Ch3 1

Chapter 3: Interdependence and the
Gains from Trade
Copyright © 2004 South-Western

Trade
● Why do people choose to be economically

interdependent?
● How can people gain from trade?
● See a two-people, two-good model.

Trade: why do people choose to interact with
each other?
Minutes Needed to Make

1 Ounce of:
Meat Potatoes
Farmer 60 min./oz. 15 min./oz.
Rancher 20 min./oz. 10 min./oz.

Absolute Advantage
● The producer that needs fewer resources (less

time) to produce a good is said to have an
absolute advantage in producing that good.

Trade: why do people choose to interact with
each other?
Minutes Needed to Make

1 Ounce of:
Meat Potatoes
Farmer 60 min./oz. 15 min./oz.

Comparative Advantage
● The producer who has a smaller opportunity

cost of producing a good is said to have a
comparative advantage in producing it.

Opportunity costs
Minutes Needed to Opportunity Cost of 1

Make 1 Ounce of: Ounce of:
Meat Potatoes Meat Potatoes

Farmer 60 15 min./oz.
min./
oz.
Rancher 20 10 min./oz.
min./
oz.

Opportunity costs
Minutes Needed to Make 1 Opportunity Cost of 1 Ounce

Ounce of: of:
Farmer 60 min./oz. 15 min./oz. 4 oz potatoes ¼ oz meat
The opportunity cost of one good is the inverse of

the opportunity cost of the other.

Opportunity costs

Ounce of: of:
Rancher 20 min./oz. 10 min./oz. 2 oz potatoes ½ oz meat
The rancher has a comparative advantage in meat.
The farmer has a comparative advantage in

potatoes.

Opportunity costs

Ounce of: of:
Rancher 20 min./oz. 10 min./oz. 2 oz potatoes ½ oz meat
It is possible for one person to have an absolute

advantage in both goods, but it is impossible for one
person to have a comparative advantage in both goods.

Specialization and Trade according to
Comparative Advantage
● Each people devotes more time to producing

the good in which he/she has a comparative
advantage.
● Rancher specializes in meat and farmer
specializes in potatoes.
● Specialization could increase total production
of both goods.
● Rancher sells meat, farmer sells potatoes. Such
trade would enable both people to consume
more of both goods than before.
Amount produced in 1 hour
Minutes Needed to Amount produced in 1

Make 1 Ounce of: hour

Farmer 60 15 min./oz. oz oz
min./
oz.
Rancher 20 10 min./oz. 3 oz 6 oz
min./
oz.

Compare production and consumption in two
scenarios
Farmer Rancher
Before Trade: 4 hours on each activity

1hour 1oz 4 oz 3 oz 6 oz
Production and
Consumption 4 hours oz
Specialization and Trade: Farmer 8 hours growing potatoes;

rancher 2 hours growing potatoes and 6 hours raising cattle
Production
Gets 5 Gives 15 Gives 5 Gets 15
Trade oz oz oz oz
Consumption
Gains from Trade
Increase in
Consumption
scenarios
Farmer Rancher

Production and
Consumption 4 hours oz

Production
Trade oz oz oz oz
Consumption
Gains from Trade
Increase in
Consumption
scenarios
Farmer Rancher

Production =
Consumption 4 hours 4 oz 16 oz 12 oz 24 oz
Production
Trade oz oz oz oz
Consumption
Gains from Trade
Increase in
Consumption
Specialization increases the total production of meat
Farmer Rancher

Production =
Production 0 32 oz 18 oz 12 oz
Trade oz oz oz oz
Consumption
Gains from Trade
Increase in
Consumption
Specialization increases the total production of
potatoes
Farmer Rancher

Production=
Trade oz oz oz oz
Consumption
Gains from Trade
Increase in
Consumption
Determine consumption after trade
Farmer Rancher

Production =
Trade oz oz oz oz
Consumption
Gains from Trade
Increase in
Consumption
scenarios
Farmer Rancher
Meat Potatoes Meat Potoates
Before Trade:
Production =
Consumption 4 oz 16 oz 12 oz 24 oz
Specialization and Trade:
Production 0 oz 32 oz 18 oz 12 oz
Trade oz oz oz oz
Consumption 5 oz 17 oz 13 oz 27 oz
Gains from Trade
Increase in
Consumption
Comparative Advantage, Specialization and Trade
● Different opportunity costs.
● Comparative advantage.
● Specialization according to CA: higher total

production.
● Trade: each people can enjoy more

consumption than before (price condition).

Prices of Trade
● For trade to take place, the price of each good

cannot be higher than the buyer’s opportunity
cost and cannot be lower than the seller’s
opportunity cost.

