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By Katie Andrews,2014-10-31 18:09
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     INTERDEPENDENCE AND THE

     3 GAINS FROM TRADE

WHAT’S NEW:

Tables have been more clearly labeled to help students understand the material better. A new In

     box has been added on “Who Has a Comparative Advantage in Producing Lamb?” the News

LEARNING OBJECTIVES:

By the end of this chapter, students should understand:

; how everyone can benefit when people trade with one another.

; the meaning of absolute advantage and comparative advantage.

; how comparative advantage explains the gains from trade.

    ; how to apply the theory of comparative advantage to everyday life and national policy.

KEY POINTS:

    1. Each person consumes goods and services produced by many other people both in our

    country and around the world. Interdependence and trade are desirable because they allow

    everyone to enjoy a greater quantity and variety of goods.

    2. There are two ways to compare the ability of two people in producing a good. The person

    who can produce the goods with a smaller quantity of inputs is said to have an absolute

     in producing the good. The person who has the smaller opportunity cost of advantage

    producing the good is said to have a comparative advantage. The gains from trade are

    based on comparative advantage, not absolute advantage.

    3. Trade makes everyone better off because it allows people to specialize in those activities in

    which they have a comparative advantage.

    4. The principle of comparative advantage applies to countries as well as people. Economists

    use the principle of comparative advantage to advocate free trade among countries.

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    2 Chapter 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

    CHAPTER OUTLINE:

     Begin by explaining that there are two basic ways that people can satisfy their wants.

    The first is to be economically self-sufficient. The second is to specialize in the production of one thing and then trade with others. With rare exceptions, individuals and nations tend to rely on specialization and trade. One way to motivate this is to survey the students on their future plans (doctors, lawyers, teachers etc.) Point out that they plan to specialize and trade. Ask them why this is optimal.

    I. A Parable for the Modern Economy

A. Example: two goods meat and potatoes and two people a cattle rancher

    and a potato farmer (both of whom like to consume both potatoes and meat).

    This example will be better received if the rancher and the farmer have interesting names such as Farmer Tom and Rancher Jerry.

    1. The gains from trade are obvious if the farmer can only grow potatoes

    and the rancher can only raise cattle.

    2. The gains from trade are also fairly obvious if, instead, the farmer can

    raise cattle as well as grow potatoes, but he is not good at it and the

    rancher can grow potatoes in addition to raising cattle, but her land is

    not well suited for it.

    3. The gains from trade are not as clear if either the farmer or the rancher

    is better at producing both potatoes and meat.

B. Production Possibilities

    Make sure that you write out all of the algebra involved in this example. If you leave out steps, students will not know where the numbers came from.

    1. The farmer and rancher both work 40 hours per week and can use this

    time to grow potatoes, raise cattle, or both.

    2. Table 3-1 shows the amount of time each takes to produce 1 pound of

    either good:

     Hours Needed to Make 1 Amount Produced in 40

    Pound Hours

    Meat Potatoes Meat Potatoes

    Farmer 20 hours/lb. 10 hours/lb. 40/20 = 2 lbs. 40/40 = 4 lbs.

    Rancher 1 hour/lb. 8 hours/lb. 40/1 = 40 lbs. 40/8 = 5 lbs.

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     Chapter 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 3

     Table 3-1

    ALTERNATIVE CLASSROOM EXAMPLE:

    Martha and Stewart each spend 40 hours a week wallpapering and painting:

     Hours Needed to Do 1 Room Rooms Finished in 40 Hours

     Paint Wallpaper Paint Wallpaper

    Martha 2 hours/room 8 hours/room 40/2=20 rooms 40/8=5 rooms

    Stewart 4 hours/room 10 hours/room 40/4=10 rooms 40/10=4 rooms

    3. The production possibilities can also be graphed.

    a. These production possibilities frontiers are drawn linearly instead

    of being bowed out. This assumes that the farmer’s and the

    rancher’s technology for producing meat and potatoes allows

    them to switch between producing one good and the other at a

    constant rate.

    b. As we saw in Chapter 2, these production possibilities frontiers

    represent the principles of tradeoffs and opportunity costs.

    It is worthwhile to take the time to explain where the x- and y-intercepts come from.

    Point out that the farmer could produce 2 pounds of meat is all time is spent on meat

    or 4 pounds of potatoes if all time is spent on potatoes.

    4. We will assume that the two divide their time equally between raising

    cattle and growing potatoes.

     Figure 3-1 Meat Meat

    40

     Farmer Rancher

     B 2 20

     A 1

     2 4 Potatoes 2 5 Potatoes

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4 Chapter 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

    a. The farmer produces (and consumes) at point A - 2 pounds of

    potatoes and 1 pound of meat.

    b. The rancher produces (and consumes) at point B - 2? pounds of

    potatoes and 20 pounds of meat.

     You should emphasize that these production possibilities frontiers represent the

    consumption possibilities if there is no trade. farmer’s and the rancher’s

    C. Specialization and Trade

    1. Suppose the rancher suggests that the farmer specialize in the

    production of potatoes and then trade with the rancher for meat.

    a. The rancher will spend 24 hours a week producing meat (24

    pounds) and 16 hours a week growing potatoes (2 pounds).

    b. The farmer will spend 40 hours a week growing potatoes (4

    pounds).

    c. The rancher will trade 3 pounds of meat for a pound of potatoes.

