IC110

GENERAL ECONOMICS

Course Description
This course deals with the behavior and performance of the economy as a whole as well as the
roles and functions of the market, the state, households and firms. It will also discuss the relations
or interactions of the said agents. The course shall use basic macro and microeconomic concepts
and methodologies in its discussions. At the macro level, the main topics will be the national
income (output), employment, agrarian reform, government fiscal policy, general price level, trade
and economic growth and development. At the micro level, the main focus will be on supply and
demand, elasticity and market structures and inefficiency

Course Outcomes

 Describe and explain how microeconomic models can be used to consider fundamental economic
choices of households and firms.
 Describe and explain how macroeconomic models can be used to analyze the economy as a whole.
 Describe and explain how government policy influences microeconomic choices and
macroeconomic outcomes.
 Interpret and use economic models, diagrams and tables and use them to analyze economic
situations
 Module 1
Introduction

Intended Learning Outcomes

 Discuss the Ten Principles of Economics
 Discuss the meaning of economics
 Determine how to use marginal reason in making decisions
 Discuss how incentives affect people’s behaviour
 Explain how economists apply the methods of science
 Differentiate microeconomics to macroeconomics
 Determine the difference between positive and normative statements

Lesson 3: INTERDEPENDENCE AND THE GAINS FROM TRADE

At the end of this lesson, challenge yourself to:

a. Determine the meaning of absolute advantage and comparative advantage

b. Apply the theory of comparative advantage to everyday life and national policy

Consider your typical day. You wake up in the morning, and you pour yourself juice from oranges
grown in Florida and coffee from beans grown in Brazil. Over breakfast, you watch a news program
broadcast from New York on your television made in Japan. 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. Then you open up your economics textbook written by
an author living in Massachusetts, published by a company located in Texas, and printed on paper made
from trees grown in Oregon.
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. Such inter- dependence is possible because people
trade with one another. Those people who provide you with goods and services are not acting out of
generosity or concern for your welfare. Nor is some government agency directing them to make what you
want and to give it to you. Instead, people provide you and other consumers with the goods and services
they produce because they get something in return.
 In subsequent chapters we will examine how our economy coordinates the activities of millions of
people with varying tastes and abilities. As a starting point for this analysis, here we consider the reasons
for economic interdependence. One of the Ten Principles of Economics highlighted in Chapter 1 is that
trade can make everyone better off. This principle explains why people trade with their neighbors and why
nations trade with other nations. In this chapter we examine this principle more closely. What exactly do
people gain when they trade with one another? Why do people choose to become interdependent?

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.
The gains from trade are most obvious if the rancher can produce only meat and the farmer can
produce only potatoes. In one scenario, the rancher and the farmer could choose to have nothing to do with
each other. But after several months of eating beef roasted, boiled, broiled, and grilled, the rancher might
decide that self-sufficiency is not all it’s cracked up to be. The farmer, who has been eating potatoes mashed,
fried, baked, and scalloped, would likely agree. It is easy to see that trade would allow them to enjoy greater
variety: Each could then have a hamburger with French fries.
Although this scene illustrates most simply how everyone can benefit from trade, the gains would be
similar if the rancher and the farmer were each capable of producing the other good, but only at great cost.
Suppose, for example, that the potato farmer is able to raise cattle and produce meat, but that he is not very
good at it. Similarly, suppose that the cattle rancher is able to grow potatoes, but that her land is not very
well suited for it. In this case, it is easy to see that the farmer and the rancher can each benefit by
specializing in what he or she does best and then trading with the other.
The gains from trade are less obvious, however, when one person is better at producing every good.
For example, suppose that the rancher is better at raising cattle and better at growing potatoes than the
farmer. In this case, should the rancher or farmer choose to remain self-sufficient? Or is there still reason for
them to trade with each other? To answer this question, we need to look more closely at the factors that
affect such a decision.

Table 3-1

HOURS NEEDED TO AMOUNT PRODUCED

MAKE 1 POUND OF: IN 40 HOURS

MEAT POTATOES MEAT POTATOES

PRODUCTION OPPORTUNITIES
20 hours/lb 10 hours/lb 2 lbs lbs OF THE FARMER AND THE
FARMER
1 hour/lb 8 hours/lb 40 lbs lbs
RANCHER RANCHER
 (a) The Farmer’s Production Possibilities
Frontier
Meat THE PRODUCTION POSSIBILITIES
(pounds) FRONTIER.

Panel (a) shows the combinations of

meat and potatoes that the farmer
can produce.

