3

Interdependence and the Gains From Trade

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE2

Why Should We Study Trade?

• People trade with each other– Do you know anyone who makes all the things he or she

consumes?• To understand our world we need to understand why

people trade so much • We need to understand whether trade is good for us

or bad for us. – Understanding this is important precisely because we

trade a lot.

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE3

A Parable For The Modern Economy

• Imagine a world with …– only two goods: potatoes and meat– only two people: a potato farmer and a cattle

rancher• What amounts should each produce?• Should they trade?

By the way…

• Q: Why am I assuming a world with only two goods and two people?

• A: Simplicity is often key to clarifying an idea• Q: Okay, but in that case why not assume a

world with just one good and/or one person?

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE4

Opportunity cost

• Suppose the farmer can produce both meat and potatoes

• As the farmer has a finite amount of the resources needed for production, the production of an additional ounce of meat necessarily reduces the quantity of potatoes the farmer can produce

• The reduction in potato production caused by the production of an additional ounce of meat is called the opportunity cost of meat

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE5

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE6

Opportunity cost and trade• Suppose the opportunity cost of an ounce of

meat is 3 ounces of potatoes for both famer and rancher

• Will they trade?• No. Trade would be pointless in this case.

Opportunity Costs

Meat Potatoes

Farmer 3

Rancher 3

By the way, can you fill in the blank cells in the table?1/3

1/3

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE7

Opportunity cost and trade• Now will they trade?• Yes!

– Rancher will offer to sell meat to farmer at a price between 2 and 4 ounces of potatoes per ounce of meat

– Farmer will gladly accept– Both farmer and rancher will be better off

Opportunity Costs

Meat Potatoes

Farmer 4

Rancher 2

Again, can you fill in the blank cells in the table?

4

2

1/4

1/2

Opportunity cost and trade• Therefore, we have just seen that opportunity cost is key

to understanding virtually every aspect of trade– If opportunity costs are equal, there will be no trade– If opportunity costs are different, there will be trade– The price at which the trading occurs will be somewhere

between the two traders’ opportunity costs– The person with the lower opportunity cost of meat will be

the meat seller (exporter) and potato buyer• This person is said to have a comparative advantage in meat

production– The person with the higher opportunity cost of meat will be

the meat buyer (importer) and potato seller

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE8

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE9

Opportunity cost and trade• Trade makes people specialize in the production of the

good they have a comparative advantage in• Rancher has a comparative advantage in producing meat. • Trade gives the rancher the incentive to expand meat

production for sale (export) to the farmer• That is, trade gives the rancher the incentive to specialize in

what he does best

Opportunity Costs

Meat Potatoes

Farmer 4 ¼

Rancher 2 ½

4

2

½

¼

Opportunity costs

• We have just seen that opportunity costs are key to trade

• What makes opportunity costs vary from person to person or from country to country?

• One answer is technology: different people may have different technologies

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE10

Production Technologies of the Farmer and Rancher

These technology numbers can be used to calculate opportunity costs

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE11

Opportunity Costs of Farmer• 1 ounce of meat → 60 minutes → 4 ounces of

potatoes. • Therefore, Farmer’s opportunity cost of 1 ounce of

meat is 4 ounces of potatoes.

Table 1 Opportunity Costs

Meat Potatoes

Farmer 4

Rancher

Opportunity Costs of Farmer• 1 ounce of potatoes → 15 minutes → 1/4 ounces of

meat. • Therefore, Farmer’s opportunity cost of 1 ounce of

potatoes is 1/4 ounces of meat.

Table 1 Opportunity Costs

Meat Potatoes

Farmer 4 ¼

Rancher

Opportunity Costs of Rancher• 1 ounce of meat → 20 minutes → 2 ounces of

potatoes. • Therefore, Rancher’s opportunity cost of 1 ounce of

meat is 2 ounces of potatoes.

Table 1 Opportunity Costs

Meat Potatoes

Farmer 4 ¼

Rancher 2

Opportunity Costs of Rancher• 1 ounce of potatoes → 10 minutes → 1/2 ounces of

meat. • Therefore, Rancher ’s opportunity cost of 1 ounce of

potatoes is 1/2 ounces of meat.

