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Interdependence and

the Gains from Trade

Chapter 3

Copyright 2001 by Harcourt, Inc.

All rights reserved. Requests for permission to make copies of any part of

the

work should be mailed to:Permissions Department, arcourt !ollege Publishers,

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arcourt, +nc. items and derived

Interdependence and Trade

Consider your typical day:

You wake up to an alarm clock made in orea!

You pour yoursel" some orange #uice made "rom

oranges grown in $lorida!

You put on some clothes made o" cotton grown in

%eorgia and sewn in "actories in &hailand!

You watch the morning news broadcast "rom 'ew

York on your &( made in )apan!

You dri*e to class in a car made o" parts

manu"actured in a hal"+doen di""erent countries!

-and you ha*en.t been up "or more than two hoursyet/

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emember, economics is the

study o" how societies produce

and distribute goods in an

attempt to satis"y the wants and

needs o" its members!

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How do we satisfy our wants and

needs in a global economy?e can be economically sel"+

su""icient!

e can specialie and

trade with others,

leading to economicinterdependence!

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A general observation . . .

Indi*iduals and nations rely onspecialied production and

echange as a way to address

problems caused by scarcity!

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3ut, this gi*es rise to two 4uestions:

hy is interdependence the norm5

hat determines production and trade5

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hy is interdependence the

norm?

Interdependence occurs because

people are better o"" when they

specialie and trade with others!

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hatdetermines the pattern of

production and trade?

6atterns o" production and tradeare based upon di""erences in

opportunity costs!

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Imagine ! ! !

only two goods: potatoes and meat

only two people: a potato "armer and acattle rancher

hat should each produce5

hy should they trade5

A !arable for the "odern

#conomy

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The !roduction $pportunities of

the %armer and the &ancher

Hours Needed to Make 1 lb. of: Amount Produced in 40 Hours"eat !otatoes "eat !otatoes

%armer 20 hours/lb 10 hours/lb 2 lbs. 4 lbs.

&ancher 1 hours/lb 8 hours/lb. 40 lbs. 5 lbs.

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'elf('ufficiency

3y ignoring each other: 7ach consumes what they each produce!

&he production possibilities "rontier is also the

consumption possibilities "rontier!

ithout trade, economic gains are

diminished!

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!roduction !ossibilities

%rontiers

Potatoes

(pounds)

Meat(pounds)

)

*

+

*

(a) The FarmersProduction

Possibilities Frontier

,

A

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%rontiers

Potatoes

(pounds)

Meat(pounds)

-

),

*,

*.-

(b) The RanchersProduction Possibilities Frontier

,

B

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The %armer and the &ancher

'pecialie and Trade7ach would be better o"" i" they specialied

in producingthe product they are more

suited to produce, and thentradewith eachother!

/he farmer should produce potatoes. /he rancher should produce meat.

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The Gains from Trade/

A 'ummaryThe $utcome

ithout Trade/

hat They !roduce

and Consume

%armer

1 lb meat (A)

2 lbs potatoes

&ancher

20 lbs meat (0)

2.5 lbs potatoes

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A 'ummaryThe $utcome

ith Trade/

hat They

!roduce

hat They

Trade

hat They

Consume

%armer

0 lbs meat

4 lbs potatoes

Gets 3 lbs meat

for 1 lb potatoes

3 lbs meat (A1)

3 lbs potatoes

&ancher

24 lbs meat

2 lbs potatoes

Gives 3 lbs meat

for 1 lb potatoes

21 lbs meat (01)

3 lbs potatoes

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Trade #2pands the 'et of

Consumption !ossibilities

Potatoes

(pounds)

Meat(pounds)

)*

*

+

(a) How Trade Increasesthe FarmersConsumption

,

A

3

3

A

Farmers

consumption withouttrade

Farmers

consumption with trade

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Potatoes

(pounds)

Meat(pounds)

-*.-

),

*,

(b) How Trade IncreasesThe RanchersConsumption

,

B

*+

3

B

Ranchersconsumptio

n withouttrade

Ranchers


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A 'ummaryThe Gains

%rom Trade/

The Increase in

Consumption

%armer

* lbs meat 3A1( A4

+ lb potatoes

&ancher+ lb meat 301( 04+5* lb potatoes

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The !rinciple of

Comparative Advantage

ho should produce what5

How much should be traded "or each

product5

Who can prouce potatoes at a lo!er

cost""the farmer or the rancher#

Differences in the costs of

production determine the following:

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6ifferences in Costs of

!roduction

&he number o" hours re4uired to produce a

unit o" output! 8"or eample, one pound o"

potatoes9 &he opportunity costo" sacri"icing one

good "or another!

