3

Interdependence and
the Gains from Trade

PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

bàn lun
A Parable for the Modern Economy
• Only two goods
– Meat
– Potatoes
• Only two people
ngi nuôi gia súc
– A cattle rancher named Rose
– A potato farmer named Frank
– Both would like to eat both meat and
potatoes

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A Parable for the Modern Economy

• If Rose produces only meat and Frank
produces only potatoes
– Both gain from trade
• If both Rose and Frank produce both
meat and potatoes
– Both gain from specialization and trade
biên gii kh nng sn xut
• Production possibilities frontier
– Various mixes of output that an economy
can produce
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1
 Figure 1
The Production Possibilities Frontier (a)

Panel (a) shows the production opportunities available to Frank the farmer and Rose
the rancher.

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Figure 1
The Production Possibilities Frontier (b, c)
(b) Frank’s production (c) Rose’s production
possibilities frontier possibilities frontier
Meat (oz) Meat (oz)
If there is no trade, Frank If there is no trade, Rose
chooses this production and 24 chooses this production and
consumption. consumption.

8
12 B

4 A

0 16 32 0 24 48
Potatoes (oz) Potatoes (oz)
Panel (b) shows the combinations of meat and potatoes that Frank can produce. Panel (c) shows
the combinations of meat and potatoes that Rose can produce. Both production possibilities
frontiers are derived assuming that Frank and Rose each work 8 hours per day. If there is no
trade, each person’s production possibilities frontier is also his or her consumption possibilities
frontier.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A Parable for the Modern Economy

• Specialization and trade
– Farmer Frank specializes in growing
potatoes
• More time growing potatoes
• Less time raising cattle
– Rancher Rose specializes in raising cattle
• More time raising cattle
• Less time growing potatoes
– Trade: 5 oz of meat for 15 oz of potatoes

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2
 Figure 2
How Trade Expands the Set of Consumption Opportunities (a, b)
(a) Frank’s production (b) Rose’s production
and consumption and consumption
Meat (oz) Meat (oz)
Frank's production Rose’s production Rose’s
and consumption with trade production and
24
without trade consumption
18 without trade
Frank's
8 consumption Rose’s
with trade 13 B*
A* 12 consumption
5 Frank's B with trade
4 production
A
with trade

0 16 17 32 0 12 24 27 48
Potatoes (oz) Potatoes (oz)
The proposed trade between Frank the farmer and Rose the rancher offers each of them a
combination of meat and potatoes that would be impossible in the absence of trade. In panel (a),
Frank gets to consume at point A* rather than point A. In panel (b), Rose gets to consume at point
B* rather than point B. Trade allows each to consume more meat and more potatoes.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 2
How Trade Expands the Set of Consumption Opportunities (c)

The proposed trade between Frank the farmer and Rose the rancher offers each of
them a combination of meat and potatoes that would be impossible in the absence of
trade. In panel (a), Frank gets to consume at point A* rather than point A. In panel (b),
Rose gets to consume at point B* rather than point B. Trade allows each to consume
more meat and more potatoes.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Comparative Advantage
• Absolute advantage
– The ability to produce a good using fewer
inputs than another producersn xut t cung t cp ít hn
các cách khác
– In producing meat: Rose
• Rose needs 20 min. to produce 1 oz. of meat
• Frank needs 60 minutes
– In producing potatoes: Rose
• Rose needs 10 min. to produce 1 oz. of
potatoes
• Frank needs 15 minutes
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3
 Comparative Advantage
• Opportunity cost
– Whatever must be given up to obtain
some item bt c gì phi t b có c
– Measures the trade-off between the two
goods that each producer faces o lng s ánh i

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Table 1
The Opportunity Cost of Meat and Potatoes

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Comparative Advantage
• Comparative advantage
– The ability to produce a good at a lower
opportunity cost than another producer
– Reflects the relative opportunity cost
• Principle of comparative advantage
• Each good should be produced by the
individual that has the smaller opportunity
cost of producing that good
– Specialize according to comparative
advantage
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4
 Comparative Advantage
• One person
– Can have absolute advantage in both
goods
– Cannot have comparative advantage in
both goods
• For different opportunity costs
• One person has comparative advantage in
one good
• The other person has comparative advantage
in the other good
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Comparative Advantage
• Opportunity cost of one good
– Inverse of the opportunity cost of the other
• Gains from specialization and trade
– Based on comparative advantage
– Total production in economy rises
• Increase in the size of the economic pie
• Everyone is better off

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Comparative Advantage
• Trade can benefit everyone in society
– Allows people to specialize
• The price of trade
– Must lie between the two opportunity costs
• Principle of comparative advantage
explains:
– Interdependence s ph thuc ln nhau
– Gains from trade

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5
 Applications of Comparative Advantage
Should Tom Brady Mow His
Own Lawn?
• Brady, in 2 hours
– Mow his lawn, or
– Film a TV commercial, earn
$20,000
• Forest Gump, in 4 hours
“ They did a
– Mow Brady’s lawn nice job mowing
this grass.”
– Work at McDonald’s, earn $40
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Applications of Comparative Advantage

Should the U.S. trade with other countries?
• Imports
– Goods produced abroad and sold
domestically
• Exports
– Goods produced domestically and sold
abroad

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Applications of Comparative Advantage

Should the U.S. trade with other countries?
• U.S and Japan
– Each produces food and cars
– One American worker, one month
• One car, or
• Two tons of food
– One Japanese worker, one month
• One car
• One ton of food

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6
 Applications of Comparative Advantage
• Principle of comparative advantage
– Each good should be produced by the
country with the smaller opportunity cost
of producing that good
• Specialization and trade
– All countries have more food and more
cars

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.