Prices of Trade
● If the price of a good is higher than the buyer’s

OC, the buyer will not buy the good.
● If the price of a good is lower than the seller’s

OC, the seller will not sell the good.

Prices of Trade
● Rancher is seller of meat: OC=2 oz potatoes.
● Farmer is buyer of meat: OC=4 oz potatoes.
● A price for 1 oz meat that is acceptable to both parties

must satisfy:
■ 2oz potatoes ≤ P ≤ 4 oz potatoes

Prices of Trade
● A price for 1 oz meat that is acceptable to both parties

must satisfy:
■ 2oz potatoes ≤ P ≤ 4 oz potatoes
● The farmer pays the rancher 15 oz potatoes to buy 5 oz

meat.
● The price of 1 oz meat is 3 oz potatoes.

Should Countries Trade with One Another?
● The principle of comparative advantage applies

to countries as well as to people.
● A country should specialize in producing the

goods in which it has a comparative advantage
and export those goods; it should import the
goods in which it does not have a comparative
advantage.

Should Countries Trade with One Another?
● Through specialization and trade, all countries can

achieve greater prosperity. This is why economists
advocate free trade among countries.
● Why are there voices against free trade?

● In our model, each country only has one citizen.
● In reality, each country has many citizens with
different interests.
● Trade can make some individuals in a country worse
off, even as it makes the country as a whole better off.

Effects of Free Trade in Car Imports into the
United States
● The United States as a whole: gain.

● U.S. consumers of cars: gain.
● U.S. firms producing cars: lose.
● U.S. workers producing cars: lose.

End-of-lecture problems
● In the rancher farmer economy, would trade

occur at each of the following three prices?
● 1 oz meat = 1 oz potatoes
● 1 oz meat = 2.5 oz potatoes
● 1 oz meat = 5 oz potatoes

Ch3 1

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Ch3 1

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Chapter 3: Interdependence and the

Gains from Trade

Copyright © 2004 South-Western

● Why do people choose to be economically

Copyright © 2004 South-Western

Minutes Needed to Make

Farmer 60 min./oz. 15 min./oz.

Rancher 20 min./oz. 10 min./oz.

Copyright © 2004 South-Western

● The producer that needs fewer resources (less

Copyright © 2004 South-Western

Minutes Needed to Make

Farmer 60 min./oz. 15 min./oz.

Rancher 20 min./oz. 10 min./oz.

Copyright © 2004 South-Western

● The producer who has a smaller opportunity

Copyright © 2004 South-Western

Minutes Needed to Opportunity Cost of 1

Meat Potatoes Meat Potatoes

Copyright © 2004 South-Western

Minutes Needed to Make 1 Opportunity Cost of 1 Ounce

The opportunity cost of one good is the inverse of

Copyright © 2004 South-Western

Minutes Needed to Make 1 Opportunity Cost of 1 Ounce

The rancher has a comparative advantage in meat.

The farmer has a comparative advantage in

Copyright © 2004 South-Western

Minutes Needed to Make 1 Opportunity Cost of 1 Ounce

It is possible for one person to have an absolute

Copyright © 2004 South-Western

● Each people devotes more time to producing

Minutes Needed to Amount produced in 1

Meat Potatoes Meat Potatoes

Copyright © 2004 South-Western

Before Trade: 4 hours on each activity

Specialization and Trade: Farmer 8 hours growing potatoes;

Before Trade: 4 hours on each activity

Specialization and Trade: Farmer 8 hours growing potatoes;

Before Trade: 4 hours on each activity

Before Trade: 4 hours on each activity

Before Trade: 4 hours on each activity

Before Trade: 4 hours on each activity

● Different opportunity costs.

● Specialization according to CA: higher total

● Trade: each people can enjoy more

Copyright © 2004 South-Western

● For trade to take place, the price of each good

Copyright © 2004 South-Western

● If the price of a good is higher than the buyer’s

● If the price of a good is lower than the seller’s

Copyright © 2004 South-Western

● Rancher is seller of meat: OC=2 oz potatoes.

● Farmer is buyer of meat: OC=4 oz potatoes.

● A price for 1 oz meat that is acceptable to both parties

Copyright © 2004 South-Western

● A price for 1 oz meat that is acceptable to both parties

● The farmer pays the rancher 15 oz potatoes to buy 5 oz

● The price of 1 oz meat is 3 oz potatoes.

Copyright © 2004 South-Western

● The principle of comparative advantage applies

● A country should specialize in producing the

Copyright © 2004 South-Western

● Through specialization and trade, all countries can