In the modern global economy:... each country could be economically self-sufficient (producing everything it consumes). In fact, countries tend to specialize and trade with others, leading to economic interdependence. Two key questions: 1. Why is interdependence the norm? (Apparently people are better off when they specialize and trade with others -- remember basic principle #5.) But why are they better off with specialization and trade?

2. What determines the pattern of production and trade? Let’s start with a simple parable: Two people (Bob and Dave) are marooned on a tropical island. Two food sources available: fish and bananas. (both required for survival)

One possibility: The economic self-sufficiency (“no-trade”) case: Each cast-away does some fishing, and some banana-picking, and each consumes the products of his own labors. Now suppose that Bob is better at fishing than Dave, and... Dave is better at banana-picking than Bob.

Obvious: Gains from trade are possible. Bob specializes in fishing. Dave specializes in banana-picking. Then trade. (Bob gives some fish to Dave in exchange for some bananas.) Not so obvious (but very! important to understand): Gains from trade may be possible even if... Bob is better at fishing than Dave, and... Bob is better at banana-picking than Dave.

To see why, let’s “shift gears” to another kind of parable: the text’s farmer/rancher, potato/meat example. Two producers: “farmer” and “rancher” Two goods: “potatoes” and “meat” Both producers can produce both goods, but they have different production opportunities.

Production opportunities for the farmer and the rancher

No trade (self-sufficiency) case: Farmer’s consumption possibilities are the same as his production possibilities. Same is true for rancher. Which points on ppfs will each chose to produce and consume? It depends. Assume (it doesn’t really matter) that they split their time equally between meat and potato production.

Farmer’s production possibilities potatoes (oz.day) meat (oz./day) Farmer’s production and consumption point (no-trade case)

Rancher’s production possibilities potatoes (oz.day) meat (oz./day) Ranchers’ production and consumption point (no-trade case)

Now consider an alternative case with specialization and trade:

potatoes (oz.day) meat (oz./day) Farmer’s production and consumption (with specialization and trade) Farmer’s production and consumption without trade Farmer’s production with trade 17 5 Farmer’s consumption with trade

potatoes (oz.day) meat (oz./day) Rancher’s production and consumption without trade Rancher’s production with trade Rancher’s consumption with trade Rancher’s production and consumption (with specialization and trade)

Gains from trade: Compared to the “no-trade” case, specialization and trade enables the farmer to consumer more meat and more potatoes. Same is true for the rancher. To put it another way: Specialization and trade enables both to consume beyond their production possibility frontiers. What’s the economic principle at work here?

Recall: Absolute advantage: The comparison among producers on the basis of resource cost. The producer who has the smaller resource cost (requires a smaller quantity of input to produce a given output) is said to have an absolute advantage over the other. The rancher has the absolute advantage over the farmer in the production of meat and potatoes.

Opportunity cost: The cost of an item measured in terms of what you give up to get it.

Comparative advantage: The comparison among producers of a good according to their opportunity cost. The producer who has the smaller opportunity cost is said to have a comparative advantage over the other. The rancher has the comparative advantage over the farmer in the production of meat but (!) the farmer has the comparative advantage over the rancher in the production of potatoes.

Here’s the main point: Differences in opportunity cost (comparative advantage) make possible gains from specialization and trade. Gains are realized when each party specializes in the production of the good in which he or she has a comparative advantage,... then trade. How does it work in this specific example?

Given the “terms of trade” (5 oz. of meat for 15 oz. of potatoes): “Trade price” of meat is 3 oz. of potatoes/oz. of meat... but this is lower than the farmer’s opportunity cost of meat (4 oz. of potatoes/oz. of meat) Trade (of potatoes for meat) is beneficial for the farmer. He can acquire meat more cheaply through trade than through a reallocation of his own labor effort.

But (very important “but”) before the farmer can trade, there has to be someone else willing to take the “other end of the deal.” (If I want to sell you a car... and you want to sell me a car -- No sale!) “Trade price” of potatoes is 1/3 oz. of meat/oz. of potatoes... and this is lower than the rancher’s opportunity cost of potatoes (1/2 oz. of meat/oz. of potatoes)

Trade (of meat for potatoes) is beneficial for the rancher. She can acquire potatoes more cheaply through trade than through a reallocation of her own labor effort. As long as opportunity costs differ, we can always find a “split-the-difference” trade price that makes the two parties willing to accept opposite ends of the trade. Differences in opportunity cost (comparative advantage) make mutually beneficial trade possible.

Trade price 3 oz. potatoes/ 1/3 oz. meat/ of: oz. of meat oz. of potatoes

Real-world lessons? In international trade (trade among nations),... trade can be mutually beneficial,... and the predominant pattern of trade flows should be consistent with comparative advantage. Generally speaking, countries should export products in which they have a comparative advantage, and import products in which their trading partners have a comparative advantage.

Consider the U.S. and Japan and trade in manufactured products vs. agricultural commodities. Some would argue that Japan has an absolute advantage in production of manufactured products. (more modern management techniques, more conscientious workers -- maybe) The U.S. definitely has an absolute and comparative advantage in the production of agricultural commodities. (more and better crop land, favorable climate)

So the U.S. has the comparative advantage over Japan in the production of agricultural commodities. (Japan has the comparative advantage over the U.S. in the production of manufactured goods.) Theory says we should see (mainly):... U.S. exports of agricultural commodities to Japan... and Japanese exports of manufactured products to the U.S.

Theory of comparative advantage and gains from trade is the reason why economists usually oppose “trade barriers.” From Chapter 2: “Is There a Consensus Among Economists in the 1990s?” American Economic Review, May “Tariffs and import quotas usually reduce general economic welfare” 93% of surveyed economists agreed! (Much more on this in Chapter 9.)