Chapter Three

Or Better Yet, Trade!

The Logic of Comparative Advantage

The Production Possibilities Frontier

The Production Possibilities Frontier (PPF) is a graph which displays the possible combinations of goods and services that can be produced by an economy given the resources and technology that they have.

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If you are getting 8 hours of sleep, then you will have 16 hours left in your day which you can divide between working and having time to do whatever you choose, or what we call leisure time. We can represent your options for how you will split your 16 hours on a graph like this one. A graph is just two number lines put together. The vertical axis represents the number of hours worked, and as you go up the vertical axis, you are increasing the numerical value of the number of hours worked from 1 up to our maximum of 16. The horizontal axis represents the number of hours spent on leisure, as you go along the horizontal axis, you are increasing the numerical value of the number of hours spent on leisure from 1 up to our maximum of 16. --We can plot some of the possible ways we can split our time. If we spend all 16 waking hours on work, we would have 0 left over for leisure. That would put us at this point on the graph. We are all the way up the vertical axis to our maximum of 16 hours, but since we have 0 hours left for leisure, we fall right on the vertical axis. If we make a change, and shift 1 hour of work to leisure, we would be giving 15 hours to work and 1 hour to leisure, which would put us here. Notice that we moved down one step and over one step, representing that trade-off between working and leisure time. In fact, we can see that the opportunity cost of leisure is giving up the chance to work that additional hour and earn a wage. And if we want, we can keep making that trade-off, paying that opportunity cost. At this point we are working 14 hours, leaving us 2 hours for leisure. And down and across we can go, transferring our resource of time from one activity to the other. At this point we are splitting our time evenly between work and leisure, with 8 hours for each. But we can keep going, giving more of our time to leisure and less to work until we end up at 1 hour worked and 15 hours for leisure, or even all the way to 0 hours worked with all 16 hours for leisure. Of course, there are even more possibilities that the ones we plotted here. Anything in between these points is an option, like working for 8 hours and 15 minutes and having 7 hours and 45 minutes for leisure. This line represents all of those infinite possibilities. --Because this line represents the full set of possibilities for how we can use our 16 hours, we call it the production possibilities frontier. It’s the frontier because we are unable to obtain any outcome beyond this line. If you think about it, anything below or on this line is attainable. You could split your time evenly, working for 8 hours and having 8 hours for leisure, which would be right on our line, but you could also spend 5 hours working, have 5 hours for leisure time, and then spend the other 6 hours just staring at a wall or something. That wouldn’t be advisable, because it wouldn’t really be an efficient use of your time, but it is possible. What you can’t do is work for 10 hours and still have 10 hours for leisure, at least given the constraint of only having 16 hours available. That would be unobtainable, and if we plotted it on the graph it would be beyond our frontier. --When it comes to how you use your time, we don’t really think of it as “production”, though it is doing something with a resource you have: time. But generally, the production possibilities frontier is a model for thinking about the economy. The Production Possibilities Frontier (or PPF) is a graph which displays the possible combinations of goods and services that can be produced by an economy given the resources and technology that they have. One of the basic questions an economy has to answer is: What will we produce? Do we want to produce X or Y? We can put that on a graph, and consider every possible combination of X and Y our economy is capable of producing. Typically, when we draw the PPF, we draw it as a curve, and not as a straight line like we did for our time. The trade-off between working and leisure time is constant. One hour of leisure means one less hour of work, and vice versa. But not all trade-offs are constant like that. Instead, when it comes to production, usually we face the Law of Diminishing Marginal Returns, which is that as additional resources are allocated to the same purpose, the marginal benefit of those resources will decline. --Imagine a traditional economy of hunters and gathers. The hunters go off and catch fish, while the gatherers collect berries. Option A shows an outcome where the tribe is devoting almost all its resources to fishing. The resources in this case is the time and effort of the people in the tribe, and in Option A, the tribe has all its hunters working on catching fish, but also most of its gatherers working on catching fish. If they move to Option B, they will catch fewer fish, but they will collect a lot more berries, because the first people to shift from catching fish to collecting berries will be the gatherers – the people who are better at gathering berries compared to catching fish. But if the tribe decides to go all the way to Option C, it means they will have to get hunters to collect berries rather than spending their time catching fish, which is what they are good at. The trade-off is a lot bigger. Going from A to B, we can see in the chart that we lost 5 fish but gained 5 berries. However, going from B to C, we had to give up 10 fish to get 5 more berries. The opportunity cost of berries is rising, and the reason is diminishing marginal returns. The Law of Diminishing Marginal Returns is that as additional resources are allocated to the same purpose, the marginal benefit from those resources will decline. What that means here is that as additional members of the tribe are allocated to collecting berries, the amount of berries the additional person will collect will be smaller. We should also think about points D and E. Point D lies below the PPF, and on the chart we can see we get 10 fish and 8 berries. This is definitely obtainable, but it means some members of the tribe aren’t pulling their weight. If everyone was working and doing their part, we could have more fish and more berries at Option B with 15 fish and 10 berries. So, while D is achievable – we can do it if that’s what we want – it isn’t efficient. Point E on the other hand just isn’t obtainable. Without more people in the tribe, catching 20 fish and still collecting 16 berries just isn’t possible. So, we call that point unobtainable. --Efficiency is an important goal for an economy. We think of efficiency as satisfying two goals. Productive efficiency is the goal of using the least costly production techniques to produce goods and services. If we have hunters gathering berries while at the same time gatherers are catching fish, then we don’t have productive efficiency, because swapping a hunter and a gatherer would increase both our fish and our berries by putting that person on the job they’re better at. We want to use our resources as efficiently as possible. Only points directly on the production possibilities frontier meet the criteria of productive efficiency. So, points A, B, and C have productive efficiency, because there is no way to get more berries without giving up some fish and vice versa. But point D does not meet the criteria of productive efficiency, because we can increase the amount of both fish and berries we are producing. Point E would be efficient except that it is just unobtainable. If we could do it we should, but since we can’t, so efficiency doesn’t really apply. The other goal is allocative efficiency, which is when resources are used for producing the combination of goods and services most wanted by society. If the goal of this tribe is to produce the most food they can, then B is probably the best option for them, and the one they will choose. But A and C could be allocatively efficient too if the tribe just loves fish or berries a lot more than the other. The key is that our choice between the options that meet productive efficiency will be determined by how our economic system tries to meet our needs and wants. And if that system is successful in that effort, the outcome will be allocatively efficient.

