Chapter 14: The Global Economy

and Policy
Appendices

Appendices to Chapter 14 of Essentials of Economics in Context

R D RSP 3R U
R R U
D D 5RDG
R R 0
G GS
Essentials of Economics in Context – Chapter 14 Appendices

APPENDIX A: A FORMAL THEORY OF GAINS FROM TRADE

Here we explore in more detail the “gains from trade” example given in the text. There, for
simplicity, we explored a case in which both countries completely specialize, producing only one
good, because their level of desired total consumption just happens to match each country’s total
production level with complete specialization. Graphing a joint PPF for the two countries enables
us to relax this assumption, while also exploring more fully the concepts of opportunity costs and
comparative advantage.

Recall that in this example, Portugal can produce a maximum of either 200 cases of wine or 100
bolts of cloth. Portugal’s PPF was shown in Figure 14.1. Realize that the slope of the PPF equals
the opportunity of production. So moving left to right starting at the (0, 200) point, a fall (or
negative “rise”) of 200 cases of wine is accompanied by a “run” of +100 bolts of cloth. Because
the curve is straight, the slope is therefore –2 throughout. Note that this is the value in Table 14.2
for the opportunity cost of Portugal producing one bolt of cloth. At any point, then, reducing wine
production by 2 cases (i.e. , a negative “rise” of 2) is needed to increase cloth production by 1 bolt
(i.e., to create a “run” of 1 unit to the right).

England can produce a maximum of 200 cases of wine or 400 bolts of cloth, as was shown in
Figure 14.2. The slope of its production possibilities frontier is –0.5 (= –200/400). For each
additional bolt of cloth, England gives up producing half a bottle of wine.

Figure 14.7 Joint Production Possibilities Frontier for England and Portugal

In Figure 14.7, we create a joint PPF for the two countries. Suppose that they both start out
producing only wine. Adding Portugal’s 200 cases to England’s 200 cases, we find that jointly
they can produce 400 cases if they produce no cloth, as shown at the point (0, 400). Now suppose
that they would like to consume some cloth, and they make a joint decision about where it should
be produced. They see that if Portugal produces the first bolt of cloth, it will cost them 2 cases of

1
Essentials of Economics in Context – Chapter 14 Appendices

wine. If England produces the first bolt of cloth, it will cost them only half a case of wine. Clearly,
England should produce it. This kind of reasoning will tell England to produce not only the first
bolt of cloth but also every succeeding bolt of cloth, as long as possible. Portugal will keep
producing only wine, at its maximum level of 200 cases.

The possibility of exploiting England’s relatively low-cost cloth production runs out when these
two countries reach point A. At point A, England produces the maximum amount of cloth it can—
400 bolts—and Portugal still produces only wine (200 cases). This was the point used as an
example in the text, for simplicity. Now if they want to continue to have even more cloth (and less
wine), Portugal will have to produce it. Each extra bolt of cloth will now cost 2 cases of wine, up
to the point (500, 0), where they both produce only cloth.

What if, instead, the countries were to follow their comparative disadvantages, having Portugal
change to cloth production first, and England only after Portugal was producing at capacity? Figure
14.8 contrasts the efficient PPF with this case. With inefficient full specialization represented by
the point where Portugal produces 100 bolts of cloth and England produces 200 cases of wine, the
PPF bends inward. The thick blue line is the efficient production-possibilities frontier, and the
thinner gray line reflects the most inefficient production choices. As you can see, following the
rule of comparative advantage leads to a much larger PPF than doing the reverse! A similarly
inefficient result would follow if you were better at cleaning, and your housemate at shopping, but
you tended to shop and your housemate tended to clean.

Figure 14.8 Efficient and Inefficient Joint Production Possibilities Frontier

As we mentioned in the chapter, along with the concept of comparative advantage economists also
discuss absolute advantage. A producer has an absolute advantage when, using the same amount
of some resource as another producer, it can produce more. Usually, labor hours are the resource
considered. For example, suppose that in a one-hour period you can buy enough groceries for six

2
Essentials of Economics in Context – Chapter 14 Appendices

days or clean three rooms. Your housemate, by contrast, moves more slowly and can buy enough
groceries for only three days, or clean only one room, in an hour. You clearly have an absolute
advantage in production of both these services. Does this mean you should do all the work?1
(See whether you can figure out the answer before looking at the endnote.)

APPENDIX B: AN ALGEBRAIC APPROACH TO THE

MULTIPLIER, IN A MODEL WITH TRADE
Just as we modified the multiplier in the appendix to Chapter 10 to take account of the impact of
taxes, we can now go a step further to consider the effect of trade. Suppose that, in addition to
consumption’s depending on income, imports depend on income according to the equation IM =
mpim Y, where mpim is the marginal propensity to import (the proportion of additional income
spent on imports). The mpim is a fraction. Starting with the equation for aggregate expenditure
with a proportional tax that we had derived in the appendix to Chapter10, we can get an equation
for aggregate expenditure in an economy including trade, as follows:

AE = C + I + G + X – IM
= C + mpc(Y - tY + TR) + I +G + X – mpim Y
= ( C + mpc T + I – G + X) +[mpc(1 – t) – mpim] Y

Solving for Y (using the same method as in the appendix to Chapter 10—but leaving out some of
the intermediate steps) yields:

𝑌 − 𝑚𝑝𝑐(1 − 𝑡)𝑌 + 𝑚𝑖𝑝𝑖𝑚 𝑌 = 𝐶̅ + 𝑚𝑝𝑐 𝑇𝑅 + 𝐼 + 𝐺 + 𝑋

1
𝑌= [ ] (𝐶̅ + 𝑚𝑝𝑐 𝑇𝑅 + 𝐼 + 𝐺 + 𝑋)
1 − 𝑚𝑝𝑐(1 − 𝑡)𝑚𝑖𝑝𝑖𝑚

The term in brackets is a new multiplier that includes both proportional taxes and imports that
depend on domestic income. This multiplier here is even smaller than the previous two. For
example, if mpc = .8, t = .2, and mpim = .1, the new multiplier is 1/(1 – .64 + .1) or 1/(0.46) or
approximately 2.2. This is because any increase in Y now “leaks” not only into saving and taxes
but also into increases in imports (which takes away from demand for domestic products).

1
No. Comparative, not absolute, advantage should guide the assignment of tasks. Although you have an absolute
advantage over your housemate in both activities, your housemate has a comparative advantage in shopping. That is,
to get enough groceries for six days would “cost” only two rooms’ worth of cleaning if your housemate does it
(taking two hours). But if you shop for six days’ worth of food, the opportunity cost is more—the three rooms you
could have cleaned. Therefore, on efficiency grounds at least, your housemate should shop and you should clean.
(You can also come to the same result by examining your own comparative advantage—in cleaning.)