Table 1 Opportunity Costs

Meat Potatoes

Farmer 4 ¼

Rancher 2 ½

16

Opportunity Costs and Comparative Advantage

• It follows that, – Farmer has a comparative advantage in potatoes

and – Rancher has a comparative advantage in meat.

Table 1 Opportunity Costs

Meat Potatoes

Farmer 4 ¼

Rancher 2 ½

Technological differences are an important reason why we trade

• To sum up, we have so far seen that– Trade happens if and only if opportunity costs vary

from person to person (or from country to country)

– Differences in technological abilities can lead to differences in opportunity costs

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE17

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE18

Differences Make Trade Useful

• Had the opportunity costs of Farmer and Rancher been equal, the proof of the Theory of Comparative Advantage would not have worked.

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE19

But Differences Can’t be the Whole Story

• Why is Canada our main trade partner despite being so similar to the US?

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE20

Other Reasons Why Trade Is Good for Us

• Trade allows us to fully utilize the benefits of bulk production by allowing each country’s production to be sold everywhere.

• Trade intensifies competition and squeezes out inefficient production.

Exercise: calculation of opportunity costs from technology

• We have seen how opportunity costs can be calculated from the 2nd and 3rd columns (blue border) of the technology table below

• But can you do it using the 4th and 5th columns (brown border) instead?

Table 1 Opportunity Costs

Meat Potatoes

Farmer

Rancher

GRAPHING PRODUCTION POSSIBILITIES

22CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE23

Rancher’s Production Possibilities: Further Details

Time Spent on Production of… Amount Produced

Meat Potatoes Meat Potatoes

0 8 0 48

2 6 6 36

4 4 12 24

6 2 18 12

8 0 24 0

Figure 1 The Rancher’s Production Possibilities Frontier

Potatoes (ounces)

12

24

B

0

Meat (ounces)

(b) The Rancher ’s Production Possibilities Frontier

48

24

If there is no trade, the rancher might choose this production and consumption.

12

18 C

Amount Produced

Meat Potatoes

0 48

6 36

12 24

18 12

24 0

36

6

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE24

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE25

The Production Possibilities Frontier

• If either person increases his production of meat, his production of potatoes must decrease. – See the table in the previous slide – and the Production Possibilities Curve in Figure 1

• When there is no trade, each person must consume what he produces.

• In that case, if either person increases his consumption of meat, his consumption of potatoes must decrease.

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 26

Farmer’s Production Possibilities

Time spent on production of… Amount Produced

Meat Potatoes Meat Potatoes

0 8 0 32

2 6 2 24

4 4 4 16

6 2 6 8

8 0 8 0

Figure 1 The Farmer’s Production Possibilities Frontier

Potatoes (ounces)

4

16

8

32

A

0

Meat (ounces)

(a) The Farmer’ s Production Possibilities Frontier

If there is no trade, the farmer might choose this production and consumption.

Amount Produced

Meat Potatoes

0 32

2 24

4 16

6 8

8 0

B

C

3. Gain 4 ounces of meat

4. Lose 16 ounces of potatoes

2. If the farmer wants more meat, he can go from A to B.

5. The opportunity cost of 1 ounce of meat is, therefore, 4 ounces of potatoes.

6. If the farmer wants more potatoes, he can go from A to C.

7. Gain 16 ounces of potatoes

8. Lose 4 ounces of meat

9. The opportunity cost of 1 ounce of potatoes is therefore ¼ ounces of meat

The Production Possibilities Frontier Can Shift

Potatoes (ounces)

4

160

Meat (ounces)

(a) The Farmer’ s Production Possibilities Frontier

B

If more or better resources become available or if more advanced technology becomes available, the PPC will move outward. In that case it might be possible to produce more of both goods, as in the move from A to B.

