Trade

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Trade

  1. 1. Absolute Advantage, Comparative Advantage, and Trade<br />
  2. 2. Production Possibilities<br />The table at the left shows the number of bananas OR potatoes that Gregory and Harrold can produce.<br />So in 8 hours, Gregory can produce ____ bananas or ____ potatoes and Harrold can produce ____ bananas or ____ potatoes.<br />Does either person have an absolute advantage?<br />Created by Janet Orr 2009<br />2<br />
  3. 3. Production Possibilities<br />The table at the left shows the number of bananas OR potatoes that Gregory and Harrold can produce.<br />So in 8 hours, Gregory can produce _32_ bananas OR _16_ potatoes and Harrold can produce _24_ bananas OR _8_ potatoes.<br />Gregory has the absolute advantage in both since he can produce more of each commodity in the same amount of time.<br />4 bananas/hour times 8 hours = 32 bananas<br />Created by Janet Orr 2009<br />3<br />
  4. 4. If Gregory is more productive than Harrold,<br /> why would Gregory and Harrold ever think about trading?<br />Isn’t the little guy going to be worse off and why would the big guy even be interested?<br />Created by Janet Orr 2009<br />4<br />
  5. 5. But what about comparative advantage?<br />A person or country has a comparative advantage when they give up less of the other good to produce the first good.<br />To determine comparative advantage, we have to look at opportunity costs.<br />Created by Janet Orr 2009<br />5<br />
  6. 6. Opportunity Costs<br />The table at the left shows the number of bananas OR potatoes that Gregory and Harrold can produce.<br />Opportunity cost is what is given up of the other good when I use my resources for one good.<br />For example, if Gregory uses one hour to pick bananas then he gets 4 bananas but foregoes the opportunity of digging 2 potatoes. Therefore the cost of 1 banana is ½ potato foregone.<br />Gregory has the comparative advantage in potatoes while Harrold has the comparative advantage in bananas.<br />4 B costs 2 P so<br />4/4 B costs 2/4 P or<br />1 B costs ½ P<br />Gregory gives up only 2 bananas to dig 1 potato while Harrold would have to give up 3 bananas to get 1 potato.<br />Conversely, Gregory would have to give up ½ potato to get 1 banana while Harrold only has to give up 1/3 potato to get 1 banana.<br />Created by Janet Orr 2009<br />6<br />
  7. 7. Now let’s see if having a comparative advantage<br />makes specializing and trading a good thing.<br />Created by Janet Orr 2009<br />7<br />
  8. 8. Let’s say that Gregory and Harrold each work for 8 hours and at the end of the day, Gregory has 12 bananas and 10 potatoes while Harrold has 9 bananas and 5 potatoes.<br />If Gregory and Harrold understand the advantages of comparative advantage they will agree to specialize and trade. They specialize in the food for which they have the comparative advantage.<br />Note that the daily production of each food has increased with specialization.<br />Daily production when each person spends 3 hours picking bananas and 5 hours digging potatoes.<br />Daily production when each person specializes.<br />Created by Janet Orr 2009<br />8<br />
  9. 9. The terms of trade* are 1 potato for 2 ½ banana. *explained on a following slide<br />If Gregory wants just as many bananas as he had originally then he will trade ____ potatoes for ____ bananas, leaving him with ____ bananas and ____ potatoes. Harrold, after trading away ____ bananas for ____ potatoes will have ____ bananas and ____ potatoes.<br />Are both parties better off with specialization and trade?<br />Daily production when each person spends 3 hours picking bananas and 5 hours digging potatoes.<br />Daily production when each person specializes.<br />Created by Janet Orr 2009<br />9<br />
  10. 10. The terms of trade are 1 potato for 2 ½ banana.* explained on next slide<br />If Gregory wants just as many potatoes as he had originally, then he will trade _6_ potatoes for _15_ bananas, leaving him with _15_ bananas and _10_ potatoes. Harrold, after trading away _15_ bananas for _6__ potatoes will have _9_ bananas and _6__ potatoes.<br />Both parties are better off with specialization and trade! Gregory has 3 extra bananas and Harrold has 1 extra potato.<br />Daily production when each person spends 3 hours picking bananas and 5 hours digging potatoes.<br />Daily production when each person specializes.<br />Daily food allotment when each person specializes and trades.<br />Created by Janet Orr 2009<br />10<br />
  11. 11. Terms of Trade<br />The terms of trade will always be somewhere between the costs for the two parties.<br />In this case, the costs are 1 potato for between 2 and 3 bananas. <br />In order to get a potato, Harrold would have to give up 3 bananas. If he can get a potato for anything less than 3 bananas, then he will be agreeable.<br />If Gregory can give up 1 potato and get more than 2 bananas for it, then he will be agreeable.<br />Terms of trade are usually set by negotiation and can be more favorable to one side or the other depending on knowledge and bargaining skills.<br />Created by Janet Orr 2009<br />11<br />
  12. 12. Conclusion<br />Specialization and trade makes both parties better off as long as a comparative advantage exists. The point of these exercises is for you to prove this point for yourself!<br />Specialization and trade improve world-wide production. Economists say that specialization and trade improve efficiency. In other words, we get more production from the same amount of resources.<br />Created by Janet Orr 2009<br />12<br />

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