CHAPTER 3:

INTERDEPENDENCE AND THE GAINS FROM TRADE

Principle of Economics
 Why Should We Study Trade?
• People trade with each other
– Do you know anyone who makes all the things he or she consumes?
• To understand our world we need to understand why people trade so
much
• We need to understand whether trade is good for us or bad for us.
– Understanding this is important precisely because we trade a lot.

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CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
 A Parable For The Modern Economy
• Imagine a world with …
– only two goods: potatoes and meat
– only two people: a potato farmer and a cattle rancher
• What amounts should each produce?
• Should they trade?

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CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
 Opportunity cost
• In our story, the farmer can produce both meat and potatoes
• However, as the farmer has a finite amount of the resources
needed for production, the production of an additional ounce
of meat necessarily reduces the quantity of potatoes the farmer
can produce
• The reduction in potato production caused by the production of
an additional ounce of meat is called the opportunity cost of
meat

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CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
 Opportunity cost and trade
• Suppose the opportunity cost of an ounce of meat is 3 ounces
of potatoes for both Farmer and Rancher
• Will they trade?
• No. Trade would be pointless in this case.

Opportunity Costs
By the way,
Meat Potatoes can you fill in
the blank
cells in the
Farmer 3 table?

Rancher 3
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CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
 Opportunity cost and trade
• Now will they trade?
• Yes!
– Rancher will offer to sell meat to farmer at a price 2, 4 ounces of
potatoes per ounce of meat for farmer
– Farmer will gladly accept
– Both farmer and rancher will be better off
Opportunity Costs
Again, can

4
Meat Potatoes you fill in the
blank cells in
the table?
Farmer 4
2
Rancher 2 6
 Opportunity cost and trade
• Therefore, we have just seen that opportunity cost is key to
understanding virtually every aspect of trade
– If opportunity costs are equal, there will be no trade
– If opportunity costs are different, there will be trade
– The price at which the trading occurs will be somewhere between the two
traders’ opportunity costs
– The person with the lower opportunity cost of meat will be the meat seller
(exporter) and potato buyer
• This person is said to have a comparative advantage in meat production
– The person with the higher opportunity cost of meat will be the meat buyer
(importer) and potato seller

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CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
 Opportunity cost and trade
• Trade makes people specialize in the production of the good they have a
comparative advantage in
• Rancher has a comparative advantage in producing meat.
• Trade gives the rancher the incentive to expand meat production for sale (export)
to the farmer
• That is, trade gives the rancher the incentive to specialize in what he does best

Opportunity Costs
4 ½
Meat Potatoes
2 Farmer 4 ¼ ¼

Rancher 2 ½ 8
Production Technologies of the Farmer and Rancher

These technology numbers can be used to

calculate opportunity costs
9
 Opportunity Costs of Farmer
• 1 ounce of meat → 60 minutes → 4 ounces of potatoes.
• Therefore, Farmer’s opportunity cost of 1 ounce of meat is 4 ounces of
potatoes.

Minutes Needed to Make 1 Ounce of: Opportunity Costs

Meat Potatoes Meat Potatoes

Farmer 60 min/oz 15 min/oz Farmer 4
Rancher 20 min/oz 10 min/oz Rancher
 Opportunity Costs of Farmer
• 1 ounce of potatoes → 15 minutes → ¼ ounces of meat.
• Therefore, Farmer’s opportunity cost of 1 ounce of potatoes is ¼ ounces
of meat.

Minutes Needed to Make 1 Ounce of: Opportunity Costs

Meat Potatoes Meat Potatoes

Farmer 60 min/oz 15 min/oz Farmer 4 ¼
Rancher 20 min/oz 10 min/oz Rancher
 Opportunity Costs of Rancher
• 1 ounce of meat → 20 minutes → 2 ounces of potatoes.
• Therefore, Rancher’s opportunity cost of 1 ounce of meat is 2 ounces of
potatoes.

Minutes Needed to Make 1 Ounce of: Opportunity Costs

Meat Potatoes Meat Potatoes

Farmer 60 min/oz 15 min/oz Farmer 4 ¼
Rancher 20 min/oz 10 min/oz Rancher 2
 Opportunity Costs of Rancher
• 1 ounce of potatoes → 10 minutes → ½ ounces of meat.
• Therefore, Rancher ’s opportunity cost of 1 ounce of potatoes is ½
ounces of meat.

Minutes Needed to Make 1 Ounce of: Opportunity Costs

Meat Potatoes Meat Potatoes

Farmer 60 min/oz 15 min/oz Farmer 4 ¼
Rancher 20 min/oz 10 min/oz Rancher 2 ½
 Opportunity Costs and Comparative Advantage
• It follows that,
– Farmer has a comparative advantage in potatoes and
– Rancher has a comparative advantage in meat.

