1. Interdependence and the Gains from Trade3
Interdependence and the Gains from Trade

2. Why Trade – PPF Model of Trade
DEFINITION of 'Production Possibility Frontier - PPF' A curve depicting all maximum output possibilities for two or more goods given a set of inputs (resources, labor, etc.). The PPF assumes that all inputs are used efficiently.
A production-possibility frontier is a budget constraint presented by the limitation of available factors of production.

3. The production--possibility frontier (PPF) is an expository figure for representing scarcity, cost, and efficiency.

4. How People Interact Principle 5: Trade can make everyone better off
Specialization
Allows each person/country to specialize in the activities he/she does best
People/countries can buy a greater variety of goods and services at lower cost

5. 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

6. The production possibilities frontier (a)1
The production possibilities frontier (a)
(a) Production Opportunities
Minutes needed to
Make 1 ounce of:
Amount produced in
8 hours
Meat
Potatoes
Farmer
Rancher
60 min/oz
20 min/oz
15 min/oz
10 min/oz
8 oz
24 oz
32 oz
48 oz
Panel (a) shows the production opportunities available to the farmer and the rancher.

7. The production possibilities frontier (b, c)1
The production possibilities frontier (b, c)
(b) The farmer’s production
possibilities frontier
(c) The rancher’s production
possibilities frontier
Meat (oz) 4 8
Meat (oz) 12 24
If there is no trade, the rancher chooses this production and consumption.
If there is no trade, the farmer chooses this production and consumption. B A
Potatoes (oz) 16 32
Potatoes (oz) 24 48
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

8. The opportunity cost of meat and potatoes1
The opportunity cost of meat and potatoes
Opportunity cost of:
1 oz of Meat
1 oz of Potatoes
Farmer
Rancher
4 oz potatoes
2 oz potatoes
¼ oz meat
½ oz meat

9. 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
Willing to trade: 3 oz of meat for 1 oz potatoes
Final trade -5 oz of meat for 15 oz of potatoes
Both gain from specialization and trade

10. Farmer’s Gains From Trade
Potatoes
Meat
No Trade
With 32 28 29 1 24 26 2 20 23 3 16 4 12 17 5 8 14 6 11 7

11. Rancher’s Gains From Trade

12. Greg’s Final Solution (text)2
Greg’s Final Solution (text)
(a) The farmer’s production
and consumption
(b) The rancher’s production
and consumption
Meat (oz) 4 8
Meat (oz) 12 24
Farmer's
production and
consumption
without trade
Rancher’s production with trade
Rancher’s production and consumption without trade
Farmer's
consumption
with trade 18 12 13 B* A* 27
Rancher’s consumption with trade B 5
Farmer's
production
with trade 17 A
Potatoes (oz) 16 32
Potatoes (oz) 24 48
Farmer and Rancher agree to trade 5 oz of Meat for 15 oz of Potatoes (3:1)
Start at corners (specialization)

13. How trade expands the set of consumption opportunities (c)2
How trade expands the set of consumption opportunities (c)
(c) The gains from trade: A summary
Farmer
Rancher
Meat
Potatoes
Without trade:
Production and consumption
With trade:
Production
Trade
Consumption
GAINS FROM TRADE:
Increase in consumption
4 oz
0 oz
Gets 5 oz
5 oz
+1 oz
16 oz
32 oz
Gives 15 oz
17 oz
12 oz
18 oz
Gives 5 oz
13 oz
24 oz
Gets 15 oz
27 oz
+3 oz

14. Comparative Advantage
Absolute advantage
Produce a good using fewer inputs than another producer
Rancher: 20 min/1 oz M; 10 min/1 oz P
Farmer: 60 min/ 1 oz M; 15 min/ 1 oz P
Opportunity cost
Measures the trade-off between the two goods that each producer faces
Rancher -1 oz M -> 2 oz P
Farmer: 3 oz P -> -1 oz M

15. The opportunity cost of meat and potatoes1
The opportunity cost of meat and potatoes
Opportunity cost of:
1 oz of Meat
1 oz of Potatoes
Farmer
Rancher
4 oz potatoes
2 oz potatoes
¼ oz meat
½ oz meat

16. 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

17. 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

18. 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

19. 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

20. 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