Lecture 3

Interdependence and
the Gains from Trade
Chapter 3
Copyright © 2001 by Harcourt, Inc.
All rights reserved. Requests for permission to make copies of any part of
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items copyright © 2001 by Harcourt,
Inc.
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!

Inc.
Remember, economics is the
study of how societies produce
and distribute goods in an
attempt to satisfy the wants and
needs of its members.

Inc.
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.

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

Inc.
But, this gives rise to two questions:
Why is interdependence the norm?
What determines production and trade?

Inc.
Why is interdependence the
norm?
Interdependence occurs because
people are better off when they
specialize and trade with others.

Inc.
What determines the pattern of
production and trade?
Patterns of production and trade
are based upon differences in
opportunity costs.

Inc.
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?
A Parable for the Modern
Economy

Inc.
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.

Inc.
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.

Inc.
Production Possibilities
Frontiers
Potatoes (pounds)
Meat
(pounds)
4
2
1
2
(a) The Farmer’s
Production
Possibilities Frontier
0
A

Inc.
Production Possibilities
Frontiers
Potatoes (pounds)
Meat
(pounds)
5
40
20
2.5
(b) The Rancher’s
Production
Possibilities Frontier
0
B

Inc.
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.

Inc.
The Gains from Trade:
A Summary
The Outcome
Without Trade:
What They Produce
and Consume
Farmer
1 lb meat (A)
2 lbs potatoes
Rancher
20 lbs meat (B)
2.5 lbs potatoes

Inc.
A Summary
The Outcome
With Trade:
What They
Produce
What They
Trade
What They
Consume
Farmer
0 lbs meat
4 lbs potatoes
Gets 3 lbs meat
for 1 lb potatoes
3 lbs meat (A*)
3 lbs potatoes
Rancher
24 lbs meat
2 lbs potatoes
Gives 3 lbs meat
for 1 lb potatoes
21 lbs meat (B*)
3 lbs potatoes

Inc.
Trade Expands the Set of
Consumption Possibilities
Potatoes (pounds)
Meat
(pounds)
42
2
1
(a) How Trade Increases
the Farmer’s Consumption
0
A
3
3
A*
Farmer’s
consumption
without trade
Farmer’s
consumption
with trade

Inc.
Trade Expands the Set of
Consumption Possibilities
Potatoes (pounds)
Meat
(pounds)
52.5
40
20
(b) How Trade Increases
The Rancher’s Consumption
0
B
21
3
B*
Rancher’s
consumption
without trade
Rancher’s
consumption
with trade

Inc.
A Summary
The Gains
From Trade:
The Increase in
Consumption
Farmer
2 lbs meat (A*- A)
1 lb potatoes
Rancher
1 lb meat (B*- B)
1/2 lb potatoes

Inc.
The Principle of
Comparative Advantage
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 the costs of
production determine the following:

Inc.
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.
Two ways to measure differences
in costs of production:

Inc.
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.

Inc.
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.

Inc.
Specialization and Trade
Who has the absolute advantage?
The farmer or the rancher?
Who has the comparative advantage?
The farmer or the rancher?

Inc.
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.

Inc.
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

Inc.
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...

Inc.
…so, the Rancher has a
comparative advantage in the
production of meat but the
Farmer has a comparative
advantage in the production
of potatoes.

Inc.
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.

Inc.
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.

Inc.
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.

Inc.
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.

Inc.
Should Tiger Woods Mow His
Own Lawn?
?
? ?

Inc.
Summary
Interdependence and trade allow
people to enjoy a greater quantity
and variety of goods and services.

Inc.
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.

Inc.
Summary
The gains from trade are based on
comparative advantage, not absolute
advantage.
Comparative advantage applies to
countries as well as to people.

Inc.
Graphical
Review

Lecture 3

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Lecture 3