Interdependence and The Gains From Trade

Consider your typical day:
Interdependence and
the Gains from Trade
You wake up to an alarm clock made in Korea.

You pour yourself orange juice made from Florida
oranges and coffee from beans grown in Brazil.
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.
Copyright 2004 South-Western/Thomson Learning

Copyright 2004 South-Western
Interdependence and the Gains

from Trade
. . . and you havent been up for more than two
hours yet!

from Trade
How do we satisfy our wants and needs in a
global economy?
We can be economically self-sufficient.
We can specialize
p
and trade
with others, leading to
economic interdependence.
Remember, economics is the study of how

societies produce and distribute goods in an
attempt to satisfy the wants and needs of its
members.

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?

from Trade
Why is interdependence the norm?
A PARABLE FOR THE MODERN

ECONOMY
Imagine . . .
Interdependence occurs because people are better

off when they specialize and trade with others.
What determines the ppattern of production

p
and
trade?
Patterns of production and trade are based upon
differences in opportunity costs.
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
Figure 1 The Production Possibilities Curve
(a) The Farmer s Production Possibilities Frontier

Meat (ounces)
(b) The Rancher s Production Possibilities Frontier

Meat (ounces)
24
If there is no trade,
the rancher chooses
this production and
consumption.
If there is no trade,
trade
the farmer chooses
this production and
consumption.
12
16
32
Potatoes (ounces)
Copyright2003 Southwestern/Thomson Learning
24
48
Potatoes (ounces)
Table 2 The Gains from Trade: A Summary
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.
Figure 2 How Trade Expands the Set of Consumption

Opportunities
Figure 2 How Trade Expands the Set of Consumption

Opportunities
(a) The Farmers Production and Consumption
(b) The Ranchers Production and Consumption
Meat (ounces)
Meat (ounces)
Rancher's
production
with trade
24
Rancher's
consumption
with trade
18
Farmer s
Farmer's
consumption
with trade
A*
5
4
13
B*
Farmer's
production and
consumption
without trade
Rancher's
production and
consumption
without trade
Farmer's
production
with trade
32
0
16
12
Potatoes (ounces)
17
Table 2 The Gains from Trade: A Summary
12
24 27
48
Potatoes (ounces)
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 p
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 productivityabsolute
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.
Opportunity Cost and Comparative

Advantage
Absolute Advantage
The Rancher needs only 10 minutes 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.
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.
The Rancher has an absolute advantage in

the production of both meat and potatoes.
Comparative Advantage and Trade
Table 3 The Opportunity Cost of Meat

and Potatoes
Who has the absolute advantage?

The farmer or the rancher?
Opportunity Cost of:
Who has the comparative advantage?

The farmer or the rancher?
1 oz of Meat
1 oz of Potatoes
Farmer
4 oz potatoes
1/4 oz meat
Rancher
2 oz potatoes
1/2 oz meat
The Ranchers opportunity cost of an ounce of

potatoes is an ounce of meat, whereas the
Farmers opportunity cost of an ounce of
ppotatoes is an ounce of meat.
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 Ranchers opportunity cost of a pound of

meat is only 4 ounces of potatoes, while the
Farmers opportunity cost of an ounce of meat
is only 2 ounces of potatoes...
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.
FYIThe Legacy of Adam Smith

and David Ricardo
APPLICATIONS OF COMPARATIVE
ADVANTAGE
Should Tiger Woods Mow His Own Lawn?
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 the United States Trade with Other Countries?
Each country has many citizens with different
interests. International trade can make some
i di id l worse off,
individuals
ff even as it
i makes
k the
h country as
a whole better off.
Importsgoods produced abroad and sold domestically
Exportsgoods 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
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.
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.

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Consider your typical day:

You wake up to an alarm clock made in Korea.

Copyright 2004 South-Western/Thomson Learning

Interdependence and the Gains

Copyright 2004 South-Western

Interdependence and the Gains

Copyright 2004 South-Western

Remember, economics is the study of how

Copyright 2004 South-Western

Interdependence and the Gains

Copyright 2004 South-Western

Interdependence and the Gains

A PARABLE FOR THE MODERN

Interdependence occurs because people are better

What determines the ppattern of production

only two goods: potatoes and meat

What should each produce?

Copyright 2004 South-Western

Table 1 The Production Opportunities of the Farmer

Copyright 2004 South-Western

Copyright 2004 South-Western

Figure 1 The Production Possibilities Curve

Copyright 2004 South-Western

Figure 1 The Production Possibilities Curve

(a) The Farmer s Production Possibilities Frontier

(b) The Rancher s Production Possibilities Frontier

Copyright2003 Southwestern/Thomson Learning

Copyright2003 Southwestern/Thomson Learning

Table 2 The Gains from Trade: A Summary

Specialization and Trade

The farmer should produce potatoes.

Copyright 2004 South-Western

Copyright 2004 South-Western

Figure 2 How Trade Expands the Set of Consumption

Figure 2 How Trade Expands the Set of Consumption

(a) The Farmers Production and Consumption

(b) The Ranchers Production and Consumption

Copyright2003 Southwestern/Thomson Learning

Table 2 The Gains from Trade: A Summary

Copyright 2004 South-Western

Who can produce potatoes at a lower

Copyright 2004 South-Western

Copyright 2004 South-Western

Copyright 2004 South-Western

Copyright 2004 South-Western

Opportunity Cost and Comparative

Compares producers of a good according to

The producer who has the smaller opportunity

The Rancher has an absolute advantage in

Comparative Advantage and Trade

Copyright 2004 South-Western

Table 3 The Opportunity Cost of Meat

Who has the absolute advantage?

Opportunity Cost of:

Who has the comparative advantage?

Copyright 2004 South-Western

Copyright 2004 South-Western

Comparative Advantage and Trade

Comparative Advantage and Trade