Chapter 3:Chapter 3:

Interdependence and Interdependence and the Gains from Tradethe Gains from Trade

Chapter 3:Chapter 3:

Interdependence and Interdependence and the Gains from Tradethe Gains from Trade

ObjectiveObjectiveObjectiveObjective1. Understand how everyone can 1. Understand how everyone can benefit from benefit from

voluntary trade.voluntary trade.

2. Learn the meaning 2. Learn the meaning of absolute of absolute and and comparativecomparative advantage.advantage.

3. Recognize how 3. Recognize how comparative advantage comparative advantage forms the forms the basis upon which basis upon which specializationspecialization and exchange benefit and exchange benefit trading partner.trading partner.

4. Be able to apply the theory of 4. Be able to apply the theory of comparativecomparativeadvantage advantage to real-world situationsto real-world situations

1. Understand how everyone can 1. Understand how everyone can benefit from benefit from voluntary trade.voluntary trade.

2. Learn the meaning 2. Learn the meaning of absolute of absolute and and comparativecomparative advantage.advantage.

3. Recognize how 3. Recognize how comparative advantage comparative advantage forms the forms the basis upon which basis upon which specializationspecialization and exchange benefit and exchange benefit trading partner.trading partner.

4. Be able to apply the theory of 4. Be able to apply the theory of comparativecomparativeadvantage advantage to real-world situationsto real-world situations

Opportunity CostOpportunity CostOpportunity CostOpportunity Cost

Opportunity Cost of some decision is Opportunity Cost of some decision is valuevalue of the of the nextnext best best alternativealternative which you have to give up because of which you have to give up because of the decisionthe decision

Opportunity Cost of some decision is Opportunity Cost of some decision is valuevalue of the of the nextnext best best alternativealternative which you have to give up because of which you have to give up because of the decisionthe decision

Absolute AdvantageAbsolute Advantage is the advantage that is the advantage that individual or countries have if they can individual or countries have if they can produce more goods or services with their produce more goods or services with their resources in a given time period than their resources in a given time period than their trading partnerstrading partners

Absolute AdvantageAbsolute Advantage is the advantage that is the advantage that individual or countries have if they can individual or countries have if they can produce more goods or services with their produce more goods or services with their resources in a given time period than their resources in a given time period than their trading partnerstrading partners

Comparative AdvantageComparative Advantage is the advantage is the advantage that individuals or countries have if they that individuals or countries have if they can produce a good or service at lower can produce a good or service at lower opportunity cost than their trading opportunity cost than their trading partnerspartners

Comparative AdvantageComparative Advantage is the advantage is the advantage that individuals or countries have if they that individuals or countries have if they can produce a good or service at lower can produce a good or service at lower opportunity cost than their trading opportunity cost than their trading partnerspartners

Interdependence and TradeInterdependence and TradeInterdependence and TradeInterdependence and Trade Consider your typical day:Consider your typical day:You wake up to an alarm clock made in Korea.You wake up to an alarm clock made in Korea.You pour yourself some orange juice made from You pour yourself some orange juice made from oranges grown in Florida.oranges grown in Florida.

You put on some clothes made of cotton grown in You put on some clothes made of cotton grown in Georgia and sewn in factories in Thailand.Georgia and sewn in factories in Thailand.

You watch the morning news broadcast from New You watch the morning news broadcast from New York on your TV made in Japan.York on your TV made in Japan.

You drive to class in a car made of parts You drive to class in a car made of parts manufactured in a half-dozen different countries.manufactured in a half-dozen different countries.

… …and you haven’t been up for more than and you haven’t been up for more than two hours yet!two hours yet!

Consider your typical day:Consider your typical day:You wake up to an alarm clock made in Korea.You wake up to an alarm clock made in Korea.You pour yourself some orange juice made from You pour yourself some orange juice made from oranges grown in Florida.oranges grown in Florida.

You put on some clothes made of cotton grown in You put on some clothes made of cotton grown in Georgia and sewn in factories in Thailand.Georgia and sewn in factories in Thailand.

You watch the morning news broadcast from New You watch the morning news broadcast from New York on your TV made in Japan.York on your TV made in Japan.

You drive to class in a car made of parts You drive to class in a car made of parts manufactured in a half-dozen different countries.manufactured in a half-dozen different countries.

… …and you haven’t been up for more than and you haven’t been up for more than two hours yet!two hours yet!

Interdependence and TradeInterdependence and TradeInterdependence and TradeInterdependence and Trade

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

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

How do we satisfy our wants and How do we satisfy our wants and needs in a global economy?needs in a global economy?

We can be economically self-We can be economically self-sufficient.sufficient.

We can specialize and We can specialize and trade with others, trade with others, leading to economic leading to economic interdependence.interdependence.

Interdependence and TradeInterdependence and Trade

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

Interdependence and TradeInterdependence and Trade

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

Why is interdependence the norm?Why is interdependence the norm?

