Unit II Discussion

MBA 6641, International Economics 1

Course Learning Outcomes for Unit II Upon completion of this unit, students should be able to:

2. Differentiate the different models of trade. 2.1 Demonstrate how the production process can lead to gains from trade.

Course/Unit Learning Outcomes

Learning Activity

2.1 Unit Lesson Chapter 3 Unit II PowerPoint Presentation

Required Unit Resources Chapter 3: The Standard Theory of International Trade

Unit Lesson Unit I demonstrated how trade is beneficial and how the gains from trade derive from differences in opportunity costs. Unit II dives into more detail on the differences in opportunity costs. One of the first differences that can arise comes from increasing opportunity costs.

Increasing Opportunity Costs Recall what you read in Chapter 2 in Unit I. Chapter 2 of the textbook introduces the production possibilities frontier graph. This is a graphical representation of how much a country (or person) can produce. For simplicity, the model assumes two goods and that there is a trade-off between producing one good or the other. The line between the extreme output combinations of the two goods, in Chapter 2, is a straight line. The slope of the line is the opportunity cost of producing one good in terms of another. In Chapter 2, there is an assumption that production and opportunity cost are constant. That is, if Sally can sell 15 seashells a day or chuck 5 tons of wood, then for every ton of wood she chucks, she gives up selling three seashells. However, it might not work out that cleanly. If Sally cuts short her time selling seashells to chuck some wood, then she might be giving up the prime selling time. Perhaps all of the other hours are spent collecting the seashells to be sold. Perhaps the hour would have been spent collecting seashells so when the time comes to sell them, there are not as many seashells to sell. All of that leads to the idea that opportunity costs may not be constant. The line between the extreme output combinations of the two goods is not necessarily straight. Typically, opportunity costs increase. As you produce more of something, the amount of the other good you have to give up increases.

UNIT II STUDY GUIDE

Sources of Gains from Trade

MBA 6641, International Economics 2

UNIT x STUDY GUIDE

Title

Take oranges for example. Florida is known for their oranges, but, ultimately, the land in Florida is limited. If there was a larger demand for oranges in the market, Florida would have to expand the land dedicated to growing oranges. Orange groves would have to be planted farther and farther north, eventually potentially pushing into Georgia. Georgia is not, however, ideally suited to growing oranges. The climate, the soil, and the conditions, in general, are not as suitable for oranges as Florida. That does not mean oranges could not be grown in Georgia, however. Perhaps an enterprising Georgian orchardist could build a greenhouse designed to grow oranges. While possible, this would certainly take more resources than would be required in southern Florida. These resources could have been used for some other type of production. Increasing opportunity costs can lead to a curved production possibilities frontier (PPF). With a curved production possibilities frontier, the slope of the curve is still the opportunity cost of producing one good in terms of another, but this slope changes as you move along the curve (that is, move to different combinations of production).

Another word for opportunity cost is the marginal rate of transformation. The marginal rate of transformation (MRT) refers to the amount of a good that must be given to produce an additional unit of another good. The marginal rate of transformation is equal to the slope of the production possibilities frontier (Salvatore, 2020). There are two main reasons opportunity costs can increase. The first, like with the oranges example, is that not all inputs are homogenous. That means, like Florida’s climate, an area may have different qualities or resource(s). The second is that the quantity of resources may be used in different fixed proportions. For example, assume you are moving and you get your friends to help you. You are fortunate enough to have a few friends who are very big and strong, but most of your friends are not the heavy-lifting type. The more you have to move, the deeper you will dip into the not-as-strong friends, and it might take many of those friends to move a single item whereas one of your stronger friends could easily move it singlehandedly.

Production and Consumption Differences Trade can also be motivated by differences in PPFs resulting from differences in factor endowments or technology. Some countries may have more labor or more capital, leading them to be able to produce more of one good but perhaps not as much of another. Similarly, technology differences between countries can lead to differences in production possibilities. These differences will be covered in more depth in Unit III with the Hecksher-Olin model. Similarly, legal systems can lead to different production possibilities. Regulations on pollution, for example, can make certain production in one area infeasible compared to an area without such restrictions. Legal protections for intellectual property can also lead to an area being better suited to certain production than another area. Another motivating factor for trade can be differences in consumption preferences. Economists use indifference curves to show various combinations of goods that yield the same satisfaction (or utility).

