ECON2103 - 3 Interdpendence and The Gains From Trade (Ch3)

Interdependence and the
Gains from Trade (Ch3)

Topic 3
Announcements
 Assigned Reading:
Textbook, Chapter 3
 Problem Set 3 (Ch3):
Quick Quiz Multiple Choice: ALL
Problem and Applications: Q3, Q4, Q7, Q8
ECON2103 L2 & 3 - Announcements 2

Specialization
ECON2103 L2 & 3 – Interdependence and the Gains from Trade 3

Introduction - Gain from Specialization
 Production Possibilities Frontier provides
a very good perspective to look into this
Very simple setup, but can go deep
What factor determine who specialize in what?
 You will also see exchange is a necessary
process to realize the gain from specialization
Exchange ratio: How many X be exchanged for Y
Mutually acceptable exchange ratio for all is
possible?
 From the exchange process, we will have the
analysis of Demand and Supply
Primary Factors of Production
 “Primary factors of production” are provided
by households, which include
Labor: work and effort from human beings
Capital: capacity to produce goods & services
Land: gifts from nature; and
Entrepreneur: Risk taking in production (residual
claimant)!
 Sometimes, factors of production can substitute
each others
Labor and machine: Labor / Capital intensive

Availability of “Labor”
 Labor NOT “a person”, but his effort
 “Labor” is MORE than “population”
 NOTE, “incentive” is important to induce a
person works effectively and efficiently (level
of effort provided)
Institution and compensation system: Right to
choose a job; To enjoy the reward from effort
Example in US – Incentive is important!!! Slavery
was allowed to buy back their freedom, if they
work hard / productive to accumulate enough
money. Why?
Availability of “Labor”
 Besides correct incentive: Machinery or tool
can improve the productivity of labor
 In developed countries, we usually can
observe correct incentive systems and high
amount of machinery stock is high (can be
measured by capital per capita)

Availability of “Entrepreneur”
&“Land”
 Entrepreneur to distinguish between “labor
effort” and “risk-taking behavior”
 Land (natural resources) was regarded as
fix in old days, but may not be true nowadays
Land, oil reserves, iron ore, coal, etc.
 Still, most Land is created by nature

Availability of “Capital”
 Capital creation (or formation) is an
interesting and important process
 An economic decision: Trade-off of current
and future consumption
 As mentioned, accumulation of capital is
highly related to productivity and the level of
living standard of an society
 ExamplE: Fisherman

ExamplE: Fisherman and Fishing
 Wing likes fish and does fishing for a living
 At first, he can only do that by bare hands!
 Fishes escape easily, and he could do fishing
at shallow water
 Tough life !!!

Fisherman and Fishing
 To improve the situation:
To buy a fishing net !!!
 He can do much better with it
Yeah! Yeah! Yeah!
 Note: spending money for it means a

reduction in consumption today and wish for
higher consumption in future. Trade-off!!!
Fisherman and Fishing
 Wing sacrificed some of his current
consumption (saving) to buy fish net
(investment - capital creation)
 With the fishing net, he can get enough to eat
and to sell (return to capital)
Increase of labor productivity with more capital
 In this example, besides supplying his own
labor, Wing is the entrepreneur as well
Any profit or loss from the production is borne by
Wing

Check Point (1)
 In the capital creation process, Wing will take
into account:
1) How much current consumption he has to
sacrifice
2) How much future consumption is expected
to gain
3) His patience on consumption across time
4) All of the above

Check Point (1)
 The correct answer is 4)
 You need 3) to be able to compare current
and future consumption: Discounting
Converting a dollar available 1 year later into the
equivalent value (how many cents?) as if
available today
 In a country of high political instability, would
citizen be more patient or impatient?
ECON2103 L2 & 3 – Question 14

Further on production - PPF

Production – Specialization
 Production Possibilities Frontier (PPF) is
always used to illustrate the gain from
specialization in Economics:
Why and how specialization can increase total
output of a society / a group of individuals
Also important: Idea on how the gain from
specialization divided between individuals
 What is a good model/theory?
 PPF model is simple. Yet simple but provides
many insights

