1. Chapter 3 Interdependence & Gains from Trade

2. Interdependence
Everyday we rely on many people from around the world, most of whom we’ve never met, to provide us with goods and services we enjoy
Principle #5: Trade can make everyone better off
We’ll now explore this principle to learn why people and nations choose to be interdependent, and how they can gain from trade
We’ll do this by using a two-country, two-goods example:
Two countries: Canada and Japan
Two goods: Computers and wheat
One resource: Labour (measured in hours)
We will consider how much of each good each country produces and consumes in two different scenarios
If each country chooses to be self-sufficient
If each trades with the other country

3. Production Possibilities in Canada
Assumptions:
50,000 hours of labour available for production each month
Producing one computer requires 100 hours of labour
Producing one ton of wheat requires 10 hours of labour
The opportunity cost of computers is constant
4,000
100
5,000
2,000
1,000
3,000
500
200
300
400
Computers
Wheat (tons)
Canada can produce 500 computers or 5,000 tons of wheat, or any combination of the two along its linear PPF
Case 1: No Trade
If it uses half its labour to produce each of the two goods, then Canada will produce and consume 250 computers and 2500 tons of wheat

4. Production Possibilities in Japan
Assumptions:
30,000 hours of labour available for production each month
Producing one computer requires 125 hours of labour
Producing one ton of wheat requires 25 hours of labour
The opportunity cost of computers is constant
900
1,200
300
600
240 60
120
180
Computers
Wheat (tons)
Japan can produce 240 computers or 1,200 tons of wheat, or any combination of the two along its linear PPF
Case 1: No Trade
If it uses half its labour to produce each of the two goods, then Japan will produce and consume 120 computers and 600 tons of wheat

5. Can Canada & Japan Gain from Trade?
Without trade
Canadian consumers get 250 computers and 2500 tons of wheat
Japanese consumers get 120 computers and 600 tons of wheat
To see if Canadian and Japanese consumers could be better off (consume more of both goods) if they trade with each other, let’s suppose
Canada instead produces 3,400 tons of wheat
Japan instead produces 240 computers
How would this assumption be reflected on their PPFs?
Canada: 3,400 tons of wheat requires 34,000 labour hours  16,000 labour hours are left to produce computers  160 computers are produced
Japan: 240 computers require 30,000 labour hours  0 labour hours are left to produce wheat  no wheat is produced

6. PPFs with Trade 900 1,200 300 600 240 60 120 180 Computers
Computers
Wheat (tons)
4,000
100
5,000
2,000
1,000
3,000
500
200
300
400
Computers
Wheat (tons)
(240, 0)
Japan
(160, 3,400)
Canada

7. How Much Do Canada & Japan Trade?
To explore this, we first need to define two terms
Exports: Goods produced domestically and sold abroad
To export means to sell domestically produced goods abroad
Imports: Goods produced abroad and sold domestically
To import means to purchase goods produced in other countries
Now let’s also suppose that Canada exports 700 tons of wheat to Japan, and imports 110 computers from Japan.
This must also mean that Japan imports 700 tons wheat and exports 110 computers
Let’s plot this consumption point on the PPF diagrams (which deal with production) for each country

8. Canadian Consumption & Production with Trade
Computers
Wheat (tons)
4,000
100
5,000
2,000
1,000
3,000
500
200
300
400
Computers
Wheat
Produced
+ Imported
– Exported
160
110
3,400
700
= Amount
Consumed
270
2,700
Production
(160, 3,400)
Consumption
(270, 2,700)

9. Japanese Consumption & Production with Trade
900
1,200
300
600
240 60
120
180
Computers
Wheat (tons)
Computers
Wheat
Produced
+ Imported
– Exported
240
110
700
= Amount
Consumed
130
Consumption
(130, 700)
Production
(240, 0)

10. Trade Makes Both Countries Better Off
Canada
Consumption Without Trade
Consumption With Trade
Gains From Trade
Computers
250
270 20
Wheat
2,500
2,700
200
Japan
120
130 10
600
700
100

