Lecture 9: A Demonstration of Why Trade Is Critical Lecture 9: A Demonstration of Why Trade Is Critical to the Production of Wealthto the Production of Wealth

Evolution of Economic Theory:Evolution of Economic Theory:

Adam Smith (1776) explained the value ofAdam Smith (1776) explained the value of

1) the division of labor and 2) specialization of labor1) the division of labor and 2) specialization of labor

Pin factory examplePin factory example

David Ricardo later explained:David Ricardo later explained:

comparative advantagecomparative advantage

No Man Is an IslandNo Man Is an Island

Crusoe stranded on island for several years.Crusoe stranded on island for several years.Based on real story.Based on real story.

Presume Crusoe spends most Presume Crusoe spends most time making breadfruit bread (BB)time making breadfruit bread (BB)loaves and cups of coconut milkloaves and cups of coconut milk(CM) (weekly output). He has (CM) (weekly output). He has ability to produce these shownability to produce these shownon production possibility curve.on production possibility curve.Maybe he eats a balanced dietMaybe he eats a balanced dietof 25 CM and 5 BB.of 25 CM and 5 BB.

Crusoe’sProductionPossibility

BB

CM0

10

5025

5

Crusoe Meets Competent FridayCrusoe Meets Competent Friday

Friday, living on other side of island, same resources, also makes BB and Friday, living on other side of island, same resources, also makes BB and CM, but is much more productive. Why? Both work hard all day long.CM, but is much more productive. Why? Both work hard all day long.

Friday also producesFriday also produces

BB and CM all weekBB and CM all week

Long. He eats a Long. He eats a

Balanced diet of 45 CMBalanced diet of 45 CM

And 15 BB loaves.And 15 BB loaves.

Then the two meet.Then the two meet.

Friday’sProductionPossibility

CM

BB

0 45 90

30

15

Friday Is Better at Making BothFriday Is Better at Making Both

Crusoe and Friday notice differences in how much of both Crusoe and Friday notice differences in how much of both goods they can produce each week. Friday is better at goods they can produce each week. Friday is better at making both – an absolute advantage. making both – an absolute advantage.

BBBB CMCM RatioRatioCrusoeCrusoe 1010 5050 1/5 1/5FridayFriday 3030 9090 1/3 1/3

But: Who is the low cost producer of what, compared to the But: Who is the low cost producer of what, compared to the other? Who has comparative advantage?other? Who has comparative advantage?

Poor Crusoe Trades with FridayPoor Crusoe Trades with Friday

Noticing relative differences in costs of producing CM and BB, Noticing relative differences in costs of producing CM and BB, let us presume they agree to trade 5 BB for 20 CM at the let us presume they agree to trade 5 BB for 20 CM at the end of the week. So Friday must make more BB; Crusoe end of the week. So Friday must make more BB; Crusoe must make more CM.must make more CM.

Assume this term of trade: 1 BB for 4 CMAssume this term of trade: 1 BB for 4 CM

Who is the winner of this trade?Who is the winner of this trade?

Trade Creates WealthTrade Creates Wealth

Exchange occurs:Exchange occurs:

Crusoe has 6 BB and 25 CM Friday has 15 BB and 50 CMCrusoe has 6 BB and 25 CM Friday has 15 BB and 50 CM

CrusoeFriday

CM

BBBB

CM

65

2015

25 45 30 45 50

Trade Exploits Trade Exploits Comparative AdvantageComparative Advantage

The process of voluntary trade makes both parties to the trade The process of voluntary trade makes both parties to the trade richer.richer.

No more effort was required – just specialization in the thing one is No more effort was required – just specialization in the thing one is relativelyrelatively better at doing compared to the trading partner. The better at doing compared to the trading partner. The less able, Crusoe, has something to offer the more able, Friday.less able, Crusoe, has something to offer the more able, Friday.

Adding thousands of goods and millions of people complicates the Adding thousands of goods and millions of people complicates the math but not the outcome.math but not the outcome.

Trade creates wealth and requires social cooperation.Trade creates wealth and requires social cooperation.

Trade Among Nations Has Same Trade Among Nations Has Same Wealth Creating EffectWealth Creating Effect

Assume companies in Japan and in Mexico make shirts Assume companies in Japan and in Mexico make shirts and cars for their consumers.and cars for their consumers.

Current production abilities are up to 5 million shirts per Current production abilities are up to 5 million shirts per week in Mexico and up to 50,000 cars per week — given week in Mexico and up to 50,000 cars per week — given current resources in labor and capital.current resources in labor and capital.

Current production abilities are up to 4 million shirts per Current production abilities are up to 4 million shirts per week in Japan and up to 100,000 cars per week — given week in Japan and up to 100,000 cars per week — given current resources in labor and capital.current resources in labor and capital.

To have more cars, resources must be taken from shirt To have more cars, resources must be taken from shirt production — opportunity cost. production — opportunity cost.

Production PossibilitiesProduction Possibilities

MexicoMexico

cars

shirtso

5m

50k

25k

2.5m

Current production — based oninternal prices in Mexico and demandsof consumers — results in 25,000 carsper week and 2.5 million shirts beingproduced and bought by consumers in Mexico each week. Domestic prices arenot relevant for trade, what matters arerelative costs — 100 shirts for 1 car isthe internal rate of trade.

Production PossibilitiesProduction Possibilities

JapanJapan

cars

shirts

100k

4m2m

50k

Current production — based oninternal prices and demand inJapan — results in 50,000 carsand 2 million shirts per week beingproduced and bought in Japan. Theinternal rate of trade is 40 shirts forone car within Japan.

What do Japan and Mexico haveto offer each other?

Gains from Trade: Gains from Trade: Comparative AdvantageComparative Advantage

Internal rate of exchange in Mexico is 100/1 shirts Internal rate of exchange in Mexico is 100/1 shirts for cars.for cars.

Internal rarte of exchange in Japan is 40/1 shirts Internal rarte of exchange in Japan is 40/1 shirts for cars.for cars.

Comparing these two producers, who is the lower Comparing these two producers, who is the lower cost producer of cars? Who is the lower cost cost producer of cars? Who is the lower cost producer of shirts?producer of shirts?

Trade will occur somewhere between 100/1 and Trade will occur somewhere between 100/1 and 40/1. Let us assume 60/1.40/1. Let us assume 60/1.

Trade: Both Become WealthierTrade: Both Become Wealthier

MexicoMexico JapanJapan

cars

0 shirts

50k

5m2m

cars

shirts0 4m3m

100k

50k

Mexico specializes in shirts — makes 5 million, sells 3 million to Japan.Japan specializes in cars — makes 100,000, sells 50,000 to Mexico for 3 million shirts. Both end up outside of their own production possibilities — trade allows people in both nations to have more of what they want.

New pointof production

New point ofproduction

So Why Is There a Problem?So Why Is There a Problem?

Japan and Mexico both become wealthier due to Japan and Mexico both become wealthier due to free trade.free trade.

Citizens in both nations get more of what they Citizens in both nations get more of what they want at the new prices available to them.want at the new prices available to them.

Note: Trade is done by Yen and Peso, but that is Note: Trade is done by Yen and Peso, but that is just for convenience — people want cars and just for convenience — people want cars and shirts — not money.shirts — not money.

Expand this to 100 nations and 10,000 goods as Expand this to 100 nations and 10,000 goods as people seek what they want. The math is more people seek what they want. The math is more complicated, but same wealth creating results.complicated, but same wealth creating results.

So why is there opposition to free trade?So why is there opposition to free trade?