Practice Questions

1. An island nation grows bananas and pineapples. Some land is better suited for growing bananas, while other land is better suited for growing pineapples. The table below shows some of their production possibilities.

Draw the Production Possibilities Frontier for this nation, labeling each of the points on the table.

Reveal the Answer

Here is how I drew it:

Don't worry if you switched the axes, that's totally ok. But notice that this PPF follows the Law of Diminishing Marginal Returns.

2. Referring to the same table above, what is the trade-off this island nation faces if they want to go from producing 50 thousand to 100 thousand pounds of bananas? What about going from 100 thousand to 150 thousand pounds?

Reveal the Answer

When the island nation is producing 50 thousand pounds of bananas, it means they are able to produce 275 thousand pounds of pineapples. That is what the table shows. If they increase banana production to 100 thousand pounds, they will have to reduce their pineapple production to 225 thousand pounds because that extra banana production will take up those resources. So, the island nation gives up 50 thousand pounds of pineapples (the difference between 275 and 225) to get the additional 50 thousand pounds of bananas.

But when they go from 100 thousand pounds of bananas to 150 thousand pounds, the trade-off has changed. That step costs them 100 thousand pounds of pineapples (going from 225 down to 125 on the table). That means the opportunity cost of bananas is increasing, because we have to give up more pineapples to get another 50 thousand pounds of bananas.

When you have diminishing marginal returns, you also have increasing opportunity costs.

