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Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Interdependence and Trade
Economics studies how society produces and distributes goods and services so that wants and needs are satisfied.
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
How Do We Satisfy Our Wants and Needs?
We can be economically
Self-Sufficient.We can specialize
and trade with others leading to Economic Interdependence.
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Interdependence & Trade
A general observation . . .– Individuals and nations rely on
specialized production and exchange as a way to address problems caused by scarcity.
This gives rise to two questions. . .–Why is interdependence the norm?
–What determines production & trade?
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Interdependence & Trade Why is interdependence the norm?
–Interdependence occurs because people are better off when they specialize and trade with others.
What determines the pattern of production & trade?
–Patterns of production and trade are based upon differences in opportunity costs.
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Interdependence and Trade: “A Parable for the Modern Economy”
Imagine...
… only two goods (potatoes and meat)
… only two people (potato farmer and a cattle rancher)
What should each produce?
Why should they trade?
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Productivity Table Amount Produced In One Hour
(in Kilograms)Meat Potatoes
Farmer 1 Kg 1 Kg
Rancher 8 Kg 2 Kg
Note that based on the Productivity Tableabove the Rancher is more productive inproducing both of the products.
Yet, we will see that both the Rancher and the Farmer can gain from trade ...
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Product Possibility FrontiersBased on the Productivity Table above we can construct Productivity Possibility Frontiers assuming an 8 hour day as follows:
Mea
t in
Kg
Farmer
Potatoes in Kg
8
8
Mea
t in
Kg
Potatoes in Kg
Rancher64
16
PPF PPF
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
A World of Self-SufficiencyAssuming self sufficiency (no trade) the Farmer produces and consumes combination A, while the Rancher is at combination B:
Mea
t in
Kg
Farmer
Potatoes in Kg
8
8
Mea
t in
Kg
Potatoes in Kg
Rancher64
16
B32
8
A4
4
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Specialization and Trade
If the farmer and the rancher were to specialize in producing the product that they were best suited to produce, and then trade with each other, they would be better off.
–Farmer should produce potatoes.
–Rancher should produce meat.
–Farmer and Rancher should trade.
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Specialization and TradeSuppose the Farmer specializes in Potatoes and the Rancher specializes in Meat. If the Farmer trades 5 Kg Potatoes for 10 Kg Meat:
Mea
t in
Kg
Farmer
Potatoes in Kg
8
8
Mea
t in
Kg
Potatoes in Kg
Rancher64
16
B48
4
A6
2
A*trade B*trade
3
10 54
5
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
The Principle of Comparative Advantage
What determines who should produce what? And how much should be traded for each product?
Differences in Costs of Production Who can produce products (e.g.
potato, meat) at a lower cost? There are two ways to measure...
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
The Principle of Comparative Advantage
Measuring differences in costs of production:–Hours required to produce a
standardized unit of output. One pound of potatoes
–Opportunity Cost - amount of one item sacrificed to obtain another.
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Absolute Advantage
Describes the productivity of one person, firm, or nation to 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.
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Productivity Table Amount Produced In One Hour
(in Kilograms)Meat Potatoes
Farmer 1 Kg 1 Kg
Rancher 8 Kg 2 Kg
Who has the Absolute Advantage in eachproduct?
Rancher, in both products. Yet, we have seen that both the Rancher
and the Farmer can gain from trade?
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Comparative Advantage
Compares producers of a good according to their opportunity cost.- The producer who has the smaller
opportunity cost of producing a good is said to have a comparative advantage in producing that good.
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
The Principle of Comparative Advantage
Comparative advantage, which refers to differences in opportunity costs, is the basis for specialized production and trade.
Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade.
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Opportunity Cost Table Cost of 1 Kg of each product in real terms
1 Kg of Meat Costs 1 Kg of Potatoes costs
Farmer 1 Kg of Potatoes 1 Kg of Meat
Rancher .25 Kg of Potatoes 4 Kg of Meat
Based on the Productivity Table (earlier slide) you can use simple math to calculate the opportunity cost of 1 unit of each good.
The Rancher has the Comparative Advantage inproducing Meat (lower opportunity cost).
The Farmer has the Comparative Advantage inproducing Potatoes (lower opportunity cost).
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Applications of Comparative Advantage
Should Canada trade with Other Countries (e.g. Japan)?–Opportunity Costs
–Imports
–Exports
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Trade: Canada and Japan
Cars Cars
FoodCanada Japan
4
2
Food2
2
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Opportunity Cost: Sacrifice of Food Production for Car Production
Computing Opportunity Cost
Slope of PPF:
(0-4) ÷ (2-0) =
2 Units of food given
up to get 1 Unit of a car.Cars
Canada4
2
Food
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Opportunity Cost: Sacrifice of Food Production for Car Production
Computing Opportunity Cost
Slope of PPF:
(0-4) ÷ (2-0) =
? Units of food
given up to get 1 Unit of a car
Cars
Canada4
2
Food
1
?
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Opportunity Cost: Sacrifice of Food Production for Car Production
Computing Opportunity Cost
Slope of PPF:
(0-4) ÷ (2-0) =
2 Units of food
given up to get 1 Unit of a car
Cars
Canada4
2
Food
2
1
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Opportunity Cost: Sacrifice of Food Production for Car Production
Computing Opportunity Cost
Slope of PPF:
( 2 ) ÷ (2 ) =
1Unit of food given up to get 1
Unit of a car
Cars
Japan2
2
Food
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Trade: Canada and Japan
Cars Cars
FoodCanada Japan
4
2
Food2
2
2
1
1
1
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Cars Cars
Food Canada Japan4
2
Food2
2
2
1
1
1
Who should produce Cars?
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Cars Cars
Food Canada Japan4
2
Food2
2
2
1
1
1
Who should produce Food?
Principles of Microeconomics & Principles of Macroeconomics: Ch. 3 First Canadian Edition
Interdependence: Canada & Japan
Interdependence and trade are desirable because they allow everyone to enjoy a
greater quantity and variety of goods and services. Founded upon the. . .
Principle of Comparative Advantage