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Chapter 3: Interdependence and the Gains from Trade Chapter 3: Interdependence and the Gains from Trade AGEC 217 Patrick S. Ward Purdue University June 17, 2009
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Chapter 3: Interdependence and the Gains from Trade
Chapter 3: Interdependence and the Gains fromTrade
AGEC 217
Patrick S. Ward
Purdue University
June 17, 2009
Chapter 3: Interdependence and the Gains from Trade
Overview
1 Overview
2 An Example of Trade
3 Absolute vs. Comparative Advantage
4 The Price of Trade
5 Applications
6 Conclusions
Chapter 3: Interdependence and the Gains from Trade
Overview
Interdependencies in the Modern Global Economy
Every day, you depend on many people from many countriesaround the world
...and many people from many countries around the worlddepend on you!
Such interdependencies are possible because people tradewith one another
People engage in trade because it is mutually beneficial
Trade can make everyone better of
Chapter 3: Interdependence and the Gains from Trade
Overview
Interdependencies in the Modern Global Economy
Every day, you depend on many people from many countriesaround the world
...and many people from many countries around the worlddepend on you!
Such interdependencies are possible because people tradewith one another
People engage in trade because it is mutually beneficial
Trade can make everyone better of
Chapter 3: Interdependence and the Gains from Trade
Overview
Interdependencies in the Modern Global Economy
Every day, you depend on many people from many countriesaround the world
...and many people from many countries around the worlddepend on you!
Such interdependencies are possible because people tradewith one another
People engage in trade because it is mutually beneficial
Trade can make everyone better of
Chapter 3: Interdependence and the Gains from Trade
Overview
Interdependencies in the Modern Global Economy
Every day, you depend on many people from many countriesaround the world
...and many people from many countries around the worlddepend on you!
Such interdependencies are possible because people tradewith one another
People engage in trade because it is mutually beneficialTrade can make everyone better of
Chapter 3: Interdependence and the Gains from Trade
Overview
How Can Individuals Satisfy Their Wants?
Two basic ways:
1 Be economically self-sufficient
2 Specialize in the production of one good and trade with others
With rare exceptions, individuals and nations tend to rely onspecialization and trade
Chapter 3: Interdependence and the Gains from Trade
Overview
A Parable of Trade
When are there gains from trade?
We can analyze this question through the use of economic models
Assumptions:
2 goods (Meat & Potatoes)2 agents (Cattle Rancher & Potato Farmer)Both agents would like to consume both of the goodsCattle rancher is very skilled in the raising of cattlePotato farmer is very skilled in growing potatoes
Chapter 3: Interdependence and the Gains from Trade
Overview
A Parable of Trade
There are gains from trade:
When both agents can produce only 1 good (completespecialization)
Cattle rancher only produces cattle and the potato farmer onlyproduces potatoesTrade allows the agents to consume the good they don’tproduce
When the farmer can raise cattle as well as grow potatoes(but he is not as good at it) and the rancher can growpotatoes as well as raise cattle (but he is not as good at it)
Trade allows the agent to specialize and produce what they aremost efficient at producing
Even when one of the agents is better at the production ofboth potatoes and cattle
Chapter 3: Interdependence and the Gains from Trade
Overview
A Parable of Trade
There are gains from trade:
When both agents can produce only 1 good (completespecialization)
Cattle rancher only produces cattle and the potato farmer onlyproduces potatoesTrade allows the agents to consume the good they don’tproduce
When the farmer can raise cattle as well as grow potatoes(but he is not as good at it) and the rancher can growpotatoes as well as raise cattle (but he is not as good at it)
Trade allows the agent to specialize and produce what they aremost efficient at producing
Even when one of the agents is better at the production ofboth potatoes and cattle
Chapter 3: Interdependence and the Gains from Trade
Overview
A Parable of Trade
There are gains from trade:
When both agents can produce only 1 good (completespecialization)
Cattle rancher only produces cattle and the potato farmer onlyproduces potatoesTrade allows the agents to consume the good they don’tproduce
When the farmer can raise cattle as well as grow potatoes(but he is not as good at it) and the rancher can growpotatoes as well as raise cattle (but he is not as good at it)
Trade allows the agent to specialize and produce what they aremost efficient at producing
Even when one of the agents is better at the production ofboth potatoes and cattle
Chapter 3: Interdependence and the Gains from Trade
Overview
A Parable of Trade
There are gains from trade:
When both agents can produce only 1 good (completespecialization)
Cattle rancher only produces cattle and the potato farmer onlyproduces potatoesTrade allows the agents to consume the good they don’tproduce
When the farmer can raise cattle as well as grow potatoes(but he is not as good at it) and the rancher can growpotatoes as well as raise cattle (but he is not as good at it)
Trade allows the agent to specialize and produce what they aremost efficient at producing
Even when one of the agents is better at the production ofboth potatoes and cattle
Chapter 3: Interdependence and the Gains from Trade
An Example of Trade
1 Overview
2 An Example of Trade
3 Absolute vs. Comparative Advantage
4 The Price of Trade
5 Applications
6 Conclusions
Chapter 3: Interdependence and the Gains from Trade
An Example of Trade
An Example
Assumptions:
Two actors: Farmer and RancherEach works 8 hours per dayEach can produce both potatoes and cattle (either specializingor mixing)Production opportunities are given as:
AmountProduced in 8 HoursMeat Potatoes
Farmer 8 oz. 32 oz.Rancher 24 oz. 48 oz.