Trade

Each of us has two ways to get what we want. We can produce it ourselves, or we can trade for it. Trade is the exchange of goods or services for other goods or services. Of course, how much we will have to trade with will depend on how much we are able to produce. Someone has the Absolute Advantage in trade if they are able to produce more of something than someone else.

Open Video Transcript

Humans, like many other species, frequently engage in trade. Trade is the exchange of goods or services between economic agents (for example: people, households, tribes, firms, cities, countries, etc.). That term, economic agents, will come up again, so just remember it represents any group of people we might have, including individuals acting on their own. Most trades that we do today, we do with money. It may surprise you, but our system of money has been taught to other species as well, and there is a funny story about that which I will let Freakonomics coauthor Stephen Dubner tell…--[Transcript available for the video-in-the-video on YouTube]--In that story about Felix the monkey, it is really important to note that the economist was trying to see if the monkeys had preferences for certain things, and if they would respond to changes in the prices of those things. With humans, and it turns out also with Capuchin monkeys, we will agree to a trade if it beneficial to us to do so, and whether or not it is beneficial is determined by our preferences. Since both parties have to agree to a trade, it will only happen if it is mutually beneficial. --When it comes to production, however, some people are better at certain things than others. We can imagine two tribes – the Blue tribe and the Orange tribe – and the people in each tribe have different skills. Blue tribe is better at catching fish, and they can catch a maximum of 200 fish if they put all their time and effort into it. Alternatively, if they spend all their time and effort on gathering berries instead, they will get 165. Over on Orange tribe, the trade-off is different. They are better at collecting berries, and they will collect 210 of them if they fully commit to berries, or they could catch 170 fish if they commit to that instead. The Absolute Advantage goes to the economic agent with the highest level of production. It goes to the group that would win the race if we were trying to see who can produce the most. In this case, when it comes to fish, Blue tribe as the absolute advantage: 200 is more than 170. But when it comes to berries, Orange tribe has the absolute advantage, 210 is more than 165. But you can see that some of Orange tribe’s possibilities go beyond the PPF of Blue tribe, and some of Blue tribe’s possibilities go beyond the PPF of Orange tribe. It may be possible then for them to work together, and help each other push beyond their PPF, reaching those previously unobtainable outcomes. --But what if instead the PPFs for Blue and Orange looked like this. Now, Blue tribe has the absolute advantage in both fish and berries. Perhaps the Blue tribe will be generous, and give some of their wealth in fish and berries to Orange tribe, but it doesn’t look like there is anything Orange tribe has to offer Blue tribe. Right? Luckily, that’s wrong. In fact, when it comes to mutually beneficial trades, absolute advantage has nothing to do with it. And thinking that it did is what led so many civilizations in the past to think of trade as zero-sum, meaning that one party’s gain was another party’s loss. But as we will see, it is possible, even in a situation like this, for both sides to find trade mutually beneficial.

Comparative Advantage

In a free market, two people will only agree to a trade if they both find it beneficial. Mutually beneficial trades are driven by Comparative Advantage, or the ability for someone to produce something at a lower opportunity cost than someone else.

