Parable for modern Economy
Every day, you rely on many people, most of whom you have never met, to
provide you with the goods and services that you enjoy. Such interdependence
Possible because people trade with one another. Those people providing you With goods and services are not acting out of generosity. Nor is some government agency directing them to satisfy your desires. Instead, people provide you and other consumers with the goods and services they produce because they get something in return.
In subsequent chapters, we examine how an economy coordinates the activities of millions of people with varying tastes and abilities. As a starting point for this analysis, in this chapter we consider the reasons for economic interdependence. One of the Ten Principles of Economics highlighted in Chapter is that trade
can make everyone better off. We now examine this principle more closely. What exactly do people gain when they trade with one another?
Why do people 'choose to become interdependent?
The answers to these questions are key to understanding the modern global economy. Most countries today import from abroad many of the goods and services they consume, and they export to foreign customers many of the goods and services they produce. The analysis in this chapter explains interdependence not only among individuals but also among nations. As we will see, the gains from trade are much the same whether you are buying a haircut from your local barber or a T-shirt made by a worker on the other side of the globe.
A Parable for the Modern Economy:
To understand why people choose to depend on others for goods and services and a how this choice improves their lives, let's examine a simple economy. Imagine that there are only two goods in the world: meat and potatoes. And there are only two
people in the world: a cattle rancher named Ruby and a potato farmer named Frank.
Both Ruby and Frank would like to eat a diet of both meat and potatoes.
The gains from trade are most obvious if Ruby can produce only meat and
Frank can produce only potätoes. In one scenario, Frank and Ruby could choose to have nothing to do with each other. But after several months of eating beef roasted, boiled, broiled, and grilled, Ruby might decide that self-sufficiency is not all it's cracked up to be. Frank, who has been eating potatoes mashed, fried, baked, and scalloped, would likely agree. It is easy to see that trade would allow both of them to enjoy greater variety: Each could then have a break with a baked potato or burger with fries. Although this scene illustrates most simply how everyone can benefit from trade, the gains would be similar if Frank and Ruby were each capable of producing the other good, but only at great cost. Suppose,
For example, that Ruby is able
to grow potatoes but her land is not very well suited for it. Similarly, suppose that Frank is able to raise cattle and produce meat but is not very good at it. In this case, Frank and Ruby can each benefit by specializing what be or she does best and then trading with the other person.
The gains from trade are less obviously tide waver, when one person is better at producing every good. for example, suppose that Ruby is better at raising cattle and better at growing potatoes than Frank. In this case, should Ruby choose to remain self-sufficient? Or is there still reason for her to trade with Frank? To answer this question, we need to look more closely at the factors that affect such a decision.
Production Possibilities:
Production possibilities curve:-
Suppose that Frank and Ruby each work 8 hours per day and can devote this time to growing potatoes, raising cattle, or a combination of the two.
The table in Figure 1 shows the amount of time each person requires to produce 1 ounce of each good. Frank can produce an ounce of potatoes in 15 minutes and an ounce of meat in 60 minutes. Ruby, who is more productive in both activities, can produce an ounce to potatoes in 10 minutes and an ounce of meat in 20 minutes. The last two columns in the table show the amounts of meat or potatoes Frank and Ruby can produce-if they devote all 8 hours to producing only that good. Panel (b) of Figure 1 illustrates the amounts of meat and potatoes that Frank can produce. If Frank devotes all 8 hours of his time to potatoes, he produces 32 ounces of potatoes (measured on the horizontal axis) and no meat. If he devotes all of his time to meat, he produces 8 ounces of meat.(measured on the vertical axis) and no potatoes. If Frank divides is time equally between the two activities, spending4 hours on each, he produces 16 ounces of potatoes and 4 ounces of meat. The figure shows these three possible outcomes and all others in between.
This graph is Frank's production possibilities frontier. As we discussed in Chapter 2, a production possibilities frontier shows the various mixes of output......,
Panel (a) shows the production opportunities available to Frank the farmer and Ruby the rancher. Panel (b) shows the combinations of meat and potatoes that Frank can produce.
