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17/11/2018 04:25:49 PM

Gains From Trade and application

In order to understand why people choose to depend on others for goods and services and how this choice improves their lives, let’s look at a simple economy. Imagine that there are two goods in the world: meat and potatoes. And there are two people in the world—a cattle rancher and a potato farmer—each of whom would like to eat both meat and potatoes.

       The gains from trade are obvious if the farmer can only grow potatoes and the rancher can only raise cattle. The rancher and the farmer could choose to have nothing to do with each other. But after several months of eating beef roasted, boiled, broiled, and grilled, the rancher might decide that self-sufficiency is not all it’s cracked up to be. The farmer, who has been eating potatoes mashed, fried, baked, and scalloped, would likely agree. It is easy to see that trade would allow them to enjoy greater variety of good or service. The gains from trade are also obvious if, instead, the farmer can raise cattle as well as grow potatoes, but he is not as good at it and the rancher can grow potatoes in addition to raising cattle, but her land is not well suited for it. The gains from trade are not as clear if either the farmer or the rancher is better at producing both potatoes and meat. To answer this question, we need to look more closely at the factors that affect such a decision.

            Suppose that the farmer and the rancher each work 8 hours per day and can devote this time to growing potatoes, raising cattle, or a combination of the two. The table in Figure 1 shows the amount of time each person requires to produce 1 ounce of each good. The farmer can produce an ounce of potatoes in 15 minutes and an ounce of meat in 60 minutes. The rancher, who is more productive in both activities, can produce an ounce of potatoes in 10 minutes and an ounce of meat in 20 minutes.

Suppose the rancher suggests that the farmer specialize in the production of potatoes and then trade with the rancher for meat. The rancher will spend six hours a day producing meat (18 ounces) and two hours a week growing potatoes (12 ounces). The farmer will spend eight hours a day growing potatoes (32 ounces). The rancher will trade 5 ounces of meat for 15 ounces of potatoes.

End results: The rancher produces 18 ounces of meat and trades 5 ounces, leaving him with 13 ounces of meat. He also grows 12 ounces of potatoes and receives 15 ounces in the trade, leaving him with 27 ounces of potatoes. The farmer produces 32 ounces of potatoes and trades 15 ounces, leaving him with 17 ounces. He also receives 5 ounces of meat in the trade with the rancher. In both cases, they are able to consume quantities of potatoes and meat after the trade that they could not reach before the trade.

1. Should Tom Brady Mow His Own Lawn?

Tiger Woods spends a lot of time walking around on grass. One of the most talented golfers of all time, he can hit a drive and sink a putt in a way that most casual golfers only dream of doing. Most likely, he is talented at other activities too. For example, let’s imagine that Woods can mow his lawn faster than anyone else. But just because he can mow his lawn fast, does this mean he should?

To answer this question, we can use the concepts of opportunity cost and comparative advantage. Let’s say that Woods can mow his lawn in 2 hours. In that same 2 hours, he could film a television commercial for Nike and earn $10,000. By contrast, Forrest Gump, the boy next door, can mow Woods’s lawn in 4 hours. In that same 4 hours, he could work at McDonald’s and earn $20.

In this example, Woods has an absolute advantage in mowing lawns because he can do the work with a lower input of time. Yet because Woods’s opportunity cost of mowing the lawn is $10,000 and Forrest’s opportunity cost is only $20, Forrest has a comparative advantage in mowing lawns.  The gains from trade in this example are tremendous. Rather than mowing his own lawn, Woods should make the commercial and hire Forrest to mow the lawn. As long as Woods pays Forrest more than $20 and less than $10,000, both of them are better off

2. Should the United States Trade with Other Countries?

Many of the goods that Americans enjoy are produced abroad, and many of the goods produced in the United States are sold abroad. Goods produced abroad and sold domestically are called imports. Goods produced domestically and sold abroad are called exports. To see how countries can benefit from trade, suppose there are two countries, the United States and Japan, and two goods, food and cars. Imagine that the two countries produce cars equally well: An American worker and a Japanese worker

can each produce one car per month. By contrast, because the United States has more and better land, it is better at producing food: A U.S. worker can produce 2 tons of food per month, whereas a Japanese worker can produce only 1 ton of food per month.

            The principle of comparative advantage states that each good should be produced by the country that has the smaller opportunity cost of producing that good.

Because the opportunity cost of a car is 2 tons of food in the United States but only 1 ton of food in Japan, Japan has a comparative advantage in producing cars. Japan should produce more cars than it wants for its own use and export some of them to the United States. Similarly, because the opportunity cost of a ton of food is 1 car in Japan but only 1⁄2 car in the United States, the United States has a comparative advantage in producing food. The United States should produce more food than it wants to consume and export some to Japan. Through specialization and trade, both countries can have more food and more cars.

MBA. Nguyen Thi My My