Interdependence & the Gains

from Trade

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Review: 10 Principles of Economics
 How People Make Decisions
 People face tradeoffs.
 The cost of something is what you give up to get it.
 Rational people think at the margin.
 People respond to incentives.
 How people interact with each other.
 Trade can make everyone better off.
 Markets are usually a good way to organize economic activity.
 Governments can sometimes improve economic outcomes.
 How the economy as a whole works.
 The standard of living depends on a country’s production.
 Prices rise when the government prints too much money.
 Society faces a short-run tradeoff between inflation and
unemployment.
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Review Questions
 Why do we have economic problems?
 Describe Economics in one sentence!
 What is the opportunity cost?
 Under what situations would market fails?
 What are the variables that are most often
discussed in Macroeconomics?
 Explain inflation/deflation!
 Explain the Phillips Curve!

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Interdependence

 Each person consumes goods and services

produced by many other people both in our
country and around the world.

 Remember from one of the 10 principles:

Trade can make everyone better off.

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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?

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A Parable for the Modern Economy
 Easiest situation:
 The farmer can only grows potatoes
 The rancher can only raise cattle.
Trade makes both better off.

 Intermediate situation:
 The farmer can raise cattle as well, but not so good at it.
 The rancher can grows potatoes, too. But his land is
not well-suited for potatoes.

Specialization and trade makes both better off.

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A Parable for the Modern Economy
 Subtle Situation
 They can both grows potatoes and raise cattle, but
 The rancher is more efficient in producing both.

Specialization and trade can still makes both better off.

 Why?
 Each specialize on what?

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The Production Opportunities of the
Farmer and Rancher

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Copyright © 2004 South-Western
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.

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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)

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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)

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Specialization and Trade
 Suppose the rancher suggests that
 the farmer specialize in the production of potatoes, i.e.
spend 8 hours a day growing potatoes (32 ounces),
and

 the rancher will spend 6 hours a day producing meat

(18 ounces) and 2 hours a week growing potatoes (12
ounces).
 the rancher then trade 5 ounces of meat for 15 ounces
of potatoes.

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How Trade Expands the Set of Consumption
Opportunities: Farmer’s situation
’

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

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How Trade Expands the Set of Consumption
Opportunities: Rancher’s situation

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)

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Copyright © 2004 South-Western
Table 2 The Gains from Trade: A Summary

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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.
 What is the most suited?

 Why would they be both better off?

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Differences in Costs of Production
 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?

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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.

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Absolute Advantage

 The producer that requires a smaller quantity of

inputs to produce a good is said to have an
absolute advantage in producing that good.

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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.
The Rancher has an absolute advantage in the
production of both meat and potatoes.

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Opportunity Cost & Comparative Advantage

 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.

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The Production Opportunities of the
Farmer and Rancher

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Copyright © 2004 South-Western
The Opportunity Cost of Meat & 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

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Opportunity Cost & Comparative Advantage

 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...

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Comparative Advantage and Trade

 Who has the absolute advantage?

 The farmer or the rancher?

 Who has the comparative advantage?

 The farmer or the rancher?

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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.

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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.
 It is possible that one enjoys absolute advantage in
producing everything. But
 It is IMPOSSIBLE that one enjoys comparative
advantage in producing everything.

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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.

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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.

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Applications of Comparative Advantage
 Should Tiger Woods Mow His Own Lawn?
 Given Wood's athleticism, it is entirely possible that
he could mow his lawn faster than most men.
 This implies that he has an absolute advantage.

 However, if the opportunity cost of his time is

$10,000 (his pay to film a commercial for Nike), it is
likely that someone else will have a comparative
advantage in mowing his lawn.
 Both he and the person hired will be better off as
long as he pays the individual more than the
individual's opportunity cost and less than $10,000.

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Applications of Comparative Advantage
 Should the United States Trade with Other
Countries?
 Just as individuals can benefit from specialization
and trade, so can the populations of different
countries.
 The principle of comparative advantage suggests
that each good should be produced by the
country with a comparative advantage in
producing that good (smaller opportunity cost).
 Through specialization and trade, countries can
have more of all goods to consume.

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Applications of Comparative Advantage

 Imports—goods produced abroad and sold

domestically
 Exports—goods produced domestically and sold
abroad

 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.

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