Check Point (2)
 Under which of the following condition(s) will
specialization between Person A and B leads
to a larger total output for them?
1) Person A is good at producing X and B is
good at Y
2) Person A is good at producing both X and Y
3) Person B is good at producing both X and Y
4) All of the above

Check Point (2)
 The correct answer is 4
 A person is good at X means he uses less
resources in providing X
 Under 1) Person A has absolute advantage
on X and B on Y
 Under 1) and 2), though one person has
absolute advantage on both X and Y.
However, difference in their marginal costs
lead to comparative advantage
 Comparative advantage is enough for
specialization to be beneficial
Production Possibilities Frontier
PPF or PPC (curve) represents:
 At a given amount of factors of production,
how many goods can be produced
What factor of production is considered in PPF
 ExamplE: A 2-Good Case: Meat & Potato;
Factor of production = 8 hours of labor
Minutes needed In 8 hours
Meat Potato Meat Potato
Wing 60 min/oz 15 min/oz 8 oz 32oz
Siu Fai 20 min/oz 30 min/oz 24 oz 16oz
Production Possibilities Frontier
An example of a model:
 2-good can be shown on a diagram, and 5-
good case to be shown by math equation
 1-good case is too simple that provides no
insight: No trade-off on what to produce and
no way to show how specialization benefits
 Learning: A good model stays as simple as
possible but with enough context/depth to
provide explanation we want to

Meat (oz)
Each axis represents one good
All 8 hours to produce Potato
All 8 hours to produce Meat
Work half time on each

8X
X
16 32
Potato (oz)
PPF – Wing
Meat (oz)
Only combinations in the blue-shaded
area (including the PPF itself) is feasible
to Wing (e.g. the bundle represented by
the red dot is NOT feasible to Wing)
8X
X
32
Potato (oz)
PPF – Wing
 Will Wing produce at a combination of meat
and potato inside the blue-shaded area?
 To maximize: Wing will produce ON the
curve/frontier ONLY
Recall: Assumption of rationality means Wing will
maximize
 If inside, Wing is wasting factors of
production or “production inefficiency”
appears

PPF – Wing
• Meaning of downward slopping PPF?
Meat (oz)
• Produce more Potato means less Meat can
be produced
• The slop (measured by ∆Y/ ∆X) represents:
produce one more unit of Potato (x), how
many unit of meat (Y) has to give up
• Cost of producing Potato
• Steeper the slope, higher the cost of
8X producing Potato
∆Y
4
X
16 32
∆X Potato (oz)
Meat (oz)
Siu Fai 20 min/oz 30 min/oz 24 oz 16 oz
• We plot also Siu Fai’ PPF together (in

24
dark red color)
• Wing’s PPF is in blue color
12
If work half time on each
8 good, that will be the
production bundle
4
8 16 32
Potato (oz)
Production Possibilities ?
Meat (oz)
• Production bundle represented by
the red-dot
24
• Impossible: Either for Siu Fai or
Wing
12 Meat, 16 Potato ?
16 32
Potato (oz)
Can Siu Fai and Wing do better?
 What we can observe: Siu Fai and Wing have
different strength !!!
 Siu Fai is better at producing Meat than
Wing, and Wing at Potato than Siu Fai
 Any chance for them to “cooperate” and be
better for both?
E.g., each have 12 Meat and 16 Potato?
Absolute Advantage
 A person has “Absolute Advantage” at a
task over another person if the person needs
less resources (time and/or other resources)
to perform it
Siu Fai has absolute advantage (use less time
than Wing) on Meat
Wing has absolute advantage (use less time than
Siu Fai) on Potato
 Should they SPECIALIZE?
Yes, why not! It bring benefit to both of them
How to show it is mutual beneficial?
Absolute vs Comparative Advantage
 However, should “Absolute Advantage” be
used to judge whether specialization would
be beneficial?
 NO…NO…NO…
 In fact, the condition should be Comparative
Advantage, which does not depend on
Absolute Advantage
 Let me show you in the following example…

Another Example
 Now, the situation changes into:
Wing 60 min/oz 15 min/oz 8oz 32oz
Siu Fai 20 min/oz 10 min/oz 24oz 48oz
 Who has absolute advantage in Meat?