Chapter 3: Interdependence and the Gains from Trade
An Example of Trade
Production Possibilities
Farmer’s Production Possibilities Rancher’s Production Possibilities
Chapter 3: Interdependence and the Gains from Trade
An Example of Trade
What Do We Observe in this Example?
The Rancher has an absolute advantage in the production ofboth meat and potatoes
Rancher is able to produce 24 oz. of meat and 48 oz. ofpotatoes in an 8 hour period, while the farmer is only able toproduce 8 oz. of meat and 32 oz. of potatoes in that sameperiod
Since both the Farmer and the Rancher would like to consumeboth meat and potatoes, in the absence of trade they willproduce and consume some combination of the two goods.
Chapter 3: Interdependence and the Gains from Trade
An Example of Trade
What Do We Observe in this Example?
The Rancher has an absolute advantage in the production ofboth meat and potatoes
Rancher is able to produce 24 oz. of meat and 48 oz. ofpotatoes in an 8 hour period, while the farmer is only able toproduce 8 oz. of meat and 32 oz. of potatoes in that sameperiod
Since both the Farmer and the Rancher would like to consumeboth meat and potatoes, in the absence of trade they willproduce and consume some combination of the two goods.
Chapter 3: Interdependence and the Gains from Trade
An Example of Trade
What Do We Observe in this Example?
The Rancher has an absolute advantage in the production ofboth meat and potatoes
Rancher is able to produce 24 oz. of meat and 48 oz. ofpotatoes in an 8 hour period, while the farmer is only able toproduce 8 oz. of meat and 32 oz. of potatoes in that sameperiod
Since both the Farmer and the Rancher would like to consumeboth meat and potatoes, in the absence of trade they willproduce and consume some combination of the two goods.
Chapter 3: Interdependence and the Gains from Trade
An Example of Trade
What Do We Observe in this Example?
The Rancher has an absolute advantage in the production ofboth meat and potatoes
Rancher is able to produce 24 oz. of meat and 48 oz. ofpotatoes in an 8 hour period, while the farmer is only able toproduce 8 oz. of meat and 32 oz. of potatoes in that sameperiod
Since both the Farmer and the Rancher would like to consumeboth meat and potatoes, in the absence of trade they willproduce and consume some combination of the two goods.
Chapter 3: Interdependence and the Gains from Trade
An Example of Trade
What Do We Observe in this Example? (cont’d)
If the Farmer and the Rancher choose to be self-suffieicnt,they will each consume what they produce
Production decisions are determined by consumption decisionsIn the PPF diagrams, these consumption combinations (ofmeat and potatoes) are given by points A and BThese points are dependent upon the individuals’ tastes andpreferencesIn this example, we assume that both the Farmer and theRancher like meat and potatoes equally
Chapter 3: Interdependence and the Gains from Trade
An Example of Trade
Production Possibilities
Farmer’s Production Possibilities Rancher’s Production Possibilities
Chapter 3: Interdependence and the Gains from Trade
An Example of Trade
With and Without Trade
Farmer Rancher
Meat Potatoes Meat Potatoes
Without Trade:Production andConsumption 4 oz. 16 oz. 12 oz. 24 oz.
