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Interdependence and the

Gains from Trade
 A Parable for the Modern Economy
• Two goods: meat and potatoes
• Two people: rancher and farmer
• If rancher produces only meat
– And farmer produces only potatoes
– Both gain from trade
• If both rancher and farmer produce both
meat and potatoes
– They still gain from specialization and trade

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 1
The production possibilities frontier (a)

(a) Production Opportunities

Minutes needed to Amount produced in

Make 1 ounce of: 8 hours
Meat Potatoes Meat Potatoes
Farmer 60 min/Kg 15 min/Kg 8 Kg 32 Kg
Rancher 20 min/Kg 10 min/Kg 24 Kg 48 Kg

Panel (a) shows the production opportunities available to the

farmer and the rancher.

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 1
The production possibilities frontier (b, c)
(b) The farmer’s production (c) The rancher’s production
Meat (Kg)possibilities frontier Meat (Kg) possibilities frontier

24 If there is no trade, the

If there is no trade, the farmer rancher chooses this
chooses this production and production and consumption.
consumption.
8
12 B

4 A

0 16 32 0 24 48
Potatoes (Kg) Potatoes (Kg)
Panel (b) shows the combinations of meat and potatoes that the farmer can
produce. Panel (c) shows the combinations of meat and potatoes that the rancher
can produce. Both production possibilities frontiers are derived assuming that the
farmer and rancher 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 4
 A Parable for the Modern Economy
• Specialization and trade
– Farmer – specialize in growing potatoes
• More time growing potatoes
• Less time raising cattle
– Rancher – specialize in raising cattle
• More time raising cattle
• Less time growing potatoes
– Trade
• 5 Kg of meat for 15 Kg of potatoes
– Both gain from specialization and trade
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 2
How trade expands the set of consumption
opportunities
(a) The farmer’s (a, b)
production (b) The rancher’s production
Meat (Kg) and consumption Meat (Kg) and consumption
Farmer's Rancher’s Rancher’s
production and 24 production production and
consumption Farmer's with trade consumption
without trade 18 without trade
consumption
8 with trade 13 B*
A* 12 Rancher’s
5 Farmer's B
consumption
4 production with trade
A with trade

0 16 17 32 0 12 24 27 48
Potatoes (Kg) Potatoes (Kg)
The proposed trade between the farmer and the rancher offers each of them a
combination of meat and potatoes that would be impossible in the absence of
trade. In panel (a), the 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 to consume more meat and more potatoes. 6
 2
How trade expands the set of consumption
opportunities (c)
(c) The gains from trade: A summary

Farmer Rancher
Meat Potatoes Meat Potatoes
Without trade:
Production and consumption 4 Kg 16 Kg 12 Kg 24 Kg
With trade:
Production 0 Kg 32 Kg 18 Kg 12 Kg
Trade Gets 5 Kg Gives 15 Kg Gives 5 Kg Gets 15 Kg
Consumption 5 Kg 17 Kg 13 Kg 27 Kg
GAINS FROM TRADE:
Increase in consumption +1 Kg +1 Kg +1 Kg +3 Kg

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 Comparative Advantage
• Absolute advantage
– Produce a good using fewer inputs than
another producer
• Opportunity cost
– Whatever must be given up to obtain some
item
– Measures the trade-off between the two
goods that each producer faces

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 1
The opportunity cost of meat and potatoes

Opportunity cost of:

1 Kg of Meat 1 Kg of Potatoes
Farmer 4 Kg potatoes ¼ Kg meat
Rancher 2 Kg potatoes ½ Kg meat

Farmer
•Produce 1 Unit of Meat by sacrificing 4 Units of Potatoes.
•Produce 1 Unit of potatoes by sacrificing 1/4 Units of Meat.
Rancher
•Produce 1 Unit of Meat by sacrificing 2 Units of Potatoes.
•Produce 1 Unit of potatoes by sacrificing 1/2 Units of Meat

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 Comparative Advantage
• Comparative advantage
– Produce a good - lower opportunity cost than
another producer
– Reflects - relative opportunity cost
• Principle of comparative advantage
– Each good - produced by the individual that
has the smaller opportunity cost of producing
that good

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 Comparative Advantage
• One person
– Can have absolute advantage in both goods
– Cannot have comparative advantage in both
goods
• For different opportunity costs
– One person - comparative advantage in one
good
– The other person - 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 – better off

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

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Applications of Comparative Advantage
• Should Tiger Woods mow his own lawn?
– Woods
• Mow his lawn in 2 hours
• Film a TV commercial and earn $10,000 (2 hours)
– Forrest Gump
• Mow Woods’s lawn in 4 hours
• Work at McDonald’s and earn $20 (4 hours)

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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
• Principle of comparative advantage
– Each good – produced by the country
• Smaller opportunity cost of producing that good
• Specialization and trade
• All countries – greater prosperity
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