INTERDEPENDENCE AND THE GAINS FROM TRADE • The figure shows these three possible

• What exactly do people gain when they trade outcomes and all others in between.
with one another? Why do people choose to
become interdependent?

A PARABLE FOR THE MODERN ECONOMY

• Cattle rancher and potato farmer producing
meat and potatoes
• Both would agree self-sufficiency is not
enough
• More trade, more variety
• Gains less obvious if one person can
produce both goods well

Production Possibilities (PP) Figure 1C. Rancher’s PPF.

• If the rancher devotes all 8 hours of her time

to potatoes, she produces 48 ounces of
potatoes and no meat.
• If she devotes all her time to meat, she
produces 24 ounces of meat and no
potatoes.
• If the rancher divides her time equally,
spending 4 hours on each activity, she
Figure 1A. The amount of time each person requires to produces 24 ounces of potatoes and 12
produce 1 ounce of each good.
ounces of meat.
• Once again, the production possibilities
• The farmer can produce an ounce of
frontier shows all the possible outcomes.
potatoes in 15 minutes and an ounce of meat
in 60 minutes.
Specialization and trade
• The rancher, who is more productive in both
activities, can produce an ounce of potatoes
in 10 minutes and an ounce of meat in 20
minutes.

Figure 1B. Farmer’s PPF.

• If the farmer devotes all 8 hours of his time

to potatoes, he produces 32 ounces of
potatoes (measured on the horizontal axis)
and no meat.
• If he devotes all his time to meat, he
produces 8 ounces of meat (measured on
the vertical axis) and no potatoes.
• People face trade-offs: farmer faces a
trade-off between producing meat and
producing potatoes.
• If the farmer divides his time equally
between the two activities, spending 4 hours
on each, he produces 16 ounces of potatoes
and 4 ounces of meat.
 of potatoes is 1⁄3 ounce of meat. This price of
potatoes is lower than her opportunity cost
of an ounce of potatoes, which is 1⁄2 ounce of
meat. The rancher benefits because she
gets to buy potatoes at a good price.
• Moral of the story: Trade makes everyone
better off.

The Price of Trade

• What determines the price at which trade
Comparative Advantage: The Driving Force of
takes place? How are the gains from trade
Specialization
shared between the trading parties?
• The precise answer to these questions is
• Absolute advantage – used by economists to
beyond the scope of this chapter, but we can
compare productivity of a person, firm, or
state one general rule: For both parties to
nation to another; the producer that requires
gain from trade, the price at which they
a smaller quantity of inputs to produce a
trade must lie between the two opportunity
good has it
costs
• For rancher, 1 ounce of potatoes requires 10
• This price is between the rancher’s
mins of work. rancher spends 10 mins less
opportunity cost (2 ounces of potatoes per
producing meat; 20 mins to produce 1 ounce
ounce of meat) and the farmer’s opportunity
of meat; 10 mins produces ½ of an ounce.
cost (4 ounces of potatoes per ounce of
• Farmer spends 15 mins producing 1 ounce of
meat).
potatoes, and 60 minutes for 1 ounce of
• The price need not be exactly in the middle
meat. 15 mins of work yields ¼ ounce of
for both parties to gain, but it must be
meat. Opportunity cost of 1 ounce of potatoes
somewhere between 2 and 4.
is ¼ ounce of meat.
• If the price of meat were below 2 ounces of
• The producer who gives up less of other
potatoes, both the farmer and the rancher
goods to produce Good X has the smaller
would want to buy meat, because the price
opportunity cost of producing Good X and is
would be below their opportunity costs.
said to have a comparative advantage in
• If the price of meat were above 4 ounces of
producing it.
potatoes, both would want to sell meat,
• An ounce of meat costs the rancher 2
because the price would be above their
ounces of potatoes, but it costs the farmer 4
opportunity costs.
ounces of potatoes.
• They cannot both be buyers of meat, nor can
• Thus, the farmer has a comparative
they both be sellers.
advantage in growing potatoes, and the
• Someone has to take the other side of the
rancher has a comparative advantage in
deal.
producing meat.
• Each party can buy at a price lower than the
• Rancher has absolute advantage in both, but
opportunity cost. Both specialize at where
it is impossible for one person to have
they have a comparative advantage at and
comparative advantage in both.
end up better off.

Applications of Comparative Advantage

Should Tiger Woods mow his own lawn?
• Mows lawn in 2 hours. In that two hours, he
can film commercial and earn $10,000.
• Forrest Gump can mow in 4 hours, but can
• Gains on trade are based on comparative
work in McDonald’s and earn $20.
advantage, not absolute
• Woods has absolute advantage due to lower
• When persons produce goods that they have
time needed.
comparative advantage at, total production
• Gump has comparative advantage because
rises
of lower ($20) opportunity cost.
• Opportunity cost – what must be given up to
• Woods should make the commercial and
obtain another good
Gump should mow the lawn.
• Economic pie size increases
• Both are better off if Woods pays Gump
• The farmer gets 5 ounces of meat in
more than $20 but less than $10,000.
exchange for 15 ounces of potatoes. In other
words, the farmer buys each ounce of meat
for a price of 3 ounces of potatoes. This price
of meat is lower than his opportunity cost
for an ounce of meat, which is 4 ounces of
potatoes.
• The rancher buys 15 ounces of potatoes for
a price of 5 ounces of meat. That is, the price
Should the United States trade with other
countries?
• Many goods consumed are produced
abroad, goods produced are consumed
abroad
• Imports – produced abroad, sold
domestically
• Exports – produced domestically, sold
abroad
• American worker and Japanese worker can
produce one car per month
• US has more, better land
• US worker can produce 2 tons of
food/month, Japanese 1 ton/month
• Since opportunity cost of a car in the US is 2
tons of food and 1 ton in Japan, Japan has a
comparative advantage in cars
• US has absolute advantage
• Opportunity cost of food is 1 car in Japan and
½ of a car in the US, US has comparative
advantage in food
• US should produce more food than it wants
to consume, export some to Japan
• Through specialization and trade, both
countries can have more food and more
cars.
• International trade can make some
individuals worse off, even as it makes the
country as a whole better off.
• When the United States exports food and
imports cars, the impact on an American
farmer is not the same as the impact on an
American autoworker.
• International trade is not like war. Trade
allows all countries to achieve greater
prosperity.

Conclusion
• The principle of comparative advantage
shows that trade can make everyone better
off.