1. Chapter 3 Interdependence and the Gains From Trade
Outline of Topics
T1 A Parable for the modern economy
T2 The principle of comparative advantage
T3 Applications of comparative advantage

2. Every day you rely on many people from around the world, most of whom you do not know, to provide you with the goods and services that you enjoy.
You wake up in the morning and you pour yourself juice from oranges grown in Florida and coffee from beans grown in Brazil. You get dressed in clothes made of cotton grown in Georgia and sewn in factories in Thailand. You drive to class in a car made of parts manufactured in more than a dozen countries around the world.
Those people who provide you with goods and services are not acting out of generosity or concern for your welfare; instead, they produce because they get something in return.

3. T1 A parable for the modern economy
To understand why people choose to depend on others for goods and services and how this choice improves their lives, let’s look at a simple economy.
Imagine that there are two goods in the world-meat and potatoes.
And there are two people in the world- a cattle rancher and a potato farmer-each of whom would like to eat both meat and potatoes.
Suppose that the farmer and the rancher each work 8 hours a day and can devote this time to growing potatoes, raising cattle or a combination of the two.
See Table 3-1 on page 49

4. Table 3-1 shows :
the farmer can produce 1 kg of meat per hour or 1 kg of potatoes per hour. If the farmer devotes all 8 hours of his time to potatoes, he produces 8 kg of potatoes and no meat. If he devotes all of his time to meat, he produces 8 kg of meat and no potatoes. If the farmer divides his time equally between the two activities, spending 4 hours on each, he produces 4 kg of potatoes and 4 kg of meat.
See Figure 3-1 on page 50

5. Panel (a) of Figure 3-1 is the farmer’s production possibilities frontier. It shows the combinations of meat and potatoes that the farmer can produce when he works 8 hours a day.
The farmer’s technology for producing meat and potatoes allows him to switch between one good and the other at a constant rate. The PPF is a downward-sloping straight line with a slope of 1.

6. Table 3-1 shows :
The rancher, who is more productive in both activities, can produce 8 kg of meat per hour or 2 kg of potatoes per hour. If the rancher devotes all 8 hours of his time to potatoes, he produces 16 kg of potatoes and no meat. If he devotes all of his time to meat, he produces 64 kg of meat and no potatoes. If the farmer divides his time equally between the two activities, spending 4 hours on each, he produces 8 kg of potatoes and 32 kg of meat.
See Figure 3-1 on page 50

7. Panel (b) of Figure 3-1 is the rancher’s production possibilities frontier. It shows the combinations of meat and potatoes that the rancher can produce when he works 8 hours a day.
The rancher’s technology for producing meat and potatoes allows him to switch between one good and the other at a constant rate.
The PPF is a downward-sloping straight line with a slope of 4.
If the farmer and the rancher choose to be self-sufficient, rather than to trade with each other, then each consumes exactly what he or she produces. In this case, the PPF is also the consumption possibilities frontier.

8. We further assume that the farmer chooses point A and the rancher chooses point B in Figure 3-1: the farmer produces and consume 4 kg of potatoes and 4 kg of meat, while the rancher produces and consumes 8 kg of potatoes and 32 kg of meat.
Initial production & consumption bundle without trade:
(4 p, 4 m) for the farmer &
(8 p, 32 m) for the rancher.
Now assume the rancher proposes a trade deal to the farmer as follows:
The Farmer works 8 hours a day growing potatoes. So, the farmer produces 8kg potatoes and 0 kg meat.
(8 p, 0 m)

9. The rancher works 5 hours a day producing meat and 3 hours a day producing potatoes. So,the rancher produces 40 kg of meat and 6 kg of potatoes.
(6 p, 40 m)
If the farmer give the rancher 3 kg of potatoes, the rancher will give the farmer 6 kg of meat in return.
New consumption bundle with trade:
(5 p, 6 m) for the farmer &
(9 p, 34 m) for the rancher.
See Figure 3-2 on page 51
See Table 3-2 on page 52
So, the farmer and the rancher can both benefit because trade allows each of them to specialize in doing what they do best. Each of them can consume both more meat and more potatoes without working any more hours.

10. T2 The principle of comparative advantage
Puzzle: If the rancher is better at both raising cattle and growing potatoes, how can the farmer ever specialize in doing what he does best? The farmer doesn’t seem to do anything best. To solve this puzzle, we need to look at the principle of comparative advantage. To develop this principle, consider the following Question:
Who can produce potatoes at lower cost - the rancher or the farmer? There are two possible ways to answer.
T 2.1 First Way: Using Absolute Advantage
Absolute Advantage: the comparison among producers of a good according to their productivity

11. Economists use the term absolute advantage when comparing the productivity of one person, firm, or nation 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.
We compare the inputs required by the two producers. The rancher needs only half hour to produce 1 kg of potatoes, whereas the farmer needs 1 hour. The rancher needs only 1/8 hour to produce 1 kg of meat, whereas the farmer needs 1 hour.
In our example, the rancher has an absolute advantage both in producing potatoes and in producing meat, because she requires less time than the farmer to produce a unit of either good.

