Econ 123 Principles of Economics: Micro Chapter 2 & 3: Interdependence and the Gains from rade Instructor: Hiroki Watanabe Fall 212 Watanabe Econ 123 2 & 3: Gains from rade 1 / 119 1 Introduction 2 Productivity 3 Production-Possibility Frontier 4 Autarky 5 Exchange 6 Summary Watanabe Econ 123 2 & 3: Gains from rade 2 / 119 1 Introduction Why Do We rade Goods? 2 Productivity 3 Production-Possibility Frontier 4 Autarky 5 Exchange 6 Summary Watanabe Econ 123 2 & 3: Gains from rade 3 / 119
Why Do We rade Goods? Question 1.1 (Agenda) Why do people trade in the first place? Watanabe Econ 123 2 & 3: Gains from rade 4 / 119 Why Do We rade Goods? Question 1.2 (Exchange Economy) Consider an economy with two producers: Liz & Kenneth two products: cheesecake & tea. Are they better off if they trade with each other? Watanabe Econ 123 2 & 3: Gains from rade 5 / 119 1 Introduction 2 Productivity Describing Productivity 3 Production-Possibility Frontier 4 Autarky 5 Exchange 6 Summary Watanabe Econ 123 2 & 3: Gains from rade 6 / 119
Describing Productivity How productive are they? wo ways to represent their productivity: 1 How many hours does Liz need to bake one cheesecake? 2 How many cheesecakes can she bake in an hour? Watanabe Econ 123 2 & 3: Gains from rade 7 / 119 Describing Productivity 1 How long do they take to produce one unit of goods? Cheesecake ea Liz 6 min/slice 15 min/cup Kenneth 2 min/slice 1 min/cup Watanabe Econ 123 2 & 3: Gains from rade 8 / 119 Describing Productivity 2 How long do they take to produce one unit of goods? Cheesecake ea Liz 1 slice/hour 4 cup/hour Kenneth 3 slice/hour 6 cup/hour Watanabe Econ 123 2 & 3: Gains from rade 9 / 119
Describing Productivity Definition 2.1 (Input & Output) 1 An input or factor of production is what a firm employs to produce goods and/or services 2 An output is what a firm produces. Watanabe Econ 123 2 & 3: Gains from rade 1 / 119 Describing Productivity Definition 2.2 (Absolute Advantage) If Kenneth can bake a cheesecake with fewer inputs than Liz, he has an absolute advantage in baking. Question 2.3 (Absolute / Comparative Advantage) Kenneth is good at producing both goods. Shouldn t he produce everything on his own instead of trading with Liz? Watanabe Econ 123 2 & 3: Gains from rade 11 / 119 1 Introduction 2 Productivity 3 Production-Possibility Frontier Production-Possibility Frontier he Slope of PPF Marks the Opportunity Cost Efficiency Change in Exogenous Variables 4 Autarky 5 Exchange 6 Summary Watanabe Econ 123 2 & 3: Gains from rade 12 / 119
Production-Possibility Frontier Not really. ake their technology one step further. Definition 3.1 (Production-Possibility Frontier) A production-possibility frontier (PPF) lists combinations of goods that the economy can produce most efficiently given 1 the technology and 2 the factors of production. Watanabe Econ 123 2 & 3: Gains from rade 13 / 119 Production-Possibility Frontier Consider the following economies: 1 An economy consisting of Liz alone (autarky). 2 An economy consisting of Kenneth alone (autarky). 3 An economy consisting of both of them. Watanabe Econ 123 2 & 3: Gains from rade 14 / 119 Production-Possibility Frontier 1 Liz s production-possibility frontier: Given 1 her technology: 1 slice an hour or 4 cups an hour 2 factor of production: let s say 1 hours her PPF marks the set of cheesecake and tea that she can produce most effectively. Watanabe Econ 123 2 & 3: Gains from rade 15 / 119