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The Comparative Advantage goes to the economic agent with the lower opportunity cost for the production of a good or service. In this example, we have Blue Tribe and the Orange tribe. We can see their Production Possibilities Frontiers on the graph on the left, and on the right, I have their maximum possibilities summarized. In the previous video, we noted that Blue tribe has an absolute advantage in the production of both fish and berries. So, why would they ever want to trade with Orange tribe? The trade will only happen if it is mutually beneficial, and it will only be beneficial to Blue tribe if it somehow lets them push beyond their PPF to something unobtainable on their own. --The key to comparative advantage is the opportunity cost of producing something. I have reformatted our information about the Blue tribe and Orange tribe into this production chart. We can note right away that since they have the larger capacity for producing fish, Blue tribe has the absolute advantage in fish. And since Blue tribe also has the larger capacity for producing berries, Blue tribe has the absolute advantage in berries. But let’s say that the people on Blue tribe want another fish. However, much fish they had, they want one more. Well, presuming they are operating efficiently and are on their PPF, it means they will have to give up some berries because they will have to shift some of their time and effort from berries to fish. So, we can measure the cost of that fish in terms of the berries given up. That is what we call the opportunity cost. If you want to calculate the opportunity cost of X, you take your quantity of Y given up, and divide it by the quantity of X gained. Let’s apply that to our numbers on the chart by creating a new chart of opportunity costs. The Blue tribe faces a trade-off. If they go all out on fish, they will produce 200 fish and 0 berries. Alternatively, if they go all in on berries, they will produce 210 berries and 0 fish. We can use those numbers to calculate the opportunity cost. The opportunity cost of a fish takes the 210 berries we give up, and divides it by the 200 fish that we get. Notice, we want the opportunity cost of a fish, and so we divide by the number of fish. That gives us 1.05 berries per fish we gain. That is the opportunity cost of one fish: 1.05 berries.Let’s do the same calculation, but for Orange tribe. For them, we take the 165 berries we give up, and divide by the 170 fish we gain, to get an opportunity cost of fish for Orange tribe of around 0.97, I rounded a bit. Now let’s do the calculation for berries. For Blue tribe, we take the 200 fish we give up and divide by the 210 berries we gain, giving us an opportunity cost for a berry of around 0.95. For Orange tribe, it is 170 divided by 165, which is around 1.03. The comparative advantage goes to the tribe with the lower opportunity cost. For fish this is Orange tribe, 0.97 is less than 1.05. For berries this is Blue tribe, 0.95 is less than 1.03. So, why does this matter. Well, if Blue tribe wants another fish, they could produce it themselves at the cost of 1.05 berries. Alternatively, let’s say they go to Orange tribe and offer one set of berries for one fish. Giving up only 1 set of berries, instead of 1.05 for a fish is a savings for Blue tribe. So, if Orange tribe accepts, they will end up better off. But is it beneficial for Orange tribe? Well, they would have to shift production from berries to fish in order to catch that extra fish for Blue tribe. To get one more fish, they give up 0.97 berries, which is less than 1! So, Orange tribe makes a little profit in berries, and doesn’t lose any fish of their own. The trade is mutually beneficial for both tribes!