Chapter 3

Interdependence

and the

Gains From Trade

Ratna K. Shrestha

Over the past 50 years, the number of Canadians who produce farm goods have decreased, while the number who produce services has expanded. Yet Canadians now enjoy a greater varieties/quantities of farm goods than before. What explains this seemingly paradoxical outcome ?

Changes in What Canadian Produce

Changes in What Canadian Produce

Overview

A Parable for the Modern Economy Principle of Comparative Advantage Application of Comparative Advantage

How Do We Satisfy Our Needs?

Economics studies how society produces and distributes goods and services so that wants and needs are satisfied.

We can be economically Self-Sufficient.

OrWe can specialize and trade with others,

leading to Economic Interdependence.

Interdependence

Every day you rely on

many people from around the world,

most of whom you do not know,

to provide you with the goods and services

you enjoy.coffee from

Brazil

dress shirt from China

cell phone from Korea

hair gel from Cleveland, OH

Interdependence & Trade

A general observation– Individuals and nations rely on specialized

production (they produce only certain goods and not all) and exchange as a way to address problems caused by scarcity.

This gives rise to two questions. – Why is interdependence the norm?– What determines production & trade?

Interdependence & Trade

Why is interdependence the norm? Interdependence occurs because people

are better off when they specialize (in the goods which they can produce at lower costs) and trade with others.

What determines the pattern of production & trade? The differences in opportunity costs. You

produce the good which you can produce at a lower opportunity cost.

Interdependence and Trade: “A Parable for the Modern Economy”

Imagine...

…only two goods (potatoes and meat)

..only two people (farmer and rancher)

What should each produce?

Why should they trade?

Productivity Table

Note that based on the Productivity Tableabove the Rancher is more productive inproducing both of the products.

Yet, we will see that both the Rancher and the Farmer can gain from trade ...

PPF(Assuming an 8 hour day)M

eat i

n K

g

Farmer

Potatoes in Kg

8

8

Mea

t in

Kg

Potatoes in Kg

Rancher

64

16

PPF PPF

A World of Self-Sufficiency

Suppose with no trade, the Farmer produces and consumes combination A, while the Rancher is at combination B

Mea

t in

Kg Farmer

Potatoes in Kg

8

8

Mea

t in

Kg

Potatoes in Kg

Rancher64

16

B48

4

A6

2

Specialization and Trade

If the farmer and the rancher were to specialize in producing the product that they were best suited to produce, and then trade with each other, they would be better off.– Farmer should produce potatoes. – Rancher should produce meat.– Farmer and Rancher should trade.

In the next slide, farmer produces 8 potatoes and no meat. Similarly, rancher 16 meat and no potatoes.

Specialization and Trade

In this example, farmer trades 5 Kg Potatoes for 10 Kg Meat:

Mea

t in

Kg

Farmer

Potatoes in Kg

8

8

Mea

t in

Kg

Potatoes in Kg

Rancher64

16

B48

4

A6

2

A*trade B*trade

3

10 54

5

Specialization and TradeM

eat i

n K

g

Farmer

Potatoes in Kg

8

8

Mea

t in

Kg

Potatoes in Kg

Rancher64

16

B48

4

A6

2

A*trade B*trade

3

10 54

5

With trade theFarmer is at A*

With trade theRancher is at B*

Examples of Specialization

The Principle of Comparative Advantage

What determines who should produce what? And how much should be traded for each product?

It depends on the opportunity costs of production for each trading partner.

Not on the total amount of resources required for production by each partner.

Comparative and 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.

The producer that has a lower opportunity cost in producing a good is said to have a comparative advantage in producing that good.

Productivity Table Amount Produced In One Hour

(in Kilograms)Meat Potatoes

Farmer 1 Kg 1 Kg

Rancher 8 Kg 2 Kg

Who has the Absolute Advantage in eachproduct? Rancher, in both products.

Yet, both the Rancher and the Farmer can gain from trade. Why?

What is the Problem with this Picture?

The Principle of Comparative Advantage

Comparative advantage is the basis for specialized production and trade.

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

Opportunity Cost Table

Cost of 1 Kg of each product in real terms

1 Kg of Meat Costs 1 Kg of Potatoes costs

Farmer 1 Kg of Potatoes 1 Kg of Meat

Rancher .25 Kg of Potatoes 4 Kg of Meat

The Rancher has the Comparative Advantage in producing Meat (lower opportunity cost).

The Farmer has the Comparative Advantage in producing Potatoes (lower opportunity cost).

Applications of Comparative Advantage

Should Canada trade with Other countries (e.g. Japan or USA)?

Who has a comparative advantage in producing lumber: Canada or US?

Comparative advantage depends on Opportunity Costs and it determines the nature of trade: who Imports or Exports.

Trade: Canada and Japan

Cars

Food

Canada Japan4

2

Food

2

2Cars

Opportunity Cost: Sacrifice Food Production for Car Production

Opportunity Cost =

Slope of PPF = 2/1

(2 Units of food given up to get 1 Unit of a car)

Cars

Canada4

2

Food

2

1

Opportunity Cost: Sacrifice Food Production for Car Production

Opportunity Cost

Slope of PPF =1/1

1 Unit of food given up to get 1 Unit of a car

Cars

Japan2

2

Food

Cars Cars

Food

CanadaJapan

4

2

Food

2

2

Who should produce Cars/Food?Trade ratio = between 2 and 1

1 1

2.5

1.5

Conclusion

Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services.

Founded upon the. . .Principle of Comparative Advantage (developed by David Ricardo in his 1816 book “Principle of Political Economy and Taxation)

Should Joe Sakic Mow His Own Lawn?

Joe Sakic is a great hockey player. Perhaps he can also mow his lawn faster

than anyone else. Does that mean he should mow his own

lawn?

Specialization and Trade

Suppose Rancher wants to consume more than 8 Potatoes that the Farmer can possibly produce. In this case, Rancher has to produce some of the potatoes on its own (even though Farmer has the comparative advantage in producing it).

For example, if the Rancher wants 9 potatoes, then she/he can get 5 from the farmer and produce 4 on its own.

Specialization and TradeM

eat i

n K

g

Farmer

Potatoes in Kg

8

8Potatoes in Kg

Rancher

64

16

B

48

4

A6

2

A*trade

B*trade

3

10

98

32

38