    Students will ask where this “price” comes from. Be prepared to explain that you

    picked a value that would work.

     Figure 3-2

     Table 3-2

    Meat Meat Farmer Rancher 40

     A* 3 B* 21 B 2 20

    A 1

     2 3 4 3 5 Potatoes 2 Potatoes

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     Chapter 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 5

    2. End results:

    a. The rancher produces 24 pounds of meat and trades 3 leaving

    him with 21 pounds of meat. He also grows 2 pounds of

    potatoes and receives 1 pound in the trade, leaving him with 3

    pounds of potatoes.

    b. The farmer produces 4 pounds of potatoes and trades 1 leaving

    him with 3 pounds. He also receives 3 pounds of meat in the

    trade with the rancher.

    3. In both cases, they are able to consume quantities of potatoes and meat

    after the trade that they could not reach before the trade.

    II. The Principle of Comparative Advantage

A. Absolute Advantage

    1. Definition of Absolute Advantage: the comparison among

    producers of a good according to their productivity.

    2. The rancher has an absolute advantage in the production of both

    potatoes and meat.

B. Opportunity Cost and Comparative Advantage

    1. Definition of Opportunity Cost: whatever must be given up to

    obtain some item.

     Table 3-3

    a. For the rancher, the opportunity cost of producing a pound of

    potatoes is 8 pounds of meat (because it takes 8 hours to

    produce 1 pound of potatoes).

    b. For the farmer, the opportunity cost of producing 1 pound of

    potatoes is only ? pound of meat (because it takes 10 hours to

    produce 1 pound of potatoes).

    c. The opportunity cost of producing 1 pound of meat is the

    inverse of producing 1 pound of potatoes.

    Your students may have a hard time comprehending this. Make sure that you go through these calculations several times and write out every step on the board.

    2. Definition of Comparative Advantage: the comparison among

    producers of a good according to their opportunity cost.

    Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.

    6 Chapter 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

    a. The farmer has a lower opportunity cost of producing potatoes

    and therefore has a comparative advantage in the production of

    potatoes.

    b. The rancher has a lower opportunity cost of producing meat and

    therefore has a comparative advantage in the production of

    meat.

    3. Because the opportunity cost of producing one good is the inverse of the

    opportunity cost of producing the other, it is impossible for a person to

    have a comparative advantage in the production of both goods.

C. Comparative Advantage and Trade

    1. When specialization in a good occurs (assuming there is a comparative

    advantage), total output will grow.

    2. As long as the opportunity cost of producing the goods differs across the

    two individuals, both can gain from specialization and trade.

    a. The rancher buys a pound of potatoes for 3 pounds of meat.

    This is lower than the rancher’s opportunity cost of 8 pounds of

    meat and is therefore beneficial to the rancher.

    b. The farmer buys 3 pounds of meat with one pound of potatoes.

    This implies that the price of each pound of meat is 1/3 pound of

    potatoes, which is lower than the farmer’s opportunity cost of 2

    pounds of potatoes. Thus, trade also benefits the farmer.

FYI: The Legacy of Adam Smith and David Ricardo III.

    A. In Adam Smith’s 1776 book An Inquiry into the Nature and Causes of the Wealth

     he writes of the ability of producers to benefit through specialization of Nations,

    and trade.

B. 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.

    C. The benefits of free trade are one issue that is generally agreed upon by

    economists, and the theories and arguments developed by these two gentlemen

    200 years ago are still used today.

    IV. Applications of Comparative Advantage

A. Should Tiger Woods Mow His Own Lawn?

    1. Given Wood’s athleticism, it is entirely possible that he could mow his

    lawn faster than most men.

    2. This implies that he has an absolute advantage.

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     Chapter 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 7

    3. However, if the opportunity cost of his time is $10,000 (his pay to film a

    commercial for Nike), it is likely that someone else will have a

    comparative advantage in mowing his lawn.

    4. Both he and the person hired will be better off as long as he pays the

    individual more than the individual’s opportunity cost and less than

    $10,000.

B. Should the United States Trade with Other Countries?

    1. Just as individuals can benefit from specialization and trade, so can the

    populations of different countries.

    2. Definition of Imports: goods produced abroad and sold

    domestically.

    3. Definition of Exports: goods produced domestically and sold

    abroad.

    4. The principle of comparative advantage suggests that each good should

    be produced by the country with a comparative advantage in producing

    that good (smaller opportunity cost).

    5. Through specialization and trade, countries can have more of all goods

    to consume.

    In the News: Who Has a Comparative Advantage in Producing Lamb? C.

    1. A tariff is a tax on an imported product, used to lower the quantity of

    specific imports.

    2. This is an opinion column from The Wall Street Journal on the use of

    tariffs in the lamb industry.

    To help convince students that importing goods is not harmful to a country, ask the students to devise a way to produce coffee domestically. Point out that it is possible to grow coffee beans in the U.S. in enclosed nurseries, but the opportunity cost of

     the resources used would be significant.

     Discuss how differences in resource endowments can be significant factors in determining opportunity cost and comparative advantage. Such differences include climate, soil composition, education and training of the labor force, capital stock, and infrastructure.

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8 Chapter 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

    ADJUNCT TEACHING TIPS AND WARM-UP ACTIVITIES:

    1. When teaching this material for the first time, it is best to walk the students through point by

    point using the book. This is not a time when you want to rely on yourself without the book

    if you are not completely confident about the material. Better to use the book than to

    stumble through the presentation.

    2. Arrange students in groups of three or four to write a comparative advantage problem of

    their own. Tell them to make creative, humorous, yet plausible examples. For instance, one

    example might be Bert and Ernie from Sesame Street producing one meal and one clean

    house. Give the students ten minutes to work on creating their examples at the end of class.

    Instruct them to bring a neatly written copy for the next class. Let the students vote on

    which group has the best example and award a small prize to each of the group’s members

    (such as a candy bar). After the class, make all the examples available to the students as

    practice problems for the exam.

SOLUTIONS TO TEXT PROBLEMS:

Quick Quizzes

    1. Figure 3-1 shows a production possibilities frontier for Robinson Crusoe between

    gathering coconuts and catching fish. If Crusoe lives by himself, this frontier limits his

    consumption of coconuts and fish, but if he can trade with natives on the island he will

    be able to consume at a point outside his production possibilities frontier.

    Figure 3-1

    2. Crusoe’s opportunity cost of catching one fish is 10 coconuts, since he can gather 10

    coconuts in the same amount of time it takes to catch one fish. Friday’s opportunity cost

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     Chapter 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 9

    of catching one fish is 15 coconuts, since he can gather 30 coconuts in the same amount

    of time it takes to catch two fish. Friday has an absolute advantage in catching fish,

    since he can catch two per hour, while Crusoe can only catch one per hour. But Crusoe

    has a comparative advantage in catching fish, since his opportunity cost of catching a

    fish is less than Friday’s.

    3. If the world’s fastest typist happens to be trained in brain surgery, he should hire a

    secretary. He has an absolute advantage in typing, but a comparative advantage in

    brain surgery, since his opportunity cost in brain surgery is low compared to the

    opportunity cost for other people.

Questions for Review

    1. Absolute advantage reflects a comparison of the productivity of one person, firm, or

    nation to that of another, while comparative advantage is based on the relative

    opportunity costs of the persons, firms, or nations. While a person, firm, or nation may

    have an absolute advantage in producing every good, they can’t have a comparative

    advantage in every good.

    2. Many examples are possible. Suppose, for example, that Roger can prepare a fine meal

    of hot dogs and macaroni in just ten minutes, while it takes Anita twenty minutes. And

    Roger can do all the wash in three hours, while it takes Anita four hours. Roger has an

    absolute advantage in both cooking and doing the wash, but Anita has a comparative

    advantage in doing the wash (the wash takes the same amount of time as 12 meals,

    while it takes Roger 18 meals’ worth of time).

    3. Comparative advantage is more important for trade than absolute advantage. In the

    example in problem 2, Anita and Roger will complete their chores more quickly if Anita

    does at least some of the wash and Roger cooks the fine meals for both, because Anita

    has a comparative advantage in doing the wash, while Roger has a comparative

    advantage in cooking.

    4. A nation will export goods for which it has a comparative advantage because it has a

    smaller opportunity cost of producing those goods. As a result, citizens of all nations are

    able to consume quantities of goods that are outside their production possibilities

    frontiers.

    5. Economists oppose policies that restrict trade among nations because trade allows all

    countries to achieve greater prosperity by allowing them to receive the gains from

    comparative advantage. Restrictions on trade hurt all countries.

Problems and Applications

1. In the text example of the farmer and the rancher, the farmer’s opportunity cost of

    producing one pound of meat is two pounds of potatoes because for every 20 hours of

    work, he can produce one pound of meat or two pounds of potatoes. With limited time

    at his disposal, producing a pound of meat means he gives up the opportunity to

    produce two pounds of potatoes. Similarly, the rancher’s opportunity cost of producing

    one pound of meat is 1/8 pound of potatoes because for every hour of work, she can

    produce one pound of meat or 1/8 pound of potatoes. With limited time at her disposal,

    producing a pound of meat means she gives up the opportunity to produce 1/8 pound of

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    10 Chapter 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

    potatoes.

    2. a. See Figure 3-2. 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 time costs are constant, so the production

    possibilities frontier is a straight line.

    Figure 3-2

    b. 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.

    3. a.

     Workers needed to make:

     One Car One Ton of Grain

    U.S. 1/4 1/10

    Japan 1/4 1/5

    b. See Figure 3-3. With 100 million workers and four cars per worker, if either

    economy were devoted completely to cars, it could make 400 million cars. Since

    a U.S. worker can produce 10 tons of grain, if the U.S. produced only grain it

    would produce 1,000 million tons. Since 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 since the tradeoff between cars and grain is constant, the production

    possibilities frontier is a straight line.

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