Interdependence and The Gains From Trade

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Interdependence and

the Gains from Trade

Chapter 3
Interdependence and Trade
Consider your typical day:
You wake up to an alarm clock made in Korea.
You pour yourself some orange juice made from
oranges grown in Florida.
You put on some clothes made of cotton grown in
Georgia and sewn in factories in Thailand.
You watch the morning news broadcast from New
York on your TV made in Japan.
You drive to class in a car made of parts
manufactured in a half-dozen different countries.
…and you haven’t been up for more than two hours
yet!
Interdependence and Trade

Remember, economics is the


study of how societies produce
and distribute goods in an
attempt to satisfy the wants and
needs of its members.
How do we satisfy our wants and
needs in a global economy?
 We can be economically self-
sufficient.
 We can specialize and
trade with others,
leading to economic
interdependence.
Interdependence and Trade

A general observation . . .
Individuals and nations rely on
specialized production and
exchange as a way to address
problems caused by scarcity.
Interdependence and Trade

But, this gives rise to two questions:


 Why is interdependence the norm?
 What determines production and trade?
Why is interdependence the
norm?

Interdependence occurs because


people are better off when they
specialize and trade with others.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
What determines the pattern of
production and trade?

Patterns of production and trade


are based upon differences in
opportunity costs.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
A Parable for the Modern
Economy
 Imagine . . .
only two goods: potatoes and meat
only two people: a potato farmer and a
cattle rancher
 What should each produce?
 Why should they trade?
The Production Opportunities of
the Farmer and the Rancher

Hours Needed to Make 1 lb. of: Amount Produced in 40 Hours


Meat Potatoes Meat Potatoes
Farmer 20 hours/lb 10 hours/lb 2 lbs. 4 lbs.
Rancher 1 hours/lb 8 hours/lb. 40 lbs. 5 lbs.
Self-Sufficiency

By ignoring each other:


 Each consumes what they each produce.
 The production possibilities frontier is also the
consumption possibilities frontier.
Without trade, economic gains are
diminished.
Production Possibilities
Frontiers
Meat
(pounds) (a) The Farmer’s Production
Possibilities Frontier

2
A
1

0 2 4 Potatoes (pounds)
Production Possibilities
Meat 40
(pounds)
Frontiers
(b) The Rancher’s Production
Possibilities Frontier

20 B

0 2.5 5 Potatoes (pounds)


The Farmer and the Rancher
Specialize and Trade
Each would be better off if they specialized
in producing the product they are more
suited to produce, and then trade with each
other.
 The farmer should produce potatoes.
 The rancher should produce meat.
The Gains from Trade:
A Summary
The Outcome
Without Trade:
What They Produce
and Consume
1 lb meat (A)
Farmer 2 lbs potatoes
20 lbs meat (B)
Rancher 2.5 lbs potatoes
The Gains from Trade:
A Summary
The Outcome
With Trade:
What They What They What They
Produce Trade Consume
0 lbs meat Gets 3 lbs meat 3 lbs meat (A*)
Farmer 4 lbs potatoes for 1 lb potatoes 3 lbs potatoes
24 lbs meat Gives 3 lbs meat 21 lbs meat (B*)
Rancher 2 lbs potatoes for 1 lb potatoes 3 lbs potatoes
Trade Expands the Set of
Consumption Possibilities
(a) How Trade Increases the
Meat Farmer’s Consumption
(pounds)

Farmer’s
A* consumption
3 with trade

2 Farmer’s
consumption
A without trade
1

0 2 3 4 Potatoes (pounds)
Trade Expands the Set of
Meat 40
(pounds)
Consumption Possibilities
(b) How Trade Increases The
Rancher’s Consumption
Rancher’s
21 B* consumption
20 with trade
B
Rancher’s
consumption
without trade

0 2.5 3 5 Potatoes (pounds)


The Gains from Trade:
A Summary
The Gains
From Trade:
The Increase in
Consumption
2 lbs meat (A*- A)
Farmer 1 lb potatoes
1 lb meat (B*- B)
Rancher 1/2 lb potatoes
The Principle of
Comparative Advantage
Differences in the costs of
production determine the following:
 Who should produce what?
 How much should be traded for each
product?