With Trade:Production 0 oz. 32 oz. 18 oz. 12 oz.Trade Gets 5 oz. Gives 15 oz. Gives 5 oz. Gets 15 oz.Consumption 5 oz. 17 oz. 13 oz. 27 oz.
Gains from Trade:Increase inConsumption +1 oz. + 1 oz. +1 oz. + 3 oz.
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
1 Overview
2 An Example of Trade
3 Absolute vs. Comparative Advantage
4 The Price of Trade
5 Applications
6 Conclusions
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Absolute Advantage
Question: If the rancher is better at producing both meat andpotatoes, how can the farmer ever specialize in doing what he doesbest?
Absolute advantage: the ability to produce a good usingfewer inputs than another producer
The rancher has an absolute advantage in the production ofboth goodsIt requires less time (labor) to produce an ounce of meat or anounce of potatoes
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Comparative Advantage
We can also think of advantage in production by comparingopportunity costs
Time spent producing potatoes takes away from producingmeat
...and vice versa
The opportunity cost measures the trade-off between the twogoods that each producer faces
Comparative Advantage: the ability to produce a good at alower opportunity costs than another producer
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Comparative Advantage
We can also think of advantage in production by comparingopportunity costs
Time spent producing potatoes takes away from producingmeat
...and vice versa
The opportunity cost measures the trade-off between the twogoods that each producer faces
Comparative Advantage: the ability to produce a good at alower opportunity costs than another producer
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Comparative Advantage
We can also think of advantage in production by comparingopportunity costs
Time spent producing potatoes takes away from producingmeat
...and vice versa
The opportunity cost measures the trade-off between the twogoods that each producer faces
Comparative Advantage: the ability to produce a good at alower opportunity costs than another producer
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Comparative Advantage
We can also think of advantage in production by comparingopportunity costs
Time spent producing potatoes takes away from producingmeat
...and vice versa
The opportunity cost measures the trade-off between the twogoods that each producer faces
Comparative Advantage: the ability to produce a good at alower opportunity costs than another producer
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Comparative Advantage
Recall the production opportunities:
AmountProduced in 8 Hours
Meat Potatoes
Farmer 8 oz. 32 oz.Rancher 24 oz. 48 oz.
Rancher can produce 1 oz. of potatoes in 10 minutes (48 oz. of potatoesin 480 minutes = 1 oz. in 10 minutes)
When the rancher uses these 10 minutes producing potatoes, she spends10 minutes less producing meat
These 10 minutes cost the Rancher 1/2 oz. of meat (24 oz. of meat in480 minutes = 1/2 oz. in 10 minutes)
The Rancher’s opportunity cost of 1 oz. of potatoes is 1/2 oz. of meat
Likewise, the Rancher’s opportunity cost of 1 oz. of meat is 2 oz. ofpotatoes
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Comparative Advantage
Recall the production opportunities:
AmountProduced in 8 Hours
Meat Potatoes
Farmer 8 oz. 32 oz.Rancher 24 oz. 48 oz.
Rancher can produce 1 oz. of potatoes in 10 minutes (48 oz. of potatoesin 480 minutes = 1 oz. in 10 minutes)
When the rancher uses these 10 minutes producing potatoes, she spends10 minutes less producing meat
These 10 minutes cost the Rancher 1/2 oz. of meat (24 oz. of meat in480 minutes = 1/2 oz. in 10 minutes)
The Rancher’s opportunity cost of 1 oz. of potatoes is 1/2 oz. of meat
Likewise, the Rancher’s opportunity cost of 1 oz. of meat is 2 oz. ofpotatoes
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Comparative Advantage
Recall the production opportunities:
AmountProduced in 8 Hours
Meat Potatoes
Farmer 8 oz. 32 oz.Rancher 24 oz. 48 oz.
Rancher can produce 1 oz. of potatoes in 10 minutes (48 oz. of potatoesin 480 minutes = 1 oz. in 10 minutes)
When the rancher uses these 10 minutes producing potatoes, she spends10 minutes less producing meat
These 10 minutes cost the Rancher 1/2 oz. of meat (24 oz. of meat in480 minutes = 1/2 oz. in 10 minutes)
The Rancher’s opportunity cost of 1 oz. of potatoes is 1/2 oz. of meat
Likewise, the Rancher’s opportunity cost of 1 oz. of meat is 2 oz. ofpotatoes
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Comparative Advantage
Recall the production opportunities:
AmountProduced in 8 Hours
Meat Potatoes
Farmer 8 oz. 32 oz.Rancher 24 oz. 48 oz.
