1. Chapter 3: Interdependence and the Gains From Trade
Udayan Roy ECO10 Intro to Microeconomics

2. Why Should We Study Trade?
People trade with each other
Do you know anyone who makes all the things he or she consumes?
To understand our world we need to understand why people trade so much
We need to understand whether trade is good for us or bad for us.
Understanding this is important precisely because we trade a lot.
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

3. A Parable For The Modern Economy
Imagine a world with …
only two goods: potatoes and meat
only two people: a potato farmer and a cattle rancher
What amounts should each produce?
Should they trade?
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

4. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
By the way…
Q: Why am I assuming a world with only two goods and two people?
A: Simplicity is often key to clarifying an idea
Q: Okay, but in that case why not assume a world with just one good and/or one person?
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

5. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
Opportunity cost
In our story, the farmer can produce both meat and potatoes
However, as the farmer has a finite amount of the resources needed for production, the production of an additional ounce of meat necessarily reduces the quantity of potatoes the farmer can produce
The reduction in potato production caused by the production of an additional ounce of meat is called the opportunity cost of meat
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

6. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
Opportunity cost
In our story, the farmer’s opportunity cost of producing an additional ounce of meat is the unavoidable reduction in his production of potatoes
Can you apply the concept of opportunity cost to your own life?
List all the activities you normally engage in every day
Think about the sacrifices you will have to make if you were to enroll in an additional economics course
That’s your opportunity cost of taking an additional economics course this semester
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

7. Opportunity cost and trade
Suppose the opportunity cost of an ounce of meat is 3 ounces of potatoes for both Farmer and Rancher
Will they trade?
No. Trade would be pointless in this case.
Opportunity Costs
Meat
Potatoes
Farmer 3
Rancher
By the way, can you fill in the blank cells in the table?
1/3
1/3
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

8. Opportunity cost and trade
Now will they trade?
Yes!
Rancher will offer to sell meat to farmer at a price between 2 and 4 ounces of potatoes per ounce of meat
Farmer will gladly accept
Both farmer and rancher will be better off
Opportunity Costs
Meat
Potatoes
Farmer 4
Rancher 2
Again, can you fill in the blank cells in the table? 4
1/4 2
1/2
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

9. Opportunity cost and trade
Therefore, we have just seen that opportunity cost is key to understanding virtually every aspect of trade
If opportunity costs are equal, there will be no trade
If opportunity costs are different, there will be trade
The price at which the trading occurs will be somewhere between the two traders’ opportunity costs
The person with the lower opportunity cost of meat will be the meat seller (exporter) and potato buyer
This person is said to have a comparative advantage in meat production
The person with the higher opportunity cost of meat will be the meat buyer (importer) and potato seller
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

10. Opportunity cost and trade
Trade makes people specialize in the production of the good they have a comparative advantage in
Rancher has a comparative advantage in producing meat.
Trade gives the rancher the incentive to expand meat production for sale (export) to the farmer
That is, trade gives the rancher the incentive to specialize in what he does best
Opportunity Costs
Meat
Potatoes
Farmer 4
Rancher 2 4 2
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

11. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
Opportunity costs
We have just seen that opportunity costs are key to trade
What makes opportunity costs vary from person to person or from country to country?
One answer is technology: different people may have different technologies
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

12. Production Technologies of the Farmer and Rancher
These technology numbers can be used to calculate opportunity costs
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

13. Opportunity Costs of Farmer
1 ounce of meat → 60 minutes → 4 ounces of potatoes.
Therefore, Farmer’s opportunity cost of 1 ounce of meat is 4 ounces of potatoes.
Minutes Needed to Make 1 Ounce of:
Meat
Potatoes
Farmer
60 min/oz
15 min/oz
Rancher
20 min/oz
10 min/oz
Opportunity Costs
Meat
Potatoes
Farmer 4
Rancher

14. Opportunity Costs of Farmer
1 ounce of potatoes → 15 minutes → ¼ ounces of meat.
Therefore, Farmer’s opportunity cost of 1 ounce of potatoes is ¼ ounces of meat.
Minutes Needed to Make 1 Ounce of:
Meat
Potatoes
Farmer
60 min/oz
15 min/oz
Rancher
20 min/oz
10 min/oz
Opportunity Costs
Meat
Potatoes
Farmer 4
Rancher

15. Opportunity Costs of Rancher
1 ounce of meat → 20 minutes → 2 ounces of potatoes.
Therefore, Rancher’s opportunity cost of 1 ounce of meat is 2 ounces of potatoes.
Minutes Needed to Make 1 Ounce of:
Meat
Potatoes
Farmer
60 min/oz
15 min/oz
Rancher
20 min/oz
10 min/oz
Opportunity Costs
Meat
Potatoes
Farmer 4
Rancher 2