11. Why Do Both Countries Gain?
Could it be that each country is better at producing one of the goods?
Since Japan produces only computers, are they better at producing them?
Absolute advantage is the ability to produce a good using fewer inputs than another producer
Canada has an absolute advantage in producing wheat
It uses only 10 labour hours to produce a ton of wheat while Japan uses 25
If each country has an absolute advantage in one good and specializes in that good, then both countries can gain from trade
But does Japan have an absolute advantage in computer production?
It uses 125 labour hours to produce one computer while Canada uses 100
No, it does not !!
Japan does not have an absolute advantage in computers
The fact is that Canada has an absolute advantage in both goods !!
So why does Japan specialize in computers?
And why do both countries gain from trade?

12. Where do the Gains Come From?
Answer: Two countries can gain from trade when each specializes in the good it produces at lowest cost
Absolute advantage measures the cost of a good in terms of the inputs required to produce it
But, from Principle #3, we know opportunity cost is another measure of cost
In our example, the opportunity cost of a computer is the amount of wheat production that would have to be given up to produce one computer
This idea leads us to the concept of comparative advantage; the ability to produce a good at a lower opportunity cost than another producer
Which country has the comparative advantage in computers?

13. Opportunity Cost of Computers
To answer this, we must determine the opportunity cost of a computer in each country
The opportunity cost of a computer in Canada is 10 tons of wheat because:
One computer requires 100 hours of labour to produce, and 100 labour hours could have instead produced 10 tons of wheat (see slide 3)
The slope of the PPF for Canada is 10 (5,000 tons of wheat/500 computers)
The opportunity cost of a computer in Japan is 5 tons of wheat because:
One computer requires 125 hours of labour to produce, and 125 labour hours could have instead produced 5 tons of wheat (see slide 4)
The slope of the PPF for Japan is 5 (1,200 tons of wheat/240 computers)
So, Japan has a comparative advantage in computers
Lessons:
Absolute advantage is not comparative advantage
Absolute advantage is not necessary for gains from trade

14. Comparative Advantage and Trade
Gains from trade arise from comparative advantage (differences in opportunity costs)
When each country specializes in the good(s) in which it has a comparative advantage, total production in all countries is higher, the world’s “economic pie” is bigger, and all countries can gain from trade
The same applies to individual producers (like the farmer and the rancher) specializing in different goods and trading with each other

15. Question & Answer
Suppose Argentina and Brazil each have 10,000 hours of labour per month. In Argentina, producing one pound of coffee requires 2 hours while producing one bottle of wine requires 4 hours. In Brazil, producing one pound of coffee requires 1 hour, while producing one bottle of wine requires 5 hours.
Which country has an absolute advantage in the production of coffee?
Brazil has an absolute advantage in coffee
It takes 1 labour hour to produce a pound of coffee in Brazil, but 2 in Argentina
Which country has a comparative advantage in the production of wine?
Argentina has a comparative advantage in wine
Argentina’s opportunity cost of wine is 2 pounds of coffee – 2 pounds of coffee (which require 4 labour hours to produce) must be given up to produce an additional bottle of wine (which also requires 4 labour hours to produce)
Brazil’s opportunity cost of wine is 5 pounds of coffee

16. As Yet Unanswered Questions
We made a lot of assumptions about the quantities of each good that each country produces, trades, and consumes, and the price at which the countries trade wheat for computers
In the real world, these quantities and prices would be determined by the preferences of consumers and the technology and resources available to producers in both countries
We will begin to study this in the next chapter
For now, though, our goal was to show that trade can make everyone better off and to explain the reason why

17. Recap: Interdependence & Gains From Trade
Interdependence and trade allow everyone to enjoy a greater quantity and variety of goods and services
Absolute advantage means being able to produce a good with fewer inputs
Comparative advantage means being able to produce a good at a lower opportunity cost
When people – or countries – specialize in the goods in which they have a comparative advantage, the economic “pie” grows and trade can make everyone better off