Rancher can produce 1 oz. of potatoes in 10 minutes (48 oz. of potatoesin 480 minutes = 1 oz. in 10 minutes)
When the rancher uses these 10 minutes producing potatoes, she spends10 minutes less producing meat
These 10 minutes cost the Rancher 1/2 oz. of meat (24 oz. of meat in480 minutes = 1/2 oz. in 10 minutes)
The Rancher’s opportunity cost of 1 oz. of potatoes is 1/2 oz. of meat
Likewise, the Rancher’s opportunity cost of 1 oz. of meat is 2 oz. ofpotatoes
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Comparative Advantage
Recall the production opportunities:
AmountProduced in 8 Hours
Meat Potatoes
Farmer 8 oz. 32 oz.Rancher 24 oz. 48 oz.
Rancher can produce 1 oz. of potatoes in 10 minutes (48 oz. of potatoesin 480 minutes = 1 oz. in 10 minutes)
When the rancher uses these 10 minutes producing potatoes, she spends10 minutes less producing meat
These 10 minutes cost the Rancher 1/2 oz. of meat (24 oz. of meat in480 minutes = 1/2 oz. in 10 minutes)
The Rancher’s opportunity cost of 1 oz. of potatoes is 1/2 oz. of meat
Likewise, the Rancher’s opportunity cost of 1 oz. of meat is 2 oz. ofpotatoes
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Comparative Advantage
Recall the production opportunities:
AmountProduced in 8 Hours
Meat Potatoes
Farmer 8 oz. 32 oz.Rancher 24 oz. 48 oz.
Rancher can produce 1 oz. of potatoes in 10 minutes (48 oz. of potatoesin 480 minutes = 1 oz. in 10 minutes)
When the rancher uses these 10 minutes producing potatoes, she spends10 minutes less producing meat
These 10 minutes cost the Rancher 1/2 oz. of meat (24 oz. of meat in480 minutes = 1/2 oz. in 10 minutes)
The Rancher’s opportunity cost of 1 oz. of potatoes is 1/2 oz. of meat
Likewise, the Rancher’s opportunity cost of 1 oz. of meat is 2 oz. ofpotatoes
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Comparative Advantage
Recall the production opportunities:
AmountProduced in 8 Hours
Meat Potatoes
Farmer 8 oz. 32 oz.Rancher 24 oz. 48 oz.
Farmer can produce 1 oz. of potatoes in 15 minutes (32 oz. of potatoesin 480 minutes = 1 oz. in 15 minutes)
The Farmer can only produce 1 oz. of meat in 60 minutes (8 oz. ofpotatoes in 8 hours = 1 oz. in 1 hour)
The 15 minutes spent growing potatoes “costs” the Farmer 1/4 oz. ofmeat
The Farmer’s opportunity cost of 1 oz. of potatoes is 1/4 oz. of meat
Likewise, the Farmer’s opportunity cost of 1 oz. of meat is 4 oz. ofpotatoes
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Comparative Advantage
Recall the production opportunities:
AmountProduced in 8 Hours
Meat Potatoes
Farmer 8 oz. 32 oz.Rancher 24 oz. 48 oz.
Farmer can produce 1 oz. of potatoes in 15 minutes (32 oz. of potatoesin 480 minutes = 1 oz. in 15 minutes)
The Farmer can only produce 1 oz. of meat in 60 minutes (8 oz. ofpotatoes in 8 hours = 1 oz. in 1 hour)
The 15 minutes spent growing potatoes “costs” the Farmer 1/4 oz. ofmeat
The Farmer’s opportunity cost of 1 oz. of potatoes is 1/4 oz. of meat
Likewise, the Farmer’s opportunity cost of 1 oz. of meat is 4 oz. ofpotatoes
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Comparative Advantage
Recall the production opportunities:
AmountProduced in 8 Hours
Meat Potatoes
Farmer 8 oz. 32 oz.Rancher 24 oz. 48 oz.
Farmer can produce 1 oz. of potatoes in 15 minutes (32 oz. of potatoesin 480 minutes = 1 oz. in 15 minutes)
The Farmer can only produce 1 oz. of meat in 60 minutes (8 oz. ofpotatoes in 8 hours = 1 oz. in 1 hour)
The 15 minutes spent growing potatoes “costs” the Farmer 1/4 oz. ofmeat
The Farmer’s opportunity cost of 1 oz. of potatoes is 1/4 oz. of meat
Likewise, the Farmer’s opportunity cost of 1 oz. of meat is 4 oz. ofpotatoes
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Comparative Advantage
Recall the production opportunities:
AmountProduced in 8 Hours
Meat Potatoes
Farmer 8 oz. 32 oz.Rancher 24 oz. 48 oz.