Interdependence occurs because Interdependence occurs because people are better off when they people are better off when they specialize and trade with others.specialize and trade with others.

WhatWhat determines the pattern determines the pattern of production and trade?of production and trade?

Patterns of production and trade Patterns of production and trade are based upon differences in are based upon differences in

opportunity costs.opportunity costs.

Imagine . . .Imagine . . .only two goods: potatoes and meatonly two goods: potatoes and meatonly two people: a potato farmer and a only two people: a potato farmer and a

cattle ranchercattle rancher

What should each produce?What should each produce? Why should they trade?Why should they trade?

A Parable for the Modern A Parable for the Modern EconomyEconomy

The Production OpportunitiesThe Production Opportunitiesof the Farmer and the Rancherof the Farmer and the Rancher

(Table 3-1)(Table 3-1)

The Production OpportunitiesThe Production Opportunitiesof the Farmer and the Rancherof the Farmer and the Rancher

(Table 3-1)(Table 3-1)

Meat Potatoes Meat PotatoesFarmer 20 10 2 4Rancher 1 8 40 5

Meat Potatoes Meat PotatoesFarmer 20 10 2 4Rancher 1 8 40 5

Hours needed toHours needed tomake 1 pound of:make 1 pound of:

Amount produced inAmount produced in40 hours (in pounds):40 hours (in pounds):

Self-SufficiencySelf-SufficiencyBy ignoring each other:By ignoring each other: Each consumes what they each produce.Each consumes what they each produce. The production possibilities frontier is The production possibilities frontier is

also the also the consumption possibilities consumption possibilities frontier.frontier.

Without trade, economic gains are Without trade, economic gains are diminished.diminished.

1

2

2 4

A

Potatoes(pounds)

Meat(pounds)

The Farmer’s ProductionPossibilities Frontier(figure 3-1a)

40

20

2.5 5 Potatoes(pounds)

Meat(pounds)

The Rancher’s ProductionPossibilities Frontier(figure 3-1b)

B

1

2

2 4

A

Potatoes(pounds)

Meat(pounds)

How trade increasesthe Farmers consumption(Figure 3-2a)

40

20

2.5 5 Potatoes(pounds)

Meat(pounds) How trade increases

the Rancher’s consumption(Figure 3-2b)

B

3

3

21

3

B*

A* Farmer’s consumptionwith trade

Farmer’s consumptionwithout trade

Rancher’s consumptionwith trade

Rancher’s consumptionwithout trade

Farmer 1 poundmeat

2 poundspotatoes

0 poundsmeat

4 poundspotatoes

Gets 3poundsmeat for1 poundpotatoes

3 poundsmeat

3 poundspotatoes

2 poundsmeat

1 poundpotatoes

Rancher 20 poundsmeat

2.5 poundspotatoes

24 poundsmeat

2 poundspotatoes

Gives 3poundsmeat for1 poundpotatoes

21 poundsmeat

3 poundspotatoes

1 poundmeat

.5 poundpotatoes

Farmer 1 poundmeat

2 poundspotatoes

0 poundsmeat

4 poundspotatoes

Gets 3poundsmeat for1 poundpotatoes

3 poundsmeat

3 poundspotatoes

2 poundsmeat

1 poundpotatoes

Rancher 20 poundsmeat

2.5 poundspotatoes

24 poundsmeat

2 poundspotatoes

Gives 3poundsmeat for1 poundpotatoes

21 poundsmeat

3 poundspotatoes

1 poundmeat

.5 poundpotatoes

WithoutWithoutTrade:Trade: With Trade:With Trade:

Production andProduction andConsumptionConsumption ProductionProduction TradeTrade ConsumptionConsumption

Gains fromGains fromTradeTrade

The Principle of The Principle of Comparative AdvantageComparative Advantage

Who should produce what?Who should produce what? How much should be traded for each How much should be traded for each

product?product?

Who can produce potatoes at a lower cost--the farmer or the rancher?

Differences in the costs of production determine the following:

Differences in Costs of Differences in Costs of ProductionProduction

The number of hours required to The number of hours required to produce a unit of output. (for example, produce a unit of output. (for example, one pound of potatoes)one pound of potatoes)

The The opportunity costopportunity cost of sacrificing one of sacrificing one good for another.good for another.

Two ways to measure differences in costs of production:

Absolute AdvantageAbsolute Advantage

Describes the productivity of one Describes the productivity of one person, firm, or nation compared to person, firm, or nation compared to that of another.that of another.

The producer that requires a smaller The producer that requires a smaller quantity of inputs to produce a good is quantity of inputs to produce a good is said to have an said to have an absolute advantageabsolute advantage in in producing that good.producing that good.

Comparative AdvantageComparative Advantage

Compares producers of a good Compares producers of a good according to their according to their opportunity cost.opportunity cost.

The producer who has the smaller The producer who has the smaller opportunity cost of producing a good opportunity cost of producing a good is said to have a is said to have a comparativecomparative advantageadvantage in producing that good. in producing that good.

