modern principles of economics third edition chapter 2 the power of trade and comparative advantage

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MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

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Page 1: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

MODERN PRINCIPLES OF ECONOMICSThird EditionChapter 2

The Power of Trade and Comparative Advantage

Page 2: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Outline

Trade and Preferences Specialization, Productivity, and the

Division of Knowledge Comparative Advantage Trade and Globalization

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Page 3: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

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Discussion Question

Think of the last time you bought or sold something. Why did you make the trade?

Answer: You probably traded because you preferred what you got over what you gave up. For example, if you bought a candy bar for $1, you probably preferred the candy bar to having $1 in your pocket.

Page 4: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Trade and Preferences

Selling a broken laser pointer on EBay (1995)

Offered at $1 and sold for $14.83 to a collector of broken laser points

One man’s junk is another man’s treasure

eBay profits by making buyers and sellers happy

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Page 5: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Tyler Cowen and Alex TabarrokModern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition

Copyright © 2015 by Worth Publishers

Page 6: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Introduction

Benefits of Trade

1. Trade makes people better off when preferences differ.

2. Trade increases productivity through specialization and the division of knowledge.

3. Trade increases productivity through comparative advantage.

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Page 7: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Trade and Preferences

Trade Creates Value

Trade moves goods from people who value them less to people who value them more.

Trade makes people with different preferences better off.

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Page 8: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Specialization

Trade Allows Specialization

With no trade, there is no specialization. People will specialize in the production of a

single good only when they can trade for other goods.

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Page 9: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Specialization

Increased Productivity

We can produce more through trade than by individual production. • People who specialize have more

knowledge about their field. • Because they sell large quantities, people

who specialize can take advantage of large-scale equipment.

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Page 10: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Specialization

Division of Knowledge

Without specialization, each person produces their own food, clothing, and so on. • Each person has the same knowledge as

everybody else. • The combined knowledge of a society is

not much more than that of a single person.

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Page 11: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Tyler Cowen and Alex TabarrokModern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition

Copyright © 2015 by Worth Publishers

Page 12: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Specialization

Division of Knowledge

With specialization, much more knowledge is used than could exist in a single brain.

Knowledge increases productivity so specialization increases total output.

Every increase in world trade is an opportunity to increase the division of knowledge.

When everyone knows something different, the combined brain power of society is huge

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Page 13: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Tyler Cowen and Alex TabarrokModern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition

Copyright © 2015 by Worth Publishers

Reducing Trade Barriers, Berlin 1989

Page 14: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

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Self-Check

One of the benefits of specialization is:

a. Less pollution.

b. More equality.

c. Increased productivity.

Answer: c – increased productivity.

Page 15: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Definition

Production Possibilities Frontier:

Shows all the combinations of goods that a country can produce given its productivity and supply of inputs.

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Page 16: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Tyler Cowen and Alex TabarrokModern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition

Copyright © 2015 by Worth Publishers

Production Possibilities Frontier

PPF is a very simplified and abstract model representing production and trade

PPF exists for a given country at a given point in time

PPF can be used to demonstrate:• Scarcity• Tradeoffs (opportunity costs)• Efficiency (unemployment of resources)• Economic growth

Page 17: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Tyler Cowen and Alex TabarrokModern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition

Copyright © 2015 by Worth Publishers

Production Possibilities Frontier

Assume that we have a two-country, two-good economic model

The table shows the labor (resource) required to produce each good for each economy

The PPF

Page 18: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Tyler Cowen and Alex TabarrokModern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition

Copyright © 2015 by Worth Publishers

Production Possibilities Frontier

The PPF for each economy based on the output table

Assuming that each economy has 24 units of labor as a resource, the PPF shows all the possible combinations of production for each country

The midpoint on each PPF represents equal division of labor between the two products (no trade occurring)

Page 19: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

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Production – Resource Inputs

Units of Labor

Country Computers Shirts

Mexico 12 2

U.S. 1 1

The U.S. can produce both computers and shirts at lower cost (less labor).

The U.S. has an absolute advantage in the production of both goods.

Page 20: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Definition

Absolute advantage:

The ability to produce the same good using fewer inputs than another producer.

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Page 21: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Tyler Cowen and Alex TabarrokModern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition

Copyright © 2015 by Worth Publishers

Production Possibilities Frontier

Page 22: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Tyler Cowen and Alex TabarrokModern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition

Copyright © 2015 by Worth Publishers

Martha Stewart: Writing Books vs Ironing

Page 23: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Comparative Advantage

Absolute and Comparative Advantage

Another reason to trade is to take advantage of differences.

Countries have different climates, levels of human capital, and so on.

Different countries are therefore suited to produce different goods.

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Page 24: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Definition

Comparative advantage:

Producing goods at the lowest opportunity cost.

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Page 25: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Opportunity Costs and the PPF

PPF illustrates the trade-offs or opportunity costs of producing more of one good by giving up the production of the other good.

i.e. What is the cost of changing the mix of production for a given country?

