1. Ch 3: Interdependence and Gains from Trade Intro: --Satisfy your wants by: self sufficiency or specialize and trade --You rely on others around the world every day for the things you need and want. --Those that provide it are NOT acting out of generosity or kindness. They provide goods and services in order to get something in return. -- 1/10 Principles of Economics: Trade can make everyone better off --What exactly do people gain from trade? Why do people choose to become interdependent?

2. Parable for the Modern Economy Simple Economic Example 2 ProducersRancher = Meat and Farmer= Potatoes -- if each could only produce the one good, then trade is quite obvious --Specialization: if rancher can raise cattle AND grow potatoes, but not efficiently and… if farmer can grow potatoes AND raise cattle but not efficiently…..then…. Trade is beneficial if both stick to their specialty But what if the Rancher is better at raising cattle AND growing potatoes,……shouldn’t he choose to be self sufficient?

3. Production Possibilities Read along and study Table 3-1 and Figure 3-1 ----------------------------------------------------------------------- Farmer 20 hours = 1lb meat 10 hours = 1lb potatoes Rancher 1 hour = 1lb meat 8 hours = 1lb potatoes ------------------------------------------------------------------------ Farmer 40 hours = 2lb meat or 4lb potatoes Rancher 40 hours = 40lb meat or 5lb potatoes ------------------------------------------------------------------------ Key Ideas Production possibilities frontier (also the consumption possibilities frontier if they remain self sufficient and do not trade) principle of tradeoffs

4. Prod. Poss. Frontier = linear not bowed b/c…… Constant opportunity costs …..technology allows them to switch from one good to another at a constant rate But ……What will they choose? ……. Need to know their TASTES …….see pt. A + B in Fig 3-1

5. What will they choose? Specialization and Trade Read and study Fig 3-2 and Table 3-2 What are the big ideas ???? Free Trade and Specialization Increased productivity, choices, increased standard of living #1 Quick Quiz pg. 52 -

6. coconuts fish Limited to the frontier – by himself Can achieve greater combination of goods if specializes and trades

7. The Key is to understand Comparative Advantage ….but first define Absolute Advantage – Requires smaller amount of inputs (or – given same inputs – can produce more) Farmer 20 hours = 1lb meat 10 hours = 1lb potatoes Rancher 1 hour = 1lb meat 8 hours = 1lb potatoes ----------------------------------------------------------------- Farmer 40 hours = 2lb meat or 4lb potatoes Rancher 40 hours = 40lb meat or 5lb potatoes

8. Rancher has absolute advantage in both Opportunity Cost and Comparative Advantage Opportunity cost – what is given up Read along and study table 3-3

9. Farmer 20 hours = 1lb meat 10 hours = 1lb potatoes If farmer wants 1lb meat, his O.C. = 2lb potatoes If farmer wants 1lb potatoes, his O.C. = ½ lb meat ====================================== Rancher 1 hour = 1lb meat 8 hours = 1lb potatoes If Rancher wants 1lb meat, his O.C. = 1/8 lb potatoes If Rancher wants 1lb potatoes, his O.C. = 8lb of meat ======================================= Define Comparative advantage- The producer who gives up less of Y in order to produce X is said to have the comparative advantage in producing X Farmer = comp. advantage for potatoes Rancher = comp. advantage for meat

10. Impossible for same person to have a comp. advantage for both goods, b/c the opp. Cost of Y is the inverse of the opp. cost of X Comparative Advantage and Trade When you specialize in producing X (with a comparative advantage), total production in the economy rises As long as two people have different opp. costs, each can benefit from trade by obtaining a good at a price lower than his opp. cost of that good. #2 Quick Quiz pg. 55 draw and show all work

11. Crusoe Friday 10 coconuts/hr 1 fish / hr 30 coconuts/hr 2 fish/hr

12. Crusoe’s OC of 1 fish 10 coconuts/hr = 10 coconuts 1 fish/hr Friday’s OC of 1 fish 30 coconuts/hr = 15 coconuts 2 fish/hr Absolute advantage for fish? Friday (2 / hr vs. 1 / hr) Absolute advantage for coconuts? Friday (30/ hr vs. 10/ hr) Comparative advantage for fish? Crusoe- he has a lower OC of catching 1 fish (he only gives up 10 coconuts vs. 15 ) He should specialize in catching fish and trade for coconuts --Continue on next slide ***HELPFUL HINT*** given two goods ( X, Y ) – when finding the o.c. of X – always put X as the denominator

13. Crusoe’s OC of 1 coconut 1 fish/hr= 1/10 of fish 10 coconuts/hr Friday’s OC of 1 coconut 2 fish/hr= 1/15 of fish 30 coconuts/hr Comparative advantage for coconuts? Friday has the lower OC of gathering coconuts (he only gives up 1/15 of fish vs. 1/10) He should specialize in gathering coconuts and trade for fish