Trade

(Chapter 8)

* ECN 104 - Fall 2024

October 24, 2024

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Outline

Announcements

Recap

The Production Possibilities Curve

The basis for trade: comparative advantage

Trade between states

Trade between countries

Arguments against free trade

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Announcements

- Mock midterm - questions?

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Recap

- Producer surplus

- From the short to the long-run

- Economies of scale, constant returns to scale, diseconomies of scale

- Long-run competitive equilibrium

- No barriers to entry/exit
- Horizontal long-run supply curve

- Perfect competition and the invisible hand

- Price guide the invisible hand
- Equity and efficiency

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Trade
Some questions you may ponder:
- Is trade good?
- Will free trade cause you to lose your job?
- Equity vs. efficiency

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Some early thoughts...

1. ”Trade” between countries is no different to ”trade” between individuals

2. Why don’t you make the clothes you wear? Farm the vegetables you eat?

Comparative advantage!

Trade = Exchange

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The Production Possibilities Curve
Exhibit 8.1 Your Production Schedule
Number of
Hours Spent Number of Web Hours Spent on
Computer
on Web Sites Sites Produced Computer Programs
Programs Produced
8 8 0 0
7 7 1 2
6 6 2 4
5 5 3 6
4 4 4 8
3 3 5 10
2 2 6 12
1 1 7 14
0 0 8 16

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Exhibit 8.1 Your Production Schedule

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Exhibit 8.1 Your Production Schedule

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Exhibit 8.1 Your Production Schedule

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Production possibilities curve
Shows the relationship between the maximum production of one good for a given level of
production of another good.

Also called production possibilities frontier.

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Exhibit 8.2 The Production Possibilities Curve

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 Exhibit 8.2 The Production Possibilities Curve

Point A is possible but would be an inefficient point of production

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 Exhibit 8.2 The Production Possibilities Curve

Point C is not possible given our productive capacity

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 Exhibit 8.2 The Production Possibilities Curve

Moving from point D to B; give up 4 programs, get 2 websites.

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The PPC divides the space into 3 parts:

1. Points B and D
- These two points (and all points on the PPC) represent levels of production of the goods
that efficiently use resources.

2. Point A
- This point (and all points below the PPC) represents a level of production of the goods
that can be achieved, but that is inefficient because it doesn’t use all resources.

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3. Point C
- This point (and all points above the PPC) represents a level of production of the goods
that cannot be achieved with the current level of resources.

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Two other things about the PPC:

1. Sign of slope
- Why is the PPC negative?

2. Size of slope
- What does the slope represent?
- What does one program ”cost” you?
- What does one Website ”cost” you?

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Exhibit 8.3 Two Production Possibilities Curves

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 Exhibit 8.3 Two Production Possibilities Curves

What if we find someone who has different strengths and trade with them?
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 Exhibit 8.3 Two Production Possibilities Curves

Your PPC: 16 programs, 8 websites

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 Exhibit 8.3 Two Production Possibilities Curves

Olivia’s PPC: 8 programs, 16 websites

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 Exhibit 8.3 Two Production Possibilities Curves

Olivia’s opportunity cost: Give up 8 programs; get 16 websites

1 program “costs” 2 websites 23 / 92
 Exhibit 8.3 Two Production Possibilities Curves

Olivia’s opportunity cost: Give up 16 websites; get 8 programs

1
1 website “costs” program
2
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Class exercise

Calculating opportunity cost

1. What does one program “cost” Olivia?

2. What does one Website “cost” Olivia?

3. What does one program “cost” You?

4. What does one Website “cost” You?

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Calculating opportunity cost
Q Loss
Opp cost =
Q Gain

Olivia’s opportunity cost

16 websites
Programs =
8 programs
8 programs 1
Websites = = program
16 websites 2

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Calculating opportunity cost
Q Loss
Opp cost =
Q Gain
Your opportunity cost
16 programs
Website =
8 websites
8 websites 1
Programs = = websites
16 programs 2

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Comparative advantage
The ability of one economic agent to produce at a lower opportunity cost than another.

- The key to determining who has a comparative advantage is to compare individual

opportunity costs.

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Opportunity costs for websites and programs

Website Opportunity Cost Computer Program Opportunity Cost

You 2 computer programs 1/2 websites
Olivia 1/2 computer program 2 websites

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 Website Opportunity Cost Computer Program Opportunity Cost
You 2 computer programs 1/2 websites
Olivia 1/2 computer program 2 websites

Person with lowest opportunity cost should produce.

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- You have a lower cost of producing programs.