Farmer can produce 1 oz. of potatoes in 15 minutes (32 oz. of potatoesin 480 minutes = 1 oz. in 15 minutes)
The Farmer can only produce 1 oz. of meat in 60 minutes (8 oz. ofpotatoes in 8 hours = 1 oz. in 1 hour)
The 15 minutes spent growing potatoes “costs” the Farmer 1/4 oz. ofmeat
The Farmer’s opportunity cost of 1 oz. of potatoes is 1/4 oz. of meat
Likewise, the Farmer’s opportunity cost of 1 oz. of meat is 4 oz. ofpotatoes
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Comparative Advantage
Recall the production opportunities:
AmountProduced in 8 Hours
Meat Potatoes
Farmer 8 oz. 32 oz.Rancher 24 oz. 48 oz.
Farmer can produce 1 oz. of potatoes in 15 minutes (32 oz. of potatoesin 480 minutes = 1 oz. in 15 minutes)
The Farmer can only produce 1 oz. of meat in 60 minutes (8 oz. ofpotatoes in 8 hours = 1 oz. in 1 hour)
The 15 minutes spent growing potatoes “costs” the Farmer 1/4 oz. ofmeat
The Farmer’s opportunity cost of 1 oz. of potatoes is 1/4 oz. of meat
Likewise, the Farmer’s opportunity cost of 1 oz. of meat is 4 oz. ofpotatoes
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Comparative Advantage
Recall the production opportunities:
AmountProduced in 8 Hours
Meat Potatoes
Farmer 8 oz. 32 oz.Rancher 24 oz. 48 oz.
Farmer can produce 1 oz. of potatoes in 15 minutes (32 oz. of potatoesin 480 minutes = 1 oz. in 15 minutes)
The Farmer can only produce 1 oz. of meat in 60 minutes (8 oz. ofpotatoes in 8 hours = 1 oz. in 1 hour)
The 15 minutes spent growing potatoes “costs” the Farmer 1/4 oz. ofmeat
The Farmer’s opportunity cost of 1 oz. of potatoes is 1/4 oz. of meat
Likewise, the Farmer’s opportunity cost of 1 oz. of meat is 4 oz. ofpotatoes
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Comparative Advantage and Trade
Opportunity cost of:
1 oz. of Meat 1 oz. of Potatoes
Farmer 4 oz. potatoes 1/4 oz. meatRancher 2 oz. potatoes 1/2 oz. meat
The Farmer has the lower opportunity cost of producingpotatoes (1/4 oz. meat vs. 1/2 oz. meat)
The Farmer will produce potatoes and trade with the Rancherto get meat
The Rancher has the lower opportunity cost of producingmeat (2 oz. potatoes vs. 4 oz. potatoes)
The Rancher will produce more meat (and fewer potatoes)than when he was self-sufficient, and will trade meat to theFarmer for potatoes
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Absolute and Comparative Advantage
It is possible for an agent to have an absolute advantage inthe production of both goods
It is not possible for an agent to have a comparativeadvantage in the production of both goods
Unless two agents have exactly the same opportunity cost,one agent will have a comparative advantage in one goodwhile the other agent will have a comparative advantage inthe other good.