Siu Fai
 Who has absolute advantage in Potato?
Siu Fai
 Siu Fai is better in all aspects, any chance for
specialization?
PPF for the Second
• In the 2nd Example, Siu Fai’s PPF rotates
Meat (oz)
outward
• Therefore, Siu Fai has absolute
advantage for both goods!
24
• Any chance for specialization?
• The answer is YES! Absolutely Advantage is
not the KEY! Comparative Advantage is!!!
16 32
Potato (oz)
Comparative Advantage
 Although Siu Fai has Absolute Advantage
over Wing on BOTH Meat and Potato
 Wing still has Comparative Advantage on
Potato over Siu Fai !!!
 Comparative Advantage depends on the
difference in opportunity cost, not on
Absolute Advantage !!!
Wing 60 min/oz 15 min/oz 8oz 32oz
Siu Fai 20 min/oz 10 min/oz 24oz 48oz
 Opportunity cost of producing Potato (Meat)
Wing use 15 min to produce 1 oz Potato, this 15
min is enough to produce 0.25 oz Meat on the
other hand: 1 P to 0.25 M (1M to 4P)
Siu Fai use 10 min to produce 1 oz Potato, this
15 min is enough to produce 0.5 oz Meat on the
other hand: 1 P to 0.5 M (1M to 2P)
 Opportunity cost of producing Potato is
represented by the steepness of the slope of
one’s PPF

 A person has “Comparative Advantage” over
another person on a task, if the person’s
“Opportunity Cost” of performing that task is
“lower” than that of the other person
Opportunity Cost, NOT amount of resources
(which is Absolute Advantage!)
 If Wing has CA on Potato over Siu Fai, it
means SIMILARITY Siu Fai has CA on Meat
over Wing
 Wisdom: May be you are not the best from
ANY aspects, you still can find a spot for
yourself
ECON2103 L2 & 3 - Interdependence and the Gains from Trade 34
Check Point (3)
Good A Good B Good A Good B

Teresa 60 min/Unit 30 min/Unit 10 Unit 20 Unit
Astor 20 min/Unit 20 min/Unit 30 Unit 30 Unit
 Which of the following statement is correct?

1) Astor has AA in B & better specializes in B
2) Astor has CA in B & better specializes in B
3) Teresa has AA in B & better specialize in B
4) Teresa has CA in B & better specialize in B
Gain from specialization
ECON2103 L2 & 3 - Interdependence and the Gains from Trade 36

Back to the 1st Example
Meat (oz)
24
12
8 16 32
Potato (oz)
Gain from specialization
 Specialization expands the amount total
output feasible for Siu Fai and Wing together,
we can see in the following “Joint PPF with
Specialization” graphically
Siu Fai has CA (lower opportunity cost) in Meat,
so he should produce Meat first, but not Wing
However, if more Meat has to be produced after
Siu Fai use up his time, then it’s Wing’s turn
 Total output without specialization – Wing and
Siu Fai produce the same item together:
Green-dash line
Joint PPF with Specialization
Meat (oz) Both produce Meat Upper Part of Joint PPF, Potato
32 are produced by Wing
Lower Part of Joint PPF, Potato

are produced by Siu Fai
24
Without specialization
8
Both produce Potato
16 32 48
Potato (oz)
Division of gain from specialization
 Specialization (in the right way) provides the
largest Joint “Production Possibilities Set”
“Larger cake” available for Siu Fai & Wing
together: 12 Meat and 16 Potato are achievable
for them when they fully specialized!
Full specialization: Individual only performs one
task – Wing ONLY Potato; Siu Fai ONLY meat
 Gain from specialization (as compared to no
specialization): Blacked shaded area in the
following diagram

Joint PPF with Specialization
Meat (oz)
32
24
16 32 48
Potato (oz)
Division of gain from specialization
 However, how the cake (additional
output/gain from specialization) be divided?
Very important! If Wing and Siu Fai cannot find a
mutually acceptable “way” to divide the cake
(including the gain from specialization),
specialization will not happen!