- Olivia has a lower cost of producing websites.

- If you each specialize and trade, more output can be produced.

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Exhibit 8.4 The Gains from Specialization

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 Exhibit 8.4 The Gains from Specialization

Point T was not possible for either individual producer.

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 Exhibit 8.4 The Gains from Specialization

- A T, you produce 16 programs.

- Olivia produces 16 websites.
- Makes the PPC “bow out”
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Something to think about...

- What if you took a course on Website design and became better than Olivia at both
Website design and computer program production?

- Q: How would this change our opportunity cost for producing websites?

- Q: Would this also change our opportunity cost for producing programs?

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Exhibit 8.5 An Illustration of Absolute Advantage

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Absolute advantage
The ability of an economic agent to produce more output than another agent with the
same resources.

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 Website Opportunity Cost Computer Program Opportunity Cost
You 2/3 computer programs (0.67) 3/2 websites (1.5)
Olivia 1/2 computer programs (0.50) 2 websites (2.0)

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Q: What if Olivia offered to trade you 1 of her Websites for 1 of your programs? Would
you do it?

Website Opportunity Cost Computer Program Opportunity Cost

You 2/3 computer programs (0.67) 3/2 websites (1.5)
Olivia 1/2 computer programs (0.50) 2 websites (2.0)

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Q: What if Olivia offered to trade you 2 of her Websites for 1 of your programs? Would
you do it?

Website Opportunity Cost Computer Program Opportunity Cost

You 2/3 computer programs (0.67) 3/2 websites (1.5)
Olivia 1/2 computer programs (0.50) 2 websites (2.0)

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Q: What if you offered to trade Olivia 1 of your programs for 3 of her websites? Would she
do it?

Website Opportunity Cost Computer Program Opportunity Cost

You 2/3 computer programs (0.67) 3/2 websites (1.5)
Olivia 1/2 computer programs (0.50) 2 websites (2.0)

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Terms of trade
The ”price” of one good in terms of the other; the exchange rate between goods.

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- Your minimum price for a program = 3/2 websites

- Olivia’s maximum price for a program = 2 websites

- Therefore, the terms of trade will be between 3/2 and 2 :

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Trade between states

- Just as individuals gain from specialization and trade, so do states.

- Q: What are products that are specific to particular, or a few provinces? Countries?

- Q: What are some sources of comparative advantage among states?

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Export
A good produced domestically and shipped to another state or country.

Import
A good produced in another state or country but sold domestically.

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We saw the combined PPC below. What would it look like if we added up everyone’s PPC?

Exhibit 8.4 The Gains from Specialization

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Exhibit 8.7 A PPC with Increasing Opportunity Cost

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B - possible and efficient
A - possible but inefficient
C - impossible (in the short run)

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Exhibit 8.8 How Improved Technology Shifts the PPC

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 Exhibit 8.8 How Improved Technology Shifts the PPC

How
to Expand Production (PPC)?
+ more resources
+ higher quality resources
+ improvement in technology

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Who should produce what?

Apricots Opportunity Cost Bananas Opportunity Cost

California 1/5 bananas 5 apricots
Florida 8 bananas 1/8 apricots

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Who should produce what?

Apricots Opportunity Cost Bananas Opportunity Cost

California 1/5 bananas 5 apricots
Florida 8 bananas 1/8 apricots

Q: Who is the low cost producer? For bananas? For apricots?

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It costs California 1/5 of a banana to produce 1 apricot
It costs Florida 8 bananas to produce 1 apricot
= it’s cheaper for California to produce apricots

Apricots Opportunity Cost Bananas Opportunity Cost

California 1/5 bananas 5 apricots
Florida 8 bananas 1/8 apricots

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It costs California 5 apricots to produce 1 banana
It costs Florida 1/8 of an apricot to produce 1 banana
= it’s cheaper for Florida to produce bananas

Apricots Opportunity Cost Bananas Opportunity Cost

California 1/5 bananas 5 apricots
Florida 8 bananas 1/8 apricots

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- Florida’s minimum price for a banana = 1/8 apricot

- California’s maximum price to pay for a banana = 5 apricots

- Therefore, the terms of trade will be between 1/8 and 5:

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Trade between countries
Exhibit 8.9 U.S. Exports and Imports Since 1960

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Exhibit 8.10 U.S. Imports and Exports of Crude Oil Since 1960

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Exhibit 8.11 Changing Trading Patterns for Manufactured Goods, 1960-2018

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- Now imagine the market for tennis shoes in Denmark

- Assume free trade - trade with no government involvement - which leads to a world
price - on the world market.