Production-Possibility Frontier If she splits her working hour in half, she can make 5 slices and brew 2 cups of tea. If she bakes for an hour and brew for 9 hours, she can make 1 slice and 36 cups of tea. If she bakes for 8 hours and brew for 2 hours, she can make 8 slices and 8 cups of tea. Watanabe Econ 123 2 & 3: Gains from rade 16 / 119 he Slope of PPF Marks the Opportunity Cost We can list all these combinations but it s easier to represent them on a graph. Watanabe Econ 123 2 & 3: Gains from rade 17 / 119 he Slope of PPF Marks the Opportunity Cost Write a number of her slices by L C. Her cups of tea by L. Definition 3.2 (Output Bundle) An output bundle is a pair of goods ( C, ) produced in an economy. E.g., ( L C, L ) = (2, 32) means Liz baked 2 slices of cheesecake and brewed32 cups of tea. Watanabe Econ 123 2 & 3: Gains from rade 18 / 119
he Slope of PPF Marks the Opportunity Cost Assumption of continuity: assume all goods can be divided by any number (> ). Watanabe Econ 123 2 & 3: Gains from rade 19 / 119 he Slope of PPF Marks the Opportunity Cost Example 3.3 (Liz s PPF) Liz s productivity: 1 slice/hour, 4 cups/hour. he most she can produce is: baking hours brewing hours ( L C, L ) 1 (, ).5 9.5 (.5, 38) 1 9 (1, 36) 2 8 (2, 32) 1 (1, ) b 1 b (b, 4(1 b)) 1 1 For algebraic expression, see Appendix 1. Watanabe Econ 123 2 & 3: Gains from rade 2 / 119 he Slope of PPF Marks the Opportunity Cost Easier way to represent the relationship between L C and L? Watanabe Econ 123 2 & 3: Gains from rade 21 / 119
he Slope of PPF Marks the Opportunity Cost 38 36 32 ea x (cups).5 1 2 1 Cheesecakes x C (slices) Watanabe Econ 123 2 & 3: Gains from rade 22 / 119 he Slope of PPF Marks the Opportunity Cost Liz s PPF: x L 36 = 4xL C + ea x L (cups) 32 28 24 2 16 12 8 4 1 2 3 4 5 6 7 8 9 1 Cheesecakes x L C (slices) Watanabe Econ 123 2 & 3: Gains from rade 23 / 119 he Slope of PPF Marks the Opportunity Cost and that was a graphical representation of Definition 3.1. See Appendix 2 or Ch2 Appendix. Watanabe Econ 123 2 & 3: Gains from rade 24 / 119
he Slope of PPF Marks the Opportunity Cost wo salient factors of the PPF above: 1 and y intercepts 2 slope of the line Watanabe Econ 123 2 & 3: Gains from rade 25 / 119 he Slope of PPF Marks the Opportunity Cost In Example 3.3, -intercept marks maximum amount of cheesecakes that she can bake when she does not brew. 1 hours allotted and bake 1 slice/hour: 1 1 = 1. his is called specialization. Watanabe Econ 123 2 & 3: Gains from rade 26 / 119 he Slope of PPF Marks the Opportunity Cost How about y-intercept? Watanabe Econ 123 2 & 3: Gains from rade 27 / 119
he Slope of PPF Marks the Opportunity Cost Exercise 3.4 (Kenneth s PPF) Kenneth takes 1 2 minutes to make a slice of cheesecake 2 1 minutes to brew a cup of tea. 1 How many slices can he bake or how many cups can he brew in an hour? 2 What is his opportunity cost of baking a cheesecake in terms of cups of tea? 3 Suppose he works for 1 hours. Draw his PPF. Watanabe Econ 123 2 & 3: Gains from rade 28 / 119 he Slope of PPF Marks the Opportunity Cost 6 x K = 2xK C +6 5 ea x K (cups) 3 2 1 5 1 15 2 25 3 Cheesecakes x K C (slices) Watanabe Econ 123 2 & 3: Gains from rade 29 / 119 he Slope of PPF Marks the Opportunity Cost What does the slope of PPF say about Liz s productivity? What exactly is the slope? Definition 3.5 (Slope) A slope of a line represents how much additional L she can get for a unit increase in L C. Watanabe Econ 123 2 & 3: Gains from rade 3 / 119
he Slope of PPF Marks the Opportunity Cost he slope of Liz s PPF is 4. If she bakes one more slice, she can increase the tea by 4 cups. i.e., for one additional cheesecake, she has to give up 4 cups of tea. Watanabe Econ 123 2 & 3: Gains from rade 31 / 119 he Slope of PPF Marks the Opportunity Cost o make one more slice, she has to spare one hour for baking. She has to give up 4 cups for one hour. Definition 3.6 (Opportunity Cost) he opportunity cost of a good is the best alternative you have to forgo to produce or buy it. Liz s opportunity cost of a slice of cheesecake is 4 cups of tea. he slope of PPF corresponds to the opportunity cost. Watanabe Econ 123 2 & 3: Gains from rade 32 / 119 Efficiency Definition 3.7 (Efficiency) An output bundle ( C, ) is efficient if, for a given, C is the largest amount that the economy can produce. Question 3.8 (Efficiency) Are the following efficient for Liz? 1 ( L C, L ) = (2, 32) 2 ( L C, L ) = (1, ) 3 ( L C, L ) = (8, 1) 4 ( L C, L ) = (, ) 5 ( L C, L ) = (8, 7) Watanabe Econ 123 2 & 3: Gains from rade 33 / 119