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
What Factors Contribute to Comparative Advantage
There are many determinants of comparative advantage. Theinclude (but are not limited to) cross-country differences in:
1 Climate
2 Soil composition
3 Education
4 Training of the labor force
5 Capital stock (for example, machinery)
6 Infrastructure
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Gains from Trade
Both the Farmer and the Rancher gain from the trade ofgoods (compared with being self-sufficient)
Farmer consumes more meat and more potatoesRancher consumes more meat and more potatoes
When each person specializes in the production of the good orservice for which he/she has a comparative advantage, totalproduction increases
Total potato production increases from 40 to 44 oz.Total meat production increases from 16 to 18 oz.The total size of the “economic pie” is bigger
Each person is able to obtain a good at a price lower thanhis/her opportunity cost of that good
Trade can benefit everyone in society because it allowspeople to specialize in activities in which they have acomparative advantage
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Gains from Trade
Both the Farmer and the Rancher gain from the trade ofgoods (compared with being self-sufficient)
Farmer consumes more meat and more potatoesRancher consumes more meat and more potatoes
When each person specializes in the production of the good orservice for which he/she has a comparative advantage, totalproduction increases
Total potato production increases from 40 to 44 oz.Total meat production increases from 16 to 18 oz.The total size of the “economic pie” is bigger
Each person is able to obtain a good at a price lower thanhis/her opportunity cost of that good
Trade can benefit everyone in society because it allowspeople to specialize in activities in which they have acomparative advantage
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Gains from Trade
Both the Farmer and the Rancher gain from the trade ofgoods (compared with being self-sufficient)
Farmer consumes more meat and more potatoesRancher consumes more meat and more potatoes
When each person specializes in the production of the good orservice for which he/she has a comparative advantage, totalproduction increases
Total potato production increases from 40 to 44 oz.Total meat production increases from 16 to 18 oz.The total size of the “economic pie” is bigger
Each person is able to obtain a good at a price lower thanhis/her opportunity cost of that good
Trade can benefit everyone in society because it allowspeople to specialize in activities in which they have acomparative advantage
Chapter 3: Interdependence and the Gains from Trade
Absolute vs. Comparative Advantage
Gains from Trade
Both the Farmer and the Rancher gain from the trade ofgoods (compared with being self-sufficient)
Farmer consumes more meat and more potatoesRancher consumes more meat and more potatoes
When each person specializes in the production of the good orservice for which he/she has a comparative advantage, totalproduction increases
Total potato production increases from 40 to 44 oz.Total meat production increases from 16 to 18 oz.The total size of the “economic pie” is bigger
Each person is able to obtain a good at a price lower thanhis/her opportunity cost of that good
Trade can benefit everyone in society because it allowspeople to specialize in activities in which they have acomparative advantage
Chapter 3: Interdependence and the Gains from Trade
The Price of Trade
1 Overview
2 An Example of Trade
3 Absolute vs. Comparative Advantage
4 The Price of Trade
5 Applications
6 Conclusions
Chapter 3: Interdependence and the Gains from Trade
The Price of Trade
What is the Price of Trade?
General Rule for Trade: For both parties to gain from trade,the price at which they trade must lie between the twoopportunity costs
The Farmer gives up 15 oz. of potatoes for 5 oz. of meatWhat is the price of exchange?One oz. of meat costs 3 oz. of potatoes
The price of meat lies between the Farmer’s and theRancher’s opportunity costs for meat
Farmer’s opportunity cost for meat: 4 oz. potatoesRancher’s opportunity cost for meat: 2 oz. potatoes
What if the price of exchange was not in this range?
Chapter 3: Interdependence and the Gains from Trade
The Price of Trade
What is the Price of Trade?
General Rule for Trade: For both parties to gain from trade,the price at which they trade must lie between the twoopportunity costs
The Farmer gives up 15 oz. of potatoes for 5 oz. of meat
What is the price of exchange?One oz. of meat costs 3 oz. of potatoes
The price of meat lies between the Farmer’s and theRancher’s opportunity costs for meat
Farmer’s opportunity cost for meat: 4 oz. potatoesRancher’s opportunity cost for meat: 2 oz. potatoes
What if the price of exchange was not in this range?
Chapter 3: Interdependence and the Gains from Trade
The Price of Trade
What is the Price of Trade?
General Rule for Trade: For both parties to gain from trade,the price at which they trade must lie between the twoopportunity costs
The Farmer gives up 15 oz. of potatoes for 5 oz. of meatWhat is the price of exchange?
One oz. of meat costs 3 oz. of potatoes
The price of meat lies between the Farmer’s and theRancher’s opportunity costs for meat
Farmer’s opportunity cost for meat: 4 oz. potatoesRancher’s opportunity cost for meat: 2 oz. potatoes
What if the price of exchange was not in this range?
Chapter 3: Interdependence and the Gains from Trade
The Price of Trade
What is the Price of Trade?
General Rule for Trade: For both parties to gain from trade,the price at which they trade must lie between the twoopportunity costs
The Farmer gives up 15 oz. of potatoes for 5 oz. of meatWhat is the price of exchange?One oz. of meat costs 3 oz. of potatoes
The price of meat lies between the Farmer’s and theRancher’s opportunity costs for meat
Farmer’s opportunity cost for meat: 4 oz. potatoesRancher’s opportunity cost for meat: 2 oz. potatoes
What if the price of exchange was not in this range?
