Interdependence and Gains from Trade

00:01 Hello, and welcome back to your online presentation on Microeconomics.

00:04 My name is James DeNicco.

00:06 In this presentation, we're gonna be talking about Interdependence and Hains from Trade, or how countries can become better off if they open themselves up to trade.

00:15 So we're gonna have to take a look what opportunity cost are.

00:18 Whatever you have to give up to get something that's one of the driving forces behind trade.

00:23 We're gonna see how countries can become better off if they specialized in what they're efficient at, let other countries specialize in what they're efficient at so we can produce more of everything and consume more of everything.

00:34 We're gonna be talking about absolute advantage and comparative advantage, terms we need to know in order to understand trade, and we're gonna look at what terms of trade can make everybody better off.

00:45 What price of trade is necessary for that to happen? So first, what are opportunity costs? Opportunity cost are whatever you must give up in order to do something.

00:55 So say I go to the movies, what are my opportunity costs? Well, obviously I have to pay for the ticket and the popcorn, those are my explicit cost.

01:02 There's also implicit cost, I give up possibly going to work and earning a wage.

01:07 There's both explicit and implicit cost in opportunity cost.

01:11 In terms of trade, what we're gonna talk about is what I have to give up in terms of producing one good in order to produce another good, and we're gonna have what's called comparative advantage which good am I more efficient at producing? That's what I'm gonna wanna specialize in.

01:27 So let's go through an example to show how this works.

01:30 So in our example here, we'll keep it simple.

01:33 We're gonna fix our resources, our resources are just hours in a day and we're gonna have 2 countries.

01:38 One country is gonna be run by Roscoe. Roscoe is actually the name of my dog, so my dog Roscoe is gonna run one country.

01:45 I'm gonna run the other country.

01:47 So we have fixed resources as I said, so in one day, Roscoe can either produce 8 IPAs or 32 wings.

01:56 IPA that's the type of beer, it's my favorite beer, its nice and hoppy and bitter; and bee stings wings, it's one of my favorite food types.

02:03 So it's a chicken wing that's fried and then they put buffalo sauce and honey on it, and when it's well done it's delicious, so two of my favorite things, that's why we're talking about them.

02:12 So in one day Roscoe can either produce 8 beers and zero wings, or 32 wings and zero beers. Now I'm a little more productive than Roscoe.

02:22 I have opposable thumbs he doesn't, so I'm more efficient.

02:25 So one day, I can either produce 24 IPAs and zero wings, or I can produce 48 wings and zero beers.

02:34 So let's take a look at what we call our production possibility frontier.

02:38 So this is a picture of basically of what I just showed you.

02:41 So these curves, these are production possibility frontiers so those are all the combinations of production that's possible, so we have to give up some beers to produce more wings or give up some wings to produce more beers.

02:54 We can't be beyond this line because our resources don't allow it.

02:58 We don't want to be inside the line because then we're being efficient.

03:01 So you can see here that Roscoe can either produce 8 beers and zero wings, or 32 wings and zero beers or any combination along this production possibility frontier.

03:12 He's kind of a moderate dog, so he's gonna choose to have 4 beers and 16 wings.

03:18 Now this is my production possibility frontier curve.

03:21 Anywhere along this is possible.

03:23 If I produce zero wings I can produce 24 beers, if I produce zero beers I can produce 48 wings.

03:30 I'm kind of a moderate guy so I'm gonna pick somewhere in the middle.

03:33 I'm gonna pick 12 beers and 24 wings.

03:36 So this is our starting point, Roscoe's at 4 and 16; I'm at 12 and 24.

03:41 And before we go too much further I wanna talk about a few terms you're gonna need to know in order to understand trade. First is absolute advantage.

03:49 You saw that I was able with the same resources to produce more of both goods than Roscoe.

03:55 I have an absolute advantage in both goods but we can still trade because absolute advantage isn't what drives trade, it's what we call comparative advantage.

04:06 Now comparative advantage, that's the ability to produce a good at a lower opportunity cost than another producer.

04:13 Here you're gonna see Roscoe is gonna have a comparative advantage in producing wings.

04:17 He gives up less beer per wing that he makes.

04:21 I'm gonna have the comparative advantage at producing beers.

04:25 I give up less wings per beer that I make than Roscoe.

04:29 So whatever you have your comparative advantage in, that's what you're more efficient.

04:33 You have the lower the opportunity cost, so you're gonna wanna specialize in that good.

04:37 Now the terms of trade, the price of trade that's gonna work to make us both better off, it has to be between our two opportunity cost.

04:46 If it's not between our two opportunity cost, one of the sides isn't gonna agree to it because they're not gonna be made better off.

04:53 Just a couple more terms you need to know when you talk about trade, imports and exports, that's what's being traded.

04:58 So if I'm the domestic country and I'm exporting, that means I'm selling goods and services to another country.

05:04 If I'm importing, I'm buying goods and services from another country.

05:07 So now we have all our terms that we need to know, absolute advantage, our comparative advantage.

05:12 We know the terms of trade that work between our two opportunity cost, and we know what imports and exports are.

05:18 So now let's get back to our example, alright? So I go to Roscoe and I try to explain this to him, I say, hey, dog, I got a great idea that's gonna make us both fatter and happier cuz that's the goal in life, right? I know your production possibility frontier.