Efficiency Liz s PPF: x L 36 = 4xL C + ea x L (cups) 32 28 24 2 16 12 8 4 1 2 3 4 5 6 7 8 9 1 Cheesecakes x L C (slices) Watanabe Econ 123 2 & 3: Gains from rade 34 / 119 Efficiency Definition 3.9 (PPF and Efficiency) he output bundles ( L C, L ) on the PPF is efficient. he output bundles ( L C, L ) inside the PPF is not efficient. he output bundles ( L C, L ) outside of the PPF is unattainable. Watanabe Econ 123 2 & 3: Gains from rade 35 / 119 Change in Exogenous Variables he PPF traces the set of output bundles that are efficient. Question 3.1 (Change in PPF) What changes the shape of PPF? When does she produce less cheesecakes? 2 2 Appendix 4. Watanabe Econ 123 2 & 3: Gains from rade 36 / 119
Change in Exogenous Variables wo types of changes: 1 Rotation (different slope) 2 Parallel shift Question 3.11 (Change in PPF) 1 What would make the PPF steeper? 2 What would shift the PPF outwards? Watanabe Econ 123 2 & 3: Gains from rade 37 / 119 Change in Exogenous Variables 1 Change in slopes: he slope of PPF marks the opportunity cost of making one slice of cheesecake in terms of the cups of tea. A steeper PPF means the opportunity cost of a slice of cheesecake is high. What does that mean? Watanabe Econ 123 2 & 3: Gains from rade 38 / 119 Change in Exogenous Variables It means: 1 If she spares one hour for an additional production of a slice of cheesecake, it used to cost her 4 cups. 2 Now it costs her more than 4 cups, which furthermore means either: 1 she s got better at brewing tea 2 she s got worse at baking cheesecakes 3 (or both). Watanabe Econ 123 2 & 3: Gains from rade 39 / 119
Change in Exogenous Variables Let s consider two scenarios: 1 She can brew as many as 8 cups of tea an hour than 4 cups before. 2 She can bake only half a slice an hour than one slice before. How do we update the PPF? 3 3 For algebraic formula, see Appendix 4. Watanabe Econ 123 2 & 3: Gains from rade / 119 Change in Exogenous Variables 8 x L 72 = 4xL C + x L 64 = 8xL C +8 56 x L = 8xL C + ea x L (cups) 48 32 24 16 8 1 2 3 4 5 6 7 8 9 1 Cheesecakes x L C (slices) Watanabe Econ 123 2 & 3: Gains from rade 41 / 119 Change in Exogenous Variables Example 3.12 (Change in Slope) Suppose that Liz 1 She can brew as many as 8 cups of tea an hour than 4 cups before, AND 2 She can bake only half a slice an hour than one slice before. What do you expect to happen to her PPF? Sketch her new PPF. Watanabe Econ 123 2 & 3: Gains from rade 42 / 119
Change in Exogenous Variables 8 72 x L = 4xL C + 64 x L = 8xL C +8 56 x L = 8xL C + 48 x L = 16xL C +8 ea x L (cups) 32 24 16 8 1 2 3 4 5 6 7 8 9 1 Cheesecakes x L C (slices) Watanabe Econ 123 2 & 3: Gains from rade 43 / 119 Change in Exogenous Variables 2 What would (parallel) shift the PPF? he opportunity cost does not change but 1 She works more or less than 1 hours. 2 Her productivity in both goods goes up or down by the same rate. Watanabe Econ 123 2 & 3: Gains from rade 44 / 119 Change in Exogenous Variables 1 Let s say she works for 2 hours. Watanabe Econ 123 2 & 3: Gains from rade 45 / 119
Change in Exogenous Variables 8 x L 72 = 4xL C + x L 64 = 8xL C +8 ea x L (cups) 56 48 32 24 16 8 1 2 3 4 5 6 7 8 9 11112131415 16171819 2 Cheesecakes x L C (slices) Watanabe Econ 123 2 & 3: Gains from rade 46 / 119 Change in Exogenous Variables 2 Now suppose that her overall productivity went up by 1%. Watanabe Econ 123 2 & 3: Gains from rade 47 / 119 Change in Exogenous Variables 8 x L 72 = 4xL C + x L 64 = 8xL C +8 ea x L (cups) 56 48 32 24 16 8 1 2 3 4 5 6 7 8 9 11112131415 16171819 2 Cheesecakes x L C (slices) Watanabe Econ 123 2 & 3: Gains from rade 48 / 119