Check Point (4)
 Siu Fai has to give needed
Minutes up 1.5 unit ofIn meat
8 hoursto
produce 1 unit of potato
Meat Potatoby himself
Meat Potato
Wing 60 min/oz 15 min/oz
 If 1potato can be exchange for8 oz 1 Meat32oz
in
“market”
1) He refuses exchange and choose self-
sufficient
2) He likes exchange and specialize in Meat
3) He likes exchange and specialize in Potato
4) None of the above

Check Point (4)
 Siu Fai has to give needed
Minutes up 1.5 unit ofIn meat
8 hoursto
produce 1 unit of potato
Meat Potatoby himself
Meat Potato
Wing 60 min/oz 15 min/oz
 If 1potato can be exchange for8 oz 1 Meat32oz
in
“market”
1) He refuses exchange and choose self-
sufficient
2) He likes exchange and specialize in Meat
3) He likes exchange and specialize in Potato
4) None of the above
Correct 2)
Division of gain from specialization –
Exchange Ratio
 Siu Fai has to give up 1.5 unit of meat to
produce 1 unit of potato by himself
 If 1 unit of potato can be exchanged by 1 unit
of meat (in the market), will Siu Fai produce
potato by himself?
 No! “Cheaper” for Siu Fai to produce meat
and use meat to exchange for potato
 He will be better-off by 0.5 unit of meat under
this exchange ratio (1 Meat for 1 Potato)
 Gain from specialization and exchange!!!
Exchange Ratio
 Wing has to give up 4 unit of Potato to
produce 1 unit of Meat by himself
 If 1 unit of Potato can be exchanged by 1 unit
of Meat, will Wing still produce meat by
himself?
 No! “Cheaper” for Wing to produce Potato
and use Potato to exchange for Meat
 He will be better-off by 3 unit of Potato under
this exchange ratio (1 Meat for 1 Potato)
 Gain from specialization and exchange!!!
Exchange Ratio
Therefore, we can see:
 The exchange ratio: 1 unit Potato for 1 unit
Meat, makes both Siu Fai and Wing happy,
and
 They will specialize and use the good
produced to exchange for the other one that
they don’t produce
 Besides 1unit Potato for 1 unit Meat, any
OTHER ratio(s) would make both Siu Fai and
Wing happy (mutually benefited/acceptable)?

Exchange Ratio
 Siu Fai specializes in Meat (1.5 M to 1 P)
 If 1 unit potato to 1.1 unit meat:
Siu Fai says Yes
 If 1unit potato to 1.2 unit meat
Siu Fai says Yes
 If 1unit Potato to 1.5 unit Meat
Indifferent
 If 1unit Potato to 1.6 unit Meat
NO, NO, NO
 Actually, Siu Fai will even switching to
produce Potato
Siu Fai Wing
0.1
Trade Ratio
1 unit potato to how many unit meat
What?
Yes
0.2 Yes What?
0.25 Yes Indifferent
0.4 Yes
Yes
0.6 Yes Yes
0.8 Yes Yes
1 Yes Yes
1.1 Yes Yes

1.2 Yes Yes
1.3 Yes Yes
1.4 Yes
Yes
1.5 Indifferent Yes
1.6 What? Yes
1.7 What? Yes
ECON2103 L2 & 3 - XXXXX …
> XXXXX What? Yes 49
Exchange Ratio
 To be mutual acceptable (mutually
beneficial), the exchange ratio for 1unit of
Potato to how many unit of Meat:
1.5 > = exchange ratio > = 0.25
The “gap” between Siu Fai and Wing’s costs
 Then, you may ask: Which exchange ratio
will be used by Siu Fai and Wing?
 To answer this, we need more information:
Siu Fai and Wing’s preference on meat and
potato (Demand)