Table 1 Opportunity Costs

Meat Potatoes
Farmer 4 ¼
Rancher 2 ½
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 Absolute Advantage and Comparative Advantage
• If Farmer can make an ounce of potatoes in less time than
Rancher needs to do the same, then Farmer is said to have an
absolute advantage in making potatoes
• On the other hand, if Farmer can make an ounce of potatoes at
a lower opportunity cost than Rancher can, then Farmer is said
to have a comparative advantage in making potatoes

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CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
 Technology and Opportunity Costs
Rancher has an absolute advantage in both goods.
Farmer has a comparative advantage in potatoes.
Rancher has a comparative advantage in meat.

Trade will happen. Farmer will export potatoes and Rancher will export meat.

Minutes Needed to Make 1 Ounce of: Opportunity Costs

Meat Potatoes Meat Potatoes

Farmer 60 min/oz 15 min/oz Farmer 4 ¼
Rancher 20 min/oz 10 min/oz Rancher 2 ½
GRAPHING PRODUCTION POSSIBILITIES

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CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
Rancher’s Production Possibilities: Further Details
Time Spent on Production of… Amount Produced
Meat Potatoes Meat Potatoes
0 8 0 48
2 6 6 36
4 4 12 24
6 2 18 12
8 0 24 0

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CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
Figure 1 The Rancher’s Production Possibilities Frontier
(b) The Rancher ’s Production Possibilities Frontier

Meat (ounces)

24

If there is no trade, Amount Produced

the rancher might choose
18
C this production and Meat Potatoes
consumption.
0 48
12 B 6 36
12 24
6
18 12
24 0

0 12 24 36 48
Potatoes (ounces)

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CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
 The Production Possibilities Frontier
• If either person increases his production of meat, his production of
potatoes must decrease.
• When there is no trade, each person must consume what he produces.
• In that case, if either person increases his consumption of meat, his
consumption of potatoes must decrease.

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CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
Farmer’s Production Possibilities
Time spent on production of… Amount Produced

Meat Potatoes Meat Potatoes

0 8 0 32

2 6 2 24

4 4 4 16

6 2 6 8

8 0 8 0

CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 21

Figure 1 The Farmer’s Production Possibilities Frontier
(a) The Farmer ’s Production Possibilities Frontier

Meat (ounces)
Amount Produced
2. If the farmer
Meat Potatoes
wants more meat,
he can go from A to 0 32
B.
If there is no trade, 2 24
the farmer might choose
8
B this production and 4 16
consumption.
3. Gain 4
ounces of meat
6 8
4 A 8 0
4. Lose 16 ounces 8. Lose 4 ounces
of potatoes of meat
C
5. The opportunity 0 16 32 Potatoes (ounces)
7. Gain 16 ounces
cost of 1 ounce of 6. If the farmer of potatoes 9. The opportunity cost of 1
meat is, therefore, 4 wants more
ounces of potatoes. ounce of potatoes is
potatoes, he can therefore ¼ ounces of meat
go from A to C.
 The Gains from Trade: A Summary
Frank Ruby
Meat Potatoes Meat Potatoes
Without Trade
Production and 4 oz 16 oz 12 oz 24 oz
consumption
With Trade
Production 0 oz 32 oz 18 oz 12 oz
Trade Gets 5 oz Gives 15 oz Gives 5 oz Gets 15 oz
Consumption 5 oz 17 oz 13 oz 27 oz
Gains from Trade
Increase in +1 oz +1 oz +1 oz +3 oz
consumption
REVISITING THE THEORY OF COMPARATIVE
ADVANTAGE

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CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
 Theory of Comparative Advantage
• The Theory of Comparative Advantage says that if each person specializes in
producing what he or she has a comparative advantage in, then total production of
every good can increase and,
• As a result, trade can benefit everybody.
• In our example, the theory says that if Farmer specializes in potatoes and Rancher
specializes in meat, the total production of meat can be increased and the total
production of potatoes can also be increased.
• As a result, if Rancher and Farmer then trade, they could both benefit.
• But is this theory true?

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CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
 The Legacy of Adam Smith and David Ricardo
• Adam Smith In his 1776 book An Inquiry into the Nature and Causes of
the Wealth of Nations, Adam Smith performed a detailed analysis of
trade and economic interdependence, which economists still adhere to
today.
• David Ricardo In his 1816 book Principles of Political Economy and
Taxation, David Ricardo developed the principle of comparative
advantage as we know it today.

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CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE
 Theory of Comparative Advantage—Proof
• Suppose Farmer increases his production of potatoes by 4 ounces.
• Then, according to Table 1, his production of meat must decrease by 1 ounce.
• Suppose Rancher increases his production of meat by 1.5 ounces. Then his
production of potatoes must decrease by 3 ounces.
• Therefore, by making these two people specialize according to their comparative
advantages, it is possible to increase the total output of meat by 0.5 ounces and of
potatoes by 1 ounce.

Table 1 Opportunity Costs

Meat Potatoes
Farmer 4 ¼
Rancher 2 ½
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• We have just witnessed a miracle—the miracle of trade. For an individual, it is
impossible to make more of one good without making less of some other good. But
for the world as a whole, it is possible to produce more of all goods simultaneously if
we embrace trade.

Change in Production
Potatoes Meat
Farmer +4 -1
Rancher -3 +1.5
Total +1 +0.5
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