1 Introduction 2 Productivity 3 Production-Possibility Frontier 4 Autarky Consumption Bundle Optimal Bundle 5 Exchange 6 Summary Watanabe Econ 123 2 & 3: Gains from rade 49 / 119 Consumption Bundle Recall Question 2.3. Watanabe Econ 123 2 & 3: Gains from rade 5 / 119 Consumption Bundle How can we tell that a certain allocation is better than others? Efficiency tells us whether the production side of the economy is performing at its best. Any output bundle on Liz s PPF is efficient. Does that mean she is equally satisfied with ( L C, L ) = (1, ) and (6, 16)? Watanabe Econ 123 2 & 3: Gains from rade 51 / 119
Consumption Bundle Definition 4.1 (Consumption Bundle) A consumption bundle is a pair of goods ( C, ) that an economy consumes. Watanabe Econ 123 2 & 3: Gains from rade 52 / 119 Consumption Bundle Suppose that Liz always prefers to consume cheesecake and tea in a 1-to-4 ratio. ( L C, L ) = (1, 4), (2, 8), (1.5, 6) etc. Also suppose that she always prefers more to less, i.e., she likes ( L C, L ) = (231, 85) better than (3, 8). If she is in an self-sufficient economy (autarky), which output bundle does she choose to produce? Watanabe Econ 123 2 & 3: Gains from rade 53 / 119 Consumption Bundle Liz s preferred bundle: x L 36 =4xL C ea x L (cups) 32 28 24 2 16 12 8 4 1 2 3 4 5 6 7 8 9 1 Cheesecakes x L C (slices) Watanabe Econ 123 2 & 3: Gains from rade 54 / 119
Optimal Bundle Which consumption bundle does she choose in the end? Watanabe Econ 123 2 & 3: Gains from rade 55 / 119 Optimal Bundle Liz s PPF: x L 36 = 4xL C + Liz s preferred bundle: x L 32 =4xL C ea x L (cups) 28 24 2 16 12 8 4 1 2 3 4 5 6 7 8 9 1 Cheesecakes x L C (slices) Watanabe Econ 123 2 & 3: Gains from rade 56 / 119 Optimal Bundle Why doesn t she choose bundles like ( L C, L ) = (3, 12), (2, 32) or (1, )? 1 more to less. 2 attainable? he chosen bundle ( L C, L ) = (5, 2) is called an optimal bundle. Watanabe Econ 123 2 & 3: Gains from rade 57 / 119
Optimal Bundle Example 4.2 (Kenneth s Optimal Bundle) Suppose that Kenneth prefers to consume cheesecake and tea in a 1-to-4 ratio as well. If he works for 1 hours and self-supplies these commodities, what is his optimal bundle? Watanabe Econ 123 2 & 3: Gains from rade 58 / 119 Optimal Bundle 6 5 ea x K (cups) 3 2 1 Kenneth s PPF: x K = 4xK C +6 Kenneth s preferred bundle: x K =4xK C 5 1 15 2 25 3 Cheesecakes x K C (slices) Watanabe Econ 123 2 & 3: Gains from rade 59 / 119 Optimal Bundle In a self-sufficient economy, Liz and Kenneth consume ( L C, L, K C, K ) = (5, 2, 1, ). Can they be better off by trading with each other? ( Question 2.3 ) Watanabe Econ 123 2 & 3: Gains from rade 6 / 119
1 Introduction 2 Productivity 3 Production-Possibility Frontier 4 Autarky 5 Exchange Aggregate PPF Comparative Advantage erms of rade rading Pattern 6 Summary Watanabe Econ 123 2 & 3: Gains from rade 61 / 119 Aggregate PPF Consider an economy consisting of Liz and Kenneth. What is the PPF of this economy? Watanabe Econ 123 2 & 3: Gains from rade 62 / 119 Aggregate PPF 6 5 Liz s PPF: x L = 4xL C + Kenneth s PPF: x K = 2xK C +6 ea x (cups) 3 2 1 5 1 15 2 25 3 Cheesecakes x C (slices) Watanabe Econ 123 2 & 3: Gains from rade 63 / 119
Aggregate PPF How do we combine Liz and Kenneth s PPFs? It s hard to see what s going on with both ( L C, L ) and ( K C, K ) moving at the same time. Let s fix ( K C, K ) at (6, ). What is the set of attainable output bundles? Watanabe Econ 123 2 & 3: Gains from rade 64 / 119 Aggregate PPF 1 If Liz specializes in brewing tea, she can produce ( L C, L ) = (, ). he economy on the whole produces C := L C L + K C K = + =. 6 1 2 Similarly, if she specializes in baking, she can produce ( L C, L ) = (1, ). he economy produces C 1 1 = + =. 6 6 Watanabe Econ 123 2 & 3: Gains from rade 65 / 119 Aggregate PPF 1 8 Attainable Output Bundles Kenneth s Output Bundle ea x (cups) 6 2 5 1 15 2 25 3 Cheesecakes x C (slices) Watanabe Econ 123 2 & 3: Gains from rade 66 / 119
