1. Interdependence and the Gains from Trade
Ashesi University, Spring 2011
Prof .S. Armah
Week 3: Chapter 3 of Mankiw
ch3
Interdependence and the Gains from Trade

2. Explore the possibilities
Consider your typical day:
You wake up to an alarm clock made in Taiwan.
You pour yourself orange juice made from Florida oranges and cocoa from beans grown in Ghana.
You put on some clothes made of cotton grown in Georgia and sewn in factories in China.
You watch the morning news broadcast from New York on your Samsung TV made in Korea.
You drive to class in a car made of parts manufactured in a half-dozen different countries.

3. . . . and you haven’t been up for more than two hours yet!

4. Interdependence and the Gains from Trade
Remember, economics is the study of how societies produce and distribute goods in an attempt to satisfy the wants and needs of its members. 2

5. Interdependence and the Gains from Trade
How do we satisfy our wants and needs in a global economy?
We can be economically self-sufficient.
We can specialize and trade with others, leading to economic interdependence.
A process whereby an increased portion of economic or other activity is carried out across national borders
Globalization (or globalisation) describes an ongoing process by which regional economies, societies, and cultures have become integrated through a globe-spanning network of communication and trade
WHAT DO YOU
UNDERSTAND
BY THE TERM
GLOBALIZATION 3

6. Interdependence and the Gains from Trade
Individuals and nations rely on specialized production and exchange as a way to address problems caused by scarcity.
But this gives rise to two questions:
Why is interdependence the norm?
What determines production and trade?
Who gets selected to produce?
What is the criterion for this selection
Globalization (or globalisation) describes an ongoing process by which regional economies, societies, and cultures have become integrated through a globe-spanning network of communication and trade 4

7. Interdependence and the Gains from Trade
Why is interdependence the norm?
Interdependence occurs because people are better off when they specialize and trade with others.
Specialization rests in reduced costs (efficiency) which in turn emanates from “learning by doing” and scale economies
What determines the pattern of production and trade?
Patterns of production and trade are based upon differences in opportunity costs.

8. A PARABLE FOR THE MODERN ECONOMY
Imagine . . .
only two goods: potatoes and meat
only two people: a potato farmer and a cattle rancher
What should each produce?
Why should they trade?
How should they decide?
What if one person is better at
producing both goods?
A “Jack of all trades”?

9. Table 1 The Production Opportunities of the Farmer and Rancher
TOTAL TIME = 8HRS
Copyright © South-Western

10. Production Possibilities
Self-Sufficiency
By ignoring each other:
Each consumes what they each produce.
(Operation Feed Your self in Ghana; The India Experiement)
The production possibilities frontier is also the consumption possibilities frontier.
Without trade, economic gains are diminished. 8

11. Figure 1 The Production Possibilities Curve
(a) The Farmer ’
s Production Possibilities Frontier
Meat (ounces)
If there is no trade,
the farmer chooses
this production and
consumption. 8 32 A 4 16
Potatoes (ounces)
Copyright©2003 Southwestern/Thomson Learning

12. Figure 1 The Production Possibilities Curve
(b) The Rancher ’
s Production Possibilities Frontier
Meat (ounces) 48 24
If there is no trade,
the rancher chooses
this production and
consumption. B 12 24
Potatoes (ounces)
Copyright©2003 Southwestern/Thomson Learning

13. Specialization and Trade
The Farmer and the Rancher Specialize and Trade
Each would be better off if they specialized in producing the product they are more suited to produce, and then trade with each other.
The farmer should produce potatoes.
The rancher should produce meat.
Definition of comparative advantage: the ability to produce a good at a lower opportunity cost than another producer.
a. The farmer has a lower opportunity cost of producing potatoes and therefore has a comparative advantage in the production of potatoes.
b. The rancher has a lower opportunity cost of producing meat and therefore has a comparative advantage in the production of meat.
3. Because the opportunity cost of producing one good is the inverse of the opportunity cost of producing the other, it is impossible for a person to have a comparative advantage in the production of both goods.
C. Comparative Advantage and Trade
1. When specialization in a good occurs (assuming there is a comparative advantage), total output will grow.
2. As long as the opportunity cost of producing the goods differs across the two individuals, both can gain from specialization and trade.
a. The farmer buys 5 ounces of meat with 15 ounces of potatoes. This implies that the price of each ounce of meat is three ounces of potatoes, which is lower than the farmer's opportunity cost of four ounces of potatoes. Trade is beneficial to the farmer.
b. The rancher buys 15 ounces of potatoes for 5 ounces of meat. The price of each ounce of potatoes is one-third ounce of meat. This is lower than the rancher's opportunity cost of one-half ounce of meat. Trade also benefits the rancher.
D. The Price of the Trade
1. For both parties to gain from trade, the price at which they trade must lie between the opportunity costs.
2. In our example, the farmer and the rancher must trade at the rate of between 2 and 4 ounces of potatoes for each of meat.
Why? 10

14. Table 2 The Gains from Trade: A Summary
Role Play
2 STUDENTS
FARMER AND RANCHER
PAGE 48-52
Copyright © South-Western

15. Table 2 The Gains from Trade: A Summary
Copyright © South-Western

16. Figure 2 How Trade Expands the Set of Consumption Opportunities
(a) The Farmer ’
s Production and Consumption
Meat (ounces)
Farmer's
consumption
with trade
Farmer's
production and
consumption
without trade 8 32 A* 5 17 4 16 A
Farmer's
production
with trade
Potatoes (ounces)
Copyright©2003 Southwestern/Thomson Learning

