International Trade
 Why do people – and nations – choose to be
economically interdependent?
 How can trade make everyone better off?
 What is absolute advantage?
What is comparative advantage?
How are these concepts similar?
How are they different?
0
Gross Domestic Product (GDP) is…
…the market value of all final goods &
services produced within a country
in a given period of time.
usually a year or a quarter (3 months).
1
The Components of GDP
 Recall: GDP is total spending.
 We can break total spending down into
four components:
• Consumption (C)
• Investment (I)
• Government Purchases (G)
• Net Exports (NX)
 These components add up to GDP (denoted Y):
Y = C + I + G + NX
2
Consumption (C)
 is total spending by households on goods and
services.
 Note:
• For renters, consumption includes their rent
payments.
• For homeowners, consumption includes the
imputed rental value of their house, NOT the
purchase price or the mortgage payments!!!
3
Investment (I)
 is total spending on goods that will be used in
the future to produce more goods.
 includes spending on
• capital equipment (e.g. machines, tools)
• structures (factories, office buildings, houses)
• inventories (goods produced but not yet sold)
Note: “Investment” does not
mean the purchase of financial
assets like stocks and bonds.
4
Government Purchases (G)
 include all spending on the goods and services
purchased by government at the federal, state,
and local levels.
 exclude transfer payments, such as
Social Security or Unemployment Insurance
benefits. These payments represent
transfers of income, not purchases of goods or
services produced.
5
Net Exports (NX)
 NX = exports – imports
 Exports represent foreign spending on the
economy’s goods & services.
 Imports are the portions of C, I, and G
that are spent on goods and services produced
abroad.
 Adding up all the components of GDP gives:
Y = C + I + G + NX
6
U.S. GDP and its components, 2004
billions
% of GDP
per capita
Y
$11,735
100.0
$39,938
C
8,230
70.1
28,009
I
1,927
16.4
6,559
G
2,184
18.6
7,432
NX
–606
–5.2
–2,063
7
Interdependence
Every day
you rely on
many people
from around
the world,
most of whom
you do not know,
to provide you
with the goods
and services
you enjoy.
hair gel from
Cleveland, OH
cell phone
from Taiwan
dress shirt
from China
coffee from
Kenya
Interdependence
 This session examines one of the
Principles of Economics :
Trade can make
everyone better off.
 In this session, we will learn why
people – and nations – choose to be
interdependent, and how they gain
from trade.
9
Our example
 Two countries: the U.S. and Japan
 Two goods: computers and wheat
 One resource: labor, measured in hours
 First, we will look at how much each country
produces and consumes if it chooses to be
self-sufficient.
 Then, we will allow the countries to trade with
each other.
10
Production Possibilities in the U.S.
 The U.S. has 50,000 hours of labor
available for production, per month.
 Producing one computer
requires 100 hours of labor.
 Producing one ton of wheat
requires 10 hours of labor.
11
The U.S. PPF
Wheat
(tons)
The U.S. has enough labor
to produce 500 computers,
or 5000 tons of wheat,
or any combination along
the PPF.
5,000
4,000
3,000
2,000
1,000
0
Computers
100
200 300 400
500
12
The U.S. without trade
Wheat
(tons)
Suppose the U.S. uses half its labor
to produce each of the two goods.
Then it will produce and consume
250 computers and
2500 tons of wheat.
5,000
4,000
3,000
2,000
1,000
0
Computers
100
200 300 400
500
13
Production Possibilities in Japan
 Japan produces 3,200 tons of wheat and 400
computers.
 They choose to consume at mid-point.
Use this information to draw Japan’s PPF.
Measure computers on the horizontal axis.
Start now.
14
Japan’s PPF
Japan has enough labor to
produce 400 computers,
Wheat
(tons)
or 3200 tons of wheat,
or any combination
along the PPF.
2,000
1,000
0
Computers
100
200
300
15
U.S. production with trade
Wheat
(tons)
Producing 3400 tons of wheat
requires 34,000 labor hours.
5,000
4,000
The remaining 16,000
labor hours are used to
produce 160 computers.
3,000
2,000
1,000
0
Computers
100
200 300 400
500
16
Japan’s production with trade
Wheat
(tons)
3,200 wheat to 400
computers
2,000
1,000
0
Computers
100
200
300
17
Trade: Exports and Imports
 Exports: goods produced domestically and
sold abroad.
 Imports: goods produced abroad and sold
domestically.
 US specializes in wheat, Japan in computers
18
Where do these gains come from?
 Absolute advantage is the ability to produce a
good using fewer inputs that another producer.
 In our example, the U.S. has an absolute
advantage in the production of wheat:
producing a ton of wheat uses 10 labor hours
in the U.S. vs. 25 in Japan.
 If each country has an absolute advantage
in one good and specializes in that good,
then both countries can gain from trade.
19
Where do these gains come from?
 Which country has an absolute advantage in
computers?
 Producing one computer requires
125 labor hours in Japan,
but only 100 in the U.S.
 The U.S. has an absolute advantage in both
goods!
So why does Japan specialize in computers?
Why do both countries gain from trade?
20
Two measures of the cost of a good
 Two countries can gain from trade when each
specializes in the good it produces at lowest cost.
 Absolute advantage measures the cost of a good
in terms of the inputs required to produce it.
 Recall there’s another way to measure cost:
opportunity cost.
 In our example, the opportunity cost of a computer
is the amount of wheat that could be produced
using the labor needed to produce one computer.
21
Opportunity cost
and comparative advantage
 Comparative advantage is the ability to produce
a good at a lower opportunity cost than another
producer.
 Which country has the comparative advantage in
computers?
 To answer this, we must determine the
opportunity cost of a computer in both countries.
22
Comparative Advantage and Trade
 Differences in opportunity cost and comparative
advantage create the gains from trade.
 When each country specializes in the good(s)
in which it has a comparative advantage,
total production in all countries is higher,
the world’s “economic pie” is bigger,
and all countries can gain from trade.
 The same applies to individual producers
(like the farmer and the rancher) specializing
in different goods and trading with each other.
23
Unanswered questions….
 We made a lot of assumptions about the quantities
of each good that each country produces, trades,
and consumes, and the price at which the
countries trade wheat for computers.
 In the real world, these quantities and prices would
be determined by the preferences of consumers
and the technology and resources in both
countries.
 For now, though, our goal was only to see that
trade, indeed, can make everyone better off.
24
SESSION SUMMARY
 Interdependence and trade allow everyone to
enjoy a greater quantity and variety of goods &
services.
 Comparative advantage means being able to
produce a good at a lower opportunity cost.
Absolute advantage means being able to produce
a good with fewer inputs.
 When people – or countries – specialize in the
goods in which they have a comparative
advantage, the economic “pie” grows and
trade can make everyone better off.
25