A

8

32

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE28

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE29

More Meat and More Potatoes?• It may be possible to increase one’s consumption of

both meat and potatoes—as in the last slide—if…– More resources or better resources become available, or– Technology becomes more advanced, or– Farmer and Rancher begin to trade

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE30

More Meat and More Potatoes?• Trade can increase the overall production—and

consumption—of both goods even if resources and technology remain unchanged.

• This is the miracle of trade.

The Production Possibilities Frontier

• The production possibilities frontier is a graph that shows the combinations of output that the economy can produce, given – the available factors (resources) of production and – the available production technology.

• This and the next three slides are from Chapter 2.

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE31

This PPF illustrates Increasing Opportunity Costs or Diminishing Returns: as production of a commodity increases, so does its opportunity cost

From E to A, the opp. cost of a car is (3000 – 2200)/600 = 1.33

From A to B, the opp. cost of a car is (2200 – 2000)/(700 – 600) = 2

From B to F, the opp. cost of a car is 2000/(1000 – 700) = 6.67

The Production Possibilities Frontier

B

D

A

Quantity ofCars Produced

2,200

600

1,000

3000 700

2,000

3,000

1,000

Quantity ofComputers

Produced

CE

F

The Production Possibilities Frontier

• Concepts illustrated by the production possibilities frontier – Efficiency– Trade-offs– Opportunity cost– Economic growth

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE33

34

A Shift in the Production Possibilities Frontier

Quantity ofCars Produced

2,200

600

2,300

6500

4,000

3,000

1,000

Quantity ofComputers

Produced

A

G

Can trade alone take us from A to G?

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

REVISITING THE THEORY OF COMPARATIVE ADVANTAGE

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE35

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE36

Why Is Trade Good for Us?• Trade benefits both the Farmer and the Rancher by

enabling each person to do only what he is better suited to do.

• Imagine what it would be like if you were required to produce everything that you needed.

• The situation would be similarly awful for a country that either chose not to trade with other countries or was forced to end all trade with other countries.– There are additional reasons why trade is good for us.

Those reasons will be briefly discussed later.

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE37

Theory of Comparative Advantage• The Theory of Comparative Advantage says that if each

person specializes in producing what he or she has a comparative advantage in, then total production of every good can increase and,

• As a result, trade can benefit everybody.• In our example, the theory says that if Farmer specializes in

potatoes and Rancher specializes in meat, the total production of meat can be increased and the total production of potatoes can also be increased.

• As a result, if Rancher and Farmer then trade, they could both benefit.

• But is this theory true?

38

Theory of Comparative Advantage—Proof

• Suppose Farmer increases his production of potatoes by 4 ounces.

• Then, according to Table 1, his production of meat must decrease by 1 ounce.

• Suppose Rancher increases his production of meat by 1.5 ounces. Then his production of potatoes must decrease by 3 ounces.

• Therefore, by making these two people specialize according to their comparative advantages, it is possible to increase the total output of meat by 0.5 ounces and of potatoes by 1 ounce.

Table 1 Opportunity Costs

Meat Potatoes

Farmer 4 ¼

Rancher 2 ½

39

Wow!• We have just witnessed a miracle—the miracle of trade. For an

individual, it is impossible to make more of one good without making less of some other good. But for the world as a whole, it is possible to produce more of all goods simultaneously if we embrace trade.

Change in Production

Potatoes Meat

Farmer +4 -1

Rancher -3 +1.5

Total +1 +0.5

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE40

Applications Of Comparative Advantage

• Should Tiger Woods mow his own lawn?• Should the United States trade with other countries?

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE41

The Legacy of Adam Smith and David Ricardo

• Adam Smith 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.

• David Ricardo In his 1816 book Principles of Political Economy and Taxation, David Ricardo developed the principle of comparative advantage as we know it today.

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE42

Terms of Trade• In showing how trade can make Farmer and Rancher

better off, I worked out an example of how trade could occur. – Specifically, I showed that if 1.25 ounces of meat are traded

for 3.5 ounces of potatoes, both Farmer and Rancher would be better off.

• But will trade take place?• And if it does, at what price will people trade?• That’s the subject of the next chapter.