Chapter 3

Interdependence
and the Gains
from Trade

©
© 2002
2002 by
by Nelson,
Nelson, aa division
division of
of Thomson
Thomson Canada
Canada Limited
Limited
In this chapter you will…
•• Consider
Consider howhow everyone
everyone can can benefit
benefit
when
when people
people trade
trade with
with another
another
country.
country.
•• Learn
Learn the
the meaning
meaning of of absolute
absolute
advantage
advantage and and comparative
comparative advantage.
advantage.
•• See
See how
how comparative
comparative advantage
advantage
explains
explains the
the gains
gains from
from trade.
trade.
•• Apply
Apply the
the theory
theory ofof comparative
comparative
advantage
advantage to to everyday
everyday lifelife and
and national
national
policy.
policy.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 2

 Interdependence and the Gains
from Trade
•• Consider
Consider youryour typical
typical day:
day:
–– You
You pour
pour yourself
yourself orange
orange juice
juice made
made
from
from Florida
Florida oranges
oranges andand coffee
coffee from
from
beans
beans grown
grown in in Brazil.
Brazil.
–– You
You put
put on
on some
some clothes
clothes made
made of of cotton
cotton
grown
grown inin Georgia
Georgia andand sewn
sewn in
in factories
factories
in
in Thailand.
Thailand.
–– You
You watch
watch the
the morning
morning news
news broadcast
broadcast
from
from New
New York
York onon your
your TVTV made
made in in
Japan.
Japan.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 3

 Interdependence and the Gains
from Trade
•• Consider
Consider your
your typical
typical dayday (more):
(more):
–– You
You drive
drive to
to class
class in in aa car
car made
made of
of parts
parts
manufactured
manufactured in in aa half-dozen
half-dozen different
different
countries.
countries.
–– Then
Then you
you open
open your
your economics
economics
textbook
textbook written
written by by authors
authors living
living in
in
Massachusetts,
Massachusetts,Alberta,
Alberta, and
and Quebec,
Quebec,
published
published by by aa company
company located
located in
in
Ontario,
Ontario, and
and printed
printed fromfrom paper
paper made
made
from
from trees
trees grown
grown in in New
New Brunswick.
Brunswick.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 4

 Interdependence and the Gains
from Trade
•• Economics
Economics studies
studies how
how society
society
produces
produces andand distributes
distributes goods
goods and
and
services
services soso that
that wants
wants and
and needs
needs are
are
satisfied.
satisfied.
•• Trade
Trade can
can make
make everyone
everyone better
better off.
off.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 5

 Interdependence and the Gains
from Trade
•• How
How do
do we
we satisfy
satisfy our
our wants
wants
and
and needs?
needs?
•• We
We can
can be economically Self-
be economically Self-
Sufficient.
Sufficient.
•• We
We can
can specialize
specialize and
and trade
trade
with
with others
others leading
leading to
to
Economic
Economic Interdependence.
Interdependence.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 6

 Interdependence and the Gains
from Trade
•• A
A general
general observation
observation .. .. ..
–– Individuals
Individuals and
and nations
nations rely
rely on
on
specialized
specialized production
production and
and exchange
exchange
as
as aa way
way to
to address
address problems
problems caused
caused
by
by scarcity.
scarcity.
•• This
This gives
gives rise
rise to
to two
two questions.
questions. .. ..
–– Why
Why is
is interdependence
interdependence the
the norm?
norm?
–– What
What determines
determines production
production && trade?
trade?

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 7

 Interdependence and the Gains
from Trade
•• Why
Why is
is interdependence
interdependence the
the norm?
norm?

 Interdependence
Interdependence occurs
occurs because
because
people
people are
are better
better off
off when
when they
they
specialize
specialize and
and trade
trade with
with others.
others.
•• What
What determines
determines the
the pattern
pattern of
of
production
production &
& trade?
trade?

 Patterns
Patterns of
of production
production and
and trade
trade
are
are based
based upon
upon differences
differences inin
opportunity
opportunity costs.
costs.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 8

 A PARABLE FOR MODERN ECONOMY
•• Imagine
Imagine that
that there
there are…
are…
…… two
two goods
goods in in the
the world:
world:
1.
1. Potatoes
Potatoes
2.
2. Meat
Meat
…… and
and two
two people
people in in the
the world:
world:
3.
3. Potato
Potato farmer
farmer
4.
4. Cattle
Cattle rancher
rancher
•• What
What should
should each
each produce?
produce?
•• Why
Why should
should they
they trade?
trade?