16. Opportunity Costs of Rancher
1 ounce of potatoes → 10 minutes → ½ ounces of meat.
Therefore, Rancher ’s opportunity cost of 1 ounce of potatoes is ½ ounces of meat.
Minutes Needed to Make 1 Ounce of:
Meat
Potatoes
Farmer
60 min/oz
15 min/oz
Rancher
20 min/oz
10 min/oz
Opportunity Costs
Meat
Potatoes
Farmer 4
Rancher 2

17. Opportunity Costs and Comparative Advantage
It follows that,
Farmer has a comparative advantage in potatoes and
Rancher has a comparative advantage in meat.
Table 1
Opportunity Costs
Meat
Potatoes
Farmer 4
Rancher 2

18. Technological differences are an important reason why we trade
To sum up, we have so far seen that
Trade happens if and only if opportunity costs vary from person to person (or from country to country)
Differences in technological abilities can lead to differences in opportunity costs
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

19. Absolute Advantage and Comparative Advantage
If Farmer can make an ounce of potatoes in less time than Rancher needs to do the same, then Farmer is said to have an absolute advantage in making potatoes
On the other hand, as we have seen already, if Farmer can make an ounce of potatoes at a lower opportunity cost than Rancher can, then Farmer is said to have a comparative advantage in making potatoes
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

20. Absolute Advantage and Comparative Advantage
At one point, economists thought that Farmer and Rancher would trade if and only if each had an absolute advantage in the production of some commodity.
David Ricardo, a nineteenth-century British economist, later showed that absolute advantage is irrelevant. Farmer and Rancher would trade if and only if each had a comparative advantage in the production of some commodity.
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

21. Technology and Opportunity Costs
Here, Rancher has an absolute advantage in both goods.
Farmer has a comparative advantage in potatoes and
Rancher has a comparative advantage in meat.
Trade will happen. Farmer will export potatoes and Rancher will export meat.
Minutes Needed to Make 1 Ounce of:
Meat
Potatoes
Farmer
60 min/oz
15 min/oz
Rancher
20 min/oz
10 min/oz
Opportunity Costs
Meat
Potatoes
Farmer 4
Rancher 2

22. Technology and Opportunity Costs
Here, Rancher has an absolute advantage in Meat and
Farmer has an absolute advantage in Potatoes.
Farmer has a comparative advantage in potatoes and
Rancher has a comparative advantage in meat.
Trade will happen. Farmer will export potatoes and Rancher will export meat.
Minutes Needed to Make 1 Ounce of:
Meat
Potatoes
Farmer
60 min/oz
15 min/oz
Rancher
40 min/oz
20 min/oz
Opportunity Costs
Meat
Potatoes
Farmer 4
Rancher 2

23. Technology and Opportunity Costs
Here, Farmer has an absolute advantage in both goods.
Farmer has a comparative advantage in potatoes and
Rancher has a comparative advantage in meat.
Trade will happen. Farmer will export potatoes and Rancher will export meat.
Minutes Needed to Make 1 Ounce of:
Meat
Potatoes
Farmer
60 min/oz
15 min/oz
Rancher
400 min/oz
200 min/oz
Opportunity Costs
Meat
Potatoes
Farmer 4
Rancher 2

24. But Differences Can’t be the Whole Story
Why is Canada our main trade partner despite being so similar to the US?
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

25. Other Reasons Why Trade Is Good for Us
Trade allows us to fully utilize the benefits of bulk production by allowing each country’s production to be sold everywhere.
Trade intensifies competition and squeezes out inefficient production.
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

26. Exercise: calculation of opportunity costs from technology
We have seen how opportunity costs can be calculated from the 2nd and 3rd columns (blue border) of the technology table below
But can you do it using the 4th and 5th columns (brown border) instead?
Table 1
Opportunity Costs
Meat
Potatoes
Farmer
Rancher

27. Graphing production possibilities
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

28. Rancher’s Production Possibilities: Further Details
Time Spent on Production of…
Amount Produced
Meat
Potatoes 8 48 2 6 36 4 12 24 18
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

29. Figure 1 The Rancher’s Production Possibilities Frontier
(b) The Rancher ’
s Production Possibilities Frontier
Meat (ounces) 48 24
Amount Produced
Meat
Potatoes 48 6 36 12 24 18
If there is no trade,
the rancher might choose
this production and
consumption. 12 18 C 12 24 B 36 6
Potatoes (ounces)
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

30. The Production Possibilities Frontier
If either person increases his production of meat, his production of potatoes must decrease.
When there is no trade, each person must consume what he produces.
In that case, if either person increases his consumption of meat, his consumption of potatoes must decrease.
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

31. Farmer’s Production Possibilities
Time spent on production of…
Amount Produced
Meat
Potatoes 8 32 2 6 24 4 16
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

