3
Interdependence
and the Gains from Trade
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.
. . . and you havent 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.
Interdependence and the Gains from Trade
Individuals and nations rely on specialized production and exchange as a way to address problems caused
by scarcity.
But this gives rise to two questions:
Why is interdependence the norm?
What determines production and trade?
Interdependence and the Gains from Trade
Why is interdependence the norm?
Interdependence occurs because
people are better off when they specialize and trade with others.
What determines the pattern of production and trade?
Patterns of production and trade are based upon differences in opportunity
costs.
A PARABLE FOR THE MODERN ECONOMY
Imagine . . .
only two goods: potatoes and meat
Table 1 The Production
Opportunities of the Farmer and Rancher
Production Possibilities
Self-Sufficiency
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.
Figure 1 The Production
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.
Table 2 The Gains from Trade: A
Summary
THE PRINCIPLE OF COMPARATIVE ADVANTAGE
Differences in the costs of production determine the following:
Who should produce what?
How much should be traded for each product?
THE PRINCIPLE OF COMPARATIVE ADVANTAGE
Differences in Costs of Production
Two ways to measure differences in costs of production:
The number of hours required to produce a unit of output (for example, one
pound of potatoes).
The opportunity cost of sacrificing one good for another.
Absolute Advantage
The comparison among producers of a good according to their productivityabsolute advantage
Describes the productivity of one person, firm, or nation compared to that
of another.
The producer that requires a smaller quantity of inputs to produce a good
is said to have an absolute advantage in producing that good.
Absolute Advantage
The Rancher needs only 10 minutes to produce an ounce of potatoes, whereas
the Farmer needs 15 minutes.
The Rancher needs only 20 minutes to produce an ounce of meat, whereas the
Farmer needs 60 minutes.
Opportunity Cost and Comparative
Advantage
Compares producers of a good according to their opportunity
cost.
Whatever must be given up to obtain
some item
The producer who has the smaller opportunity cost of producing a good is
said to have a comparative advantage in producing that
good.
Comparative Advantage and Trade
Who has the absolute advantage?
The farmer or the rancher?
Who has the comparative advantage?
The farmer or the rancher?
Table 3 The Opportunity Cost
of Meat and Potatoes
Comparative Advantage and Trade
The Ranchers opportunity cost of an ounce of potatoes is Ό an ounce of
meat, whereas the Farmers opportunity cost of an ounce of potatoes is ½ an
ounce of meat.
The Ranchers opportunity cost of a pound of meat is only 4 ounces of
potatoes, while the Farmers opportunity cost of an ounce of meat is only 2
ounces of potatoes...
Comparative Advantage and Trade
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.
FYIThe 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.
APPLICATIONS OF COMPARATIVE ADVANTAGE
Should Tiger Woods Mow His Own Lawn?
APPLICATIONS OF COMPARATIVE ADVANTAGE
Should the United States Trade with Other Countries?
Each country has many citizens with different interests. International
trade can make some individuals worse off, even as it makes the country as a
whole better off.
Importsgoods produced abroad and
sold domestically
Exportsgoods produced
domestically and sold abroad
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.