Ch3- INTERDEPENDENCE AND THE GAINS FROM TRADE

• 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 neighbours
and why nations trade with other nations.
• What exactly do people gain when they trade with one another?
• Why do people choose to become interdependent?

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PRODUCTION POSSIBILITIES
• Production possibilities frontier: A graph that shows the
combinations of output that the economy can possibly produce
given the available factors of production and the available
production technology.

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PRODUCTION EFFICIENCY

• Production efficiency means that there are no missed

opportunities in production; there is no way to produce more of
one good without producing less of some other good.
• Points on PPF achieve production efficiency.
• At any point inside the frontier, such as at point D, production
is inefficient.
• At D, resources are either unemployed or misallocated (i.e. they
are assigned to tasks for which they are not the best match). If
we produce inside PPF like D, we can use our resources more
efficiently to produce more computers or more cars or more of
both computers and cars.

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TRADEOFF ALONG THE PPF

• Every choice along the PPF involves a tradeoff.

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 OPPORTUNITY COST
• The true cost of any good is not just the amount of money it
costs to buy, but everything else in addition to money that must
be given up in order to get the good- opportunity cost. The
PPF makes the concept of opportunity cost precise. On the PPF,
if we want to produce more of one good, we have to give up
production of the other good. The opportunity cost of
producing more cars is the amount of computers we have to
give up.

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INCREASING OPPORTUNITY COST
• The shape of the PPF reflects the assumption about how
opportunity costs change as the mix of output changes. With
this bowed-out shape, the economy faces increasing
opportunity cost; the more cars we produce, the
computers we have to give up to produce one more car.
• Why? Many resources are better suited at producing one good
rather than other goods. If we start at A and move to B, we can
shift resources that are more productive in car production, but
as we move from G to E, resources highly productive in car
production become increasingly scarce. To get more cars,
resources more productive in computers will be needed. It will
take more and more of such resources and therefore greater
sacrifices of computers to achieve each incremental increase of 1
unit of car production.

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• If resources were equally efficient in both activities, then PPF
would look like

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ECONOMIC GROWTH
• The expansion of production
possibilities—and increase in the
standard of living—is called
economic growth.
• Two key factors influence economic
growth:
• Technological change- development
of new goods and of better ways of
producing goods and services
• Capital accumulation-growth of
capital resources, which includes
human capital.

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GAINS FROM TRADE
• Gains from trade- mutual gains that individuals can achieve
from specializing in doing different things and trading with one
another.
• A person (or nation) has an absolute advantage if that person
(or nation) can produce more goods with a given amount of
resources than another person (or nation) can. Absolute
advantage arises from differences in productivity.
• A person (or nation) has a comparative advantage producing a
good if that person (or nation) can produce the good at a lower
opportunity cost than anyone else. Because abilities and the
quality of their resources differ, people or nations have different
opportunity costs of producing various goods. Such differences
give rise to comparative advantage.

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GAINS FROM TRADE
• Suppose Frank and Rose each work 8 hrs a day and can devote
this time to growing potatoes, raising cattle or a combination of
the two.
• Suppose, Frank is able to raise cattle and produce meat, but that
he is not very good at it.
• Suppose that Rose is able to grow potatoes, but that her land is
not very well suited for it.
• Frank and Rose 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.
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GAINS FROM TRADE
• Suppose the production opportunities available to Frank
and Rose are given as below:

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GAINS FROM TRADE
• Frank has lower opportunity cost of producing potatoes compared
to Rose, therefore
• has a comparative advantage in producing potatoes

• Rose has lower opportunity cost of producing meat compared to

Frank, therefore
• has a comparative advantage in producing meat

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FIGURE 3.2
How Trade Expands the Set of Consumption Opportunities

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COMPARATIVE ADVANTAGE: THE DRIVING FORCE OF
SPECIALIZATION
COMPARATIVE ADVANTAGE AND TRADE
• The gains from specialization and trade are based not on
absolute advantage but rather on comparative advantage.
• When each person specializes in producing the good for which
he or she has a comparative advantage, total production in the
economy rises.
• Each benefits from trade by obtaining a good at a price that is
lower than his or her opportunity cost of that good.

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COMPARATIVE ADVANTAGE: THE DRIVING FORCE OF
SPECIALIZATION
COMPARATIVE ADVANTAGE AND TRADE (CONTINUED)
• The moral of the story:
Trade can benefit everyone in society because it
allows people to specialize in activities in which
they have a comparative advantage.

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COMPARATIVE ADVANTAGE: THE DRIVING FORCE OF
SPECIALIZATION
THE PRICE OF TRADE
• What determines the price at which trade takes place?
• How are the gains from trade shared between the trading
parties?
• For both parties to gain from trade, the price at which they
trade must lie between the two opportunity costs.

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• In our example, Frank and Rose agreed to trade at a rate of 3 kg of potatoes for each 1 kg
of meat. This price is between Rose’s opportunity cost (2 kg of potatoes per 1 kg of meat)
and Frank’s opportunity cost (4 kg of potatoes per 1 kg of meat). The price need not be
exactly in the middle for both parties to gain, but it must be somewhere between 2 and
4. To see why the price has to be in this range, consider what would happen if it were not.
• If the price of 1 kg of meat was below 2 kg of potatoes, both Frank and Rose would want
to buy meat, because the price would be below their opportunity costs. Similarly, if the
price of meat was above 4 kg of potatoes, both would want to sell meat, because the
price would be above their opportunity costs.
• But there are only two members of this economy. They cannot both be buyers of meat,
nor can they both be sellers. Someone has to take the other side of the deal. A mutually
advantageous trade can be struck at a price between 2 and 4. In this price range, Rose
wants to sell meat to buy potatoes, and Frank wants to sell potatoes to buy meat.

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