--We can think about the benefits of trade using the PPF. Let’s say each tribe has picked a point on their PPF. Since Orange tribe has the comparative advantage in fish, and Blue tribe has it in berries, they will each want to shift some of their production in that direction. Then, they can trade with each other one-for-one – or according to whatever agreement they come to – which allows them to push beyond their respective PPFs to previously unobtainable outcomes. And the reason they can do this is because they are able to take advantage of each other’s lower opportunity costs. --Let’s look at another example which might clarify this even more. Let’s say we have two bakers, Sandra and Rob. To bake a cake, they have to produce some batter and some frosting. The table shows some of the possibilities each of them have in terms of baking cakes each day. Sandra is very good at making batter, but slow when it comes to frosting. Rob is the opposite. He is good at making frosting, but not batter. --We can chart out their production possibilities frontiers here, just like we did when we first looked at the PPF. To get one cake, you need one batter and one frosting. So, this 45-degree dotted line shows where we need to fall to get full cakes without any leftover batter or frosting. If Sandra and Rob work separately, then they each end up producing 13.33 cakes per day. Sandra has to devote most her time to frosting, because it takes her longer to produce frosting. Rob has to devote most of his time to batter, because it takes him longer to get one cake’s worth of batter. Total, we have 26.66 cakes. But what if they traded. The opportunity cost of batter for Sandra is 20 frosting divided by 40 batters, which is 0.5. For Rob, the opportunity cost of batter is 40 frosting divided by 20 batter, which is 2. Since 0.5 is less than 2, Sandra has the comparative advantage in batter. And, likewise, Rob has the comparative advantage in frosting. If they each specialize in what they are good at, and trade with each other one-for-one, they are able to produce 20 cakes each. Sandra makes 40 batter, Rob makes 40 frostings. They give each other half, and so both end up with 20 whole cakes. And we all end up with 40 cakes instead of 26.66. It’s mutually beneficial! Indeed, one mistake many small business owners make is trying to do everything themselves, instead of contracting with other businesses to take care of things they’re better at doing. --Let’s do one more example, just to make sure we’ve got it. Here I have two countries, A and B, and they are each going to produce lemons and/or limes. Country A maxes out at 120 lemons, or instead they could max out at 135 limes. Country B maxes out at 100 lemons or 125 limes. So, who has the absolute advantage in lemons? That would be Country A, who can produce 120 to B’s 100. And who has the absolute advantage in limes? Again, it is Country A, where 135 is more than 125. So, is there any opportunity for mutually beneficial trade? Certainly. To see what it is, we need to calculate their opportunity costs. In country A, the opportunity cost of a lemon is 135 limes divided by 120 lemons. You always divide by the thing you are getting the opportunity cost for. What this means is that in order to get those 120 lemons, Country A is giving up the chance to produce 135 limes. That is 1.125 limes given up per lemon gained. And the value of knowing this is that we know if Country A decided they want one more lemon, they would need to forego 1.125 limes, because those resources will be redirected. In Country B, the opportunity cost of a lemon is 125 limes divided by 100 lemons. If Country B wants one more lemon, they have to give up 1.25 limes. The opportunity cost of a lime in Country A is calculated just the opposite way, 120 lemons divided by 135 limes, which rounds to 0.89 lemons per lime. For Country B, it is 100 lemons divided by 125 limes, or 0.8 lemons per lime. With these calculations, we can find the country with the comparative advantage in each thing. Since 1.125 is less than 1.25, Country A has the comparative advantage in lemons. Since 0.8 is less than 0.89, Country B has the comparative advantage in limes. If you haven’t noticed yet, there is a short-cut you can take when determining who has a comparative advantage. In this example, Country A has an absolute advantage in both lemons and limes. That’s possible with absolute advantage. One country can have it with both goods, just one of them, or none of them. But when it comes to comparative advantage, the two countries will always split it. So, once we know that Country A has the comparative advantage in lemons, we can immediately conclude that Country B has the comparative advantage in limes, the math will always work out that way.

