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Macroeconomics 3: Trade Makes All Parties Better Off

As mentioned in the previous article, "Ten Principles of Economics" (the 5th principle, to be precise), trade between people tends to make all the parties involved better off than if trade is restricted or forbidden. We mentioned also that the main reason behind this is the concept of comparative advantage. In order to see how this works, let's consider an example.

Let's say that Robinson Crusoe and Friday are neighbors on a remote area, far from any other people. This gives us a simple, closed economy, that produces 2 goods - coconuts and fish. Let's say that Robinson is good at gathering coconuts, and that Friday is a good fisherman. It does not take a big leap of logic to see how trade can benefit the two. Robinson can trade with Friday: give up some of his coconuts for some of Friday's fish, and they can both eat a more varied diet.

The less obvious case comes if one of them is better at doing both things, fishing AND gathering coconuts. It may seem that in this situation, the person who is better at doing both things has nothing to gain by trading with someone who can't match his productive prowess. Let's put some numbers down to help us see how this could play out. Let's say that each of our subjects works 40 hours per week, and out of that, they can devote any number of hours they wish to either fishing or picking coconuts. The table below shows how much time each person needs to devote to each activity, in order to yield 1 lb. of each product:

The production opportunities of Robinson Crusoe and Friday
  Hours req'd to make 1 lb. of: Lbs produced in a week (40 hrs.):
Robinson 20 hrs/lb 10 hrs/lb 2 lbs 4 lbs
Friday 1 hr/lb 8 hrs/lb 40 lbs 5 lbs

From this table, it is clear that Friday is better at producing both goods. Is there any reason at all for him to trade with Robinson? Let's draw a production possibilities frontier diagram for each of our two friends, to see their production for all possible time allocation combinations, and see what information we can glean from it:

Production Possibilities Frontier for Potato Farmer

This chart, known as a production possibilities frontier, simply uses the information from the table and presents it in graphical format, so that it is easy to see all the possibilities. Let's focus on one of the possibilities - Robinson dedicates 20 hours to fishing, and 20 hours to gathering coconuts, and for his efforts, he is rewarded with 1 lb of fish and 2 lbs of coconuts.

Now let's take a look at a production possibilities frontier for Friday:

Production Possibilities Frontier for Cattle Rancher

We find that if Friday splits his time evenly between fishing and gathering coconuts, his yield will be 20 lbs of fish AND 2.5 lbs of coconuts - as we said, both are higher than Robinson's, no matter how they split their time, as long as they both split their time in the same way.

As we can see from Principle 1 of the 10 Principles of Economics, people face tradeoffs: if you spend 20 hours gathering coconuts, you will have 20 hours less to spend fishing. The result will be that you will have more coconuts, but at the expense of some of your fish production.

The lesson from this is that if these two people decide never to trade with each other, as Friday may be tempted to do since he is better at producing everything, then they can each consume only what they themselves produce. In other words, their consumption possibilities frontier will be the same as their production possibilities frontier. Now let's see what happens to their consumption possibilities frontiers if they do decide to trade.

To make things simple, let's assume that they agree to the following terms: Robinson will spend the entire 40 hour work week gathering coconuts, and Friday will spend 24 hours fishing and 16 hours gathering coconuts. According to the above table, this will result in Robinson collecting 4 lbs of coconuts and no fish, while Friday collects 24 lbs of fish and 2 lbs of coconuts. Then, Robinson proposes to give Friday 1 lb of coconuts in exchange for 3 lbs of fish. This may seem like a dubious proposal at first, but let's look at the bottom line. Robinson will now be able to consume 3 lbs of coconuts and 3 lbs of fish - a great improvement over his previous total of 2 lbs of coconuts and 1 lb of fish, so he certainly has something to gain from this trade, as we suspected. Friday, however, will now be able to consume 21 lbs of fish and 3 lbs of coconuts - also more than what he was used to before the deal (20 lbs of fish and 2.5 lbs of coconuts). Although Friday does not gain as much as Robinson, he does experience an increase in his standard of living (or at least in his consumption possibilities).

This is illustrated in the charts below. Please note that both of their consumption levels lie outside the production possibilities frontier, meaning that trade allows both of them to consume more than they would without trade.

Consumption with Trade for Robinson Crusoe

Consumption with Trade for Friday

Because they each specialized in what they do best, and then traded, they are each better off than if they didn't trade at all. It all comes down to a concept we alluded to at the beginning of this article - comparative advantage. Even though Friday has an absoulte advantage in the production of both coconuts AND fish, Robinson has a comparative advantage in gathering coconuts. If you look at it from an opportunity cost point of view, you will notice that Friday's opportunity cost of producing 1 lb of coconuts is 8 lbs of fish. He has to spend 8 hours producing 1 lb of coconuts, while he could instead go fishing and catch 8 lbs of fish in those same 8 hours. Robinson's opportunity cost for producing 1 lb of coconuts, on the other hand, is only 1/2 lb of fish. Since Robinson's opportunity cost of producing coconuts is much lower, it makes sense for him to focus on that, and then trade some of his coconuts for some of Friday's fish. The table below illustrates these opportunity costs:

Opportunity Cost of Coconuts and Fish
1 lb of fish 1 lb of coconuts
Robinson 2 lbs of coconuts 1/2 lb of fish
Friday 1/8 lb of coconuts 8 lbs of meat

You will notice that even though we talk about "costs", there is no money involved. The costs are simply how much of one product each person has to give up to get a set amount of the other product. This relationship shows up very often in economics, and is how economists visualize scarcity. If they both had unlimited fish and unlimited coconuts at their disposal, this would all be meaningless. They do not, however, so it is not.

What combination of coconuts and fish they will each choose cannot be predicted from this model. Since people base their decisions on a cost-benefit analysis (even if it's subconscious) and the benefits are dependent on their personal preferences, then this model gives us no information on that. We only have the costs part of the equation. What this model does offer though, is a menu of choices, and it allows us to see that the best choices on the menu, for both parties, involve trade rather than isolation.

The same principles of production specialization based on comparative advantage can be applied to nations: if each nation focuses on producing what it has a comparative advantage in producing, and then trading with another nation, both parties benefit as a result of the "gains from trade". It should also be noted that, while a nation can in theory have an absoloute advantage at producing everything, the very definition of comparative advantage makes it impossible for a nation to have a comparative advantage at producing everything.

Continue to Macroeconomics 4: The Market Forces of Supply and Demand

<< Ten Principles of Economics Market Forces of Supply and Demand >>

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