Why Trade Is Critical to the Production of Wealth

1
Why Trade Is Critical to the Production of Wealth

• Evolution of Economic Theory
• Traditional idea Mercantilism (protectionism)
  believed best policy still very popular
• Adam Smith (1776) explained the value of
• 1) the division of labor and
• 2) specialization of labor

2
Adam Smith and the Pin Factory
3
Evolution of Economic Knowledge

• Smiths Pin Factory
• One man can make one bad pin a day
• 10 men could make 48,000 pins a day
• 18 steps in production that exploits economies
  of scale
• What prevents the world from being covered in
  pins? The extent of the market.
• This helps explain some features of wealth
  creation, but there is more.

4
A Completely Original Concept

• David Ricardo (1817)
• Comparative Advantage
• The great economist, Paul Samuelson, was asked by
  a great mathematician at MIT to name a concept in
  social science that was both true and nontrivial.
  The answer Comparative Advantage
• Thousands of intelligent men have never been
  able to grasp the doctrine or to believe it
  after it was explained to them.

5
Most People Cannot Comprehend It

• Poll of American Democrat voters
• By 54-21 margin they agree that free trade
  agreements have been a bad deal for the U.S.
• Poll of American Republican voters
• By 59-32 margin they agree that free trade is
  a bad idea.
• Poll of all American voters
• 60 nationwide agreed with the statement that
  foreign trade has been bad for the U.S.
  economy.

6
To Understand a Complex Subject, Break It Down to
the Simplest Level

• Consider the most basic economy
• One man with two goods
• he can only trade with himself.
• Then make it more complicated
• two men trading two goods.
• The real world is very difficult to comprehend
  models help us to understand the workings of
  complex trade.

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The first modern novel in English based on a true
story (like this lecture)
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A Side Note What was he doing there?
9
The Island Today
10
No Man Is an Island

• Crusoe stranded alone on an island for years.
• Presume Crusoe spends his
• time making breadfruit bread (BB)
• loaves and cups of coconut milk
• (CM). He has ability to produce
• these as seen on the production
• possibility curve.
• Maybe he eats a balanced diet
• of 25 CM and 5 BB a week.

BB
Crusoes weekly Production Possibility
10
5
CM
0
25
50
11
Crusoe Meets Competent Friday

• Friday, living on other side of island, same
  resources, also makes BB and CM, but is more
  productive. Why? Both work hard every day.
• Friday also produces
• BB and CM. He eats a
• balanced diet of 45 CM
• and 15 BB loaves.
• Then the two meet.

BB
Fridays weekly Production Possibility
30
15
CM
0
45
90
12
Friday Is Better at Making Both

• Crusoe and Friday notice differences in how much
  of both goods they can produce each week. Friday
  is better at making both an absolute advantage.
  
• BB CM Ratio Note these ratios are
• Crusoe 10 50 1/5 personal opportunity
• Friday 30 90 1/3 costs.
• But Who is the low cost producer of which good,
  compared to the other? Who has comparative
  advantage?

13
Poor Crusoe Trades with Rich Friday

• Noticing differences in costs of producing CM and
  BB, let us presume they agree to trade 5 BB for
  20 CM at the end of the week. So Friday must make
  5 more BB Crusoe must make 20 more CM.
• Assume this term of trade 1 BB for 4 CM (5 BB
  for 20 CM)
• Who is the winner from this trade? Who is the
  loser?

14
Trade Creates Wealth

• Exchange occurs
• Crusoe has 6 BB and 25 CM Friday has
  15 BB and 50 CM

BB
BB
Crusoe
Friday
6 5
20 15
1
CM
CM
25
45
30 45 50
50
15
Trade Exploits Comparative Advantage

• The process of voluntary trade makes both parties
  richer.
• No more effort was required just specialization
  in the thing one is relatively better at doing
  compared to the trading partner. The less
  productive person, Crusoe, has something to offer
  the more productive Friday.
• Adding thousands of goods and millions of people
  complicates the math but not the outcome.
• Trade creates wealth. There are no exceptions to
  this.
• Trade also requires social cooperation.

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Trade Among Nations

• Assume companies in Japan and in Mexico make
  shirts and cars for their consumers.
• Current production abilities are up to 5 million
  shirts per week in Mexico and up to 50,000 cars
  per week given current resources in labor and
  capital.
• Current production abilities are up to 4 million
  shirts per week in Japan and up to 100,000 cars
  per week given current resources in labor and
  capital.

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Creating New Wealth

• To have more cars, resources must be taken from
  shirt production opportunity cost.
• Resources are scarce. We cannot have everything.
  One person or one nation cannot be best at making
  everything. We trade goods for goods based at
  what we are best at doing. Specialization and
  division of labor follow.

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Mexican Shirts Japanese Cars
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Production Possibility Mexico

• Car and shirt production without trade

cars
Current production based on internal costs in
Mexico and demands of consumers results in
25,000 cars per week and 2.5 million shirts
being produced and bought by consumers in Mexico
each week. Domestic prices are not relevant for
trade with foreigners, what matters are relative
costs 100 shirts for 1 car is the internal
rate of trade.
50k
25k
shirts
o
5m
2.5m
20
Production Possibility Japan

• Cars and shirt production without trade

cars
Current production based on internal prices and
demand in Japan results in 50,000 cars and 2
million shirts per week being produced and bought
in Japan. The internal rate of trade is 40 shirts
for one car within Japan. What do Japan and
Mexico have to offer each other?
100k
50k
shirts
4m
2m
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Gains from Trade Comparative Advantage

• Internal rate of exchange in Mexico is 100/1
  shirts for cars.
• Internal rate of exchange in Japan is 40/1 shirts
  for cars.
• Comparing these two producers
• Who is the lower cost producer of cars?
• Who is the lower cost producer of shirts?
• Trade will occur somewhere between 100/1 and
  40/1. Bargaining. Let us assume 60/1.

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Trade Both Become Wealthier

• Mexico Japan

New point of production
cars
cars
New point of production
100k
50k
50k
shirts
shirts
0
4m
3m
0
5m
2m
Mexico specializes in shirts makes 5 million,
sells 3 million to Japan. Japan specializes in
cars makes 100,000, sells 50,000 to Mexico for
3 million shirts. Both end up beyond their own
production possibilities trade allows people
in both nations to have more of what they want.
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Is There a Problem?

• Japan and Mexico both are wealthier due to trade.
• Citizens in both nations get more of what they
  want at lower cost.
• Note Trade is done by Yen and Peso, but that is
  just for convenience people want cars and
  shirts not money.
• Expand this to 100 nations and 10,000 goods. The
  math is more complicated, but same wealth
  creation results.
• So why is there opposition to free trade?
• What about new technology?

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Name This Piece of Land
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Tale of Two Nations

• South Korea North Korea
• 30,000 per capita 1,800 per capita
• Market oriented Juche Stalinist

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Milton Friedman explained it best

• The most important single central fact about a
  free market is that no exchange takes place
  unless both parties benefit.