05:31 If you give mw 15 of the 32 bee sting wings you can make, I'll give you 5 IPAs, now you're gonna be better off, you're gonna have 16 wings and five IPAs a day as opposed to 16 wings and only 4 IPAs a day, so you're gonna be better off if you trade with me.

05:49 So Roscoe is a little cautions, doesn't quite trust me, so he said, yes, sounds good but it must be scam, how's that gonna be better off for you? So I say, settle down Roscoe, let me show you how this is gonna work, alright.

06:00 So to start off with, you see Roscoe has his 4 IPAs and the 16 wings.

06:05 I've got my 12 IPAs and my 24 wings.

06:08 Now I know looking at Roscoe's production possibility frontier that he has comparative advantage in producing wings, so if he produces zero beers, he could produce 32 wings.

06:20 What does he have to give up? He has to give up 8 beers to produce 32 wings, so what's his opportunity cost of producing wings? It's a fourth of a beer per wing, 8 divided by 32 is one fourth, so he has to give up a fourth of a beer per wing that he makes.

06:37 If you take a look at mine, you can see that in one day I can produce 24 beers and zero wings or 48 wings and zero beers, so how many beers do I have to give up in order to make one wing? So that'd be 24 divided by 48, or a half.

06:55 I would have to give up a half a beer per wing that I make; Roscoe only gives up a fourth of a beer per wing that he makes, so he's got the comparative advantage in making wings.

07:05 So I'm gonna say, hey, Roscoe, you just concentrate on making the wings and then I'll see how much I have to make of beer and wings for us both to be better off.

07:14 So my proposal here is you concentrate on the wings, you just make 32 of those, don't make any beers and then I'll go ahead, I'll make 18 beers and 12 wings.

07:25 Now we can trade and both be better off.

07:28 I will give you 5 beers, you'll give me 17 wings.

07:32 What does that resolve in that means you get plus one in beers, you have an extra beer, you have an extra wing, you go from 16 to 17.

07:40 I had 12 beers now I've got 13 beers, I'm up one.

07:44 I had 24 wings, now I have 27, I'm up 3, we're both better off.

07:50 And now Roscoe is saying, wow, this does kind of work, wow.

07:54 So, yes, I told you, this example right here shows how both people, or both countries can be better off due to trade.

08:02 So let's take a look a little closer here at the comparative advantage or the opportunity cost.

08:07 So again, you're gonna see Roscoe, his opportunity cost are producing wings.

08:12 He has to give up a fourth of a beer, 8 divided by 32.

08:16 That means his opportunity cost of producing IPAs he has to give up 4 wings.

08:22 You see for me, I have an opportunity cost of producing bee sting wings of a half a beer.

08:27 I have to give up half a beer to produce a wing, but I only have to give up two wings to produce a beer, so I have a comparative advantage at producing beer compared to Roscoe.

08:38 I only give up 2 wings, he gives up 4 wings.

08:41 He has the comparative advantage in producing wings, he only has to give up a fourth of a beer per wing; I have to give up a half of a beer per wing.

08:48 So that means he should specialize in wings and I should specialize in beers.

08:53 Now what price of trade do we come up with? Well, we traded 5 beers for 15 wings or one third.

09:00 You'll see that one third is between a half and a fourth; or between a fourth and a half, so it works, those terms of trade work.

09:08 Or if you look at it the other way, we have 15 wings for 5 beers or you have to give up 3 wings per beer, that's between 2 and 4, it works.

09:18 The price of trade works there so that we're both better off.

09:21 Now you can set this up and figure it out by putting the schedule out there so how many beers per wing do I have to give up? And you go down the list and you can write it out.

09:31 So here Roscoe can have zero beers, 32 wings.

09:34 He can have 2 beers, 24 wings; 4 beers, 16 wings.

09:38 Why have I already decided, I have the absolute advantage so the best way for this to go, I'm gonna propose the trade to you, Roscoe.

09:44 I know you have the comparative advantage on wings so you just concentrate on that, you just produce the 32 wings and the zero beers.

09:52 I'll go from my starting point of 12 and 24 and work my way down until I find terms of trade that work.

09:59 So you can go through these slides and you can see that there's different prices that will work as long as they're in between the opportunity cost.

10:07 Production possibility frontier, this is what it's all about.

10:11 Before we were stuck on these curves, we couldn't break these curves.

10:14 So Roscoe decided to have 4 and 16, I was stuck, with my production possibility frontier, I was stuck with 12 and 24. Now we're both beyond that.

10:24 So this picture it shows you that we can be both better off when we trade.

10:29 We can both have more of both goods now, so we broke our production possibility frontier curve, that's the idea of this.

10:37 So what have we learned here today? Well, first, we know what opportunity cost are, they're what you have to give up to do something in terms of trade.

10:46 How much of one good do I have to give up to produce another good? That's the driving force behind trade, whoever is more efficient, whoever has the comparative advantage.

10:56 Alright, we know about absolute advantage and comparative advantage.

10:58 We know the terms of trade to make this better off, it has to be between our two opportunity cost, and we know that terms of trade allows us to be better off, we can break our production possibilities frontier.

11:10 So, that's how trade can make us both better off, that's the presentation. Thank you.