Gains from Trade and Division of Labor

Interdependence versus Subsistence

J.F. O’Connor

Main Points

• Voluntary trade or exchange is mutually beneficial

• Specialization and division of labor can increase total output of a community

• Comparative advantage (opportunity cost) is a key factor in determining the pattern of specialization

• International trade is generally beneficial in the long run

Basis for Trade or Exchange

• Differences in endowments

• Differences in preferences

• Comparative advantage (opportunity cost)

G a i n s fr o m T r a d e U n d e r P u r e E x c h a n g e ( N o P r o d u c t i o n )

E x a m p l e 1 . Id e n t i c a l P r e fe r e n c e s b u t D i ffe r e n t E n d o w m e n t s

P r e fe r e n c e s :

B u n d l e s o f e q u a l m e r i t o r s a t i s fa c t i o n

M a r y J o e

O r a n g e s A p p l e s O r a n g e s A p p l e s

2 2 2 2 2 2

3 1 5 3 1 5

4 1 0 4 1 0

5 6 5 6

E n d o w m e n t

M a r y J o e

2 2 2 5 6

M a r y i s w i l l i n g t o g i ve u p a s J o e i s w i l l i n g t o t a k e a s fe w a s

m a n y a s 7 a p p l e s i n r e t u r n fo r 4 a p p l e s i n r e t u r n fo r o n e

o n e o r a n g e o r a n g e

W h a t a r e t h e t r a d e s t h a t w i l l m a k e b o t h o f t h e m b e t t e r o f f

o n e o r a n g e f o r f i v e a p p l e s

o n e o r a n g e f o r s i x a p p l e s

L o o k a t t h e s e c o n d a l t e r n a t i v e

A f t e r t h e t r a d e o r e x c h a n g e

N e w e n d o w m e n t

M a r y J o e

3 1 6 4 1 2

H o w d o w e k n o w t h a t b o t h a r e b e t t e r o f f t h a n b e f o r e ?

T h e y w o u l d h a v e b e e n h a p p y t o h a v e t h e f o l l o w i n g

3 1 5 4 1 0

b u t t h e y h a v e b e t t e r b u n d l e s .

E x a m p l e 2 . Id e n t i c a l E n d o w m e n t s b u t D i f fe r e n t P r e fe r n c e s

P r e fe r e n c e s :

B u n d l e s o f e q u a l m e r i t o r s a t i s fa c t i o n

M a r y J o e

O r a n g e s A p p l e s O r a n g e s A p p l e s

2 2 2 2 1 8

3 1 5 3 1 5

4 1 0 4 1 3

5 6 5 1 2

E n d o w m e n t

3 1 5 3 1 5

M a r y i s w i l l i n g t o g i v e u p a s J o e i s w i l l i n g t o t a k e a s fe w a s

m a n y a s 5 a p p l e s i n r e t u r n fo r 3 a p p l e s i n r e t u r n fo r o n e

o n e o r a n g e o r a n g e

W h a t a r e t h e t r a d e s t h a t w i l l m a k e b o t h o f t h e m b e t t e r o f f

o n e o r a n g e f o r f o u r a p p l e s

A f t e r t h e t r a d e o r e x c h a n g e

N e w e n d o w m e n t

4 1 1 2 1 9

H o w d o w e k n o w t h a t b o t h a r e b e t t e r o f f t h a n b e f o r e ?

T h e y w o u l d h a v e b e e n h a p p y t o h a v e t h e f o l l o w i n g

4 1 0 2 1 8

b u t t h e y h a v e b e t t e r b u n d l e s .

Two Bases for Trade

• If two persons have identical preferences, what would cause them to trade?

• If two persons have identical endowments, is there any basis for trade?

Gains from Exchange

• Key point of the foregoing discussion is that voluntary trade is mutually beneficial. It makes both parties to the trade better off. We say that voluntary trade is a positive-sum game.

• What is an example of involuntary trade or exchange?

Comparative Advantage

• Joan is a physician and also an excellent typist ( 120 wpm error free). As a physician, she earns $90 an hour. She has also been doing her own typing but that reduces the number of patients that she can see. Joan advertises the position. The best person available is Mary who types 50 wpm and is willing to work for $8 per hour.

Comparative Advantage

• Mary, while being a less efficient typist than Joan, has a comparative advantage in typing because the opportunity cost of Joan’s typing is her best alternative which is seeing patients at $90 an hour while Mary’s opportunity cost is $8 an hour.

Gains from Specialization

• Consider a farmer and a rancher. Each has 40 hours available. They can produce meat and potatoes. For the farmer, it takes 2 hours to produce a pound of meat and 10 hours to produce a pound of potatoes. For the rancher, it takes one hour to produce a pound of meat and 8 hours to produce a pound of potatoes. Rancher is better at both. We say he has an absolute advantage in both activities.

Gains from Specialization:

Increasing Combined Output

0

5

10

15

20

25

30

35

40

Rancher

Farmer

5 4 3 2 1 0 1 2 3 4 5

Me

at

Potatoes

Demonstration of Gains

• Suppose that the farmer is producing 2lb. of potatoes and 10 lb. of meat while the rancher is producing 2lb. of potatoes and 24lb of meat. The combined output is 4lb. of potatoes and 34lb of meat.

• Note that each individual is efficiently using his resources. We will show that by each producing more of what he is relatively good at, combined output can be increased.

• Key point is to note that if the rancher produces on more unit of potatoes, he has to give up 8 units of meat while if the farmer produces another unit of potatoes, he has to give up only 5 units of meat.

• Thus, if the rancher produces one less unit of potatoes and 8 more units of meat while the farmer produces one more unit of potatoes and 5 fewer unit of beef, combined output of beef is increased by 3 units while the output of potatoes remains constant.

• Opportunity cost of potatoes for the rancher is 8lb. of meat while that for the farmer is 5lb. of meat. Therefore, the farmer has a comparative advantage in the production of potatoes. His opportunity cost of producing potatoes is less than that of the rancher.

Efficient Joint Production

• How should they organize production so as to maximize the output of meat for each level of output of potatoes? Use the Principle of Comparative Advantage

• The PPF is drawn up using CA. Start where both are devoting all their resources to meat production. Let us increase potato production by one unit. How should it be done?

• If the farmer produces it, the output of meat is reduced by 5. If the rancher produces it, the output of meat is reduced by 8. If the farmer produces 1/2 and the rancher produces ½, then the output of meat is

reduced by 6.5.

Production Possibilities Frontier

0

10

20

30

40

50

60

Rancher

Farmer

PPF

0 1 2 3 4 5 6 7 8 9 10

Me

at

Potatoes

Comparative Advantage for Regions and Countries

• Does the principle of comparative advantage apply to regions and countries?

• Some examples:– Eastern Kentucky and Bluegrass– Colorado and Iowa– U.S and Haiti– U.S. and Mexico– U.S and Japan