PART 9

TRADE

19 INTERDEPENDENCE AND
THE GAINS FROM TRADE

C onsider your typical day. You wake up in the morning and you make yourself some coffee from beans
grown in Kenya, or tea from leaves grown in Sri Lanka. Over breakfast, you listen to a radio programme
on your radio set made in Japan. You get dressed in clothes manufactured in Thailand. You drive to the
university in a car made of parts manufactured in more than a dozen countries around the world. Then you
open up your economics textbook published by a company located in Hampshire in the UK, printed on
paper made from trees grown in Finland and written by authors from the US and England.
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 interdependence 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 or supra-governmental agency directing them to
make products you want and to give them to you. Instead, people provide you and other consumers with
the goods and services they produce because they get something in return.

THE PRODUCTION POSSIBILITIES FRONTIER

We begin our analysis by looking at a model of the economy where no trade takes place. Although real
economies produce thousands of goods and services, this model will simplify the production of goods
into two categories, capital goods and consumer goods. The country has a certain amount of resources
of land, labour and capital available to allocate between the production of capital goods and consumer
goods. The way in which the country can divide the allocation of resources between these two goods can
be shown using a production possibilities frontier (PPF). (You might also see this referred to as a produc-
tion possibilities boundary or production possibilities curve – they are the same thing). The production
possibilities frontier is a graph that shows the various combinations of output – in this case, capital goods
and consumer goods – that the economy can possibly produce given the available factors of production
and the available production technology that firms can use to turn these factors into output.

405
406 PART 9 TRADE

production possibilities frontier a graph that shows the combinations of output that the economy can possibly
produce given the available factors of production and available production technology

Figure 19.1 is an example of a PPF. In this economy, if all resources were devoted to the production of
capital goods, the economy would produce 1 million units of capital goods and no consumption goods.

FIGURE 19.1
Quantity of
The P
Th Production
d ti P Possibilities Frontier capital goods
The production possibilities frontier shows the (millions of
units)
combinations of output – in this case, capital
and consumer goods – that the economy can
possibly produce given its factor endowment.
1 D
The economy can produce any combination
on or inside the frontier. Points outside the
frontier are not feasible given the economy’s 0.75 C
resources. 0.7 A
Production
possibilities
frontier
0.3 B

0.8 1.7 2 3
Quantity of
consumer goods
(millions of units)

If all resources were used to produce consumer goods, the economy would produce 3 million units and
no capital goods. The two end points of the production possibilities frontier represent these extreme pos-
sibilities. If the economy were to divide its resources between the two goods, it could produce 700,000
capital goods and 2 million consumer goods, shown in the figure by point A. By contrast, the outcome at
point D is not possible because resources are scarce: the economy does not have enough of the factors
of production to support that level of output. In other words, the economy can produce at any point on or
inside the production possibilities frontier, but it cannot produce at points outside the frontier.
An outcome is said to be efficient if the economy is getting all it can from the scarce resources it has
available. Points on the PPF represent efficient levels of production. When the economy is producing at
such a point, say point A, there is no way to produce more of one good without producing less of the
other. Point B represents an inefficient outcome. For some reason, the economy is producing less than it
could from the resources it has available and so some of its resources are lying idle (they are unemployed
or underemployed). At point B, the country is producing only 300,000 units of capital goods and 800,000
consumer goods. If the source of the inefficiency were eliminated, the economy could move from point B
to point A, increasing production of both capital goods (to 700,000) and consumer goods (to 2 million).
One of the Ten Principles of Economics discussed is that people face trade-offs. The production pos-
sibilities frontier shows one trade-off that society faces. Once we have reached the efficient points on the
frontier, the only way of getting more of one good is to get less of the other. When the economy moves
from point A to point C, for instance, society produces more consumer goods but at the expense of pro-
ducing fewer consumer goods.
Another of the Ten Principles of Economics is that the cost of something is what you give up to get it.
This is called the opportunity cost (OC). The production possibilities frontier shows the opportunity cost of
one good as measured in terms of the other good. When society reallocates some of the factors of produc-
tion from the capital goods industry to the consumer goods industry, moving the economy from point A
to point C, it gives up 300,000 consumer goods to get 50,000 additional capital goods. In other words,
when the economy is at point A, the opportunity cost of 300,000 consumer goods is 50,000 capital goods.
 CHAPTER 19 INTERDEPENDENCE AND THE GAINS FROM TRADE 407

Calculating Opportunity Costs

Remember that the opportunity cost is the cost expressed in terms of the next best alternative sacrificed –
what has to be given up in order to acquire something. In the example the country had to give up 300,000
consumer goods to acquire 50,000 additional capital goods. The opportunity cost can be expressed in
terms of either capital goods or consumer goods – they are the reciprocal of each other.
As a general principle we can express the opportunity cost as a ratio expressed as the sacrifice in one
good in terms of the gain in the other:

Sacrifice of good x
Opportunity cost of good y =
Gain in good y

Expressing the opportunity cost in terms of good x would give:

