Lecture 1

Exchange and Trade

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Learning Outcomes
What is the benefit of trade?
What is absolute advantage?
What is comparative advantage?
What determines the pattern of specialization and
trade?
What dete4rmines the rate of exchange?

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Our Example
Two countries: the U.S. and Japan
Two goods: computers and wheat
One input: labour (measured in hours)
Two cases:
1. if the country chooses to be self-sufficient;
2. if it trades with the other country.

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Production Possibilities in the U.S.
The U.S. has 50,000 hours of labour available for
production, per month.
Producing one computer requires 100 hours of
labour.
Producing one ton of wheat requires 10 hours of
labour.

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The
Whe U.S. PPF
at Computers Wheat LabourUsed(hours)
(tonsD
5,00 A 500 0 500x100 + 0x10 = 50000
0) B 250 2500 250x100 + 2500x10 =50000
4,00 C 100 4000 100x100 + 4000x10 = 50000
0 D 0 5000 0x100 + 5000x10 = 50000
3,00
0
2,00
0
1,00
0
A
Computer
0
10 20 30 40 50 s
0 0 0 0 0
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The
Whe U.S. Without Trade
at
(tonsD Suppose the U.S. uses half its
5,00
0)
labour to produce each of the
4,00 twoThen
goods.
it will produce and
0 consume
3,00 250 computers and
0 B
2500 tons of wheat.
2,00
0
1,00
0
A
Computer
0
10 20 30 40 50 s
0 0 0 0 0
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ACTIVE LEARNING 1: Japans PPF
Without Trade
Use the following information to draw Japans PPF.
Japan has 50,000 hours of labour available for
production, per month.
Producing one computer requires 125 hours of
labour.
Producing one ton of wheat requires 25 hours of
labour.

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 ACTIVE LEARNING 1: Japans PPF
Without Trade
Whe Suppose Japan produces 100
at computers and the rest of
(tons labours are used to produce
)
2,00 wheat.
0 Computer Wheat LabourUsed(hours)
s
X 0 0 x125 + x25 = 50000
1,00 Y 100 100x125 + x25 = 50000
0 Z 0 x125 + 0 x25 = 50000

0 Computer
200 400 600 s
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ACTIVE LEARNING 2: Production
with Trade
Suppose the U.S. specializes in production of wheat
and decides to produce 5000 tons of wheat. How
many computers would the U.S. be able to produce
with its remaining labour? Draw the point
representing this combination of computers and
wheat on the U.S. PPF.
Suppose Japan decides to specialize in computer
production and produces 400 computers. How many
tons of wheat would Japan be able to produce with
its remaining labour? Draw this point on Japans
PPF.
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ACTIVE LEARNING 2: U.S.
Whe
Production
at with Trade
(tons
5,00 Producing 5000 tons of wheat
0) requires 50,000 labour hours.
4,00
0 The remaining labour hours are
3,00 used to produce _____
0 computers.
2,00
0
1,00
0
Computer
0
10 20 30 40 50 s
0 0 0 0 0
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 ACTIVE LEARNING 2: Japans
Production with Trade
Whe Producing 400 computers
at requires all of Japans 50,000
(tons
)
2,00
labour hours.
0 So, Japan would produce ____
tons of wheat.
1,00
0

0 Computer
200 400 600 s
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ACTIVE LEARNING 3: Consumption
with Trade
Suppose the U.S. exports 1500 tons of wheat to
Japan, and imports 250 computers from Japan.
or
Japan imports 1500 tons wheat and exports 250
computers.
How much of each good is consumed in the U.S.?
Plot this combination on the U.S. PPF.
How much of each good is consumed in Japan? Plot
this combination on Japans PPF.

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ACTIVE LEARNING 3: U.S.
Consumption
Whe with Trade
at compute wheat
(tons produced rs
0 5000
5,00 +
0) imported
250 0
4,00
= 0 1500
0 exported
amount
3,00 250 3500
consume
0
d
2,00
0
1,00
0
Computer
0
10 20 30 40 50 s
0 0 0 0 0
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 ACTIVE LEARNING 3: Japans
Consumption with Trade
computer wheat
Whe produced s
400 0
at +
(tons 0 1500
imported

)
2,00 250 0
exported
= amount
0
consume 150 1500
d
1,00
0

0 Computer
200 400 600 s
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Trade Makes Both Countries Better Off
U.S.
consumptio consumptio gains
n without n with from
computer trade
250 trade
250 trade
0
s
wheat 2,500 3,500 1,000
Japan
consumptio consumptio gains
n without n with from
computer trade
100 trade
150 trade
50
s
wheat 1500 1500 0
Summary
What is the benefit of specialization and
international trade?
Why Japan should specialize in production of
Computer and export Computer? Why not Wheat?
Why the rate of exchange is 1500 tons of wheat for
250 computers?

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Driving Force of Specialization:
Absolute Advantage
Absoluteadvantage: the ability to produce a good
using fewer inputs than another producer
This expresses the efficiency of one person, firm,
or nation compared to that of another
Two countries can gain from trade when each
specializes in the good that they can produce
efficiently.

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Driving Force of Specialization:
Absolute Advantage
The U.S. has an absolute advantage in the production
of wheat:
Producing a ton of wheat uses 10 labour hours
in the U.S. vs. 25 in Japan.
Which country has an absolute advantage in
computers?
Producing one computer requires 125 labour
hours in Japan, but only 100 in the U.S.
The U.S. has an absolute advantage in both goods!
Whoshouldspecializeincomputerandinwheat?
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Driving Force of Specialization:
Comparative Advantage
Another measure of cost is opportunity cost.
In our example, the opportunity cost of a computer is
the amount of wheat that could be produced using
the labour needed to produce one computer.
Comparativeadvantage: the ability to produce
a good at a lower opportunity cost than another
producer

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Driving Force of Specialization:
Comparative Advantage
The opportunity cost of a computer is
10 tons of wheat in the U.S., because producing
one computer requires 100 labour hours,
which instead could produce 10 tons of wheat.
5 tons of wheat in Japan, because producing one
computer requires 125 labour hours,
which instead could produce 5 tons of wheat.
So, Japan has a comparative advantage in computers.

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ACTIVE LEARNING 4: Absolute &
Comparative Advantage
Indonesia and China each have 50 million hours of
labour per month, and the following technologies:
China
producing one kg of tea requires 2 labour hours
producing one kg of rice requires 4 labour hours
Indonesia
producing one kg of tea requires 4 labour hours
producing one kg of rice requires 4 labour hours
Which country has an absolute advantage in the
production of tea? Which country has a comparative
advantage in the production of tea?
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ACTIVE LEARNING 4: Absolute &
Comparative Advantage
Opportunity cost of producing tea:
____ kg of rice in China
____ kg of rice in Indonesia
Opportunity cost of producing rice:
____ kg of tea in China
____ kg of tea in Indonesia

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ACTIVE LEARNING 4: Absolute &
Comparative Advantage
What is the rate of exchange?

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Further Reading
Mankiw (2015): Chapter 3
Colander (2017): Chapter 9
Krugman and Wells (2015): Chapter 8
Mankiw, Quah and Wilson (2013): Chapter 3
McConnell, Brue and Flynn (2015): Chapter 24
Taylor and Weerapana (2012): Chapter 29

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