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 9

Table 3-1: the Production Opportunities of
the Farmer and the Rancher
Amount produced in Amount produced in
1 Hour (in Kg) 8 Hours (in Kg)

Meat Potatoes Meat Potatoes

Farmer 1 1 8 8

Rancher 8 2 64 16

 Note
Notethat
that based
basedon onthe
theProductivity
Productivity Table
Tableabove
above
the
theRancher
Rancher is is more
more productive
productiveinin producing
producing
both
both of
of the
the products.
products.
 Yet,
Yet,we
wewill
will see
seethat
that both
both the
the Rancher
Rancherand
andthe
the
Farmer
Farmercancangain
gainfrom
fromtrade
trade...
...
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 10
 Figure 3-1(A): The Farmer’s Production
Possibilities Frontier
Meat
(kilograms) Derived from Table 3-1 by working 8 hours a day

A
4

0 4 8 Potatoes
(kilograms)

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 11

 Figure 3-1(B): The Rancher’s Production
Possibilities Frontier
Meat
(kilograms) Derived from Table 3-1 by working 8 hours a day

64

B
32

0 8 16 Potatoes
(kilograms)

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 12

 Specialization and Trade
•• The
The Farmer
Farmer and
and the
the Rancher
Rancher Specialize
Specialize
and
and Trade
Trade
–– Each
Each would
would be
be better
better off
off ifif they
they
specialized
specialized in
in producing
producing the the product
product
they
they are
are more
more suited
suited to
to produce,
produce, and and
then
then trade
trade with
with each
each other.
other.

The farmer should produce potatoes.

The rancher should produce meat.
They should trade
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 13
 Figure 3-2 (A): How Trade Increases the
Framer’s Consumption
Meat
(kilograms)

A* Consumption
6 with trade

A
4 Consumption
without trade

0 4 5 8 Potatoes
(kilograms)

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 14

 Figure 3-2 (B): How Trade Increases the
Rancher’s Consumption
Meat
(kilograms)

64

Consumption
B* with trade
34
32 Consumption
B without trade

0 8 9 16 Potatoes
(kilograms)

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 15

 THE PRINCIPLE OF
COMPARATIVE ADVANTAGE
•• Differences
Differences in
in the
the costs
costs of
of
production
production determine
determine thethe following:
following:
–– Who
Who should
should produce
produce what?
what?
–– How
How much
much should
should bebe traded
traded for
for
each
each product?
product?

Who can produce potatoes at a lower

cost? The farmer or the rancher!

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 16

 THE PRINCIPLE OF
COMPARATIVE ADVANTAGE
•• Measuring
Measuring differences
differences in
in costs
costs of
of
production:
production:
–– Number of hours required to produce
Number of hours required to produce
aa standardized
standardized unit
unit of
of output.
output.

 One
Onepound
pound of
of potatoes
potatoes
–– Opportunity
Opportunity Cost:
Cost: Whatever
Whatever must
must be
be
given
given up
up to
to obtain
obtain some
some item.
item.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 17

 Absolute Advantage
•• Describes
Describes the
the productivity
productivity of of one
one
person,
person, firm,
firm, or
or nation
nation to to that
that of
of
another.
another.
-- The
The producer
producer that
that requires
requires aa
smaller
smaller quantity
quantity of
of inputs
inputs to to
produce
produce aa good
good is
is said
said to to have
have an
an
absolute
absolute advantage
advantage in in producing
producing
that
that good
good

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 18

Table 3-3: The Opportunity Cost of
Meat and Potatoes
Opportunity Cost of 1 Kg of

Meat (in terms of Potatoes (in terms of

potatoes given up) meat given up)

Farmer 1 1
Rancher 1/4 4

•• Who
Who has
hasthe
the Absolute
AbsoluteAdvantage
Advantagein
in each
each
product?
product?
•• Rancher,
Rancher,in
in both
both products!
products!
•• Yet,
Yet,we
wehave
haveseen
seen that
that both
boththe
theRancher
Rancher and
andthe
the
Farmer
Farmercan
cangain
gainfrom
fromtrade?
trade?
Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 19
 Opportunity Cost and
Comparative Advantage
•• The
The comparison
comparison among
among producers
producers
of
of aa good
good according
according to
to their
their
opportunity
opportunity cost.
cost.
-- The
The producer
producer whowho has
has the
the smaller
smaller
opportunity
opportunity cost
cost of
of producing
producing aa good
good
is
is said
said to
to have
have aa comparative
comparative
advantage
advantage in in producing
producing that
that good.
good.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 20

 Opportunity Cost and
Comparative Advantage
•• Comparative
Comparative advantage,
advantage, which
which
refers
refers to
to differences
differences in in opportunity
opportunity
costs,
costs, is
is the
the basis
basis for
for specialized
specialized
production
production and and trade.
trade.
•• Whenever
Whenever potential
potential trading
trading parties
parties
have
have differences
differences in in opportunity
opportunity
costs,
costs, they
they can
can each
each benefit
benefit from
from
trade.
trade.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 21

Comparative Advantage and Trade
•• Based
Based onon the
the earlier
earlier Productivity
Productivity Table
Table
(Table
(Table 3-3
3-3 -- Slide
Slide 19)…
19)…
–– The
TheRancher’s
Rancher’sopportunity
opportunitycost
costof
of11 Kg
Kg of
of
potatoes
potatoesis
is44Kg
Kgof
of meat,
meat,whereas
whereasthe
the
Farmer’s
Farmer’sopportunity
opportunitycost
cost of
of aaKg
Kgof
of
potatoes
potatoesis
is11Kg
Kgof
of meat.
meat.