Aggregate PPF If instead ( K C, K ) = (5, 5), Watanabe Econ 123 2 & 3: Gains from rade 67 / 119 Aggregate PPF 1 9 8 ea x (cups) 7 6 5 3 2 1 5 1 15 2 25 3 Cheesecakes x C (slices) Watanabe Econ 123 2 & 3: Gains from rade 68 / 119 Aggregate PPF... and keep going... Watanabe Econ 123 2 & 3: Gains from rade 69 / 119
Aggregate PPF 1 9 8 ea x (cups) 7 6 5 3 2 1 5 1 15 2 25 3 35 Cheesecakes x C (slices) Watanabe Econ 123 2 & 3: Gains from rade 7 / 119 Aggregate PPF By the assumption of continuity, the aggregate PPF is Watanabe Econ 123 2 & 3: Gains from rade 71 / 119 Aggregate PPF 1 8 ea x (cups) 6 2 1 2 3 Cheesecakes x C (slices) Watanabe Econ 123 2 & 3: Gains from rade 72 / 119
Comparative Advantage Question 5.1 (Aggregate PPF) Can the following be the aggregate PPF too? 1 8 ea x (cups) 6 2 1 2 3 Cheesecakes x C (slices) Watanabe Econ 123 2 & 3: Gains from rade 73 / 119 Comparative Advantage Short answer: ( C, ) = (1, 8) is attainable but off the PPF contradiction. Long answer: Watanabe Econ 123 2 & 3: Gains from rade 74 / 119 Comparative Advantage Definition 5.2 (Comparative Advantage) If Kenneth can bake a cheesecake at a lower opportunity cost (in terms of cups of tea), he has a comparative advantage in baking. Equivalently, if Liz bakes cheesecake at a higher opportunity cost (in terms of cups of tea), she has a comparative advantage in brewing tea. Watanabe Econ 123 2 & 3: Gains from rade 75 / 119
Comparative Advantage Question 5.3 (Who Produces What) Starting from the output bundle ( C, ) = (, 1), if we want to spare some inputs for cheesecake baking, who should take on baking? Watanabe Econ 123 2 & 3: Gains from rade 76 / 119 Comparative Advantage If we have Liz bake cheesecake, we will follow the PPF in Question 5.2. But why would we do that? Kenneth can bake at a lower opportunity cost, i.e., 1 i.e., if we let Liz bake, we have to give up 4 cups for a slice, 2 while if Kenneth bakes, we sacrifice only 2 cups for a slice. Watanabe Econ 123 2 & 3: Gains from rade 77 / 119 Comparative Advantage he aggregate PPF bulges outwards. A producer whose opportunity cost of a slice is the lowest (i.e., Kenneth) switches production from brewing tea to baking first. Only after Kenneth has completely switched his production plan, Liz starts to switch her production from brewing tea to baking. Watanabe Econ 123 2 & 3: Gains from rade 78 / 119
erms of rade Getting back to Question 2.3, do they benefit from exchanging products? Recall, in autarky, the best they can do is ( L C, L, K C, K ) = (5, 2, 1, ). ake this as a reference point and see if they can do any better by trading with each other. Watanabe Econ 123 2 & 3: Gains from rade 79 / 119 erms of rade wo options: 1 Kenneth bakes more than he consumes and sell Liz extra slices in exchange for extra tea she made. 2 Kenneth brews more tea than he consumes and sell Liz extra cups in exchange for extra cheesecake she baked. Watanabe Econ 123 2 & 3: Gains from rade 8 / 119 erms of rade Definition 5.4 (erms of rade) he terms of trade measures the units of imports that a unit of exports can buy. he terms of trade measures the cups of tea that Kenneth can get by selling Liz a slice of cheesecake. For Liz, the terms of trade is the number of cheesecakes she can get for a cup of tea. Watanabe Econ 123 2 & 3: Gains from rade 81 / 119
