1. Interdependence and The Gains From Trade
Chapter 3
Interdependence
and
The Gains From Trade 1

2. Interdependence and Trade
Economics studies how society produces and distributes goods and services so that wants and needs are satisfied. 2

3. How Do We Satisfy Our Wants and Needs?
We can be economically
Self-Sufficient.
We can specialize and trade with others leading to Economic Interdependence. 3

4. Interdependence & Trade
A general observation . . .
Individuals and nations rely on specialized production and exchange as a way to address problems caused by scarcity.
This gives rise to two questions. . .
Why is interdependence the norm?
What determines production & trade? 4

5. Interdependence & 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 & trade?
Patterns of production and trade are based upon differences in opportunity costs. 5

6. Interdependence and Trade: “A Parable for the Modern Economy”
Imagine...
… only two goods (potatoes and meat)
… only two people (potato farmer and a cattle rancher)
What should each produce?
Why should they trade? 6

7. A World of Self-Sufficiency
Farmer
Rancher
PPF
PPF
Meat
Meat
Potatoes
Potatoes 7

8. A World of Self-Sufficiency
By ignoring each other:
the farmer and rancher will produce a limited amount of meat and potatoes.
each consumes what they each produce.
each is not subject to tradeoffs between meat and potatoes. 8

9. Self-Sufficiency: without trade, economic gains are limited.
Farmer
Rancher 2 40
Meat
Meat 1 20
2.5 5 2 4
Potatoes
Potatoes 9

10. Specialization and Trade [Table 3-2 & Figure 3-2]
If the farmer and the rancher were to specialize in producing the product that they were more suited to produce, and then trade with each other, they would be better off.
Farmer should produce potatoes.
Rancher should produce meat.
Farmer and Rancher should trade. 10

11. The Principle of Comparative Advantage
What determines who should produce what? And how much should be traded for each product?
Differences in Costs of Production
Who can produce products (e.g. potato, meat) at a lower cost?
There are two ways to measure... 11

12. The Principle of Comparative Advantage
Measuring differences in costs of production:
Hours required to produce a standardized unit of output.
One pound of potatoes
Opportunity Cost - amount of one item sacrificed to obtain another. 12

13. Absolute Advantage
Describes the productivity of one person, firm, or nation to that of another.
- The producer that can produce more with the same quantity of inputs is said to have an absolute advantage in producing that good. 13

14. Comparative Advantage
Compares producers of a good according to their opportunity cost.
- The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good. 14

15. Specialization and Trade
Who has the absolute advantage:
The Farmer or The Rancher?
Who has the comparative advantage: 15

16. Self-Sufficiency: without trade, economic gains are limited.
Farmer
Rancher 2 40
Meat
Meat 1 20
2.5 5 2 4
Potatoes
Potatoes 9

17. Specialization and Trade
If the Rancher and the Farmer trade, who will trade meat and who will trade potatoes?

18. The Principle of Comparative Advantage
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. 16

19. The Principle of Comparative Advantage
Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage. 17

20. Applications of Comparative Advantage
Michael Jordan mowing his lawn or shooting a commercial?
Opportunity Costs. . .
Absolute Advantage. . .
Gains from trade. . . 18

21. Applications of Comparative Advantage
Should the United States trade with Other Countries (e.g. Japan)?
Imports
Exports
Opportunity costs 19

22. Trade: U.S. and Japan
Food
Food
U.S.
Japan 4 2 2 2
Cars
Cars 20

23. Opportunity Cost: Sacrifice of Food Production for Car Production
U.S.
Computing Opportunity Cost
Slope of PPF:
(0-4) ÷ (2-0) =
2 Units of food given up to get Unit of a car. 4 2
Cars 21

24. Opportunity Cost: Sacrifice of Food Production for Car Production
U.S.
Computing Opportunity Cost
Slope of PPF:
(0-4) ÷ (2-0) =
1/2 Unit of a car given up to get 1 Unit of food 4 2
Cars 23

25. Opportunity Cost: Sacrifice of Food Production for Car Production
U.S.
Computing Opportunity Cost
Slope of PPF:
(0-4) ÷ (2-0) =
2 Units of food given up to get 1 Unit of a car 4 2
Cars 23

26. Opportunity Cost: Sacrifice of Food Production for Car Production
Japan
Computing Opportunity Cost
Slope of PPF:
( ) ÷ ( ) =
__ Units of food given up to get __Unit of a car 2 2
Cars 24

27. Interdependence: U.S. & Japan
Who should produce cars and who should produce food?
Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services. Founded upon the. . .
Principle of Comparative Advantage 25