2 Panel (b) shows the combinations

of meat and potatoes that the
Figurecan
rancher 3-1 produce.
1 A

Both production possibilities

frontiers are derived from Table 3-1
0 2 4Potatoes (pounds) and the assumption that the farmer
and rancher each work 40 hours per
(b) The Rancher’s Production Possibilities week
Frontier
Meat
(pounds)

40

20 B

0 2 1/2 5 Potatoes (pounds)

PRODUCTION POSSIBILITIES

Suppose that the farmer and the rancher each work 40 hours a week and can de- vote this time to
growing potatoes, raising cattle, or a combination of the two. Table 3-1 shows the amount of time each
person requires to produce 1 pound of each good. The farmer can produce a pound of potatoes in 10 hours
and a pound of meat in 20 hours. The rancher, who is more productive in both activities, can produce a
pound of potatoes in 8 hours and a pound of meat in 1 hour.
Panel (a) of Figure 3-1 illustrates the amounts of meat and potatoes that the farmer can produce. If
the farmer devotes all 40 hours of his time to potatoes, he produces 4 pounds of potatoes and no meat. If he
devotes all his time to meat, he produces 2 pounds of meat and no potatoes. If the farmer divides his time
equally between the two activities, spending 20 hours on each, he produces 2 pounds of potatoes and 1
pound of meat. The figure shows these three possible outcomes and all others in between.
This graph is the farmer’s production possibilities frontier. As we discussed in Chapter 2, a
production possibilities frontier shows the various mixes of output that an economy can produce. It
illustrates one of the Ten Principles of Economics in Chapter 1: People face tradeoffs. Here the farmer faces
a tradeoff between producing meat and producing potatoes. You may recall that the production
possibilities frontier in Chapter 2 was drawn bowed out; in this case, the tradeoff between the two goods
depends on the amounts being produced. Here, however, the farmer’s technology for producing meat and
potatoes (as summarized in Table 3-1) allows him to switch between one good and the other at a constant
rate. In this case, the production possibilities frontier is a straight line.
Panel (b) of Figure 3-1 shows the production possibilities frontier for the rancher. If the rancher
devotes all 40 hours of her time to potatoes, she produces 5 pounds of potatoes and no meat. If she devotes
all her time to meat, she produces 40 pounds of meat and no potatoes. If the rancher divides her time
equally, spend- ing 20 hours on each activity, she produces 2 1/2 pounds of potatoes and 20 pounds of
meat. Once again, the production possibilities frontier shows all the possible outcomes.
If the farmer and rancher choose to be self-sufficient, rather than trade with each other, then each consumes
exactly what he or she produces. In this case, the production possibilities frontier is also the consumption
possibilities frontier. That is, without trade, Figure 3-1 shows the possible combinations of meat and
potatoes that the farmer and rancher can each consume.
Although these production possibilities frontiers are useful in showing the tradeoffs that the farmer
and rancher face, they do not tell us what the farmer and rancher will actually choose to do. To determine
their choices, we need to know the tastes of the farmer and the rancher. Let’s suppose they choose the
combinations identified by points A and B in Figure 3-1: The farmer produces and consumes 2 pounds of
potatoes and 1 pound of meat, while the rancher produces and consumes 2 1/2 pounds of potatoes and 20
pounds of meat.

(a) How Trade Increases the Farmer’s

Consumption
Meat
(pounds)

HOW TRADE EXPANDS THE SET

Farmer’s
consumption OFCONSUMPTION OPPORTUNITIES.
A
3 * with trade
The proposed trade between the
farmer and the rancher offers each of
2 Farmer’s them a combination of meat and
consumption potatoes that would be impossible in
without trade
the absence of trade. In panel (a), the
A
1 farmer gets to consume at point A*
rather than point A. In panel (b), the
rancher gets to consume at point B*
rather than point B. Trade allows each
0 2 3 4Potatoes (pounds)
to consume more meat and more
(b) How Trade Increases the Rancher’s
potatoes.
Consumption
Meat
(pounds)

40

Rancher’s
consumption
B* with trade
21
20 B Rancher’s
consumption
without trade

0 2 1/2 3 5 Potatoes (pounds)

 WHAT THEY WHAT THEY WHAT THEY WHAT THEY THE INCREASE IN
PRODUCE
AND CONSUME PRODUCE TRADE CONSUME CONSUMPTION

FARMER1 lb meat
2 lbs potatoes } point
0 lbs meat
4 lbs potatoes
Gets 3 lbs meat3 lbs meat
for 1 lb potatoes3 lbs potatoes } point
2 lbs meat
1 lb potatoes } A* –

RANCHER 20 lbs meat 24 lbs meat Gives 3 lbs meat21 lbs meat for 1 lb 1 lb meat
2 1/2 lbs potatoes A 2 lbs potatoes potatoes3 lbs potatoes A*
1/2 lb potatoes
}
AB* – B

} point }point B*

B
Table 3-2 THE GAINS FROM TRADE: A SUMMARY

The rancher’s explanation of the gains from trade, though correct, poses a 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.
As a first step in developing this principle, consider the following question: In our example, who
can produce potatoes at lower cost—the farmer or the rancher? There are two possible answers, and in
these two answers lie both the solution to our puzzle and the key to understanding the gains from trade.