12. T 2.2 Second Way: Using Opportunity cost and comparative advantage
Recall from Chapter 1 that the opportunity cost of some item is what we give up to get that item
comparative advantage: the comparison among producers of a good according to their opportunity cost
Let’s first consider the farmer’s opportunity cost. Producing 1 kg of potatoes takes him 1 hour of work. When the farmer spends that hour producing potatoes, he spends 1 hour less producing meat. Since he produces 1 kg of meat per hour, he produces 1 kg of meat less for every extra 1 kg of potatoes he produces.The farmer’s PPF reflects this opportunity cost. The downward-sloping PPF has a slope equal to 1.

13. Now consider the rancher’s opportunity cost
Now consider the rancher’s opportunity cost. Every hour she spends producing potatoes instead of meat, she produces 2 kg more potatoes and 8 kg less meat. So every half-hour she spends producing potatoes, she produces 1 kg more potatoes and 4 kg less meat. Hence, the rancher’s opportunity cost of 1 kg of potatoes is 4 kg of meat. Hence, the rancher’s opportunity cost of 1 kg of potatoes is 4 kg of meat. The rancher’s PPF reflects this opportunity cost by having a slope equal to 4.
Economists use the term comparative advantage when describing the opportunity cost of two producers.

14. The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good.
See Table 3-3
From Table 3-3, the farmer has a lower opportunity cost of producing potatoes than the rancher ( 1 kg vs. 4 kg of meat). The rancher has a lower opportunity cost of producing meat than the farmer ( 1/4 kg vs. 1 kg of potatoes).
Thus, the farmer has a comparative advantage in growing potatoes, and the rancher has a comparative advantage in producing meat.
Notice that it would be impossible for the same person to have a comparative advantage in both goods.

15. Because the opportunity cost of one good is the inverse of the opportunity cost of the other,if a person’s opportunity cost of one good is relatively high, his or her opportunity cost of the other good must be relatively low. Comparative advantage reflects the relative opportunity cost.
Unless two people have exactly the same opportunity cost, one person will have a comparative advantage in one good, and the other person will have a comparative advantage in the other good.
T 2.3 Comparative advantage and trade
Differences in opportunity cost and comparative advantage create the gains from trade.
When each person specializes in producing the good for which he or she has a comparative advantage,

16. total production in the economy rises, and this increase in the size of the economy pie can be used to make everyone better off.
Quick Quiz ( page 55)
Robinson Crusoe can gather 10 coconuts or catch 1 fish per hour. His friend Friday can gather 30 coconuts or catch 2 fish per hour.
What is Crusoe’s opportunity cost of catching 1 fish? What is Friday’s?
Who has an absolute advantage in catching fish?
Who has a comparative advantage in catching fish?

17. T3 Applications of Comparative Advantage
T 3.1 Should Joe Sakic mow his own lawn?
Joe Sakic is a great NHL hockey player. Let’s say that Sakic can mow his lawn in 2 hours. In that same 2 hours, he could film a television commercial for hockey skates and earn $10,000. By contrast, Jennifer,the girl next door, can mow Sakic’s lawn in 4 hours. In that same 4 hours, she could work at McDonald’s and earn $20.
Sakic’s opportunity cost of mowing the lawn is $10,000, and Jennifer’s opportunity cot is $20.
Sakic has an absolute advantage in mowing lawns because he can do the work in less time.

18. Yet Jennifer has a comparative advantage in mowing lawns because she has the lower opportunity cost.
The gains from trade in this example are tremendous.
Rather than mowing his own lawn, Sakic should make the commercial and hire Jennifer to mow the lawn. As long as he pays her more than $20 and less than $10,000, both of them are better off.

19. T 3.2 Should Canada trade with other countries
Imports: goods and services that are produced abroad and sold domestically
Exports: goods and services that are produced domestically and sold abroad.
Suppose there are two countries: Canada and Japan
& there are two goods: food and cars
Assume:
A Canadian worker and a Japanese worker can each produce 1 car per month.
A Canadian worker can produce 2 tones of food per month, whereas a Japanese worker can produce only 1 tone of food per month.

20. Japan has a comparative advantage in producing cars because the opportunity cost of a car is 2 tones of food in Canada but only 1 tone of food in Japan. Japan should produce more cars than it wants for its own use and export some of them to Canada
Canada has a comparative advantage in producing food because the opportunity cost of a tone of food is 1 car in Japan but only ½ car in Canada. Canada should produce more food than it wants to consume and export some of it to Japan.
Through specialization and trade, both countries can have more food and more cars.