BUSINESS

ECONOMICS:
Principles of
economics
Lecturer J. Miquel Puertas
E-mail: [email protected]

INTERDEPENDENCE AND
THE GAINS FROM TRADE
Interdependence and the Gains from
Trade
 Consider your typical day:
 You wake up to an alarm clock made in Korea.
 You pour yourself orange juice made from
Valencia oranges and coffee from beans
grown in Brazil.
 You put on some clothes made of cotton
grown in Togo and sewn in factories in
Thailand.
 You watch the morning news broadcast from
Barcelona or Vilnius on your TV made in
China.
 You drive to class in a bike made of parts
manufactured in a half-dozen different
countries.
 . . . and still at 2 pm your mum is
waiting with her delicious paella made
with rice from El Delta del Ebro and
sea-food from Galicia (Spain)

 I miss the
paella of my
mum!!!!
Interdependence and the
Gains from 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.
Interdependence and the
Gains from Trade
 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 the
Gains from Trade
 Individuals and nations rely on
specialized production and exchange
as a way to address problems caused
by scarcity.
 But this gives rise to two questions:
 Why is interdependence the norm?
 What determines production and
trade?
Interdependence and the
Gains from Trade
 Why is interdependence the norm?
 Interdependence occurs because
people are better off when they
specialize and trade with others.
 What determines the pattern of
production and trade?
 Patterns of production and trade are
based upon differences in opportunity
costs.
 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?
Table 1 The Production Opportunities of the
Farmer and Rancher
Production Possibilities

 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.
Figure 1 The Production Possibilities Curve

(a) The Farmer’ s Production Possibilities Frontier

Meat (ounces)

If there is no trade,
the farmer chooses
8 this production and
consumption.

4 A

0 16 32 Potatoes (ounces)
Figure 1 The Production Possibilities Curve

(b) The Rancher ’s Production Possibilities Frontier

Meat (ounces)

24

If there is no trade,
the rancher chooses
this production and
consumption.

12 B

0 24 48
Potatoes (ounces)
Specialization and Trade

 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.
Table 2 The Gains from Trade: A Summary
Figure 2 How Trade Expands the Set of Consumption
Opportunities

(a) The Farmer’ s Production and Consumption

Meat (ounces)

Farmer's
consumption
with trade
8 Farmer's
production and
consumption
5 A* without trade
4
A Farmer's
production
with trade

0 32 Potatoes (ounces)
16 17
Figure 2 How Trade Expands the Set of Consumption
Opportunities

(b) The Rancher’s Production and Consumption

Meat (ounces)

24 Rancher's
production
with trade
Rancher's
consumption
18 with trade

13
B* Rancher's
production and
B
12 consumption
without trade

0 12 24 27 48
Potatoes (ounces)
Table 2 The Gains from Trade: A Summary
 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?
 THE PRINCIPLE OF
COMPARATIVE ADVANTAGE
 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

 The comparison among producers of a good

according to their productivity—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.
 The Rancher
Absolute
 needs only 10 minutes
Advantage
to produce an ounce of potatoes,
whereas the Farmer needs 15
minutes.
 The Rancher needs only 20 minutes
to produce an ounce of meat,
whereas the Farmer needs 60
minutes.

The Rancher has an absolute advantage in

the production of both meat and potatoes.
Opportunity Cost and Comparative
Advantage

 Compares producers of a good

according to their opportunity cost.
 Whatever must be given up to obtain
some item
 The producer who has the smaller
opportunity cost of producing a good
is said to have a comparative advantage
in producing that good.
Comparative Advantage and Trade

 Who has the absolute advantage?

 The farmer or the rancher?

 Who has the comparative advantage?

 The farmer or the rancher?
 Table 3 The Opportunity Cost
of Meat and Potatoes

Opportunity Cost of:

1 oz of Meat 1 oz of Potatoes
Farmer 4 oz potatoes 1/4 oz meat
Rancher 2 oz potatoes 1/2 oz meat
Comparative Advantage and Trade
 The Rancher’s opportunity cost of an
ounce of potatoes is ¼ an ounce of
meat, whereas the Farmer’s
opportunity cost of an ounce of
potatoes is ½ an ounce of meat.

 The Rancher’s opportunity cost of a

pound of meat is only 4 ounces of
potatoes, while the Farmer’s
opportunity cost of an ounce of meat
is only 2 ounces of potatoes...
Comparative Advantage and trade

…so, the Rancher has a

comparative advantage in the
production of meat but the
Farmer has a comparative
advantage in the production of
potatoes.
Comparative Advantage and trade

 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.
Comparative Advantage and 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.
 The Legacy of Adam Smith
and David Ricardo
 Adam Smith
 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
 In his 1816 book Principles of Political
Economy and Taxation, David Ricardo
developed the principle of comparative
advantage as we know it today.
 APPLICATIONS OF
COMPARATIVE ADVANTAGE
 Should Lithuania trade with other countries?

 Each country has many citizens with different interests.

International trade can make some individuals worse off,
even as it makes the country as a whole better off.
 Imports—goods produced abroad and sold domestically
 Exports—goods produced domestically and sold abroad
 Summary

 Each person consumes goods and services

produced by many other people both in our
country and around the world.
 Interdependence and trade are desirable
because they allow everyone to enjoy a greater
quantity and variety of goods and services.
 Summary

 There are two ways to compare the ability of two

people producing a good.
 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.
 Trade makes everyone better off because it
allows people to specialize in those activities
in which they have a comparative advantage.
 The principle of comparative advantage
applies to countries as well as people.