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Chapter 3 Summary.pdf

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Bridget O' Shaughnessy

Chapter 3/Interdependence and the Gains from Trade ☞ Summary of Notes from Chapter 3 and Practice Questions KEY POINTS: 1. Each person consumes goods and services produced by many other people both in our country and around the world. Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services.1 2. There are two ways to compare the ability of two people in producing a good. The person who can produce the good with a smaller quantity of inputs is said to have anbsolute advantage in producing the good. The person who has the smaller opportunity cost of producing the good is said to have a comparative advantage. The gains from trade are based on comparative advantage, not absolute advantage. 3. Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage. 4. The principle of comparative advantage applies to countries as well as people. Economists use the principle of comparative advantage to advocate free trade among countries. I. A Parable for the Modern Economy: This is the example that is available on text book. In class a different example will be discussed. A. Example: two goods—meat and potatoes and two people—a cattle rancher and a potato farmer (each of whom like to consume both potatoes and meat). 1. The gains from trade are obvious if the farmer can only grow potatoes and the rancher can only raise cattle. 2. The gains from trade are also fairly 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. 3. The gains from trade are not as clear if either the farmer or the rancher is better at producing both potatoes and meat. B. Production Possibilities 1. The farmer and rancher both work 8 hours per day and can use this time to grow potatoes, raise cattle, or both. 2. The table below shows the amount of time each takes to produce 1 kilogram of either good: 1 Page Chapter 3/Interdependence and the Gains from Trade ☞ Minutes Needed to Amount Produced in 8 Hours Make 1Kilogram of: Meat Potatoes Meat Potatoes Farmer 60 min./kg 15 min./kg 8/1=8 kg 8/0.25=32 kg Rancher 20 min./kg 10 min./kg 8/0.33=24 kg 8/0.16=48 kg 3. The production possibilities can also be graphed. a. These production possibilities frontiers are drawn linearly instead of being bowed out. This assumes that the farmer's and the rancher's technology for producing meat and potatoes allows them to switch between producing one good and the other at a constant rate. b. As we saw in Chapter 2, these production possibilities frontiers represent the principles of tradeoffs and opportunity costs. 4. We will assume that the farmer and rancher divide their time equally between raising cattle and growing potatoes. Figure 3.1 a. The farmer produces (and consumes) at point A—16 kilograms of potatoes and 4 kilograms of meat. b. The rancher produces (and consumes) at point B—24 kilograms of potatoes and 12 kilograms of meat. C. Specialization and Trade 2 Page Chapter 3/Interdependence and the Gains from Trade ☞ 1. Suppose the rancher suggests that the farmer specialize in the production of potatoes and then trade with the rancher for meat. a. The rancher will spend 6 hours a day producing meat (18 kilograms) and 2 hours a week growing potatoes (12 kilograms). b. The farmer will spend 8 hours a day growing potatoes (32 kilograms). c. The rancher will trade 5 kilograms of meat for 15 kilograms of potatoes. Figure 3.2 2. End results: a. The rancher produces 18 kilograms of meat and trades 5 leaving him with 13 kilograms of meat. He also grows 12 kilograms of potatoes and receives 15 kilograms in the trade, leaving him with 27 kilograms of potatoes. b. The farmer produces 32 kilograms of potatoes and trades 15 leaving him with 17 kilograms. He also receives 5 kilograms of meat in the trade with the rancher. 3. In both cases, they are able to consume quantities of potatoes and meat after the trade t
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