Topic #6: The Gains from Trade Dr David Penn Associate Professor of Economics and Director of the...
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Transcript of Topic #6: The Gains from Trade Dr David Penn Associate Professor of Economics and Director of the...
Topic #6: The Gains from Trade
Dr David Penn
Associate Professor of Economics and Director of the Business and Economic Research Center
Gains from Trade
Importance of specialization Comparative advantage Economic growth by trade Absolute advantage
Gains from Trade in Economic History
Adam Smith (1776) Trade allows us to specialize Specialization makes us more productive
David Ricardo (1816) Countries should trade based on their comparative
advantage Even when one country is more productive than the
other, trade can benefit both.
Gains from Trade Model
Model: Two countries: U.S. and Brazil Two goods: large jets and small jets Simplifying assumption: the
production possibilities frontier is linear (constant opportunity costs)
Gains from Trade Argument
Compare consumption of large jets and small jets in two scenarios:1) No trade between the U.S.
and Brazil2) U.S. and Brazil engage in
trade Does total consumption
increase when the two countries engage in trade?
Gains from Trade
U.S. production possibilities frontier with no trade:
Large jets
Small jets40
30
The U.S. consumes 18 large jets and 16 small jets with
given resources.
18
16
The opportunity cost of one small jet for the U.S. is ¾ of
a large jet.
Gains from Trade
Brazil’s PPF with no Trade:
Small jets30
10
6
8
Brazil consumes 8 large jets and 6 small jets.
Large jetsThe opportunity cost of one small jet for Brazil is 1/3 of a
large jet.
Comparative Advantage and Opportunity Cost
Gains from trade arise from comparative advantage.
Comparative advantage depends on differences in opportunity costs, not production costs.
Countries with differing opportunity costs will gain from trade, even if one country is more productive than the other.
Opportunity Costs
What is the opportunity cost of producing 1 small jet? Brazil: 1/3 of a large jet U.S.: ¾ of a large jet Conclusion: Brazil is the low cost producer of small
jets since its opportunity cost is lower. Brazil has a comparative advantage in small jets.
Opportunity Costs
What is the opportunity cost for producing 1 large jet? Brazil: 3 small jets U.S.: 4/3 of a small jet Conclusion: the U.S. is the low cost producer of
large jets since its opportunity cost is smaller. The U.S. has a comparative advantage in large jets.
Gains from Trade Both countries should specialize in production
according to their comparative advantage. Consequently, the U.S. should produce more
large jets and Brazil should produce more small jets.
Then the two countries should trade to obtain the other type of jet.
Gains from Trade After specialization:
U.S. production: 30 large jets and 0 small jets Brazil production: 0 large jets and 30 small jets
Then both countries engage in trade.
Trade With no trade, both countries must consume
only what they produce. With trade, both countries may specialize and
trade for the other good. With trade, both countries benefit from
comparative advantage.
Gains from Trade Results
• With no trade, both countries can only consume what they produce.
No TradeProduction
and Consumption
U.S. Large jets 18Small jets 16
Brazil Large jets 8Small jets 6
Gains from Trade Results
• With trade, each country specializes according to its comparative advantage.
• Suppose each country produces only one type of jet according to comparative advantage and trades for the other type of jet.
Comparative advantage & opportunity costs (again)
U.S. Opportunity
Cost
Brazilian Opportunity
CostOne small jet 3/4 large jet 1/3 large jetOne large jet 4/3 small jets 3 small jets
• Suppose the U.S. can trade for 2 small jets in exchange for 1 large jet. The U.S. benefits. (why?)
• Suppose Brazil can trade 2 small jets for one large jet. Brazil benefits.
Gains from Trade Results
• When trading 2 small jets for one large jet both countries benefit. These are the terms of trade.
• Other mutually beneficial terms of trade are possible.
Gains from Trade Results
• The terms of trade are 2 small jets in exchange for one large jet.
• Both countries can consume more of both types of aircraft with trade compared with no trade.
No TradeProduction
and Consumption Production Consumption
Gains from Trade
U.S. Large jets 18 30 20 2Small jets 16 0 20 4
Brazil Large jets 8 0 10 2Small jets 6 30 10 4
With Trade
Gains from Trade
U.S. production possibilities frontier with trade
Large jets
Small jets40
30
U.S. consumption with no trade18
16
20
20
U.S. consumption with trade
Gains from Trade
Brazil’s PPF with Trade:
Small jets30
10
6
8
Brazilian consumption with no
trade.
Large jets
Brazilian consumption with trade.
10
Summary
• Two important points:• 1) The gains from trade model shows that with
specialization and trade, countries can consume more than if they were self-sufficient.
• 2) Every country (and every person) has a comparative advantage in something (and therefore a comparative disadvantage in something else.)