1. Interdependence and the Gains from Trade19
Interdependence and the Gains from Trade
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2. Interdependence and the Gains from Trade
Consider your typical day:
You wake up to an alarm clock made in China.
You pour yourself orange juice made from Brazilian oranges and coffee from beans grown in Costa Rica.
You put on some clothes made of cotton grown in Egypt and sewn in factories in Morocco.
You watch the morning news broadcast from London on your TV made in Malaysia.
You drive to class in a car made of parts assembled in Slovakia using components from half a dozen different countries.
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3. The Production Possibility Frontier
The production possibilities frontier is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology.
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4. The Production Possibilities Frontier
Concepts Illustrated by the Production Possibilities Frontier
Efficiency
Trade-offs
Opportunity Cost
Economic Growth
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5. Figure 1 The Production Possibilities Frontier
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6. Production Possibility Frontier
In figure 1
Production is efficient at points on the curve e.g. points A and C.
Production is inefficient inside the curve e.g. point B.
Production at a point outside of the curve is not possible (e.g. point D) given the economy’s current level of resources and technology.
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7. The Shape of the Production Possibilities Frontier
See figure 2
The shape of the production possibilities frontier indicates that the opportunity cost of consumer goods in terms of capital goods increases as the country produces more consumer goods and fewer capital goods.
Some resources are better suited to the production of consumer goods than capital goods (and vice versa).
The production possibilities frontier can shift if resource availability or technology changes.
The production possibilities frontier simplifies a complex economy to help clarify some basic ideas.
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8. Figure 2 The Shape of the Production Possibilities Frontier
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9. Figure 3a. A Shift in The Production Possibilities Frontier
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10. Figure 3b. A Shift in the Production Possibilities Frontier
Quantity of
Computers
Produced
4,000
3,000
1,000
2,100
750 E
2,000
700 A
Quantity of
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Cars Produced

11. International Trade
How do we satisfy our wants and needs in a global economy?
We can be economically self-sufficient. OR
We can specialize and trade with others, leading to economic interdependence.
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12. A Parable for the Modern Economy
Imagine
Only two goods in an economy: potatoes and meat.
Only two people: a market gardener and a cattle farmer.
What should each produce?
Why should they trade?
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13. A Parable for the Modern Economy
Obvious gains if:
The market gardener can only grow potatoes and the farmer can only raise beef cattle.
The market gardener can raise cattle as well as grow potatoes, but he is not as good at it, and the farmer can grow potatoes in addition to raising cattle, but her land is not well suited for it.
Each faces different opportunity costs (figure 4)
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14. Figure 4 Facing Different Opportunity Costs
Each producer faces different opportunity costs

15. Table 1 The Production Opportunities of the Farmer and Farmer
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16. Production Possibilities
Potion of Self-Sufficiency
By ignoring each other:
Each consumes what they each produce.
The production possibilities frontier is also the consumption possibilities frontier.
Without trade, economic gains are diminished.
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17. Figure 5a. The Production Possibilities Curve for the Gardener
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18. Figure 5b The Production Possibilities Curve for the Cattle Farmer
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19. Specialization and Trade
The gardener and the farmer decide to 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 gardener should produce potatoes.
The farmer should produce meat.
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20. Table 2 The Gains from Trade: A Summary
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21. Figure 6a How Trade Expands the Set of Consumption Opportunities
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22. Figure 6b How Trade Expands the Set of Consumption Opportunities
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23. Table 2 The Gains from Trade: A Summary
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24. The Principle Of Comparative Advantage
Differences in the 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 gardener or the farmer?
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25. The Principle Of Comparative Advantage
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).
The opportunity cost of sacrificing one good for another.
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26. 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.
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27. Absolute Advantage
The farmer needs only 1 hour to produce a kilogram of potatoes, whereas the gardener needs 1.5 hours.
The farmer needs only 2 hours to produce a kilogram of meat, whereas the gardener needs 6 hours.
The farmer has an absolute advantage in the production of both meat and potatoes.
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28. 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.
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29. 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.
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30. Comparative Advantage and Trade
Who has the absolute advantage?
The farmer or the gardener?
Who has the comparative advantage?
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31. Table 3 The Opportunity Cost of Meat and Potatoes
1 kilogram of meat
1 kilogram of potatoes
Gardener
4kg of potatoes
0.25kg of meat
Farmer
2 kg of potatoes
0.5kg of meat

32. Comparative Advantage and Trade
The farmer’s opportunity cost of a kilo of potatoes is ½ of a kilo of meat, whereas the gardener’s opportunity cost of a kilo of potatoes is ¼ a kilo of meat.
The farmer’s opportunity cost of a kilo of meat is only 2 kilos of potatoes, while the gardener’s opportunity cost of a kilo of meat is 4 kilos of potatoes...
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33. Comparative Advantage and Trade
…so, the farmer has a comparative advantage in the production of meat but the gardener has a comparative advantage in the production of potatoes.
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34. 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.
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.
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35. Summary
Production Possibilities Frontiers provide a model to show potential output of goods and services in an economy and the opportunity cost ratios of diverting resources to different uses.
The PPF can shift outwards if countries find ways of improving their factor productivity or exploit factor endowments more effectively.
The shape and position of a PPF is dependent on the productivity of factor inputs and degree of specialization involved in the country in different industries.
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36. 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.
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.
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37. 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.
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