erms of rade What would be the terms of trade that Kenneth becomes indifferent between 1 self-production of tea 2 purchase of tea from Liz? He brews 2 cups of tea for a slice of cheesecake. If the terms of trade is... 1 2 cups of tea for a slice of cheesecake, it makes no difference (t of t = op cost of cheesecake). 2 more than 2 cups of tea for a slice, importing tea is more productive than brewing tea by himself (t of t > op cost of cheesecake) 3 less than 2 cups of tea for a slice, he can brew tea for less by himself (t of t < op cost of cheesecake) Watanabe Econ 123 2 & 3: Gains from rade 82 / 119 erms of rade 9 8 7 Kenneth s PPF: x K = 2xK C +6 Favorable of Unfavorable of ea x K (cups) 6 5 3 2 1 5 1 15 2 25 3 Cheesecakes x K C (slices) Watanabe Econ 123 2 & 3: Gains from rade 83 / 119 erms of rade Similarly for Liz, if the terms of trade is... 1 1 slice of cheesecake for 4 cups of tea, it makes no difference (reciprocal her t of t = op cost of cheesecake) 2 more than 1 slice for 4 cups, importing cheesecake is more productive than baking by herself (reciprocal of t of t < op cost of cheesecake) 3 less than 1 slice for 4 cup, she can bake for less by herself (t of t > op cost of cheesecake) Watanabe Econ 123 2 & 3: Gains from rade 84 / 119
erms of rade ea x L (cups) 36 32 28 24 2 16 12 8 4 Liz s PPF: x L = 4xL C + Favorable of Unfavorable of 1 2 3 4 5 6 7 8 9 1 Cheesecakes x L C (slices) Watanabe Econ 123 2 & 3: Gains from rade 85 / 119 rading Pattern Proposition 5.5 (Acceptable erms of rade) Both Kenneth and Liz can raise their (effective) productivity by handing off part of their production to the other if the terms of trade falls in the range: Kenneth s op cost = 2 Kenneth s t of t 4 = Liz s op cost. Equivalently, 1 Kenneth s op cost = 2 4 = Liz s op cost. Liz s t of t If the terms of trade drops below or rises above the range above, exchange won t pay. Now, what type of trade pattern do we expect to see? Watanabe Econ 123 2 & 3: Gains from rade 86 / 119 rading Pattern Suppose that Kenneth has better negotiating skills. His terms of trade is 4 (tea / cheesecake). He can have Liz specialize in tea production and sell her 5 cheesecakes for 2 cups of tea. Let s say that he will stick to K = 1. How many C cups of tea will he consume? Watanabe Econ 123 2 & 3: Gains from rade 87 / 119
rading Pattern ea x L (cups) 36 32 28 24 2 16 12 Liz s PPF: x L = 4xL C + 8 Pre rade Output 4 Post rade Output Post rade Consumption 1 2 3 4 5 6 7 8 9 1 Cheesecakes x L C (slices) Watanabe Econ 123 2 & 3: Gains from rade 88 / 119 rading Pattern Liz accepts Kenneth s offer because the end result is the same before and after the trade ( L C, L ) = (5, 2). Kenneth, on the other hand, can consume more tea than before. Watanabe Econ 123 2 & 3: Gains from rade 89 / 119 rading Pattern 6 5 ea x K (cups) 3 2 Kenneth s PPF: x K = 2xK C +6 PPF after rade 1 Pre rade Output Post rade Output Post rade Consumption 5 1 15 2 25 3 Cheesecakes x K C (slices) Watanabe Econ 123 2 & 3: Gains from rade 9 / 119
rading Pattern Kenneth ends up consuming the bundle K C 15 5 1 K = + =, 3 2 5 which was unattainable before. 4 Kenneth becomes better off. Recall his preferences on Slide 55. 4 hough this outcome is an improvement, he can do even better than this. he best result is in Appendix 5. Watanabe Econ 123 2 & 3: Gains from rade 91 / 119 rading Pattern Example 5.6 (When Liz Has Bargaining Power) Now suppose instead that Liz has better negotiating skills. 1 What is the terms of trade? 2 Suppose she wants to stick to L = 2. How many slices she can get by trading with Kenneth? Watanabe Econ 123 2 & 3: Gains from rade 92 / 119 rading Pattern 1 Liz can specialize in brewing tea. 2 She can brew cups max. 3 Sell 2 of cups produced for 1 slices (the terms of trade is 2 cups for a slice). 4 She ends up with ( L C, L ) = ( + 1, 2) as opposed to (5, 2). Watanabe Econ 123 2 & 3: Gains from rade 93 / 119
