Macro

Ch3: Interdependence and the Gains from Trade

Interdependence
• “Trade can make everyone better off”
–One of the Ten Principles from Chapter 1
–We now learn why people – and nations – choose to be
interdependent
–And how they can gain from trade

Example:
• Two countries: – The U.S. and Japan
• Two goods: – Computers and wheat
• One resource: – Labor, measured in hours
• 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
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
• Comparison
→ Consumption without trade vs. consumption with trade
→ We need to see how much of each good is produced and
traded by the two countries

Exports and Imports

• Imports –Goods produced abroad and sold domestically
• Exports –Goods produced domestically and sold abroad
Where Do These Gains Come From?
• Absolute advantage:
–The ability to produce a good using fewer inputs than another
producer
–The U.S. has absolute advantage in wheat
• Producing a ton of wheat uses 10 labor hours in the U.S. vs. 25
in Japan
–The U.S. has 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?
• Two countries can gain from trade
–When each specializes in the good it produces at lowest cost

Two Measures of the Cost of a Good

• Absolute advantage
– Measures the cost of a good in terms of the inputs required to
produce it
• Another measure of cost: opportunity cost
–The opportunity cost of a computer = amount of wheat that could
be produced using the labor needed to produce one computer
Comparative Advantage
• Comparative advantage
–The ability to produce a good at a lower opportunity cost than
another producer
• Principle of comparative advantage
–Each good should be produced by the individual that has the
smaller opportunity cost of producing that good.
Specialize according to comparative advantage
• The opportunity cost of a computer is
– 10 tons of wheat in the U.S.:
• Producing one computer requires 100 labor hours, which
instead could produce 10 tons of wheat
– 5 tons of wheat in Japan:
• Producing one computer requires 125 labor hours, which
instead could produce 5 tons of wheat. Japan has comparative
advantage in computers

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
–All countries can gain from trade
Summary 4. Which goods will a nation typically import?
• Interdependence and trade are desirable d. those goods in which other nations have a comparative advantage
– Allow everyone to enjoy a greater quantity and variety of goods 5. Suppose that in the United States, producing an aircraft takes
and services 10,000 hours of labor and producing a shirt takes 2 hours of labor. In
• Comparative advantage: being able to produce a good at a lower China, producing an aircraft takes 40,000 hours of labor and
opportunity cost producing a shirt takes 4 hours of labor. What will these nations
• Absolute advantage: being able to produce a good with fewer trade?
inputs b. China will export shirts, and the United States will export aircraft.
• The gains from trade are based on comparative advantage, not 6. Kayla can cook dinner in 30 minutes and wash the laundry in 20
absolute advantage minutes. Her roommate takes half as long to do each task. How
• Trade makes everyone better off should the roommates allocate the work?
– It allows people to specialize in those activities in which they have d. There are no gains from trade in this situation.
a comparative advantage
• The principle of comparative advantage applies to countries as
well as to people
• Economists use the principle of comparative advantage to
advocate free trade among countries

