Interdependence and the
Gains from Trade
Chapter 3
Interdependence and Trade
Consider your typical day:
– You wake up to a alarm clock made in Wenzhou
– You put on some clothes made of cotton grown in Xinjiang and
sewn in factories in Fujian Province.
– You drink a cup of milk made in Nanchang
– You go to classroom by bicycle made in Shanghai
– You read some books published in Beijing
– You browse some news on internet using your PC made in
Suzhou
– …… and many other things
– And all the things mentioned above can be imported
from a dozen of countries
Interdependence and 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.
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 Trade
A general observation…
– Individuals and nations rely on specialized
production and exchange as a way to address
problems caused by scarcity.
Interdependence and Trade
But,this gives rise to two questions:
– Why is the interdependence the norm?
– What determine production and trade?
Why is the 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 the differences in opportunity costs
A Parable for Modern Economy
Imagine…
– Only two goods,potatoes and meat
– Only two people,a farmer and a rancher
What should each produce?
Why should they trade?
The Production Opportunities of
the Farmer and the Rancher
H our s N e e de d t o M ake 1 l b,of,A m ount P r oduc e d i n 4 0 H our s
M e a t P ot a t oe s M e a t P ot a t oe s
Fa r m e r 2 0 h o u r s / l b 1 0 h o u r s / l b 2 l b s,4 l b s,
R a n c h e r 1 h o u r s / l b 8 h o u r s / l b,4 0 l b s,5 l b s,
Production Possibilities
Frontiers
Potatoes (pounds)
Meat
(pounds)
4
2
1
2
(a) The Farmer’s Production
Possibilities Frontier
0
A
Production Possibilities Frontiers
Potatoes (pounds)
Meat
(pounds)
5
40
20
2.5
(b) The Rancher’s Production
Possibilities Frontier
0
B
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.
The Farmer and the Rancher
Specialize and Trade
Each would be better off if they specialize
in producing product they are more suited
to produce,and then trade with each other
The farmer should produce potatoes,and
the rancher should produce meat.
The Gains from Trade:
A Summary
Th e O ut c om e
W i t ho ut Tra de,
W ha t Th e y P r od uc e
a nd C on s um e
Fa r m e r
1 l b m e a t ( A )
2 l b s p o t a t o e s
R a nc he r
2 0 l b s m e a t ( B )
2,5 l b s p o t a t o e s
The Gains from Trade:
A Summary
Th e O ut c om e
W i t h Tr a de,
W ha t Th e y
P r od uc e
W ha t Th e y
Tr a de
W ha t Th e y
C on s um e
Fa r m e r
0 l b s m e a t
4 l b s p o t a t o e s
G e t s 3 l b s m e a t
f o r 1 l b p o t a t o e s
3 l b s m e a t ( A* )
3 l b s p o t a t o e s
R a nc he r
2 4 l b s m e a t
2 l b s p o t a t o e s
G i v e s 3 l b s m e a t
f o r 1 l b p o t a t o e s
2 1 l b s m e a t ( B* )
3 l b s p o t a t o e s
Trade Expands the Set of
Consumption Possibilities
Potatoes (pounds)
Meat
(pounds)
42
2
1
(a) How Trade Increases the
Farmer’s Consumption
0
A
3
3
A*
Farmer’s
consumption
without trade
Farmer’s
consumption
with trade
Trade Expands the Set of
Consumption Possibilities
Potatoes (pounds)
Meat
(pounds)
52.5
40
20
(b) How Trade Increases The
Rancher’s Consumption
0
B
21
3
B*
Rancher’s
consumption
without trade
Rancher’s
consumption
with trade
The Principle of
Comparative Advantage
Differences in the cost of production
determines the following:
– Who should produce what
– How much should be trade for each product
Who can produce potatoes at a lower cost?
The farmer or the rancher?
Differences in Costs of Production
Two ways to measure differences in costs
of production:
The number of hours required to produce
one unit of product.
The opportunity cost of sacrificing one
good for another.
Absolute 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 unit of
good is said to have an absolute advantage
in producing that good.
Comparative advantage
Compares producers of a good according
to their opportunity cost.
The producer who has a smaller
opportunity cost of producing a good is
said to have a comparative advantage in
producing that good.
Specialization and Trade
Who has the absolute advantage? The
Farmer or the rancher?
Who has the comparative advantage? The
Farmer or the rancher?
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 opportunities costs,they can
each benefit from trade.
Smith and Ricardo
In his 1776 book An Inquiry into the Nature and
Causes of the Wealth of Nations,Adam Smith
(1723-1790) performed a detailed analysis of
trade and economic interdependence,which
economists still adhere to today.
In his 1816 book Principles of Political Economy
and Taxation,David Ricardo (1772-1823)
developed the principle of comparative
advantage as we know it today.
Applications
Should Tiger Woods himself mow his own
lawn?
Should a chef himself cook for his family?
Now China is regarded as the world
factory,we can produced everything
necessary to life,should China still trade
with other countries?
The Ten Principles of Economics
People face tradeoffs.
The cost of something is what you give up
to get it.
Rational people think at the margin.
People respond to incentives.
Trade can make everyone better off.
Summary
Interdependence and trade allow people
to enjoy a greater quantity and variety of
goods and services.
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,
Comparative advantage applies to
countries as well as to people,
Question
What range will the trade price be in?
