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Interdependence andthe Gains from Trade
Chapter 3
Interdependence and Trade
Remember, economics is thestudy of how societies produceand distribute goods in anattempt to satisfy the wants andneeds of its members.
How do we satisfy our wants and needsin a global economy?
We can beeconomically self-sufficient.
We can specialize andtrade with others,leading to economicinterdependence (I.e.Globalization)
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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
The Production Opportunities of theFarmer and the Rancher
Hours Needed to Make 1 lb. of: Amount Produced in 40 HoursMeat 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.
Production Possibilities Frontiers
Potatoes (pounds)
Meat(pounds)
4
2
1
2
(a) The Farmer’s Production Possibilities Frontier
0
A
3
Production Possibilities Frontiers
Potatoes (pounds)
Meat(pounds)
5
40
20
2.5
(b) The Rancher’s Production Possibilities Frontier
0
B
The Gains from Trade:A Summary
The OutcomeWithout Trade:What They Produceand Consume
Farmer1 lb meat (A)2 lbs potatoes
Rancher20 lbs meat (B)2.5 lbs potatoes
The Gains from Trade:A Summary
The OutcomeWith Trade:What TheyProduce
What TheyTrade
What TheyConsume
Farmer0 lbs meat 4 lbs potatoes
Gets 3 lbs meatfor 1 lb potatoes
3 lbs meat ( A*)3 lbs potatoes
Rancher24 lbs meat 2 lbs potatoes
Gives 3 lbs meatfor 1 lb potatoes
21 lbs meat (B*)3 lbs potatoes
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Trade Expands the Set of ConsumptionPossibilities
Potatoes (pounds)
Meat(pounds)
42
2
1
(a) How Trade Increases theFarmer’s Consumption
0
A
3
3
A*
Farmer’sconsumptionwithout trade
Farmer’sconsumptionwith trade
Trade Expands the Set of ConsumptionPossibilities
Potatoes (pounds)
Meat(pounds)
52.5
40
20
(b) How Trade Increases TheRancher’s Consumption
0
B
21
3
B*
Rancher’sconsumptionwithout trade
Rancher’sconsumptionwith trade
The Gains from Trade:A Summary
The GainsFrom Trade:The Increase in Consumption
Farmer2 lbs meat (A*- A)1 lb potatoes
Rancher1 lb meat (B*- B)1/2 lb potatoes
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The Farmer and the RancherSpecialize and Trade
Each would be better off if theyspecialized in producing the product theyare more suited to produce, and thentrade with each other. The farmer should produce potatoes. The rancher should produce meat.
The Principle ofComparative Advantage
Who should produce what?How much should be traded for each
product?
Who can produce potatoes at a lowercost--the farmer or the rancher?
Differences in the costs ofproduction determine the following:
Absolute AdvantageDescribes the productivity of one person,
firm, or nation compared to that of another.Absolute advantage can be measured in
two ways: Least number of hours to produce a good. Most number of goods produced in a given
amount of time.
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Comparative Advantage
Compares producers of a goodaccording to their opportunity cost.
The producer who has the smalleropportunity cost of producing agood is said to have a comparativeadvantage in producing that good.
The Opportunity Costof Meat and Potatoes
8 pounds ofmeat
1/8 pounds ofpotatoes
Rancher
1/2 pound ofmeat
2 pounds ofpotatoes
Farmer
1 pound ofpotatoes
1 pound ofmeat
Should Tiger Woods Mow His OwnLawn?
?? ?
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What are the pros and cons ofGlobalization?
Globalization meansthat free trade isspread to all cornersof the world with nohindrances.GlobalizationVideo