PPF after Trade/Exchange
Meat (oz)
32
Trade line @ a trade ratio
mutually accepted
24 Represents the slop of Siu

Fai’ PPF
Feasible Consumption Set

after Trade (Yellow area)
8
Wing specializes in Potato
16 32 48
Potato (oz)
Summary
 We shown that specialization increases total
output
We want varieties in consumption, but
specialization leads to having one good ONLY
 Then, we shown that mutual acceptable
exchange ratio(s) must exist
Mutual benefited trade can happen
 Specialization and trade together improve the
welfare of Siu Fai and Wing
Can you see from the diagram, consumption
bundle beyond blue line is achievable by wing
Summary
 One question remains unanswered: Which
exchange ratio would be adopted by Siu Fai
and Wing finally?
1.5 > = exchange ratio > = 0.25
You may say it depends whose bargaining power
is bigger!
 What factors determine the bargaining power
of each of them?
How much they like Meat and Potato (their
preference)

Check Point (5)
 Assume for the United States that the
opportunity cost of each airplane is 100 cars.
Which of these pairs of points could be on the
United States' production possibilities frontier?
1) (200 airplanes, 10000 cars) and (150 airplanes,
20000 cars)
25000 cars)
4000 cars)
40000 cars)
Check Point (5)
 Assume for the United States that the
opportunity cost of each airplane is 100 cars.
Which of these pairs of points could be on the
United States' production possibilities frontier?
20000 cars)
25000 cars)
4000 cars)
40000 cars)
A few more on PPF

Shape of PPF – Cost of Production
 Cost of production changes when more of a
good is produced:
If cost remains constant, PPF is a straight line
In previous examples, cost of a Meat is always 4
Potato for Wing
 If cost of a good rises as the economy
produces more of the good, PPF is bow-
shaped (outward). Why?

As the economy shifts
Meat
resources
from Meat to Potato:
 PPF becomes
steeper
 Cost of Potato
increases
Potato

At A, cost of
At point A,
Meat
A Potato is low
most resources are
producing Meat,
even those who
are better suited
to building Potato
So, do not have to
give up much Meat
to get more Potato
Potato

Cost of Production – Society
Perspective
 Recall – Joint PPF
previous
 Siu Fai produces Meat
first and then Wing
 What’s its shape?
 Imagine if we have
many member in the
society and each of
them has different skills
 Different opportunity
costs of producing a
good

Growth and PPF (I)
 With additional
Meat
resources, an
economy can produce
more Meat and/or
Potato
 Same as technology
improvement: Same
amount of factors of
production, but can
produce more
Potato

Growth and PPF (I)
 However, technology
Meat
improvement can be
biased
 In the graph, the
technology
improvement is
biased to Meat
Production
 Example of tech
improvement?
Potato

Growth and PPF (II)
 Growth can be achieved
through capital building
(similar case of Siu Fai)
 Capital building: Tradeoff
between current
consumption and future
consumption
 We can produce pizzas or
pizza ovens along PPF0
 By using some resources to
produce pizza ovens today,
the PPF shifts outward in the
future (PPF1)

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Interdependence and the

Gains from Trade (Ch3)

ECON2103 L2 & 3 - Announcements 2

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 3

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 5

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 7

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 8

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 9

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 10

 Note: spending money for it means a

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 12

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 13

ECON2103 L2 & 3 – Question 14

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 15

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 16

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 17

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 20

All 8 hours to produce Potato

All 8 hours to produce Meat

Work half time on each

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 23

• We plot also Siu Fai’ PPF together (in

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 29

 Who has absolute advantage in Meat?

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 33

Good A Good B Good A Good B

 Which of the following statement is correct?

ECON2103 L2 & 3 - Interdependence and the Gains from Trade 36

Lower Part of Joint PPF, Potato

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 40

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 42

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 43

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 47

0.8 Yes Yes

1.1 Yes Yes

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 50

24 Represents the slop of Siu

Feasible Consumption Set

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 53

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 56

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 57

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 58

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 59

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 60

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 61

ECON2103 L2 & 3 – Interdependence and the Gains from Trade 62

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