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Exhibit 8.12 Equilibrium for Tennis Shoes in Denmark

Will Denmark
import or export tennis shoes?

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 Exhibit 8.13 Winners and Losers in an Exporting Nation

The answer? It depends on how the world price compares to the domestic price.
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 Exhibit 8.13 Winners and Losers in an Exporting Nation

When the world price is above the domestic price: Export

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 Exhibit 8.13 Winners and Losers in an Exporting Nation

Danish suppliers
would gain the areas B and C
Consumers would lose area B
Area
C is only available through trade

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What is happening in this example...

Danish consumers
Less product at a higher price.

Danish producers
More product at a higher price.

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 Exhibit 8.13 Winners and Losers in an Exporting Nation

Consumer surplus before trade: Area B + D

Consumers surplus after trade: Area D
Loss in consumer surplus: Area B

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 Exhibit 8.13 Winners and Losers in an Exporting Nation

Producer surplus before trade: Area A

Producer
surplus after trade: Areas A + B + C
Gain in producer surplus: Areas B + C

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 Exhibit 8.13 Winners and Losers in an Exporting Nation

Q: Who had Area C before trade?

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Summary of winners and losers

- Producers gain areas B + C

- Consumers lose Area B

- Net overall gain = Area C

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 Exhibit 8.14 Winners and Losers in an Importing Nation

When the world price is below the domestic price: Import

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 Exhibit 8.14 Winners and Losers in an Importing Nation

Suppose the world price is $25

Danish suppliers
would reduce supply at that price, BUT
Danish consumers
would buy more shoes at that price

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 Exhibit 8.14 Winners and Losers in an Importing Nation

Danish
consumers would gain the areas C and D
Producers would lose area C
Area D is only available through trade

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What is happening in this example...

Danish producers
Less product at a lower price

Danish consumers
More product at a lower price

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 Exhibit 8.14 Winners and Losers in an Importing Nation

Consumer surplus before trade: Area B

Consumer surplus after trade: Areas B + C + D
Gain in consumer surplus: Areas C + D

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 Exhibit 8.14 Winners and Losers in an Importing Nation

Producer surplus before trade: Areas C + A

Producer surplus after trade: Area A
Loss of consumer surplus: Area C

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 Exhibit 8.14 Winners and Losers in an Importing Nation

Q: Who had Area D before trade?

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Summary of winners and losers

- Consumers gain Areas C + D

- Producers lose Area C

- Net overall gain = Area D

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- In both cases - net exporter or net importer - Denmark is made better off through
trading.

- The specific winners and losers change, but overall well-being is increased.

- Winners could be required to compensate the losers.

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Why would a domestic price be different than the world price?

1. Natural resources

2. Stocks of human-made resources

3. Technology

4. Education, work habits, and experience of labour

5. Relative abundance of labour and physical capital

6. Climate

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Arguments against free trade

1. National security concerns

- Over-reliance on other countries for needed goods and services

2. Fear of the effects of globalization - shift toward interdependent economies - on a

nation’s culture
- Desire to protect culture from dilution or infringement of other values

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3. Environmental and resource concerns
- Countries vary by how stringent their environmental policies are. Free trade can lead to
greater pollution and resource depletion in those countries with lax standards because of
the increase in demand.

4. Infant industry arguments

- When industries are first getting started, they may need some government protection
from free trade until they get established.

5. Potential negative effects of local wages and jobs

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Protectionism
The view that governments should control trade due to the harmful effects of free trade.

Tariffs
- A tax added on to the price of an imported product
- One of the most popular forms of protectionism

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 Exhibit 8.15 The Effect of a Tariff

A tariff increases the market price of the product

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 Exhibit 8.15 The Effect of a Tariff

Consumer surplus before the tariff: Areas B + F + E + G + H + I + J

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 Exhibit 8.15 The Effect of a Tariff

Consumer surplus after the tariff: Areas B + F + H

Loss in consumer surplus: Areas E + G + I + J 86 / 92
 Exhibit 8.15 The Effect of a Tariff

Producer surplus before the tariff: Area A

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 Exhibit 8.15 The Effect of a Tariff

Producer surplus after the tariff: Area A + E

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Government gets Area I
The government generates
revenues by taxing imports
Area I=$15 million

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 Exhibit 8.15 The Effect of a Tariff

No one gets Areas G + J

Deadweight Loss
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Exhibit 8.16 Changes in Import Tariffs in the United States, 1891-2016

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Next week: Monopoly (chpt. 12)

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