–– The
TheRancher’s
Rancher’sopportunity
opportunitycost
costof
of11 Kg
Kg of
of
meat
meat isisonly
only1/4
1/4 Kg
Kg of
of potatoes,
potatoes, while
whilethe
the
Farmer’s
Farmer’sopportunity
opportunitycost
cost of
of 11Kg
Kgof
of meat
meat is
is
only
only 11 Kg
Kgof
ofpotatoes...
potatoes...

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 22

Comparative Advantage and Trade
•• The
The Rancher
Rancher hashas the
the Comparative
Comparative
Advantage
Advantage inin producing
producing Meat
Meat (lower
(lower
opportunity
opportunity cost).
cost).
•• The
The Farmer
Farmer has
has the
the Comparative
Comparative
Advantage
Advantage inin producing
producing Potatoes
Potatoes (lower
(lower
opportunity
opportunity cost)
cost)

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 23

Comparative Advantage and Trade
•• Comparative
Comparative advantage
advantage andand
differences
differences inin opportunity
opportunity costs
costs are
are
the
the basis
basis for
for specialized
specialized production
production
and
and trade.
trade.
•• Whenever
Whenever potential
potential trading
trading parties
parties
have
have differences
differences inin opportunity
opportunity
costs,
costs, they
they can
can each
each benefit
benefit from
from
trade.
trade.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 24

Comparative Advantage and Trade
Moral
Moral of
of the
the Story:
Story:

“Trade
“Trade can
can benefit
benefit everyone
everyone inin aa society
society
because
because itit allows
allows people
people to
to specialize
specialize inin
activities
activities in
in which
which they
they have
have aa
comparative
comparative advantage.”
advantage.”

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 25

APPLICATIONS OF COMPARATIVE
ADVANTAGE

•• The
The principle
principle of
of comparative
comparative advantage
advantage
has
has many
many applications.
applications. Here
Here are
are two
two
examples:
examples:
–– Joe Sakic and his lawn.
Joe Sakic and his lawn.
–– Canada and other countries.
Canada and other countries.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 26

 Should Joe Sakic Mow His Own
Lawn?

•• Absolute
AbsoluteAdvantage.
Advantage. .. ..
•• Opportunity
Opportunity Costs.
Costs. .. ..
•• Gains
Gains from
from trade.
trade. .. ..

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 27

 Should Canada Trade with other
Countries?
•• Each
Each country
country has
has many
many citizens
citizens with
with
different
different interests.
interests. International
International trade
trade can
can
make
make some
some individuals
individuals worse
worse off,
off, even
even as
as
itit makes
makes the
the country
country asas aa whole
whole better
better off.
off.
––Imports
Imports:: goods
goods produced
produced abroad
abroad and
and
sold
sold domestically
domestically
––Exports
Exports:: goods
goods produced
produced domestically
domestically
and
and sold
sold abroad
abroad

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 28

 Summary

•• Each
Each person
person consumes
consumes goods
goods and
and
services
services produced
produced byby many
many other
other people
people
both
both in
in our
our country
country and
and around
around the
the world.
world.
•• Interdependence
Interdependence and and trade
trade are
are desirable
desirable
because
because they
they allow
allow everyone
everyone toto enjoy
enjoy aa
greater
greater quantity
quantity and
and variety
variety of
of goods
goods and
and
services.
services.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 29

Summary

•• There
There areare two
two ways
ways toto compare
compare the
the ability
ability
of
of two
two people
people producing
producing aa good.
good.
–– The
The person
person who
who can
can produce
produce aa good
good
with
with aa smaller
smaller quantity
quantity of
of inputs
inputs has
has an
an
absolute
absolute advantage.
advantage.
–– The
The person
person with
with aa smaller
smaller opportunity
opportunity
cost
cost has
has aa comparative
comparative advantage.
advantage.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 30

Summary

•• The
The gains
gains from
from trade
trade are
are based
based on on
comparative
comparative advantage,
advantage, not
not absolute
absolute
advantage.
advantage.
•• Trade
Trade makes
makes everyone
everyone better
better off
off because
because
itit allows
allows people
people toto specialize
specialize in
in those
those
activities
activities inin which
which they
they have
have aa
comparative
comparative advantage.
advantage.
•• The
The principle
principle of
of comparative
comparative advantage
advantage
applies
applies to to countries
countries asas well
well as
as people.
people.

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 31

The End

Mankiw et al.: Principles of Microeconomics, 2nd Canadian edition. Chapter 3: Page 32