Practice Questions

1. Use the chart below to answer each question.

Which country has an absolute advantage in cloth? Which one has an absolute advantage in wine?

Reveal the Answer

Absolute Advantage goes to the country who can produce the most. If England produces only cloth, they can produce 150 units of it compared to Portugal's 175. That gives Portugal the absolute advantage in cloth.

Likewise, if each country focuses on their efforts on producing wine, England can produce 125 units while Portugal can produce 200 units. Again, the absolute advantage goes to Portugal.

2. What is the opportunity cost of producing cloth in England and in Portugal?

Reveal the Answer

The opportunity cost of cloth in England is found by:

(125 wine)/(150 cloth) = 0.8333 wine per cloth

The opportunity cost of cloth in Portugal is found by:

(200 wine) / (175 cloth) = 1.1429 wine per cloth

Another way to think about it is this:

In England, they have the choice between 125 wine and 150 cloth. So, we could say...

The opportunity cost of producing 150 cloth is 125 wine.

But how much is it per cloth? Well, to find out we just divide both numbers by 150:

The opportunity cost of producing (150/150) cloth is (125/150) wine.

That gives...

The opportunity cost of producing 1 cloth is 0.8333 wine.

Our math just finds the trade-off each country faces.

3. Which country has a comparative advantage in cloth? Which one has a comparative advantage in wine?

Reveal the Answer

The opportunity cost of cloth in England was:

(125 wine)/(150 cloth) = 0.8333 wine per cloth

The opportunity cost of cloth in Portugal was:

(200 wine) / (175 cloth) = 1.1429 wine per cloth

Since 0.8333 < 1.1429, England has the comparative advantage in cloth.