absolute advantage: the ability to produce a good using fewer

inputs than another producer
opportunity cost: whatever must be given up to obtain some item
comparative advantage: the ability to produce a good at a lower
opportunity cost than another producer
*Absolute Advantage: Focuses on who can produce more with the
same resources. It’s about total productivity.
*Comparative Advantage: Focuses on who can produce at a lower
opportunity cost. It’s about relative efficiency.
imports goods: produced abroad and sold domestically exports
goods: produced domestically and sold abroad
*Each person consumes goods and services produced by many other
people both in the United States and around the world.
Interdependence and trade are desirable because they allow
everyone to enjoy a greater quantity and variety of goods and
services.
*There are two ways to compare the ability of two people to
produce a good. The person who can produce the good with the
smaller quantity of inputs is said to have an absolute advantage in
producing the good. The person who has the smaller opportunity
cost of producing the good is said to have a comparative advantage.
The gains from trade are based on comparative advantage, not
absolute advantage
*Trade makes everyone better off because it allows people to
specialize in those activities in which they have a comparative
advantage.
*The principle of comparative advantage applies to countries as well
as to people. Economists use the principle of comparative advantage
to advocate free trade among countries.
1. In an hour, Mateo can wash 2 cars or mow 1 lawn, and Tyler can
wash 3 cars or mow 1 lawn. Who has the absolute advantage in car
washing, and who has the absolute advantage in lawn mowing?
d. Tyler in washing, neither in mowing.
2. Once again, in an hour, Mateo can wash 2 cars or mow 1 lawn,
and Tyler can wash 3 cars or mow 1 lawn. Who has the comparative
advantage in car washing, and who has the comparative advantage
in lawn mowing?
b. Tyler in washing, Mateo in mowing.
3. When two individuals produce efficiently and then make a
mutually beneficial trade based on comparative advantage,
a. they both obtain consumption outside their production
possibilities frontier
 • The roommate takes half as long to do each task, indicating they
1. Absolute Advantage have an absolute advantage in both tasks. To determine
• Absolute advantage is determined by who can produce more of a comparative advantage:
good with the same resources. o Kayla:
• Car Washing: Mateo can wash 2 cars per hour, Tyler can wash 3 cars ▪ 1 dinner = 1.5 laundry (30 minutes for dinner vs 20 minutes for
per hour. Thus, Tyler has the absolute advantage in car washing. laundry)
• Lawn Mowing: Mateo can mow 1 lawn per hour, Tyler can mow 1 o Roommate:
lawn per hour. Since they can mow the same number of lawns, ▪ 1 dinner = 1.5 laundry (15 minutes for dinner vs 10 minutes for
neither has an absolute advantage in lawn mowing. laundry)
Answer: d. Tyler in washing, neither in mowing. • Since the ratios are identical, there are no gains from specialization
2. Comparative Advantage and trade.
• Comparative advantage is determined by who has the lower Answer: d. There are no gains from trade in this situation.
opportunity cost for a task.
• Mateo's Opportunity Cost:
o 1 lawn = 2 cars (since in 1 hour he can either wash 2 cars or mow 1
lawn)
o 1 car = 0.5 lawn
• Tyler's Opportunity Cost:
o 1 lawn = 3 cars (since in 1 hour he can either wash 3 cars or mow 1
lawn)
o 1 car = 1/3 lawn
• Mateo has a lower opportunity cost for mowing lawns (1 lawn = 2
cars for Mateo vs 1 lawn = 3 cars for Tyler). Thus, Mateo has the
comparative advantage in lawn mowing.
• Tyler has a lower opportunity cost for washing cars (1 car = 1/3 lawn
for Tyler vs 1 car = 0.5 lawn for Mateo). Thus, Tyler has the
comparative advantage in car washing.
Answer: b. Tyler in washing, Mateo in mowing.
3. Mutually Beneficial Trade
• When two individuals trade based on comparative advantage, they
can both achieve consumption outside their individual production
possibilities frontiers because they are specializing and trading
efficiently.
Answer: a. they both obtain consumption outside their production
possibilities frontier.
4. Importing Goods
• A nation typically imports goods in which other nations have a
comparative advantage because it allows for trade that benefits
both nations.
Answer: d. those goods in which other nations have a comparative
advantage.
5. Trade between Nations
• United States:
o Aircraft: 10,000 hours
o Shirts: 2 hours
o Opportunity cost of 1 aircraft = 10,000 / 2 = 5,000 shirts
• China:
o Aircraft: 40,000 hours
o Shirts: 4 hours
o Opportunity cost of 1 aircraft = 40,000 / 4 = 10,000 shirts
• The United States has a comparative advantage in aircraft (lower
opportunity cost in aircraft production), and China has a
comparative advantage in shirts (lower opportunity cost in shirt
production).
Answer: b. China will export shirts, and the United States will export
aircraft.
6. Allocating Work between Roommates
• Kayla:
o Dinner: 30 minutes
o Laundry: 20 minutes
• Roommate:
o Dinner: 15 minutes
o Laundry: 10 minutes