Exercise #3
Problems and applications:
– #2,#3,#5,#8,#10
Gains from Trade
Chapter 3
Interdependence and Trade
Consider your typical day:
– You wake up to a alarm clock made in Wenzhou
– You put on some clothes made of cotton grown in Xinjiang and
sewn in factories in Fujian Province.
– You drink a cup of milk made in Nanchang
– You go to classroom by bicycle made in Shanghai
– You read some books published in Beijing
– You browse some news on internet using your PC made in
Suzhou
– …… and many other things
– And all the things mentioned above can be imported
from a dozen of countries
Interdependence and 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.
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 Trade
A general observation…
– Individuals and nations rely on specialized
production and exchange as a way to address
problems caused by scarcity.
Interdependence and Trade
But,this gives rise to two questions:
– Why is the interdependence the norm?
– What determine production and trade?
Why is the 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 the differences in opportunity costs
A Parable for Modern Economy
Imagine…
– Only two goods,potatoes and meat
– Only two people,a farmer and a rancher
What should each produce?
Why should they trade?
The Production Opportunities of
the Farmer and the Rancher
H our s N e e de d t o M ake 1 l b,of,A m ount P r oduc e d i n 4 0 H our s
M e a t P ot a t oe s M e a t P ot a t oe s
Fa r m e r 2 0 h o u r s / l b 1 0 h o u r s / l b 2 l b s,4 l b s,
R a n c h e r 1 h o u r s / l b 8 h o u r s / l b,4 0 l b s,5 l b s,
Production Possibilities
Frontiers
Potatoes (pounds)
Meat
(pounds)
4
2
1
2
(a) The Farmer’s Production
Possibilities Frontier
0
A
Production Possibilities Frontiers
Potatoes (pounds)
Meat
(pounds)
5
40
20
2.5
(b) The Rancher’s Production
Possibilities Frontier
0
B
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.
The Farmer and the Rancher
Specialize and Trade
Each would be better off if they specialize
in producing product they are more suited
to produce,and then trade with each other
The farmer should produce potatoes,and
the rancher should produce meat.
The Gains from Trade:
A Summary
Th e O ut c om e
W i t ho ut Tra de,
W ha t Th e y P r od uc e
a nd C on s um e
Fa r m e r
1 l b m e a t ( A )
2 l b s p o t a t o e s
R a nc he r
2 0 l b s m e a t ( B )
2,5 l b s p o t a t o e s
The Gains from Trade:
A Summary
Th e O ut c om e
W i t h Tr a de,
W ha t Th e y
P r od uc e
W ha t Th e y
Tr a de
W ha t Th e y
C on s um e
Fa r m e r
0 l b s m e a t
4 l b s p o t a t o e s
G e t s 3 l b s m e a t
f o r 1 l b p o t a t o e s
3 l b s m e a t ( A* )
3 l b s p o t a t o e s
R a nc he r
2 4 l b s m e a t
2 l b s p o t a t o e s
G i v e s 3 l b s m e a t
f o r 1 l b p o t a t o e s
2 1 l b s m e a t ( B* )
3 l b s p o t a t o e s
Trade Expands the Set of
Consumption Possibilities
Potatoes (pounds)
Meat
(pounds)
42
2
1
(a) How Trade Increases the
Farmer’s Consumption
0
A
3
3
A*
Farmer’s
consumption
without trade
Farmer’s
consumption
with trade
Trade Expands the Set of
Consumption Possibilities
Potatoes (pounds)
Meat
(pounds)
52.5
40
20
(b) How Trade Increases The
Rancher’s Consumption
0
B
21
3
B*
Rancher’s
consumption
without trade
Rancher’s
consumption
with trade
The Principle of
Comparative Advantage
Differences in the cost of production
determines the following:
– Who should produce what
– How much should be trade for each product
Who can produce potatoes at a lower cost?
The farmer or the rancher?
Differences in Costs of Production
Two ways to measure differences in costs
of production:
The number of hours required to produce
one unit of product.
The opportunity cost of sacrificing one
good for another.
Absolute 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 unit of
good is said to have an absolute advantage
in producing that good.
Comparative advantage
Compares producers of a good according
to their opportunity cost.
The producer who has a smaller
opportunity cost of producing a good is
said to have a comparative advantage in
producing that good.
Specialization and Trade
Who has the absolute advantage? The
Farmer or the rancher?
Who has the comparative advantage? The
Farmer or the rancher?
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 opportunities costs,they can
each benefit from trade.
Smith and Ricardo
In his 1776 book An Inquiry into the Nature and
Causes of the Wealth of Nations,Adam Smith
(1723-1790) performed a detailed analysis of
trade and economic interdependence,which
economists still adhere to today.
In his 1816 book Principles of Political Economy
and Taxation,David Ricardo (1772-1823)
developed the principle of comparative
advantage as we know it today.
Applications
Should Tiger Woods himself mow his own
lawn?
Should a chef himself cook for his family?
Now China is regarded as the world
factory,we can produced everything
necessary to life,should China still trade
with other countries?
The Ten Principles of Economics
People face tradeoffs.
The cost of something is what you give up
to get it.
Rational people think at the margin.
People respond to incentives.
Trade can make everyone better off.
Summary
Interdependence and trade allow people
to enjoy a greater quantity and variety of
goods and services.
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,
Comparative advantage applies to
countries as well as to people,
Question
What range will the trade price be in?
Exercise #3
Problems and applications:
– #2,#3,#5,#8,#10