OPPORTUNITY COST OF 1 POUND OFOPPORTUNITY COST OF 1 POUND OFOPPORTUNITY COST OF 1 POUND OFOPPORTUNITY COST OF 1 POUND OF

MEAT (IN TERMS OFMEAT (IN TERMS OF

POTATOES GIVEN UP)POTATOES GIVEN UP)

MEAT (IN TERMS OFMEAT (IN TERMS OF

POTATOES GIVEN UP)POTATOES GIVEN UP)POTATOES (IN TERMS POTATOES (IN TERMS

OF MEAT GIVEN UP)OF MEAT GIVEN UP)

POTATOES (IN TERMS POTATOES (IN TERMS

OF MEAT GIVEN UP)OF MEAT GIVEN UP)

FARMERFARMER

RANCHERRANCHER

FARMERFARMER

RANCHERRANCHER

22

1/81/8

22

1/81/8

1/21/2

88

1/21/2

88

Table 3-3Table 3-3Table 3-3Table 3-3

THE OPPORTUNITY COST OF THE OPPORTUNITY COST OF MEAT AND POTATOESMEAT AND POTATOES

THE OPPORTUNITY COST OF THE OPPORTUNITY COST OF MEAT AND POTATOESMEAT AND POTATOES

Comparative AdvantageComparative AdvantageComparative AdvantageComparative Advantage

…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 The Principle of Comparative AdvantageComparative Advantage

Comparative advantage and differences Comparative advantage and differences in opportunity costs are the basis for in opportunity costs are the basis for specialized production and trade.specialized production and trade.

Whenever potential trading parties have Whenever potential trading parties have differences in opportunity costs, they differences in opportunity costs, they can each benefit from trade.can each benefit from trade.

ImportsImports are goods or services produced are goods or services produced abroad and sold domestically.abroad and sold domestically.

ExportsExports are goods or services produced are goods or services produced domestically and sold abroad.domestically and sold abroad.

ImportsImports are goods or services produced are goods or services produced abroad and sold domestically.abroad and sold domestically.

ExportsExports are goods or services produced are goods or services produced domestically and sold abroad.domestically and sold abroad.

Adam Smith and TradeAdam Smith and TradeAdam Smith and TradeAdam Smith and TradeIn his 1776 book In his 1776 book An Inquiry into An Inquiry into the Nature and Causes of the the Nature and Causes of the Wealth of NationsWealth of Nations, , Adam SmithAdam Smith performed a detailed analysis of performed a detailed analysis of trade and economic trade and economic interdependence, which interdependence, which economists still adhere to today.economists still adhere to today.

In his 1776 book In his 1776 book An Inquiry into An Inquiry into the Nature and Causes of the the Nature and Causes of the Wealth of NationsWealth of Nations, , Adam SmithAdam Smith performed a detailed analysis of performed a detailed analysis of trade and economic trade and economic interdependence, which interdependence, which economists still adhere to today.economists still adhere to today.

David Ricardo and TradeDavid Ricardo and TradeDavid Ricardo and TradeDavid Ricardo and Trade

In his 1816 book In his 1816 book Principles of Principles of Political Economy and TaxationPolitical Economy and Taxation, , David RicardoDavid Ricardo developed the developed the principle of comparative principle of comparative advantage as we know it today.advantage as we know it today.

In his 1816 book In his 1816 book Principles of Principles of Political Economy and TaxationPolitical Economy and Taxation, , David RicardoDavid Ricardo developed the developed the principle of comparative principle of comparative advantage as we know it today.advantage as we know it today.

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

Mow His Own Lawn?Mow His Own Lawn?

?? ?

SummarySummaryInterdependence and trade Interdependence and trade

allow people to enjoy a greater allow people to enjoy a greater quantity and variety of goods quantity and variety of goods and services.and services.

SummarySummaryThe person who can The person who can

produce a good with a produce a good with a smaller quantity of inputs smaller quantity of inputs has an absolute advantage. has an absolute advantage.

The person with a smaller The person with a smaller opportunity cost has a opportunity cost has a comparative advantage.comparative advantage.

SummarySummaryThe gains from trade are The gains from trade are

based on comparative based on comparative advantage, not absolute advantage, not absolute advantage. advantage.

Comparative advantage Comparative advantage applies to countries as well applies to countries as well as to people. as to people.

Graphical Review

Production Possibilities FrontiersProduction Possibilities Frontiers

Potatoes (pounds)

Meat (pounds)

4

2

1

2

(a) The Farmer’s Production Possibilities Frontier

0

A

Production Possibilities FrontiersProduction Possibilities Frontiers

Potatoes (pounds)

Meat (pounds)

5

40

20

2.5

(b) The Rancher’s Production Possibilities Frontier

0

B

Trade Expands the Set of Consumption Trade Expands the Set of Consumption PossibilitiesPossibilities

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

Trade Expands the Set of Consumption Trade Expands the Set of Consumption PossibilitiesPossibilities

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