Chapter 3: Interdependence and the Gains from Trade
The Price of Trade
What is the Price of Trade?
General Rule for Trade: For both parties to gain from trade,the price at which they trade must lie between the twoopportunity costs
The Farmer gives up 15 oz. of potatoes for 5 oz. of meatWhat is the price of exchange?One oz. of meat costs 3 oz. of potatoes
The price of meat lies between the Farmer’s and theRancher’s opportunity costs for meat
Farmer’s opportunity cost for meat: 4 oz. potatoesRancher’s opportunity cost for meat: 2 oz. potatoes
What if the price of exchange was not in this range?
Chapter 3: Interdependence and the Gains from Trade
The Price of Trade
What is the Price of Trade?
General Rule for Trade: For both parties to gain from trade,the price at which they trade must lie between the twoopportunity costs
The Farmer gives up 15 oz. of potatoes for 5 oz. of meatWhat is the price of exchange?One oz. of meat costs 3 oz. of potatoes
The price of meat lies between the Farmer’s and theRancher’s opportunity costs for meat
Farmer’s opportunity cost for meat: 4 oz. potatoesRancher’s opportunity cost for meat: 2 oz. potatoes
What if the price of exchange was not in this range?
Chapter 3: Interdependence and the Gains from Trade
Applications
1 Overview
2 An Example of Trade
3 Absolute vs. Comparative Advantage
4 The Price of Trade
5 Applications
6 Conclusions
Chapter 3: Interdependence and the Gains from Trade
Applications
Should Kobe Bryant Mow His Own Lawn?
Imagine that Kobe Bryant can
mow his lawn faster than anyone
else can
Absolute advantage!
Suppose it takes him 1.5 hours tomow his lawn
In that same 1.5 hours, he couldfilm a commercial for Nike forwhich he would earn $15,000
What is the opportunity cost of
mowing his lawn?
$15,000
Chapter 3: Interdependence and the Gains from Trade
Applications
Should Kobe Bryant Mow His Own Lawn?
Imagine that Kobe Bryant can
mow his lawn faster than anyone
else can
Absolute advantage!
Suppose it takes him 1.5 hours tomow his lawn
In that same 1.5 hours, he couldfilm a commercial for Nike forwhich he would earn $15,000
What is the opportunity cost of
mowing his lawn?
$15,000
Chapter 3: Interdependence and the Gains from Trade
Applications
Should Kobe Bryant Mow His Own Lawn?
Imagine that Kobe Bryant can
mow his lawn faster than anyone
else can
Absolute advantage!
Suppose it takes him 1.5 hours tomow his lawn
In that same 1.5 hours, he couldfilm a commercial for Nike forwhich he would earn $15,000
What is the opportunity cost of
mowing his lawn?
$15,000
Chapter 3: Interdependence and the Gains from Trade
Applications
Should Kobe Bryant Mow His Own Lawn?
Imagine that Kobe Bryant can
mow his lawn faster than anyone
else can
Absolute advantage!
Suppose it takes him 1.5 hours tomow his lawn
In that same 1.5 hours, he couldfilm a commercial for Nike forwhich he would earn $15,000
What is the opportunity cost of
mowing his lawn?
$15,000
Chapter 3: Interdependence and the Gains from Trade
Applications
Should Kobe Bryant Mow His Own Lawn?
Imagine that Kobe Bryant can
mow his lawn faster than anyone
else can
Absolute advantage!
Suppose it takes him 1.5 hours tomow his lawn
In that same 1.5 hours, he couldfilm a commercial for Nike forwhich he would earn $15,000
What is the opportunity cost of
mowing his lawn?
$15,000
Chapter 3: Interdependence and the Gains from Trade
Applications
Should Kobe Bryant Mow His Own Lawn?
It is likely that someone else (just
about anybody!!) would have a
lower opportunity cost of mowing
Bryant’s lawn
This other individualwould have a comparativeadvantage in mowinglawns
Both parties would gain fromtrade as long as Kobe pays thisindividual more than theiropportunity cost and less than hisopportunity cost of $15,000
Chapter 3: Interdependence and the Gains from Trade
Applications
Should Kobe Bryant Mow His Own Lawn?
It is likely that someone else (just
about anybody!!) would have a
lower opportunity cost of mowing
Bryant’s lawn
This other individualwould have a comparativeadvantage in mowinglawns
Both parties would gain fromtrade as long as Kobe pays thisindividual more than theiropportunity cost and less than hisopportunity cost of $15,000
Chapter 3: Interdependence and the Gains from Trade
Applications
Should Kobe Bryant Mow His Own Lawn?
It is likely that someone else (just
about anybody!!) would have a
lower opportunity cost of mowing
Bryant’s lawn
This other individualwould have a comparativeadvantage in mowinglawns
Both parties would gain fromtrade as long as Kobe pays thisindividual more than theiropportunity cost and less than hisopportunity cost of $15,000
Chapter 3: Interdependence and the Gains from Trade
Applications
International Trade
A quick introduction to trade
Imports
Goods produced abroad and sold domestically
Exports
Goods produced domestically and sold abroad
Trade can benefit entire countries rather than just individualsas we have studies so far
Chapter 3: Interdependence and the Gains from Trade
Applications
International Trade: US & Japan
Two countries: US and Japan
Two goods: food and cars
Each country produces cars equally well
In both US and Japan, one worker produces one car in onemonth
The US is better at producing food
In the US, one worker produces 2 tons of food in one monthIn Japan, one worker produces 1 ton of food in one month
Chapter 3: Interdependence and the Gains from Trade
Applications
International Trade: US & Japan
The rules of comparative advantage say that each goodshould be produced by the country with the lower opportunitycost of producing that good
What are the opportunity costs of cars in Japan and the US?
Japan: Opportunity cost of a car is 1 ton of foodUS: Opportunity cost of a car is 2 tons of food
Chapter 3: Interdependence and the Gains from Trade
Applications
International Trade: US & Japan
The rules of comparative advantage say that each goodshould be produced by the country with the lower opportunitycost of producing that good
What are the opportunity costs of cars in Japan and the US?
Japan: Opportunity cost of a car is 1 ton of food
US: Opportunity cost of a car is 2 tons of food
Chapter 3: Interdependence and the Gains from Trade
Applications
International Trade: US & Japan
The rules of comparative advantage say that each goodshould be produced by the country with the lower opportunitycost of producing that good
What are the opportunity costs of cars in Japan and the US?
Japan: Opportunity cost of a car is 1 ton of foodUS: Opportunity cost of a car is 2 tons of food
Chapter 3: Interdependence and the Gains from Trade
Applications
International Trade: US & Japan
In this case, Japan should make cars (opportunity cost is 1ton of food, compared to 2 tons of food for US)
The US should make food (opportunity cost of 1 ton of foodis 1/2 car, compared to 1 car in Japan)
What is a reasonable price for trading food for cars?
Chapter 3: Interdependence and the Gains from Trade
Applications
International Trade: US & Japan
In this case, Japan should make cars (opportunity cost is 1ton of food, compared to 2 tons of food for US)
The US should make food (opportunity cost of 1 ton of foodis 1/2 car, compared to 1 car in Japan)
What is a reasonable price for trading food for cars?
Chapter 3: Interdependence and the Gains from Trade
Applications
Should the United States Trade With Other Countries
Just as individuals benefit from specialization and trade, socan the populations of different countries
The United States could probably be somewhat self-sufficient,but the opportunity costs associated with producing goods forwhich we do not hold a comparative advantage are very high
Through specialization and trade, countries can have more ofall goods to consume
Chapter 3: Interdependence and the Gains from Trade
Conclusions
1 Overview
2 An Example of Trade
3 Absolute vs. Comparative Advantage
4 The Price of Trade
5 Applications
6 Conclusions
Chapter 3: Interdependence and the Gains from Trade
Conclusions
Conclusions I
1 Interdependence and trade are desirable because they alloweveryone to enjoy a greater quantity and variety of goods andservices
2 The person who can produce a good with a smaller quantityof inputs is said to have an absolute advantage in producingthat good
3 The person who can produce a good at a lower opportunitycost is said to have a comparative advantage in producingthat good
Chapter 3: Interdependence and the Gains from Trade
Conclusions
Conclusions II
4 The gains from trade are based on comparative advantage,not absolute advantage
5 Trade makes everyone better off because it allows people tospecialize in those activities for which they have a comparativeadvantage
6 Comparative advantage applies to countries as well as people
