in Australia are sold abroad.
To see how countries can benefit from trade, suppose there are two countries, Australia and Japan, and two goods, food and cars. Imagine that the two countries produce cars equally well – an Australian worker and a Japanese worker can each produce one car per month. In contrast, because Australia has more and better land, it is better at producing food – an Australian worker can produce two tonnes of food per month, whereas a Japanese worker can produce only one tonne of food per month.
The principle of comparative advantage states that each good should be produced by the country that has the smaller opportunity cost of producing that good. Because the opportunity cost of a car is two tonnes of food in Australia but only one tonne of food in Japan, Japan has a comparative advantage in producing cars. Japan should produce more cars than it wants for its own use and export some of them to Australia.
Similarly, because the opportunity cost of a tonne of food is one car in Japan but only half a car in Australia, Australia has a comparative advantage in producing food. Australia should produce more food than it wants to consume and export some of it to Japan.
Through specialisation and trade, both countries can have more food and more cars.
Trade allows all countries to achieve greater prosperity.
What are imports?
Goods and services that are produced abroad and sold domestically.
What are exports?
Goods and services that are produced domestically and sold abroad.
What is the invisible hand?
People are motivated by rational self interest.
Prices reflect scarcity of supply relative to intensity of consumers’ demand.
Definition - the unobservable market force that helps the Demand and supply of goods in a free market to reach equilibrium automatically is the invisible hand.
Phrase was introduced by Adam Smith. The
Two sides of rational self-interest.
Exchange theory (covered in MAE101)
. Gains from production and trade
- investment, exchange, ingenuity and industry
- more in textbook
Conflict theory (covered elsewhere, but a little in MAE101)
. Gains from conflict
- war, litigation, strikes, crime, rent-seeking and politics
Chase theorem.
“Opportunity to cooperate by means of mutually advantageous exchange”