rading Pattern ea x L (cups) 36 32 28 24 2 16 12 8 4 Liz s PPF: x L = 4xL C + PPF after rade Pre rade Output Post rade Output Post rade Consumption 5 1 15 2 Cheesecakes x L C (slices) Watanabe Econ 123 2 & 3: Gains from rade 94 / 119 rading Pattern Does Kenneth accept this trade agreement? Watanabe Econ 123 2 & 3: Gains from rade 95 / 119 rading Pattern 6 5 ea x K (cups) 3 2 Kenneth s PPF: x K = 2xK C +6 1 Pre rade Output Post rade Output Post rade Consumption 5 1 15 2 25 3 Cheesecakes x K C (slices) Watanabe Econ 123 2 & 3: Gains from rade 96 / 119
rading Pattern In summary, better negotiator economy ( L C, L ) ( K C, K ) autarky (5, 2) (1, ) Kenneth pre-trade output (, ) (15, 3) net import (5, 2) ( 5, 2) post-trade consumption (5, 2) (1, 5) ± + Liz pre-trade output (, ) (2, 2) net import (1, 2) ( 1, 2) post-trade consumption (1, 2) (1, ) + ± Watanabe Econ 123 2 & 3: Gains from rade 97 / 119 rading Pattern Example 5.7 (International rade) Suppose that they produce wine and cars in US and France. French workers can produce 2 bottles of wine in an hour or 1 car in an hour. US workers can produce 4 bottles of wine or 4 cars in an hour. 1 Suppose that French workers work for 1 hours and US workers work for 15 hours. Sketch their production-possibility frontiers. 2 Is there any point for US to engage in an international trade with France? Suppose, for example, US currently consume ( A C, A ) = (2, ), W has negotiating power and intends to consume 2 cars after trade. France would like to consume ( F C, F ) = (5, 1). Find their trading pattern. W Watanabe Econ 123 2 & 3: Gains from rade 98 / 119 rading Pattern US has an absolute advantage in both. France has a comparative advantage in wine production. US outsources wine production to France and pay in the form of cars. US can set the terms of trade at France s opportunity cost 2 [bottles/car]. US can ask France to produce 1 bottles for them in exchange for 5 cars. Watanabe Econ 123 2 & 3: Gains from rade 99 / 119
rading Pattern 6 Wine x W (bottles) 55 5 45 35 3 25 2 PPF (US) effective PPF (US) autarky (US) pre trade output (US) post trade cons. (US) 15 PPF (FR) 1 autarky (FR) pre trade output (FR) 5 post trade consumption (FR) 5 1 15 2 25 3 35 45 5 55 6 Cars x C Watanabe Econ 123 2 & 3: Gains from rade 1 / 119 1 Introduction 2 Productivity 3 Production-Possibility Frontier 4 Autarky 5 Exchange 6 Summary Watanabe Econ 123 2 & 3: Gains from rade 11 / 119 Production-possibility frontier Comparative advantage Exchange economy Watanabe Econ 123 2 & 3: Gains from rade 12 / 119
Appendix : Algebraic Expression of PPF In general, the most efficient output bundle satisfies L C = b L = 4(1 b). (1) his means L = 4 L C +. Watanabe Econ 123 2 & 3: Gains from rade 13 / 119 Appendix 1: he Coordinate System Why do we use graphs? 1 Visually express ideas that might be less clear if described with equations or words 2 Powerful way of finding and interpreting patterns Watanabe Econ 123 2 & 3: Gains from rade 14 / 119 Appendix 1: he Coordinate System he coordinate system displays two variables on a single graph. o plot the output bundle ( L C, L ) on a graph, 1 mark L on the x-coordinate C 2 mark L on the y-coordinate Watanabe Econ 123 2 & 3: Gains from rade 15 / 119
Appendix 1: he Coordinate System Liz s PPF: x L 36 = 4xL C + ea x L (cups) 32 28 24 2 16 12 8 4 1 2 3 4 5 6 7 8 9 1 Cheesecakes x L C (slices) Watanabe Econ 123 2 & 3: Gains from rade 16 / 119 Appendix 1: he Coordinate System How do we understand the graph? 1 Negatively related variables 1 he two variables move in opposite direction 2 Downward-sloping curve 2 Positively related variables 1 he two variables move in the same direction 2 Upward-sloping curve Watanabe Econ 123 2 & 3: Gains from rade 17 / 119 Appendix 2: Movement along the Line vs Line Shifts Keep the following separate: 1 Movement along the line 2 Shifts in the line itself. Watanabe Econ 123 2 & 3: Gains from rade 18 / 119