Who can produce potatoes at a lower


cost--the farmer or the rancher?
Differences in Costs of
Production
Two ways to measure differences
in costs of production:
 The number of hours required to produce a
unit of output. (for example, one pound of
potatoes)
 The opportunity cost of sacrificing one good
for another.
Absolute Advantage

 Describes the productivity of one


person, firm, or nation compared to
that of another.
 The producer that requires a smaller
quantity of inputs to produce a good is
said to have an absolute advantage in
producing that good.
Comparative Advantage

 Compares producers of a good


according to their opportunity cost.

 The producer who has the smaller


opportunity cost of producing a good
is said to have a comparative
advantage in producing that good.
Specialization and Trade

 Who has the absolute advantage?


The farmer or the rancher?

 Who has the comparative advantage?


The farmer or the rancher?
Absolute Advantage
 The Rancher needs only 8 hours to
produce a pound of potatoes, whereas the
Farmer needs 10 hours.
 The Rancher needs only 1 hour to
produce a pound of meat, whereas the
Farmer needs 20 hours.

The Rancher has an absolute


advantage in the production of both
meat and potatoes.
The Opportunity Cost
of Meat and Potatoes

Opportunity Cost of:


1 lb of Meat 1 lb of Potatoes
Farmer 2 lb potatoes ½ lb meat
Rancher 1/8 lb potatoes 8 lb meat
Comparative Advantage
 The Rancher’s opportunity cost of a pound
of potatoes is 8 pounds of meat, whereas
the Farmer’s opportunity cost of a pound
of potatoes is 1/2 pound of meat.

 The Rancher’s opportunity cost of a pound


of meat is only 1/8 pound of potatoes, while
the Farmer’s opportunity cost of a pound
of meat is 2 pounds of potatoes...
Comparative Advantage

…so, the Rancher has a


comparative advantage in the
production of meat but the
Farmer has a comparative
advantage in the production
of potatoes.
The Principle of
Comparative Advantage

 Comparative advantage and differences


in opportunity costs are the basis for
specialized production and trade.
 Whenever potential trading parties have
differences in opportunity costs, they can
each benefit from trade.
Benefits of Trade

Trade can benefit everyone in


a society because it allows
people to specialize in activities
in which they have a
comparative advantage.
Adam Smith and Trade

In his 1776 book An Inquiry into the


Nature and Causes of the Wealth of
Nations, Adam Smith performed a
detailed analysis of trade and economic
interdependence, which economists still
adhere to today.
David Ricardo and Trade

In his 1816 book Principles of Political


Economy and Taxation, David Ricardo
developed the principle of comparative
advantage as we know it today.
Should Tiger Woods Mow His
Own Lawn?

?
? ?
Summary

 Interdependence and trade allow


people to enjoy a greater quantity
and variety of goods and services.
Summary

 The person who can produce a good


with a smaller quantity of inputs has
an absolute advantage.
 The person with a smaller
opportunity cost has a comparative
advantage.
Summary

 The gains from trade are based on


comparative advantage, not absolute
advantage.
 Comparative advantage applies to
countries as well as to people.
Graphical
Review
Production Possibilities
Frontiers
Meat
(pounds) (a) The Farmer’s Production
Possibilities Frontier

2
A
1

0 2 4 Potatoes (pounds)
Production Possibilities
Meat 40
(pounds)
Frontiers
(b) The Rancher’s Production
Possibilities Frontier

20 B

0 2.5 5 Potatoes (pounds)


Trade Expands the Set of
Consumption Possibilities
(a) How Trade Increases the
Meat Farmer’s Consumption
(pounds)

Farmer’s
A* consumption
3 with trade

2 Farmer’s
consumption
A without trade
1

0 2 3 4 Potatoes (pounds)
Trade Expands the Set of
Meat 40
(pounds)
Consumption Possibilities
(b) How Trade Increases The
Rancher’s Consumption
Rancher’s
21 B* consumption
20 with trade
B
Rancher’s
consumption
without trade

0 2.5 3 5 Potatoes (pounds)

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