Gains from Trade

Lecture 2

Trade creates value out of thin air!

Value is subjective.

Classical economists of the 18th and 19th centuries held to a labor theory of value.

Value is subjective.

Classical economists of the 18th and 19th centuries held to a labor theory of value.

Water–Diamond Paradox:

“Nothing is more useful than water, but it will purchase scarce anything […] A diamond, on the contrary, has scarce any value in use, but a great quantity of other goods may frequently be had in exchange for it.” Adam Smith, The Wealth of Nations

Value is subjective.

Classical economists held to a labor theory of value.

Water–Diamond Paradox: water is more useful yet less valuable than diamonds.

Clearly scarcity has something to do with value.

Value is subjective.

Classical economists held to a labor theory of value.

Water–Diamond Paradox: water is more useful yet less valuable than diamonds.

Clearly scarcity has something to do with value.

More fundamentally, it has to do with individuals’ valuation of goods on the margin.

Value is subjective.

What’s a glass of water worth?

Value is subjective.

What’s a glass of water worth?

Depends on what the marginal unit available is being used for.

Each additional unit goes to its most pressing use, so later units are worth less to you.

Value is subjective.

Depends on what the marginal unit available is being used for.

Law of Diminishing Marginal Utility:

Each unit of a good that becomes available brings an individual higher marginal utility than will subsequent units of the good that become available, all else equal.
As you consume more of something, each additional unit is worth a little less to you than the one before.

Diminishing marginal utility implies positive time preference.

Individuals are “impatient.”

Diminishing marginal utility implies positive time preference.

Individuals are “impatient.”

They value having resources now at a premium relative to having them later.

Diminishing marginal utility implies positive time preference.

Individuals are “impatient.”

They value having resources now at a premium relative to having them later.

Law of Diminishing Marginal Utility applied to time:

Each unit of time that becomes available is put towards the most pressing (highest-value) use.
Subsequent units are put towards increasingly less pressing (lower-value) uses.
Therefore, time available in the future is worth less than time available now.

Trade creates value out of thin air!

Value is subjective.

When individuals voluntarily exchange goods, those goods move from lower-value to higher-value uses.

Trade creates value out of thin air!

Value is subjective.

When individuals voluntarily exchange goods, those goods move from lower-value to higher-value uses.

If there is no value to be created, then an exchange will not be made voluntarily!

Comparative Advantage

By moving goods to more highly valued uses, there are inherent gains from voluntary exchange (trade).

Comparative Advantage

By moving goods to more highly valued uses, there are inherent gains from voluntary exchange (trade).

There are also gains from trade when producers focus on their comparative advantages.

Comparative Advantage: the ability of an individual, firm, or country to produce a good at a lower opportunity cost than others can.

Production Possibilities Frontier

To illustrate how comparative advantage creates gains from trade, we introduce the production possibilities frontier (PPF).

Production Possibilities Frontier: a curve showing the maximum attainable combinations of two goods that may be produced with available inputs and technology.

Production Possibilities Frontier

A curve showing the maximum attainable combinations of two goods that may be produced with available inputs and technology.

Consider an example of the PPFs of two countries (US & Saudi Arabia) that each can produce two goods (oil and food).

Example: US & Saudi Arabia

Assume the opportunity cost of producing 1 ton of food in Saudi Arabia is 10 barrels of oil…

Example: US & Saudi Arabia

Opportunity cost of 1 ton of food in Saudi Arabia = 10 barrels of oil.

If Saudi Arabia reallocates inputs to produce 1 more ton of food, it must sacrifice producing 10 barrels of oil.

Example: US & Saudi Arabia

Opportunity cost of 1 ton of food in Saudi Arabia = 10 barrels of oil.

If Saudi Arabia produces 1 more ton of food, it sacrifices 10 barrels of oil.

Likewise, if it produces 10 more barrels of oil, it sacrifices 1 ton of food.

Example: US & Saudi Arabia

Opportunity cost of 1 ton of food in Saudi Arabia = 10 barrels of oil.

…And the opportunity cost of producing 1 ton of food in the US = &frac110; barrel of oil.

Example: US & Saudi Arabia

Saudi Arabia: 1 ton food costs 10 barrels oil | US: 1 ton food costs &frac110; barrel oil.

Current production:

	Food (tons)	Oil (barrels)
Saudi Arabia	60	400
United States	400	60
Combined	460	460

Example: US & Saudi Arabia

Saudi Arabia: 1 ton food costs 10 barrels oil | US: 1 ton food costs &frac110; barrel oil.

We observe:

Saudi Arabia has a comparative advantage in the production of oil.
The United States has a comparative advantage in the production of food.
Each country’s production is already skewed toward its comparative advantage.

US & Saudi Arabia, Production Possibilities Frontiers

Saudi Arabia

United States

Current production

Current production, combined totals

Combined production: 460 tons of food & 460 barrels of oil.

If both countries specialize in their comparative advantage…

Combined production after specialization: 1,000 tons of food & 1,000 barrels of oil, an increase of 540 units of each good.

Then they can trade and both be better off.

	Food (tons)	Oil (barrels)
Before specialization, Saudi Arabia	60	400
Before specialization, United States	400	60
After trade, Saudi Arabia	160	840
After trade, United States	840	160

Both countries end up with more of both goods than they had before trade.

Comparative vs. Absolute Advantage

Note that the US not only has a comparative advantage in food production, but also an absolute advantage.

Comparative vs. Absolute Advantage

The US has both comparative and absolute advantage in food production.

Likewise, Saudi Arabia has an absolute advantage in oil production.

Comparative vs. Absolute Advantage

The US has both comparative and absolute advantage in food production.

Saudi Arabia has an absolute advantage in oil production.

Absolute Advantage: the ability of an individual, firm, or country to produce more of a particular good than others can using the same inputs.

Comparative vs. Absolute Advantage

	Food	Oil
Absolute advantage	United States	Saudi Arabia
Comparative advantage	United States	Saudi Arabia

The US can produce absolutely more food than Saudi Arabia. Saudi Arabia can produce absolutely more oil than the US.

Does a country need an absolute advantage in something for it to gain from trade?

Example: Texas & Massachusetts, Beef vs. Beer

Texas

Massachusetts

Texas has an absolute advantage in both beef and beer. Massachusetts cannot produce more of either good with the same inputs.

Texas has an absolute advantage in both goods. Who has the comparative advantage in beer?

	OC of 1,000 gal beer	OC of 1 ton beef
Texas	2 tons of beef	500 gal beer
Massachusetts	~1.33 tons of beef	~750 gal beer

Massachusetts has the comparative advantage in beerit gives up fewer tons of beef per thousand gallons of beer produced. Texas has the comparative advantage in beef.

Both states specialize toward their comparative advantage

Texas, more beef

Massachusetts, more beer

Total production: 60 tons of beef & 40,000 gallons of beer. Before specialization: 55 tons of beef & 40,000 gallons of beer. Both states gained 5 tons of beefand now there’s room to trade for more beer too.

After specialization and tradeeveryone can consume more!

	Beer before	Beer after trade	Beef before	Beef after trade
Texas	20k gal	22k gal	40 tons	40 tons
Massachusetts	20k gal	18k gal	15 tons	20 tons

Texas gains beer. Massachusetts gains beef. Both states are better offeven though Texas had an absolute advantage in everything.