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Page 26: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

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Comparative Advantage

Units of Labor

Country Computers Shirts

Mexico 12 2

U.S. 1 1

Assuming each country has 24 units of labor:

Production Possibilities

Country Computers Shirts

Mexico 2 12

U.S. 24 24

OROR

Page 27: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

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Comparative Advantage

Units of Labor

Country Computers Shirts

Mexico 12 2

U.S. 1 1

Production Possibilities

Country Computers Shirts

Mexico 2 12

U.S. 24 24

Page 28: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Production Possibilities

Country Computers Shirts

Mexico 2 12

U.S. 24 24

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Comparative Advantage

With no trade, each country will produce some of each good.

The opportunity cost of a good is the amount of the other good that is given up.

Page 29: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Production Possibilities

Country Computers Shirts

Mexico 2 12

U.S. 24 24

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Comparative Advantage

In Mexico, 1 computer will cost 6 shirts, while 1 shirt will cost 1/6 of a computer.

In the U.S., 1 computer will cost 1 shirt, and 1 shirt will cost 1 computer.

Page 30: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

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Comparative Advantage

Opportunity Cost

Country 1 Computer 1 Shirt

Mexico 6 shirts 1/6 computer

U.S. 1 shirt 1 computer

Mexico has a comparative advantage (lowest opportunity cost) in shirts.

U.S. has a comparative advantage (lowest opportunity cost) in computers.

Page 31: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

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Self-Check

If country A is able to produce furniture at a lower cost than country B, we would say that country A has a(n):

a. Absolute advantage.

b. Comparative advantage.

c. No advantage.

Answer: a – absolute advantage means producing a good with fewer inputs (lower cost).

Page 32: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Comparative Advantage

Absolute and Comparative Advantage

To benefit from trade, a country doesn’t need to have an absolute advantage.

A country can benefit from trade if it has a comparative advantage.

Comparative advantage can be illustrated with a production possibilities frontier.

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Page 33: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

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Trade Increases Productivity

If each country produces some of each good and only consumes what it produces:

Production Possibilities (no trade)

Country Computers Shirts

Mexico 1 6

U.S. 12 12

TOTAL: 13 18

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Trade Increases Productivity

If each country specializes and trades, there is more of everything:

Production Possibilities (before trade)

Country Computers Shirts

Mexico 0 12

U.S. 14 10

TOTAL: 14 22

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Trade Increases Productivity

If each country specializes and trades, there is more of everything (Mexico is giving 3 shirts for 1 computer):

Production Possibilities (after trade)

Country Computers Shirts

Mexico 1 9

U.S. 13 13

TOTAL: 14 22

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Trade Increases Productivity

Page 37: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Comparative Advantage

Comparative Advantage and Wages

Differences in wages reflect differences in productivity.

Wages will be higher in high-productivity countries than in low-productivity countries.

Trade raises wages to the highest levels allowed by a country’s productivity.

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Page 38: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Trade and Globalization

Globalization and Wages

Wages will rise in high-demand industries and fall in low-demand industries.

Workers will move from low-wage industries to high-wage industries until wages equalize.

The transition isn’t always quick or easy.

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Page 39: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Trade and Globalization

More on Globalization and Wages • While trade will improve worker’s standard

of living, domestic wages are determined by labor productivity

• Simply increasing wages by government dictate will not make workers better off unless there is, somehow, an increase in productivity and output,

• i.e. raising wages will likely result in inflation

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Page 40: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Trade and Globalization

“Tariffs and import quotas usually reduce the general welfare of a society.” % of American Economics Association members

Agree 92% Disagree 6%

“The U.S. should eliminate remaining tariffs and other barriers to trade.” % of AEA members

Agree 88% Disagree 8%

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Page 41: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Example 1

Erin has a choice between two activities: She can repair one transmission per hour or she can repair two fuel injectors per hour. What is the opportunity cost of repairing one fuel injector?

a) 1 transmission

b) ½ transmission

c) 2 transmissions

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Page 42: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Example 2

Deirdre has a choice between writing one more book this year or five more articles this year. What is the opportunity cost of writing half of a book this year, in terms of articles?

a) 1/5 article

b) 1 article

c) 2.5 articles

d) 10 articles

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Page 43: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Example 3

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Which country has the absolute advantage in producing high-quality cars? Low-quality cars?

a) North has absolute advantage in both

b) South has absolute advantage in both

c) North: high-quality, South: low-quality

d) South: high-quality, North: low-quality

Page 44: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Example 4

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What is the opportunity cost of each high-quality car (HQ) in the South?

a) ½ of a low-quality (LQ) car

b) 1 LQ car

c) 2 LQ cars

d) 1.5 LQ cars

Page 45: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

Example 5

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What is the opportunity cost of each high-quality car (HQ) in the NORTH?

a) ½ of a low-quality (LQ) car

b) 1 LQ car

c) 2 LQ cars

d) 1.5 LQ cars

Page 46: MODERN PRINCIPLES OF ECONOMICS Third Edition Chapter 2 The Power of Trade and Comparative Advantage

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Takeaway

Trade makes people better off when preferences differ.

With specialization and trade, the total sum of knowledge used in an economy increases tremendously.

A country can increase its standard of living by specializing in what it can make at low (opportunity) cost and trading.

"When goods don't cross borders, armies will.“ - attributed incorrectly to Frederic Bastiat, but it sounds a lot like Bastiat