Appendix 2: Movement along the Line vs Line Shifts 1 he output bundle ( L C, L ) moves along the PPF if either L C or L change while everything else is held constant. 2 he PPF shifts if anything other than L C or L changes: hours worked, technology etc. Watanabe Econ 123 2 & 3: Gains from rade 19 / 119 Appendix 2: Movement along the Line vs Line Shifts Definition 6.1 (Endogenous and Exogenous Variables) 1 An endogenous variable is a variable that is determined within the model. 2 An exogenous variable is a parameter that is given (predetermined) outside of the model. In other words, 1 Movement along the PPF is caused by a change in endogenous variables ( L C, L ). 2 Shifts in the PPF itself is caused by a change in exogenous variables (technology, hours worked etc) Watanabe Econ 123 2 & 3: Gains from rade 11 / 119 Appendix 2: Movement along the Line vs Line Shifts 1 Movement along the line: Currently the output bundle is ( L C, L ) = (1, 36). She has decided to make one more slice. If everything else is held constant (ceteris paribus), she has to give up 4 cups of tea for that. he new output bundle is ( L C, L ) = (2, 32). movement along the line. Watanabe Econ 123 2 & 3: Gains from rade 111 / 119
Appendix 2: Movement along the Line vs Line Shifts Liz s PPF: x L 36 = 4xL C + ea x L (cups) 32 28 24 2 16 12 8 4 1 2 3 4 5 6 7 8 9 1 Cheesecakes x L C (slices) Watanabe Econ 123 2 & 3: Gains from rade 112 / 119 Appendix 2: Movement along the Line vs Line Shifts 2 Line shift: Currently the output bundle is ( L C, L ) = (1, 36). She has decided to work one more hour. She can produce either one more slice or four more cups. PPF shifts outwards by 1 to the east or by 4 to the north. Comparative statics examines how the endogenous variables are affected by a change in exogenous variables. Watanabe Econ 123 2 & 3: Gains from rade 113 / 119 Appendix 2: Movement along the Line vs Line Shifts 44 Liz s PPF: x L = 4xL C + ea x L (cups) 36 32 28 24 2 16 12 8 4 Liz s new PPF: x L = 4xL C +44 1 2 3 4 5 6 7 8 9 1 11 Cheesecakes x L C (slices) Watanabe Econ 123 2 & 3: Gains from rade 114 / 119
Appendix 3: Shifting of PPF 1 If she can brew 8 cups an hour, (1) updates as: L C = b = 8(1 b). L L = 8 L C + 8. 2 Similarly, if she can bake half a slice an hour, (1) becomes: L C = 1 2 b = 4(1 b). L L = 8 L C +. Watanabe Econ 123 2 & 3: Gains from rade 115 / 119 Appendix 4: he Best rade Agreement for Kenneth he best outcome for Kenneth is ( K C, K ) = (35/3, 1/3). his can be derived as follows: 1 Kenneth s efficient production can be given as K = 2 + 6. 2 rading with Liz shifts the PPF by = 5. 2 3 Kenneth prefers the consumption bundle c K = 4 Solving K + = c K b. 4b gives c K = (35/3, 1/3) with the associated output of K = (5/3, 3/3). Watanabe Econ 123 2 & 3: Gains from rade 116 / 119 Appendix 4: he Best rade Agreement for Kenneth 6 46.7 ea x K (cups) 26.7 Kenneth s PPF: x K = 2xK C +6 Preferred Bundles Pre rade Output Post rade Output Post rade Consumption 111.7 16.7 3 Cheesecakes x K C (slices) Watanabe Econ 123 2 & 3: Gains from rade 117 / 119
Airline du Jour oday s color theme is provided by courtesy of Northwest Airlines Watanabe Econ 123 2 & 3: Gains from rade 118 / 119 Index absolute advantage, 11 ceteris paribus, 111 comparative advantage, 75 comparative statics, 113 consumption bundle, 52 efficient, 33 endogenous variable, 11 exogenous variable, 11 factor of production, 1 input, 1 opportunity cost, 32, 75 optimal bundle, 57 output, 1 output bundle, 18 production-possibility frontier, 13 slope, 3 specialization, 26 terms of trade, 81, 82, 86 unattainable, 35 Watanabe Econ 123 2 & 3: Gains from rade 119 / 119