Lecture 3

Interdependence and
the Gains from Trade

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.
A general observation . . .
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?
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.
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 . . .
¼only two goods: potatoes and meat
¼only 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 Frontiers
Meat 40
(pounds)
(b) The Rancher’s Production

Possibilities Frontier
B
20
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
A Summary
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 Consumption
Meat 40
(pounds)
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)

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.
 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
 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...
…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 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.
Summary
 Interdependence and trade allow people to enjoy
a greater quantity and variety of goods and
services.
 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.
 Comparative advantage applies to countries as
well as to people.

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Interdependence and

the Gains from Trade

(b) The Rancher’s Production

0 2.5 5 Potatoes (pounds)

 The farmer should produce potatoes.

0 2.5 3 5 Potatoes (pounds)

Differences in the costs of

Who can produce potatoes at a lower

Two ways to measure differences

 Describes the productivity of one person,

 Who has the absolute advantage?

The Rancher has an absolute

Opportunity Cost of:

…so, the Rancher has a

 Comparative advantage and differences in

Trade can benefit everyone in a

In his 1776 book An Inquiry into the Nature

In his 1816 book Principles of Political

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