Panel (c) shows the combinations of meat and potatoes that Ruby can produce. Both production possibilities frontiers are derived assuming that Frank and Ruby each work 8 hours per day. If there is no trade, each person's production possibilities frontier is also his or her consumption possibilities frontier. (a) Production
that an economy can produce. It illustrates one of the Ten Principles of Economics in People face trade-offs. Here Frank faces a trade-off between producing You may recall that the production possibilities frontier in meat and producing potatoes. drawn bowed out. In that case, the rate at which society could trade one good for the other depended on the amounts that were being produced. Here, how-ever, Frank's technology for producing meat and potatoes (as summarized in Figure 1) allows him to switch between the two goods at a constant rate. When-ever Frank spends 1 hour less producing meat and 1 hour more producing potatoes, he reduces his output of meat by 1 ounce and raises his output of potatoes by 4 ounces and this is true regardless of how much he is already producing. As a result, the production possibilities frontier is a straight line.
Production possibilities curve example:
Panel (c) of Figure 1 shows the production possibilities frontier for Ruby. If Ruby devotes all 8 hours of her time to potatoes, she produces 48 ounces of potatoes and no meat. If she devotes all of her time to meat, she produces 24 ounces of meat and no potatoes, If Ruby divides her time equally, spending 4 hours on each activity, she produces 24 ounces of potatoes and 12 ounces of meat: Once again, the production possibilities frontier shows all the possible outcomes.
IF Frank and Ruby choose to be self-sufficient rather than trade with each other, then each consumes exactly what he or she produces. In this case, the production possibilities frontier is also the consumption possibilities frontier. That is, without trade, Figure 1 shows the possible combinations of meat and potatoes that Frank and Ruby can each produce and then consume. These production possibilities frontiers are useful in showing the trade-offs that Frank and Ruby face, but they do not tell us what Frank and Ruby will actually choose to dr. To determine their choices, we need to know the tastes of Frank and Ruby. Let's suppose they choose the combinations identified by points A and Bin Figure 1. Based on his production opportunities and food preferences, Frank decides to produce and consume 16 ounces of potatoes and 4 ounces of meat, while Ruby decides to produce and consume 24 ounces of potatoes and 12 ounces of meat.
Specialization and Trade
After several years of eating combination B, Ruby gets an idea and goes to talk to
Frank:
RUBY: Frank, my friend, have I goat deal for you! I know how to improve
life for both of us. I think you should stop producing meat altogether and devote all your time to growing potatoes. According to
my calculations, if you work 8 hours a day growing potatoes, you'll
produce 32 ounces of potatoes. If you give me 15 of those 32 ounces, I1 give you 5 ounces of meat in return. In the end, you'll get to eat 17 ounces of potatoes and 5 ounces of meat every day, instead of the 16 ounces of potatoes and 4 ounces of meat you now get. If you go along with my plan, you'll have more of both foods.
[To illustrate her point, Ruby shows Frank panel (a) of Figure 2.]
FRANK: (sounding skeptical) That seems like a good deal for me. But I don't understand why you are offering it. If the deal is so good for me, it
can't be good for you too.
RUBY: Oh, but it is! Suppose I spend 6 hours a day raising cattle and
2 hours growing potatoes. Then can produce 18 ounces of meat and 12 ounces of potatoes. AfterI give you 5 ounces of my meat in exchange for 15 ounces of your potatoes, I'il end up with 13 ounces.
The proposed trade between Frank the farmer and Ruby the rancher offers each of them a combination of meat and potatoes that would be impossible in the absence of trade. In panel (a), Frank gets to consume at point A* rather than point A. In panel (b), Ruby gets to consume at point B* rather than point B. Trade allows each to consume more meat and more potatoes.
of meat and 27 ounces of potatoes, instead of the 12 ounces of meat and 24 ounces of potatoes that I now get. So I will also consume more of both foods than I do now. She points out panel (b) of Figure 2.1
FRANK: I don't know.. This sounds too good to be true.
RUBY: If's really not as complicated as it first seems. Here-I've summarized my proposal for you in a simple table: [Ruby shows Frank a copy of the table at the bottom of Figure 2.]
FRANK: (after pausing to study the table) These calculations seem correct, but I am puzzled. How can this deal make us both better off?
RUBY: We can both benefit because trade allows each of us to. Specialize in
doing what we do best. You will spend more time growing potatoes and less time raising cattle. I will spend more time raising cattle and less time growing potatoes. As a result of specialization and trade, each of us can consume more meat and more potatoes with out working any more hours.
Draw an example of a production possibilities frontier for Robinson
Quick Quiz
Crusoe, a shipwrecked sailor who spends his time gathering coconuts and catching fish. Does this frontier limit Crusoe's consumption of coconuts and fish if he lives by himself? Would he face the same limits if he could trade with natives on the island?
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