32. Figure 1 The Farmer’s Production Possibilities Frontier
(a) The Farmer ’
s Production Possibilities Frontier
Meat (ounces)
Amount Produced
Meat
Potatoes 32 2 24 4 16 6 8
2. If the farmer wants more meat, he can go from A to B.
If there is no trade,
the farmer might choose
this production and
consumption. B 8 32
3. Gain 4 ounces of meat A 4 16
4. Lose 16 ounces of potatoes
8. Lose 4 ounces of meat C
5. The opportunity cost of 1 ounce of meat is, therefore, 4 ounces of potatoes.
7. Gain 16 ounces of potatoes
Potatoes (ounces)
6. If the farmer wants more potatoes, he can go from A to C.
9. The opportunity cost of 1 ounce of potatoes is therefore ¼ ounces of meat

33. The Production Possibilities Frontier Can Shift
(a) The Farmer ’
s Production Possibilities Frontier
Meat (ounces)
If more or better resources become available or if more advanced technology becomes available, the PPC will move outward. In that case it might be possible to produce more of both goods, as in the move from A to B. 8 32 B A 4 16
Potatoes (ounces)
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

34. More Meat and More Potatoes?
It may be possible to increase one’s consumption of both meat and potatoes—as in the last slide—if…
More resources or better resources become available, or
Technology becomes more advanced, or
Farmer and Rancher begin to trade
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

35. More Meat and More Potatoes?
Trade can increase the overall production—and consumption—of both goods even if resources and technology remain unchanged.
This is the miracle of trade.
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

36. The Production Possibilities Frontier
The production possibilities frontier is a graph that shows the combinations of output that the economy can produce, given
the available factors (resources) of production and
the available production technology.
This and the next three slides are from Chapter 2.
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 14

37. The Production Possibilities Frontier
Quantity of
Computers
This PPF illustrates Increasing Opportunity Costs or Diminishing Returns: as production of a commodity increases, so does its opportunity cost
From E to A, the opp. cost of a car is (3000 – 2200)/600 = 1.33
From A to B, the opp. cost of a car is (2200 – 2000)/(700 – 600) = 2
From B to F, the opp. cost of a car is 2000/(1000 – 700) = 6.67
Produced
3,000 E C A
2,200
600 B
700
2,000
1,000
300 D F
Quantity of
1,000
Cars Produced

38. The Production Possibilities Frontier
Concepts illustrated by the production possibilities frontier
Efficiency
Trade-offs
Opportunity cost
Economic growth
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 21

39. A Shift in the Production Possibilities Frontier
Quantity of
Computers
Produced
4,000
Can trade alone take us from A to G?
3,000
1,000
2,300
650 G
2,200
600 A
Quantity of
Cars Produced

40. Revisiting the theory of comparative advantage
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

41. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
Why Is Trade Good for Us?
Trade benefits both the Farmer and the Rancher by enabling each person to do only what he is better suited to do.
Imagine what it would be like if you were required to produce everything that you needed.
The situation would be similarly awful for a country that either chose not to trade with other countries or was forced to end all trade with other countries.
There are additional reasons why trade is good for us. Those reasons will be briefly discussed later.
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

42. Theory of Comparative Advantage
The Theory of Comparative Advantage says that if each person specializes in producing what he or she has a comparative advantage in, then total production of every good can increase and,
As a result, trade can benefit everybody.
In our example, the theory says that if Farmer specializes in potatoes and Rancher specializes in meat, the total production of meat can be increased and the total production of potatoes can also be increased.
As a result, if Rancher and Farmer then trade, they could both benefit.
But is this theory true?
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

43. Theory of Comparative Advantage—Proof
Suppose Farmer increases his production of potatoes by 4 ounces.
Then, according to Table 1, his production of meat must decrease by 1 ounce.
Suppose Rancher increases his production of meat by 1.5 ounces. Then his production of potatoes must decrease by 3 ounces.
Therefore, by making these two people specialize according to their comparative advantages, it is possible to increase the total output of meat by 0.5 ounces and of potatoes by 1 ounce.
Table 1
Opportunity Costs
Meat
Potatoes
Farmer 4
Rancher 2

44. Wow! Change in Production Potatoes Meat Farmer +4 -1 Rancher -3 +1.5
We have just witnessed a miracle—the miracle of trade. For an individual, it is impossible to make more of one good without making less of some other good. But for the world as a whole, it is possible to produce more of all goods simultaneously if we embrace trade.
Change in Production
Potatoes
Meat
Farmer +4 -1
Rancher -3
+1.5
Total +1
+0.5

45. The 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.
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

46. CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
Terms of Trade
In showing how trade can make Farmer and Rancher better off, I worked out an example of how trade could occur.
Specifically, I showed that if 1.25 ounces of meat are traded for 3.5 ounces of potatoes, both Farmer and Rancher would be better off.
But will trade take place?
And if it does, at what price will people trade?
That’s the subject of the next chapter.
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE