Interdependence and
the Gains from Trade
Chapter 3
Copyright © 2001 by Harcourt, Inc.
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Interdependence and Trade
Consider your typical day:
uYou wake up to an alarm clock made in Korea.
uYou pour yourself some orange juice made from
oranges grown in Florida.
uYou put on some clothes made of cotton grown in
Georgia and sewn in factories in Thailand.
uYou watch the morning news broadcast from New
York on your TV made in Japan.
uYou drive to class in a car made of parts
manufactured in a half-dozen different countries.
…and you haven’t been up for more than two hours
yet!
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Interdependence and Trade
Remember, economics is the
study of how societies produce
and distribute goods in an
attempt to satisfy the wants and
needs of its members.
How do we satisfy our wants and
needs in a global economy?
uWe can be economically self-
sufficient.
uWe can specialize and
trade with others,
leading to economic
interdependence.
Interdependence and Trade
A general observation . . .
Individuals and nations rely on
specialized production and
exchange as a way to address
problems caused by scarcity.
Why is interdependence the
norm?
Interdependence occurs because
people are better off when they
specialize and trade with others.
u Imagine . . .
¼only two goods: potatoes and meat
¼only two people: a potato farmer
and a cattle rancher
A Parable for the Modern
Economy
The Production Opportunities of
the Farmer and the Rancher
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Production Possibilities Frontiers
Potatoes (ounces)
Meat
(ounces)
32
8
4
16
(a) The Farmer’s Production
Possibilities Frontier
0
A
If there is no trade,the farmer
chooses this production and
consumption
Production Possibilities
Frontiers
Potatoes (ounces)
Meat
(ounces)
48
12
24
(b) The Rancher’s Production
Possibilities Frontier
0
B
If there is no trade,the rancher
chooses this production and
consumption
24
The Gains from Trade:
A Summary
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The Gains from Trade:
A Summary
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How Trade Expands the Set of Consumption
Opportunities
Copyright©2003 Southwestern/Thomson Learning
Potatoes (ounces)
4
16
5
17
8
32
A
A*
0
Meat (ounces)
(a) The Farmer’s Production and Consumption
Farmer's
production and
consumption
without trade
Farmer's
consumption
with trade
Farmer's
production
with trade
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How Trade Expands the Set of Consumption
Opportunities
Potatoes (ounces)
12
24
13
27
B
0
Meat (ounces)
(b) The Rancher’s Production and Consumption
48
24
12
18
B*
Rancher's
consumption
with trade
Rancher's
production
with trade
Rancher's
production and
consumption
without trade
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The Gains from Trade:
A Summary
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Differences in Costs of
Production
u The number of hours required to produce a
unit of output. (for example, one pound of
potatoes)
u The opportunity cost of sacrificing one good
for another.
Two ways to measure differences
in costs of production:
Absolute Advantage
uDescribes the productivity of one
person, firm, or nation compared to
that of another.
uThe producer that requires a smaller
quantity of inputs to produce a good is
said to have an absolute advantage in
producing that good.
Absolute Advantage
uThe Rancher needs only 10 minutes to
produce a pound of potatoes, whereas the
Farmer needs 15 minutes.
uThe Rancher needs only 20 minutes to
produce a pound of meat, whereas the
Farmer needs 60 minutes.
The Rancher has an absolute
advantage in the production of both
meat and potatoes.
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Comparative Advantage
uCompares producers of a good
according to their opportunity cost.
uThe producer who has the smaller
opportunity cost of producing a good
is said to have a comparative
advantage in producing that good.
The Opportunity Cost of Meat and Potatoes
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Comparative Advantage and Trade
u The Rancher’s opportunity cost of an ounce of
potatoes is 1/2 ounce of meat, whereas the
Farmer’s opportunity cost of an ounce of
potatoes is 1/4 an ounce of meat.
u The Rancher’s opportunity cost of an ounce of
meat is only 2 ounces pound of potatoes, while
the Farmer’s opportunity cost of an ounce of
meat is 4 ounces of potatoes...
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Comparative 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.
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The Principle of
Comparative Advantage
uComparative advantage and differences
in opportunity costs are the basis for
specialized production and trade.
uWhenever potential trading parties have
differences in opportunity costs, they can
each benefit from trade.
Benefits of Trade
Trade can benefit everyone in
a society because it allows
people to specialize in activities
in which they have a
comparative advantage.
Adam Smith and Trade
In his 1776 book An Inquiry
into the Nature and Causes of
the Wealth of Nations, Adam
Smith performed a detailed
analysis of trade and economic
interdependence, which
economists still adhere to
today.
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David Ricardo and Trade
In his 1816 book
Principles of Political
Economy and Taxation,
David Ricardo developed
the principle of
comparative advantage as
we know it today.
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Should Tiger Woods Mow His
Own Lawn?
?
? ?
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APPLICATIONS OF COMPARATIVE ADVANTAGE
n Should the United States Trade with
Other Countries?
n Each country has many citizens with
different interests. International trade
can make some individuals worse off,
even as it makes the country as a whole
better off.
ä Imports—goods produced abroad and sold domestically
äExports—goods produced domestically and sold abroad
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Summary
uInterdependence and trade allow
people to enjoy a greater quantity
and variety of goods and services.
Summary
u There are two ways to compare the ability of
two people producing a good.
The person who can produce a good with a
smaller quantity of inputs has an absolute
advantage.
The person with a smaller opportunity cost has a
comparative advantage.
u The gains from trade are based on
comparative advantage, not absolute
advantage.
Summary
uTrade makes everyone better off because
it allows people to specialize in those
activities in which they have a
comparative advantage.
uComparative advantage applies to
countries as well as to people.