17. Figure 2 How Trade Expands the Set of Consumption Opportunities
(b) The Rancher ’
s Production and Consumption
Meat (ounces)
Rancher's
production
with trade 48 24
Rancher's
consumption
with trade 12 18 13 27
Rancher's
production and
consumption
without trade B* 12 24 B
Potatoes (ounces)
Read page 54 paragraph 3
Copyright © South-Western

18. THE PRINCIPLE OF COMPARATIVE ADVANTAGE
Differences in the (opportunity costs) of production determine the following:
Who should produce what?
How much should be traded for each product?
Who can produce potatoes at a lower cost--the farmer or the rancher? 11

19. THE PRINCIPLE OF COMPARATIVE ADVANTAGE
Differences in Costs of Production
Two ways to measure differences in costs of production:
The number of hours required to produce a unit of output (for example, one pound of potatoes).
--Absolute advantage
The opportunity cost of sacrificing one good for another.---comparative advantage

20. Absolute Advantage
The comparison among producers of a good according to their productivity—absolute advantage
Describes the productivity of one person, firm, or nation compared to that of another.
The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good. 13

21. Absolute Advantage
The Rancher needs only 10 minutes to produce an ounce of potatoes, whereas the Farmer needs 15 minutes.
The Rancher needs only 20 minutes to produce an ounce of meat, whereas the Farmer needs 60 minutes.
The Rancher has an absolute advantage in the production of both meat and potatoes.

22. Opportunity Cost and Comparative Advantage
Compares producers of a good according to their opportunity cost.
Whatever must be given up to obtain some item
The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good. 14

23. Comparative Advantage and Trade
Who has the absolute advantage?
The farmer or the rancher?
Who has the comparative advantage? 15

24. Table 3 The Opportunity Cost of Meat and Potatoes

25. Comparative Advantage and Trade
The Rancher’s opportunity cost of an ounce of potatoes is ½ an ounce of meat, whereas the Farmer’s opportunity cost of an ounce of potatoes is ¼ an ounce of meat.
The Rancher’s opportunity cost of a pound of meat is only 2 ounces of potatoes, while the Farmer’s opportunity cost of an ounce of meat is only 4 ounces of potatoes...

26. Comparative Advantage and Trade
…so, the Rancher has a comparative advantage in the production of meat but the Farmer has a comparative advantage in the production of potatoes.

27. THE PRINCIPLE OF COMPARATIVE ADVANTAGE
Definition of comparative advantage: the ability to produce a good at a lower opportunity cost than another producer.
a. The farmer has a lower opportunity cost of producing potatoes and therefore has a comparative advantage in the production of potatoes.
The rancher has a lower opportunity cost of producing meat and therefore has a comparative advantage in the production of meat.
Because the opportunity cost of producing one good is the inverse of the opportunity cost of producing the other, it is impossible for a person to have a comparative advantage in the production of both goods.

28. Comparative Advantage and Trade
Comparative advantage and differences in opportunity costs are the basis for specialized production and trade.
Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade.
Where the difference in opportunity cost is zero trade is not better or worse than the no trade situation (Autarky) 16

29. Comparative Advantage and Trade
Benefits of Trade
Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage.
I NEED A VOLUNTEER TO READ PAGE 54
And 55 (FYI) OF THE TEXTBOOK
The gains from specialization and trade are based not on absolute advantage but on comparative advantage. When a person specializes in producing the goods for which he or she has a comparative advantage, total production in the economy rises.
Gains from trade has another explanation when considered in terms of opportunity cost. For the reason that both the farmer and the rancher have different opportunity costs they both think they are getting a bargain in terms of the price they actually pay for the good. Each of them think they are getting a price lower than his/her opportunity cost for the good. This makes sense because the good was produced by that trading partner who has the lowest opportunity cost for producing the good. 17

30. Comparative Advantage and Trade
Questions Still Answered and Beyond the Scope of this Chapter
1) What determines the price at which trade takes place? (lies between the 2 OC numbers)
2) How are the gain from trade distributed among the trading partners
The gains from specialization and trade are based not on absolute advantage but on comparative advantage. When a person specializes in producing the goods for which he or she has a comparative advantage, total production in the economy rises.
Gains from trade has another explanation when considered in terms of opportunity cost. For the reason that both the farmer and the rancher have different opportunity costs they both think they are getting a bargain in terms of the price they actually pay for the good. Each of them think they are getting a price lower than his/her opportunity cost for the good. This makes sense because the good was produced by that trading partner who has the lowest opportunity cost for producing the good. 17

31. FYI—The Legacy of Adam Smith and David Ricardo
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.

32. APPLICATIONS OF COMPARATIVE ADVANTAGE
Should Tiger Woods Mow His Own Lawn?
Should Sarkodie
go to College? ? ? ?

33. APPLICATIONS OF COMPARATIVE ADVANTAGE
Should the United States Trade with Other Countries?
Should the GHANATrade with Other Countries?
Should the CHINATrade with Other Countries?
Each country has many citizens with different interests. International trade can make some individuals worse off, even as it makes the country as a whole better off.
Imports—goods produced abroad and sold domestically
Exports—goods produced domestically and sold abroad

34. Summary
Each person consumes goods and services produced by many other people both in our country and around the world.
Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services.

35. Summary
There are two ways to compare the ability of two people producing a good.
The person who can produce a good with a smaller quantity of inputs has an absolute advantage.
The person with a smaller opportunity cost has a comparative advantage.

36. Summary
The gains from trade are based on comparative advantage, not absolute advantage.
Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage.
The principle of comparative advantage applies to countries as well as people.