Interdependence and The Gains From Trade

Interdependence and
the Gains from Trade

3
Copyright © 2004 South-Western/Thomson Learning
• Consider your typical day:
• You wake up to an alarm clock made in Korea.
• You pour yourself orange juice made from Florida
oranges and coffee from beans grown in Brazil.
• You put on some clothes made of cotton grown in
Georgia and sewn in factories in Thailand.
• You watch the morning news broadcast from New
York on your TV made in Japan.
• You drive to class in a car made of parts
manufactured in a half-dozen different countries.
Copyright © 2004 South-Western
• . . . and you haven’t been up for more than two
hours yet!

Interdependence and the Gains
from 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.

Interdependence and the Gains
from Trade
• How do we satisfy our wants and needs in a
global economy?
• We can be economically self-sufficient.
• We can specialize and trade
with others, leading to
economic interdependence.

Two ways of satisfy people needs
1.Self sufficient 2.Specialize and

trade
Produce and consume Produce what they think they

Whatever they got Do best, then trade with other

A PARABLE FOR THE MODERN
ECONOMY
• Let start the story!
Both of them
• There are two goods in the world. like to eat
both.
Farmer Rancher
• There are two people in the world.
A PARABLE FOR THE MODERN
ECONOMY
 Suppose that the farmer/rancher each work
8hrs/day.
 They devote 8hrs to produce
1. grow potatoes.
2. raise cattle.
3. produce a combination of the two.

Table 1 The Production Opportunities of the Farmer
and Rancher

Production Possibilities
• Farmer
1. If farmer devotes all 8hrs to grow meat.
60min make 1oz
8hr make 8oz

• Farmer
1. If farmer devotes all 8hrs to grow potatoes.
15min make 1oz
1hr make 4oz
32oz
8hr make

• Rancher
1. If rancher devotes all 8hrs to grow meat.
20min make 1oz
1hr make 3oz
24oz
8hr make

• Rancher
2. If rancher devotes all 8hrs to grow potatoes.
10min make 1oz
1hr make 6oz
48oz
8hr make

1.Self Sufficient
• By ignoring each other:

• Each consumes what they each produce.
• The production possibilities frontier is also the
consumption possibilities frontier.
• Without trade, economic gains are diminished.
Diminish means become less.

Figure 1 The Production Possibilities Curve
(a) The Farmer’ s Production Possibilities Frontier
Meat (ounces)
If there is no trade,
the farmer chooses
8 this production and
consumption.
4 A
0 16 32 Potatoes (ounces)
Copyright©2003 Southwestern/Thomson Learning

Figure 1 The Production Possibilities Curve
(b) The Rancher ’s Production Possibilities Frontier
Meat (ounces)
24
If there is no trade,
the rancher chooses
this production and
consumption.
12 B
0 24 48
Potatoes (ounces)

2.Specialization and Trade
• The Farmer and the Rancher Specialize and

Trade
• Each would be better off if they specialized in
producing the product they are more suited to
produce, and then trade with each other.
The farmer should produce potatoes.

The rancher should produce meat.

Let’s assume;
Rancher Farmer
suggests
Specialize and
trade

Rancher suggests Farmer to;
1. Farmer produce only potatoes and trade with the
rancher for meat.
2. The Rancher will spend 6hrs./day producing meat
and 2hrs/week growing potatoes.
# How many ounces of meat that Rancher can produce
in 6hrs/day?
Ans. 18 ounces per day
# How many ounces of potatoes that Rancher can
produce in 2hrs/week?
Ans. 12 ounces per week

3. The Farmer will spend 8hrs/day growing

potatoes.
#How many ounces that Farmer can produce
potatoes in 8hrs/day?
Ans. 32 ounces per day
4. The Rancher will trade 5 ounces of meat for 15
ounces of potatoes.
#How many ounces of meat that Rancher got left
after trade?
Ans. 13 ounces (18oz – 5oz = 13oz)
Table 2 The Gains from Trade: A Summary

Figure 2 How Trade Expands the Set of Consumption
Opportunities
(a) The Farmer’ s Production and Consumption

s Production and Consumption
Meat (ounces)
Farmer's
consumption
with trade
8 Farmer's
production and
consumption
5 A* without trade
4
A Farmer's
production
with trade
0 32 Potatoes (ounces)
16 17

Figure 2 How Trade Expands the Set of Consumption
Opportunities
(b) The Rancher’s Production and Consumption
Meat (ounces)
24 Rancher's
production
with trade
Rancher's
consumption
18 with trade
13
B* Rancher's
production and
B
12 consumption
without trade
0 12 24 27 48
Potatoes (ounces)

Table 2 The Gains from Trade: A Summary

Absolute Advantage, Opportunity
Cost, Comparative Advantage
Absolute
Advantage
Opportunity cost
Comparative
Advantage

1.Absolute Advantage
• Absolute Advantage
The ability to produce a good using
fewer inputs than another
producer.

• When we use absolute advantage?

 When we want to compare the productivity of
one person, firms , nations
Smaller Get an absolute

quantity advantage in
producing
of input products.

Example 1: Time is an input.

o Rancher needs 20 min to make 1oz of meat.
o Farmer needs 60 min to make 1 oz of meat
Who get better absolute advantage??

2. Opportunity Cost
• .Opportunity cost
Whatever must be given up to obtain
some item.
Let’s see
example2..

2. Opportunity Cost
• .Example 2: Opportunity cost

o We assumed that Farmer/Rancher spend 8hrs to
produce two products.
o Time spend producing potatoes take away from time
available for producing meat.
o They should reallocate time between producing two
goods.
o They give up unit of one good to produce unit of the
other.

