Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Interdependence and Trade Remember, economics is the study of how societies produce and distribute goods to best satisfy the wants and needs of its members.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Interdependence is the norm u People are better off when they specialize and trade with others. Patterns of production and trade are based on differences in opportunity costs.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. u Imagine...  only two goods: potatoes and meat  only two people: a farmer and a rancher A Textbook Economy

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Production Possibilities Frontiers Potatoes (pounds) Meat (pounds) (a) The Farmer’s Production Possibilities Frontier 0 A

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Production Possibilities Frontiers Potatoes (pounds) Meat (pounds) (b) The Rancher’s Production Possibilities Frontier 0 B

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Principle of Comparative Advantage u Who should produce what? u How much should be traded for each product? Who can produce potatoes at a lower cost--the farmer or the rancher? Differences in the costs of production determine

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Opportunity Cost of Meat and Potatoes

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Opportunity costs and willingness to trade n The farmer would gladly trade 1 pound of potatoes for ½ pound of meat or more. n The rancher would gladly trade as much as 8 pounds of meat for 1 pound of potatoes. n Suppose the “terms of trade” settle at 3 pounds of meat per pound of potatoes.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Trade Expands Consumption Possibilities The Farmer specializes in potatoes and trades 1 lb of potatoes for 3 lbs of meat. Potatoes (pounds) Meat (pounds) A 3 3 A* Farmer’s consumption without trade Farmer’s consumption with trade

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Trade Expands Consumption Possibilities : The Rancher produces 24 lbs of meat and 2 lbs of potatoes. He trades 3 lbs of meat for an additional lb of potatoes. Potatoes (pounds) Meat (pounds) B 21 3 B* Rancher’s consumption without trade Rancher’s consumption with trade

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Gains from Trade: A Summary

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Absolute Advantage and Comparative Advantage u The producer who requires a smaller quantity of inputs to produce a good has an absolute advantage in producing that good. u The producer who has the lower opportunity cost producing a good has a comparative advantage in producing that good.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. u Who has the absolute advantage? The farmer or the rancher? u Who has the comparative advantage? The farmer or the rancher?

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u Interdependence and trade allow people to enjoy a greater quantity and variety of goods and services.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u The gains from trade are based on comparative advantage, not absolute advantage. u Comparative advantage applies to countries as well as to people.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Graphical Review

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Production Possibilities Frontiers Potatoes (pounds) Meat (pounds) (a) The Farmer’s Production Possibilities Frontier 0 A

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Production Possibilities Frontiers Potatoes (pounds) Meat (pounds) (b) The Rancher’s Production Possibilities Frontier 0 B

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Trade Expands the Set of Consumption Possibilities Potatoes (pounds) Meat (pounds) (a) How Trade Increases the Farmer’s Consumption 0 A 3 3 A* Farmer’s consumption without trade Farmer’s consumption with trade

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Trade Expands the Set of Consumption Possibilities Potatoes (pounds) Meat (pounds) (b) How Trade Increases The Rancher’s Consumption 0 B 21 3 B* Rancher’s consumption without trade Rancher’s consumption with trade