And while it is always fun to do more math, it is unnecessary. Once we know England has the comparative advantage in cloth, we know that Portugal has the comparative advantage in wine.

Gains From Trade

The logic of comparative advantage applies not just to individuals, but also to entire nations. When nations specialize in the production of goods and services for which they have a comparative advantage, they will be able to reach points beyond their production possibilities frontier.

The gains from trade and the division of labor are huge! If you take something as simple as a sandwich, specialization along the entire production process has driven costs to a small fraction of what they would be if you tried to do it all by yourself. Check out this short video: How to make a $1500 Sandwich in Only 6 Months. The big takeaway: specialization and trade not only make sandwiches cheaper, they make them taste better too!

Open Video Transcript

Let’s take a deeper look at this example with two countries each producing lemons and limes. We already found that Country A has the absolute advantage in the production of both lemons and limes; they are able to produce more of them than country B. However, when we compute the opportunity cost for each country, we find that Country A has the lower opportunity cost – and thus the comparative advantage – in lemons, while Country B has the lower opportunity cost and comparative advantage in limes. What this means is that there is an opportunity for mutually beneficial trade. Country A should shift production towards lemons, Country B should shift production towards limes, and they should trade them with each other. --To see how this kind of specialization and trade benefits both countries, let’s walk through scenarios of trade and no trade. For ease, let’s imagine that each country is splitting their resources evenly between lemons and limes. In the chart, we see that Country A can produce a maximum of 120 lemons, so if they only give it half, they will produce 60 lemons. And the other half of their resources will get them 67.5 limes. Remember, Country A cannot have both 120 lemons and 135 limes, they have to choose either/or, unless they split their resources between them. So, we will say that in a no trade scenario, Country A will produce 60 lemons and 67.5 limes. If Country B does the same, splitting their resources between lemons and limes, they will end up with 50 lemons (half of their maximum of 100) and 62.5 limes (half their maximum of 125). Therefore, in the world of just Country A and B, we have 110 total lemons, and 130 total limes. Ok, now let’s have each country specialize in the thing they have a comparative advantage for. Since Country A has the absolute advantage in both, I am going to have them shift production mostly but not completely to lemons. Let’s say they produce 112 lemons and 9 limes. To understand where I am coming up with these numbers, imagine that Country A was producing 120 lemons and 0 limes. To get one lime, they have to give up 0.89 lemons. We know that from their opportunity cost of limes. If they do that 9 times, and get 9 limes, they will have given up 9*0.89 lemons, which is 8 total lemons, leaving them with 112 lemons and 9 limes. I am stopping at 9 limes just for our example. In practice, Country A can stop wherever they want. Over in Country B, we will have them fully specialize. They will produce only limes, meaning they will produce 125 limes and 0 lemons. But check this out. In the world now, we have 112 total lemons and 134 total limes. After specialization, the world has more lemons and more limes. And the two countries can split this up however they want. For example, perhaps Country A sends 51 lemons to Country B, and in exchange Country B sends 60.5 limes to Country A. That leaves Country A with 61 lemons and 69.5 limes, and Country B with 51 lemons and 64.5 limes. Each country ends up with 1 extra lemon and 2 extra limes, and the gains from trade across both countries are 2 lemons and 4 limes! Specialization and trade is like magic, it is able to create something out of nothing! --Here is another example with numbers that are a little more straightforward. Because Countries A and B split the absolute advantage, they will both want to go all in on their comparative advantage. With no trade, each country splits their resources between lemons and limes, and the world will end up with 110 lemons and 110 limes. But if they specialize, and Country A only makes lemons while Country B only makes limes, the world ends up with 120 lemons and 120 limes. They can split these according to whatever agreement they want, but if they split the gains evenly, both countries end up with 5 extra lemons and 5 extra limes compared to when they weren’t trading with each other. The gains from trade for the world are 10 lemons and 10 limes. The economic problem of scarcity is presented to us by a bleak and dismal universe. It’s no good that we face so many limits. But the logic of comparative advantage is a true blessing from on high, because it shows us that it doesn’t matter if you are the best at something or not, trade doesn’t depend on absolute advantage. Instead, it depends on how different from everyone else you are. So long as you are different from others, and face different opportunity costs, you will always have a comparative advantage in something and thus an opportunity for mutually beneficial trade. Trade which leaves both you and your trading partner better off!--Let’s look at it from the perspective of the production possibilities frontier. Here we have the PPFs for Countries A and B. I drew them as straight lines, with a constant trade-off between lemons and limes, for ease, but this logic still works with a curved PPF. Each country has chosen a point on their PPF, one that splits their resources between each good, and which is entirely efficient. They are getting the most out of their economy as is possible on their own. But through specialization and trade, countries move to producing the thing they have a comparative advantage in, and then they are able to trade it to the other country at a rate higher than their own opportunity cost. That is to say, their opportunity cost is reflected in the slope of their PPF, but the exchange rate they give each other is somewhere in-between their slopes. This allows each country to achieve a level of consumption that is beyond the production possibilities frontier. An outcome that is unobtainable on their own is suddenly very obtainable! --What applies to nations also applies to individuals. As humans started to gather into larger and larger cities, there was opportunity for greater and greater specialization through the division of labor. Adam Smith, who we’ll talk about a lot more, opens his seminal book The Wealth of Nations with this: “The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is anywhere directed, or applied, seem to have been the effects of the division of labour.”We all end up better off when we specialize and trade. It is probably what you are doing right now, watching this video. You are specializing in whatever your major is at school and this course is part of the specialized knowledge you need to have. I have specialized in the teaching of economics, it is pretty much the only thing I produce, but I am able to obtain enough value to trade for everything else I need. It works for me, it works for you, and it even works for this guy who seems to have a comparative advantage in appearing in stock photos. This is the magic of comparative advantage, specialization, and trade!