/wo ways to measure differences

in costs of production:

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Absolute Advantage

escribes the producti*ity o" one

person, "irm, or nation compared to

that o" another!

&he producer that re4uires a smaller

4uantity o" inputs to produce a good issaid to ha*e an absolute ad*antagein

producing that good!

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Compares producers o" a good

according to their opportunity cost.

&he producer who has the smaller

opportunity cost o" producing a goodis said to ha*e a comparati*e

ad*antagein producing that good!

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'pecialiation and Trade

ho has the absolute ad*antage5

&he "armer or the rancher5

ho has the comparati*e ad*antage5

&he "armer or the rancher5

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Absolute Advantage

&he ancher needs only ; hours toproduce a pound o" potatoes, whereas the

$armer needs 10 hours!

&he ancher needs only 1 hour toproduce a pound o" meat, whereas the

$armer needs 20 hours!

$he %ancher has an absolute

avanta&e in the prouction of both

meat an potatoes.

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The $pportunity Cost

of "eat and !otatoes

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&he ancher.s opportunity cost o" a pound

o" potatoes is ; pounds o" meat, whereas

the $armer.s opportunity cost o" a pound

o" potatoes is 1>2 pound o" meat!

&he ancher.s opportunity cost o" a pound

o" meat is only 1>; pound o" potatoes, whilethe $armer.s opportunity cost o" a pound

o" meat is 2 pounds o" potatoes!!!

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'so the %ancher has a

comparative avanta&e in the

prouction of meat but the

armer has a comparative

avanta&e in the prouction

of potatoes.

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The !rinciple of


Comparati*e ad*antage and di""erences

in opportunity costs are the basis "orspecialied production and trade!

hene*er potential trading parties ha*e

di""erences in opportunity costs, they caneach bene"it "rom trade!

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Adam 'mith and Trade

In his 1??@ bookAn Inquiry into the

Nature and Causes of the Wealth ofNations,Adam Bmithper"ormed a

detailed analysis o" trade and economic

interdependence, which economists still

adhere to today!

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6avid &icardo and Trade

In his 1;1@ bookPrinciples of Political

Economy and Taxation,a*id icardode*eloped the principle o" comparati*e

ad*antage as we know it today!

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'hould Tiger oods "ow His

$wn 7awn?

5

5 5

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'ummary

Interdependence and trade allow

people to en#oy a greater 4uantity

and *ariety o" goods and ser*ices!

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'ummary

&he person who can produce a good

with a smaller 4uantity o" inputs has

an absolute ad*antage!

&he person with a smaller

opportunity cost has a comparati*ead*antage!

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'ummary

&he gains "rom trade are based on

comparati*e ad*antage, not absolute

ad*antage!

Comparati*e ad*antage applies to

countries as well as to people!

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%raphicale*iew

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%rontiers

Potatoes

(pounds)

Meat(pounds)

)

*

+

*

(a) The FarmersProduction Possibilities Frontier

,

A

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%rontiers

Potatoes

(pounds)

Meat(pounds)

-

),

*,

*.-

(b) The RanchersProduction Possibilities Frontier

,

B

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Potatoes

(pounds)

Meat(pounds)

)*

*

+

(a) How Trade Increasesthe FarmersConsumption

,

A

3

3

A

Farmersconsumption withouttrade

Farmers


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i d d i d



Potatoes

( d )

Meat(pounds)

-*.-

),

*,

(b) How Trade IncreasesThe RanchersConsumption

,

B*+

3

B

Ranchersconsumption withouttrade

Ranchersconsumption with trade

Chapter 0344qf

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