Sacrifice of good y
Opportunity cost of good x =
Gain in good x

What is the opportunity cost of 1 additional unit of consumer goods or capital goods? This can be
calculated by the following process. If we want to find the opportunity cost of consumer goods in relation
to capital goods then firstly write out the known quantities:

The OC of 300,000 consumer goods is 50,000 capital goods

Now divide both quantities by the number of consumer goods:

300,000 50,000
The OC of consumer goods is capital goods
300,000 300,000

Now complete the calculation to get the opportunity cost of 1 additional unit of consumer goods in
terms of capital goods sacrificed:

The OC of 1 consumer good is 0.16 capital goods

This tells us that for every 1 additional unit of consumer goods acquired, we have to give up 0.16 of a
capital good.
To find the opportunity cost of capital goods in terms of consumer goods, follow the same process but
in reverse.
The OC of 50,000 capital goods is 300,000 consumer goods
50,000 300,000
The OC of capital goods is consumer goods
50,000 50,000
The OC of 1 capital good is 6 capital goods

The Shape of the Production Possibilities Frontier

The production possibilities frontier in Figure 19.2 is bowed outward (concave to the origin). This is due
to the fact that when economies move resources from one use to another, unless they are perfect sub-
stitutes (in which case the PPF would be a straight line), as the rate at which the increase in output of
one good increases, the opportunity cost in terms of the other changes. For example, if the economy is
using most of its resources to make consumer goods at point A in Figure 19.2, land, labour and capital
is being used to make consumer goods even if these resources are not best suited to making these
goods. If the country moves from point A to point B, the gain in capital goods is 250,000 units but the
sacrifice in consumer goods is 200,000. The opportunity cost of 1 additional unit of capital goods will
be 0.8 consumer goods sacrificed. Resources released from producing consumer goods are now able
to produce capital goods, a use to which they are more appropriately suited. If the economy moves
from point B to point C the gain in capital goods is a further 200,000 units but the sacrifice in terms of
consumer goods is now 700,000. The opportunity cost of 1 additional unit of capital goods now is 3.5
consumer goods sacrificed.
408 PART 9 TRADE

FIGURE 19.2
Quantity of
Th Sh
The Shape off th
the P
Production capital goods
Possibilities Frontier (millions of D
The PPF is concave to the origin. The units) 0.9
shape of the PPF reflects the opportunity
cost of producing different quantities of C
0.65
capital goods and consumer goods. If the
country switches resources from consumer
goods to capital goods the opportunity 0.45 B
cost in terms of the increase in consumer
goods sacrificed for every additional
unit of capital goods rises as the output 0.2 A
combination moves from point A to point D.

0.9 2.0 2.7 2.9

Quantity of
consumer goods
(millions of units)

If the country continues to shift resources to capital goods from consumer goods the ease of substi-
tutability of factors becomes weaker and the sacrifice in consumer goods becomes greater. Moving from
point C to point D yields an additional 250,000 capital goods but at a cost of 1.1 million units of consumer
goods. The opportunity cost of 1 additional unit of capital goods is now 4.4 units of consumer goods. The
reason that the opportunity cost in terms of consumer goods is rising is that the resources being put to
use producing more capital goods are now less suited to the purpose and so the sacrifice in consumer
goods is rising.
The PPF illustrates two of the key questions any economy has to answer: what is to be produced and
how will the output be produced? Most economies could use the resources it has at its disposal in a vari-
ety of ways. For example, it is possible that the UK could allocate resources to the production of oranges.
Large amounts of land could be set aside for the construction of glasshouses in which the climate, water
and nutrition needs of orange trees is controlled by computer technology. In Spain the same amount of
oranges could be produced using far fewer resources simply because the climate is more conducive
to growing oranges. The opportunity cost of using resources in this way in the UK is likely to be high,
therefore.

A Shift in the Production Possibilities Frontier

The production possibilities frontier shows the trade-off between the production of different goods at
a given time, but the trade-off can change over time. For example, technological advances can mean
that factors of production are considerably more productive in terms of output per unit per time period.
Countries might also be in a position to recover or make use of more natural resources or the effects
of education in the country means the labour force is more productive. Over time, therefore, oppor-
tunity cost ratios of production change and this can affect the shape and position of the production
possibilities frontier. Figure 19.3 shows three possible outcomes. In panel (a) the PPF has shifted out-
wards showing that it is now possible to produce more of both capital goods and consumer goods as
indicated by the move to point B. If all resources were devoted to capital goods, the economy could
now produce 1.2 million units and if all resources were devoted to consumer goods the country could
now produce 3.6 million units. The relative opportunity cost ratios, however, remain the same because
the PPF has shifted outwards parallel at every point to the original curve. Because of this economic
growth, society might move production from point A to point B, enjoying more consumer goods and
more capital goods.
 CHAPTER 19 INTERDEPENDENCE AND THE GAINS FROM TRADE 409