ABSOLUTE ADVANTAGE

One way to answer the question about the cost of producing potatoes is to com- pare the inputs
required by the two producers. The rancher needs only 8 hours to produce a pound of potatoes, whereas
the farmer needs 10 hours. Based on this in- formation, one might conclude that the rancher has the lower
cost of producing potatoes.
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. 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.

OPPOR TUNITY COST AND COMPARATIVE ADVANTAGE

There is another way to look at the cost of producing potatoes. Rather than com- paring inputs
required, we can compare the opportunity costs. Recall from Chapter 1 that the opportunity cost of some
item is what we give up to get that item. In our example, we assumed that the farmer and the rancher each
spend 40 hours a week working. Time spent producing potatoes, therefore, takes away from time available
for producing meat. As the rancher and farmer change their allocations of time between producing the two
goods, they move along their production possibility frontiers; in a sense, they are using one good to
produce the other. The opportunity cost measures the tradeoff that each of them faces.
Let’s first consider the rancher’s opportunity cost. Producing 1 pound of potatoes takes her 8 hours of
work. When the rancher spends those 8 hours producing potatoes, she spends 8 hours less producing meat.
Because the rancher needs only 1 hour to produce 1 pound of meat, 8 hours of work would yield 8 pounds
of meat. Hence, the rancher’s opportunity cost of 1 pound of potatoes is 8 pounds of meat. Now consider
the farmer’s opportunity cost. Producing 1 pound of potatoes takes him 10 hours. Because he needs 20
hours to produce 1 pound of meat, 10 hours would yield 1/2 pound of meat. Hence, the farmer’s
opportunity cost of 1pound of potatoes is 1/2 pound of meat.
Table 3-3 shows the opportunity cost of meat and potatoes for the two producers. Notice that the
opportunity cost of meat is the inverse of the opportunity cost of potatoes. Because 1 pound of potatoes
costs the rancher 8 pounds of meat, 1 pound of meat costs the rancher 1/8 pound of potatoes. Similarly,
because 1 pound of potatoes costs the farmer 1/2 pound of meat, 1 pound of meat costs the farmer 2
pounds of potatoes.
Economists use the term comparative advantage when describing the opportunity cost of two
producers. The producer who has the smaller opportunity cost of producing a good—that is, who has to
give up less of other goods to produce it—is said to have a comparative advantage in producing that good.
In our example, the farmer has a lower opportunity cost of producing potatoes than the rancher (1/2 pound
versus 8 pounds of meat). The rancher has a lower opportunity cost of producing meat than the farmer (1/8
pound versus 2 pounds of potatoes). Thus, the farmer has a comparative advantage in growing potatoes,
and the rancher has a comparative advantage in producing meat.

Table 3-3

OPPORTUNITY COST OF:

THE OPPORTUNITY COST OF
MEAT AND POTATOES POUND OF MEAT 1 POUND OF POTATOES

FARMER lbs potatoes 1/8 lb 1/2 lb meat 8 lbs meat

RANCHER potatoes

Notice that it would be impossible for the same person to have a comparative advantage in both
goods. 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 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.

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, total
production in the economy rises, and this increase in the size of the economic pie can be used to make
everyone better off. In other words, as long as two people have different opportunity costs, each can benefit
from trade by obtaining a good at a price lower than his or her opportunity cost of that good.
Consider the proposed deal from the viewpoint of the farmer. The farmer gets 3 pounds of meat in
exchange for 1 pound of potatoes. In other words, the farmer buys each pound of meat for a price of 1/3
pound of potatoes. This price of meat is lower than his opportunity cost for 1 pound of meat, which is 2
pounds of potatoes. Thus, the farmer benefits from the deal because he gets to buy meat at a good price.
 Now consider the deal from the rancher’s viewpoint. The rancher buys 1 pound of potatoes for a
price of 3 pounds of meat. This price of potatoes is lower than her opportunity cost of 1 pound of potatoes,
which is 8 pounds of meat. Thus, the rancher benefits because she gets to buy potatoes at a good price.
These benefits arise because each person concentrates on the activity for which he or she has the lower
opportunity cost: The farmer spends more time growing potatoes, and the rancher spends more time
producing meat. As a result, the total production of potatoes and the total production of meat both rise,
and the farmer and rancher share the benefits of this increased production. The moral of the story of the
farmer and the rancher should now be clear: Trade can benefit everyone in society because it allows people to
specialize in activities in which they have a comparative advantage.