2. Opportunity Cost
• Let’s see Rancher’s opportunity cost in 1hr first!

o Rancher spend 10min to make 1oz of potatoes.
It makes rancher spend less

10min of producing meat.
o Because Rancher needs 20min to produce 1oz of meat

o 10min of producing potatoes is the time that he could
produce ½ oz of meat.
Rancher’s opportunity cost of
producing 1oz potatoes is ½ oz of meat
2. Opportunity Cost
• Let’s see Farmer's opportunity cost in 1hr.

o Farmer needs 15min to make 1oz of potatoes.
o Because he needs 60 min to make 1oz of meat.
o So,15min of producing 1oz of potatoes is ¼ oz of meat
The farmer’s opportunity cost

of 1oz of potatoes is ¼ oz of meat .
Inverse: 1oz of meat cost

the farmer 4oz of potatoes
3.Comparative Advantage
• Comparative Advantage
The ability to produce a good at a
lower opportunity cost than another
person.
Let’s see
example3.

Example 3.1: Farmer’s comparative advantage

o Farmer has a lower opportunity cost of
producing potatoes than does the rancher.
o 1oz of potatoes costs farmer on ¼ oz of meat.
o But 1oz of potatoes costs rancher ½ oz of meat.
Farmer has a comparative advantage

in growing potatoes.

Example 3.2: rancher’s comparative advantage

o Rancher has a lower opportunity cost of
producing meat than does the farmer.
o 1oz of meat costs rancher on 2 oz of potatoes.
o But it costs farmer 4 oz of potatoes.
rancher has a comparative advantage

in producing meat.

Absolute Advantage, Opportunity
Cost, Comparative Advantage
• Absolute Advantage: The ability to produce a
good using fewer inputs than another
producer.
• Opportunity Cost: Some item is what we give
up to get that item.
• Comparative Advantage: The ability to
produce a good at a lower opportunity cost
than another producer.

Comparative Advantage and Trade
• Comparative advantage and differences in

opportunity costs are the basis for specialized
production and trade.
• Whenever potential trading parties have
differences in opportunity costs, they can each
benefit from trade.

Comparative Advantage and 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.

APPLICATIONS OF COMPARATIVE
ADVANTAGE
• Example 4: Should Tiger Woods mow his own
lawn??
• Let’s imagine!!
 Woods can mow his lawn faster than anyone else.
Should he mow his lawn??
Let’s answer this question by
using concept of opportunity
cost and comparative
advantage.

APPLICATIONS OF
COMPARATIVE ADVANTAGE
• Say that Woods can mow his lawn in 2hrs.
• In the same 2hrs, he could film a TV commercial for
Nike and earn $10,000.
• There is Forrest Gump (the guy next door).
• Forrest Gump can now mow Woods’s lawn in 4hrs.
• In this 4hrs, he could work at McDonalds and earn $20
Please help me
to answer this!!

APPLICATIONS OF
• To answer:
• Woods opportunity cost of mowing lawn is $10,000
and Forest’s opportunity cost is $20.
• Woods has an absolute advantage in mowing the lawn.
Because he can work with a lower input of time.(2hrs)

• Forest has comparative advantage in mowing lawns.
Because he has the lower opportunity cost.($20)

APPLICATIONS OF
• In conclusion:
• Rather than mowing his lawn, Woods should make
the commercial to get $10,000 and hire Forrest to
mow his lawn.
• As long as Woods pays Forrest more than $20 and
less than $10,000, both of them are better off.

Summary
• Each person consumes goods and services
produced by many other people both in our
country and around the world.
• Interdependence and trade are desirable
because they allow everyone to enjoy a greater
quantity and variety of goods and services.

Summary
• 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.

Summary
• The gains from trade are based on comparative
advantage, not absolute advantage.
• Trade makes everyone better off because it
allows people to specialize in those activities in
which they have a comparative advantage.
• The principle of comparative advantage applies
to countries as well as people.

Interdependence and The Gains From Trade

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Interdependence and

the Gains from Trade

Copyright © 2004 South-Western

Copyright © 2004 South-Western

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1.Self sufficient 2.Specialize and

Produce and consume Produce what they think they

Copyright © 2004 South-Western

Copyright © 2004 South-Western

Copyright © 2004 South-Western

60min make 1oz

8hr make 8oz

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15min make 1oz

1hr make 4oz

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20min make 1oz

1hr make 3oz

Copyright © 2004 South-Western

10min make 1oz

1hr make 6oz

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• By ignoring each other:

Diminish means become less.

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(a) The Farmer’ s Production Possibilities Frontier

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(b) The Rancher ’s Production Possibilities Frontier

Copyright©2003 Southwestern/Thomson Learning

• The Farmer and the Rancher Specialize and

The farmer should produce potatoes.

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Copyright © 2004 South-Western

3. The Farmer will spend 8hrs/day growing

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(a) The Farmer’ s Production and Consumption

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(b) The Rancher’s Production and Consumption

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• When we use absolute advantage?

Smaller Get an absolute

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Example 1: Time is an input.

Who get better absolute advantage??

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• .Example 2: Opportunity cost

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• Let’s see Rancher’s opportunity cost in 1hr first!

It makes rancher spend less

o Because Rancher needs 20min to produce 1oz of meat

• Let’s see Farmer's opportunity cost in 1hr.

The farmer’s opportunity cost

Inverse: 1oz of meat cost

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Example 3.1: Farmer’s comparative advantage

Farmer has a comparative advantage

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Example 3.2: rancher’s comparative advantage