Panel (b) shows a shift in the PPF but this time the economic advances in the productivity of the capital
goods industry is greater than that of the consumer goods industry. If all resources were now devoted to
capital goods production, the country could produce 1.5 million units and if it devoted all output to con-
sumer goods it could produce 3.2 million units. The opportunity cost ratio at all points on the new PPF will
now be different to those on the original PPF.
Panel (c) shows the opposite situation where the economic advances in productivity in the consumer
goods industry is greater than in the capital goods industry. In this case, if all resources were devoted
to producing consumer goods, the country could now produce 3.7 million units and if all resources were
devoted to producing capital goods, 1.1 million units could be produced.
It may also be possible that productivity in one industry might actually reduce whilst that in the other rises
in which case the PPF might take the look of that in panel (d) of Figure 19.3. In this case there has been an
increase in productivity in the capital goods industry but a reduction in the consumer goods industry.

FIGURE 19.3
Shifts iin the
Shift th Production
P d t Possibilities Frontier
Panels (a) to (d) show different shifts in the PPF as a result of changes in the productivity of factors used in producing capital and
consumer goods.

Quantity of Quantity of
capital goods capital goods
(millions of units) (millions of units)

1.2 1.5

1.0 B 1.0
A

3.0 3.6 3.0 3.2

Quantity of Quantity of
consumer goods consumer goods
(millions of units) (millions of units)
(a) (b)

Quantity of Quantity of
capital goods capital goods
(millions of units) (millions of units)

1.5
1.1
1.0 1.0

3.0 3.7 2.8 3.0

Quantity of Quantity of
consumer goods consumer goods
(millions of units) (millions of units)
(c) (d)
410 PART 9 TRADE

The production possibilities frontier simplifies a complex economy to highlight and clarify some basic
ideas. We can now extend the analysis to look at how different factor endowments and factor productivity
in different countries can lead to countries trading and gaining advantages.

SELF TEST Use the information in Figure 19.3 to calculate the opportunity cost ratios of both capital and
consumer goods in each scenario presented in the different panels. Assume, in each case, that the country
moves from devoting all its resources to capital goods and then switches to devoting all its resources to
consumer goods.

INTERNATIONAL TRADE
Each country has its own PPF and in isolation faces choices about the use of resources to produce
goods. If the country wants to increase the amount of goods available to all its citizens then it can rely on
increasing the number of factors it has at its disposal or the efficiency with which its resources are used
to shift the PPF outwards. In addition to this, countries might also choose to engage in trade as a means
of providing benefits to its citizens and effectively shift the PPF. One of the Ten Principles of Economics
is that trade can make everyone better off. This principle explains why people trade with their neighbours
and why nations trade with other nations.

A Parable for the Modern Economy

We are going to use a simple example to illustrate how trade can benefit all. Imagine that there are two
goods in the world – beef and potatoes. And there are two people in the world (our analogy for two differ-
ent countries) – a cattle farmer named Silvia and a market gardener named Johan – each of whom would
like to eat both beef and potatoes.
The gains from trade are most obvious if the cattle farmer can produce only meat and the market
gardener can produce only potatoes. In one scenario, the farmer and the gardener could choose to have
nothing to do with each other. But after several months of eating beef roasted, boiled, fried and grilled,
the cattle farmer might decide that self-sufficiency is not all she expected. The market gardener, who has
been eating potatoes mashed, fried and baked, would most likely agree. It is easy to see that trade would
allow them to enjoy greater variety: each could then have steak and chips.
Although this scene illustrates most simply how everyone can benefit from trade, the gains would
be similar if the farmer and the gardener were each capable of producing the other good. In this case
each has a PPF analogous to two different countries. Suppose, for example, that the market gardener is
able to rear cattle and produce meat, but that he is not very good at it. Similarly, suppose that the cattle
farmer is able to grow potatoes, but that her land is not very well suited for it. The PPF for Johan and Silvia
would look like those in Figure 19.4. Panel (a) shows Silvia’s PPF and panel (b) shows Johan’s. Because
Silvia is more efficient in the production of meat than she is producing potatoes, the shape of the PPF
reflects the opportunity cost of any decision to divert more of her resources away from producing meat
to producing potatoes. If Silvia devoted all her time and resources to producing potatoes she could pro-
duce QM, the vertical intercept. If she makes the decision to divert resources to the production of meat
the sacrifice in terms of lost meat output is relatively high compared to the gains in output of potatoes.
The opportunity cost of shifting resources from meat to potatoes is high in terms of the sacrifice in meat
output she makes to secure a relatively small amount of additional potatoes as shown by the move from
point A to point B.
Johan’s situation is the reverse of this and is shown in panel (b). If Johan allocates all resources to
producing potatoes, he produces QP. If he diverts resources away from potato production towards meat
production he sacrifices a relatively large amount of output of potatoes to gain a relatively small amount of
meat. The opportunity cost of diverting resources to meat for Johan is high, therefore.