Trade Restrictions

Ever since humans banded together in cities and nations, they began to place restrictions on trade with other cities and nations. A tariff is a tax on imports, which are goods and services produced beyond our borders. Tariffs were and remain a popular policy which reduces imports, but quotas - a direct limit on the quantity of a good or service that can be imported - is also commonly used.

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Despite the gains that can be had from trade, some policies are aimed at reducing trade. The two most common types of trade restrictions that are placed between nations are tariffs and quotas. Tariffs are a tax on imports. The foreign producer is required to pay a tax in order to bring their goods into the country, whereas the domestic producers do not have to pay the tax, giving them a new-found competitive advantage. For example, we might put a tariff on cars imported from Japan. Any cars which come from Japan have to pay the tariff, say $1,000 per vehicle, but any cars produced within the country do not have to pay it. A quota is a limit on the quantity of imports. Unlike a tariff, this one does not typically generate revenue for the government, but it has a similar effect otherwise. For example, we might just put an outright limit on the number of cars that can come from Japan, say, 10 million. Once 10 million cars have arrived, we turn back any others. --Trade restrictions reduce the number of imports that come into our country, which reduces the foreign competition our producers face. Back in medieval times, cities would often construct castles by the river, not for defense, but to impose tariffs on passing trade ships. The ships had to pay the tariff in order to pass by and deliver their goods. This raised revenues for the town government, but it also protected domestic producers from having to lower their prices to compete. While this is good for the government and for producers, it is at the expense of consumers, or the people who buy the goods and services. --No one offered such a blistering critique of trade restrictions as Frédéric Bastiat, who sent a satirical petition to the French government in the 1830s after they imposed many new tariffs. Bastiat feigned concern for the poor candlestick makers. He said on their behalf, “We are suffering from the ruinous competition of a foreign rival who apparently works under conditions so far superior to our own for the production of light that he is flooding the domestic market with it at an incredibly low price; for the moment he appears, our sales cease, all the consumers turn to him, and a branch of French industry whose ramifications are innumerable is all at once reduced to complete stagnation.”These arguments were as familiar then as they are now. We have to protect our industries and our jobs. But then Bastiat revealed which foreign rival he was talking about: The Sun. Bastiat’s satire suggested that the French government should require everyone to board up their doors and windows so as to not let any of the sun’s light into their home, forcing them to buy more candles. He hoped that the policymakers would see that such a move would be horrible for the welfare of ordinary people, and so too are trade restrictions. --After the bubonic plague – long before Bastiat’s day – cities across Eurasia were grappling with an economy in turmoil. While wages were high, and poverty was down, producers struggled to regain their foothold after the loss in demand. Some towns responded by increasing the tariffs they applied on imported goods from other towns. But some did the opposite. They got rid of their tariffs, and saw trade increase to the benefit of all. This would set the stage for some Scottish thinkers to completely rewrite the book on economics. --In the time after the plague, advancements in ships led to more trade across Eurasia, and a sort of arms race began. It wasn’t just for military power, but for economic power, and by the 17th century most of Europe was employing some kind of mercantilist system. Mercantilism is an economic policy that is designed to maximize the exports and minimize the imports for an economy. These policies stemmed from a belief that trade was zero-sum, and depended on the absolute advantage. Nations believed that if they could attract more and more gold and silver bullion to their reserves through exports, they would see the wealth of their nation grow. And if you remember our equation for GDP, which has net exports in it, the exports minus the imports, that might make sense. But this effort often had the opposite effects. It is hard to promote exports when everyone is restricting imports. And so many nations turned to colonialism and exploitation to fill their coffers with gold. And while this did make some people in these countries very wealthy, it didn’t do much for the typical person, and was clearly awful to the many people who were subjected to the horrors of colonialism. Despite many millennia of backwards economic thinking, slow growth which was quickly eaten up by a larger population, and a lack of economic freedom, humanity was about to witness an enlightenment that would change the world more than just about anything that had come before it.

Practice Question

1. Initially, the Pagong and Tagi tribes are not trading with each other. Each tribe devotes half of their resources to catching fish, and the other half to the collection of coconuts. What are the islandwide gains from trade if each tribe specialized and traded with the other?

Reveal the Answer

Step 1: Before Trade
Each tribe is splitting their resources between fish and coconuts, so each tribe gets half of their maximum production for each.

Total Fish: 125 from Pagong + 87.5 from Tagi = 212.5 fish
Total Coconuts: 100 from Pagong + 112.5 from Tagi = 212.5 coconuts

Step 2: Specialization
The opportunity of fish at Pagong is:

(200 coconuts) / (250 fish) = 0.8 coconuts per fish

The opportunity cost of fish at Tagi is:

(225 coconuts) / (175 fish) = 1.2857 coconuts per fish

Since Pagong has the lower opportunity cost, they should specialize in catching fish, and Tagi should then specialize in collecting coconuts.

Step 3: After Trade
Each tribe specializes in the production where they have a comparative advantage. Since the tribes split absolute advantage, they will go all in, producing only that thing.

Total Fish: 250 from Pagong + 0 from Tagi = 250 fish
Total Coconuts: 0 from Pagong + 225 from Tagi = 225 coconuts

Step 4: Gains from Trade

Our After-Trade totals show a gain of 37.5 fish and 12.5 coconuts!

Quick Quiz

Now is the time to test yourself on these concepts! This quick quiz is a great way to see what has clicked and what needs more attention. It is also a good time to reach out to your instructor with questions.

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Example Question
Use the table below to answer the question.

Lemons Limes

Country A 34 60

Country B 67 31

Country A and B both start by splitting their efforts equally between lemons and limes and trading nothing with each other, meaning that they each produce exactly half of the quantities listed in the table.

What would be the total worldwide gains in lemons and limes if both countries decided to specialize and trade?

Do not round your answer.

Video Solution

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