Curved PPF (Everlong, 2006)

MBA 6641, International Economics 3

UNIT x STUDY GUIDE

Title

Any point on a given indifference curve is equally valued as any other point on that same indifference curve. Indifference curves that are further up and to the right are preferred to indifference curves down and to the left. Much like how the slope of a production possibilities frontier is the marginal rate of transformation, the slope of an indifference curve is called the marginal rate of substitution (MRS). The marginal rate of substitution conveys information about how much of one good consumers are willing to trade off for another good and be just as satisfied. Put the two together and visualize how an area might be able to produce a large amount of a particular good, but the consumers in that area may not get much satisfaction from that good. Imagine workers in a sausage factory. By the time they are done working and making sausage all day, the last thing they may want to see when they get home is a sausage for dinner. Even if the consumers in an area are satisfied with the good(s) they produce, they may simply produce more of it than the community needs and wants. Alaskan fishing

boats catch large quantities of fish, but there are not nearly enough people in Alaska to eat all of the fish they catch.

Autarky versus Trade Autarky is the absence of trade (Salvatore, 2020). If a country does not engage in trade, it can only consume what it produces. Revisit the example from earlier about Sally. Recall that Sally can sell 15 seashells or chuck 5 tons of wood. Therefore, if she decides she wants as much chucked wood as possible, then the most she can have chucked is five tons. A woodchuck then comes along who wants to sell seashells. The woodchuck can only sell four seashells a day but is able to chuck 10 tons of wood a day. Therefore, by itself, the most seashells the woodchuck would be able to sell is four. Sally and the woodchuck strike a deal. Sally will spend all day selling the woodchuck’s seashells and the woodchuck will spend all day chucking Sally’s wood. What is the result? Sally is able to get 10 tons of wood chucked and the woodchuck is able to get 15 seashells sold. Compare that to the maximum production they could have done individually. The woodchuck would have only been able to sell four seashells but now has 15 sold. Sally would have only been able to chuck 5 tons of wood but now has 10 tons of wood chucked. Both the woodchuck and Sally are better off from the trade. From this information, we can even derive the relative price. Sally sold 15 seashells and received 10 tons of wood chucked. Therefore, Sally sold 1.5 seashells per ton of wood chucked. They do not have to do a straight swap of all of their production. Sally could decide to sell some of her own seashells and just get less wood chucked. It is the same, but reversed, for the woodchuck. Whatever combination they decided to do, their ability to consume would be beyond their own production possibilities frontier. Another point we can take from that example is that even if a country could produce the goods that it wants, it still benefits from trade because it is able to, ultimately, consume more than if it just produced by itself.

Indifference curve (SilverStar, 2006)

MBA 6641, International Economics 4

UNIT x STUDY GUIDE

Title

Specialization Focusing on the production of one good means specializing in that good. Aside from the simple example illustrated above, specialization brings benefits to production such as increased knowledge and efficiency. This specialization can even lead to constant, if not decreasing, opportunity costs. Even if opportunity costs do, ultimately, increase, countries can benefit from incomplete specialization. With incomplete specialization, countries produce up to the point that their opportunity costs increase such that it is no longer worth it for them to keep producing, and they are better off obtaining the goods by trade. This is why you might see a country import and export the same type of good. There are numerous reasons for trade, whether because of the production capabilities or the consumer preferences. Regardless of the reason, trade makes society better off. Unit I relied on basic logic that if trade did not make people better off, they would not trade. Unit II starts to unpack where some of that benefit comes from.

References Everlong. (2006). Production possibilities frontier curve [Graph]. Wikimedia.

https://commons.wikimedia.org/wiki/File:Production_Possibilities_Frontier_Curve.svg Salvatore, D. (2020). International economics (13th ed.). Wiley.

https://online.vitalsource.com/#/books/9781119554950 SilverStar. (2006). Simple indifference curves [Graph]. Wikipedia. https://en.wikipedia.org/wiki/File:Simple-

indifference-curves.svg