The principle of comparative advantage explains interdependence and the gains from trade.
Because interdependence is so prevalent in the modern world, the principle of comparative advantage has
many applications. Here are two examples, one fanciful and one of great practical importance.

SHOULD TIGER WOODS MOW HIS OWN LAWN?

Tiger Woods spends a lot of time walking around on grass. One of the most talented golfers of all
time, he can hit a drive and sink a putt in a way that most casual golfers only dream of doing. Most likely,
he is talented at other activities too. For example, let’s imagine that Woods can mow his lawn faster than
anyone else. But just because he can mow his lawn fast, does this mean he should?
To answer this question, we can use the concepts of opportunity cost and comparative advantage.
Let’s say that Woods can mow his lawn in 2 hours. In that same 2 hours, he could film a television
commercial for Nike and earn $10,000. By contrast, Forrest Gump, the boy next door, can mow Woods’s
lawn in 4 hours. In that same 4 hours, he could work at McDonald’s and earn $20.
In this example, Woods’s opportunity cost of mowing the lawn is $10,000 and Forrest’s opportunity
cost is $20. Woods has an absolute advantage in mowing lawns because he can do the work in less time.
Yet Forrest has a comparative ad- vantage in mowing lawns because he has the lower opportunity cost.

SHOULD THE UNITED STATES TRADE WITH OTHER COUNTRIES?

Just as individuals can benefit from specialization and trade with one another, as the farmer and
rancher did, so can populations of people in different countries. Many of the goods that Americans enjoy
are produced abroad, and many of the goods produced in the United States are sold abroad. Goods
produced abroad and sold domestically are called imports. Goods produced domestically and sold abroad
are called exports.
To see how countries can benefit from trade, suppose there are two countries, the United States and
Japan, and two goods, food and cars. Imagine that the two countries produce cars equally well: An
American worker and a Japanese worker can each produce 1 car per month. By contrast, because the
United States has more and better land, it is better at producing food: A U.S. worker can produce 2 tons of
food per month, whereas a Japanese worker can produce only 1 ton of food per month.
The principle of comparative advantage states that each good should be produced by the country
that has the smaller opportunity cost of producing that good. Because the opportunity cost of a car is 2 tons
of food in the United States but only 1 ton of food in Japan, Japan has a comparative advantage in
producing cars. Japan should produce more cars than it wants for its own use and export some of them to
the United States. Similarly, because the opportunity cost of a ton of food is 1 car in Japan but only 1/2 car
in the United States, the United States has a comparative advantage in producing food. The United States
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.
In reality, of course, the issues involved in trade among nations are more complex than this example
suggests, as we will see in Chapter 9. Most important among these issues is that each country has many
citizens with different interests. International trade can make some individuals worse off, even as it makes
the country as a whole better off. When the United States exports food and imports cars, the impact on an
American farmer is not the same as the impact on an American autoworker. Yet, contrary to the opinions
sometimes voiced by politicians and political commentators, international trade is not like war, in which
some countries win and others lose. Trade allows all countries to achieve greater prosperity.

 Each person consumes goods and services produced by many other people both in our country and
around the world. Interdependence and trade are desirable because they allow everyone to enjoy a
greater quantity and variety of goods and services.
 There are two ways to compare the ability of two people in producing a good. The person who can
produce the good with the smaller quantity of inputs is said to have an absolute advantage in
producing the good. The person who has the smaller opportunity cost of producing the good is said
to have a comparative advantage. The gains from trade are based on comparative advantage, not
absolute advantage.
 Trade makes everyone better off because it allows people to specialize in those activities in which
they have a comparative advantage.
 The principle of comparative advantage applies to countries as well as to people. Economists use
the principle of comparative advantage to advocate free trade among countries.

REFERENCES

1. Principles of Economics, 7th edition / N. Gregory Mankiw, N.

2. Business Economics / Cruz, Milagros / 2017
3. Applied Economics . Dinio, Rosemary / 2017
4. Introductory Microeconomics, 4th edition / Pagoso, Cristobal / 2014
 Assessment

1. Explain how absolute advantage and comparative advantage differ and connect it in rice
importation/trade between Philippines and Vietnam.

2. Give an example in which one person has an absolute advantage in doing something but
another person has a comparative advantage.

3. Is absolute advantage or comparative advantage more important for trade? Explain your
reasoning, using the example in your answer to Question 2.

4. Will a nation tend to export or import goods for which it has a comparative advantage?
Explain in not less than 5 sentences.

5. Why do economists oppose policies that restrict trade among nations? Explain in not less
than 5 sentences.