CHAPTE

R 3
International trade
(Interdependence and
gains )
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© 2009 South-Western, a part of Cengage Learning, all rights reserved

Interdependence and the Gains from
Trade
Consider your typical day:
You wake up to an alarm clock made in Korea
You pour yourself coffee from beans grown in
Brazil
You put on some clothes made of cotton
grown in Georgia and sewn in factories in
Thailand
You watch the morning news broadcast on
your TV made in Japan
. . . and you haven’t been up for more than two
hours yet!
Interdependence and the Gains from
Trade

• Remember, economics is the study of how

societies manage scarcity, produce and
distribute goods in an attempt to satisfy the
wants and needs of its members.
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
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:

[Link] exactly do people gain when they trade with

one another?

2. Why do people choose to become

interdependent?
A PARABLE FOR THE MODERN
ECONOMY

Imagine . . .
•only two goods: potatoes and meat
•only two people: a potato farmer and a
cattle rancher
[Link] should each produce?
[Link] should they trade?
A PARABLE FOR THE MODERN
ECONOMY

• Imagine 1st scenario.. .

• A rancher produces only meat
• A farmer produces only potatoes

1. They decide not to trade

After several months, they got bored
2. They decide to trade
Obviously they enjoy now greater diversity
A PARABLE FOR THE MODERN
ECONOMY

• Imagine 2nd scenario...

• A rancher produces meat and potatoes but the
latter at a great cost.
• A farmer produces potatoes and meat but the
latter at a great cost.
• In this case too, it is easy to see that it is
better for both of them to specialize in their
fields and to trade with each other.
Table 1 The Production Opportunities of
the Farmer and Rancher

Hours needed to make 1 Amount produced in 40

pound of: hours (hrs):

Meat Potatoes Meat Potatoes

Farmer 20 hrs/lb 10hrs/lb 2 lbs 4 lbs

Rancher 1 hour/lb 8hrs/lb 40 lbs 5 lbs

Production Possibilities
Frontier
1. 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.
Figure 1 The Production Possibilities
Curve
(a) The Farmer’s Production Possibilities
Frontier

Meat (pound)

If there is no trade, the

farmer chooses this
2 production and
consumption

1 A

0 2
4 Potatoes (pound)
Figure 1 The Production Possibilities
Curve
(b) The Rancher’s Production Possibilities
Frontier
40
Meat (pounds)
If there is no trade,
the rancher chooses
this production and
consumption

20 B

0 2½ 5
Potatoes
(pounds)
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. Why?
THE PRINCIPLE OF COMPARATIVE
ADVANTAGE

• Differences in the costs of production

determine the following:

1. Who should produce what?

2. How much should be traded for each product?
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
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.
Absolute Advantage
Hours needed to make 1 Amount produced in 40
pound of: hours (hrs):

Meat Potatoes Meat Potatoes

Farmer 20 hrs/lb 10hrs/lb 2 lbs 4 lbs

Rancher 1 hour/lb 8hrs/lb 40 lbs 5 lbs

• The Rancher needs only 8 hours to produce a

pound of potatoes, whereas the Farmer needs
10 hours.
• The Rancher needs only 1 hour to produce one
pound
Even ofRancher
if the meat, whereas the Farmer
has an absolute needs 20
advantage in
hours.
the production of both meat and potatoes, it is still
beneficial for him to trade. Why?
Opportunity Cost and Comparative
Advantage
• Compares producers of a good according to their
opportunity Costs: 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.
Hours needed to make 1 Amount produced in 40
pound of: hours:

Meat Potatoes Meat Potatoes

Farmer 20 hours/lb 10hrs/lb 2 lbs 4 lbs

Rancher 1 hour/lb 8hrs/lb 40 lbs 5 lbs

Who has the comparative advantage (lowest opportuni

cost)?

TableOpportunity
2-Opportunity
cost of: costs

1 pound of Meat (M) 1 pound of Potatoes(P)

Farmer 2 lbs potatoes ½ lb meat

Rancher 1/8 lb potatoes 8 lb meat

Comparative Advantage
and Trade
The Rancher’s opportunity cost of one pound of
potatoes is 8 pounds of meat, whereas the Farmer’s
opportunity cost of one pound of potatoes is
½pound of meat
The farmer has a lower opportunity cost of producing
potatoes

The Rancher’s opportunity cost of a pound of meat is

only 1/8 pound of potatoes, while the Farmer’s
opportunity cost of one pound of meat is 2 pound of
potatoes.
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

The no-trade relative price of one good

equals the opportunity cost of its production.
The trade relative price must lie between the
two opportunity costs.
Comparative Advantage and
Trade
 Relative price of meat for the farmer or the rancher =
opportunity cost of meat in a competitive framework
1. The relative price of meat for the farmer is PM/Pp =
Opportunity cost of Meat = 2 lbs Potatoes.
2. The relative price of meat for the rancher is PM/Pp =
Opportunity cost of Meat = 1/8 lbs Potatoes

Therefore, the rancher would want to trade meat for

potatoes —he/she can make it for 1/8 lbs Potatoes and
sell it for more than 1/8 lbs Potatoes . The opposite is
true for potatoes.
 So If they decide to trade, the equilibrium relative price
of meat has to be >1/8 and <2 lbs Potatoes. 22
Benefits of 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
Benefits from trade.
of Trade
Trade can benefit everyone in a society because
it allows people to specialize in activities in
which they have a comparative advantage.
FYI—The Legacy of Adam Smith and
David Ricardo
Adam Smith
•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
Let’s practise
 Maria can read 20 pages of economics in an hour.
She can also read 50 pages of sociology in an hour.
She spends 5 hours per day studying.
 a. Draw Maria’s production possibilities frontier for
reading economics and sociology (economics in the
vertical axis).
 b. What is Maria’s opportunity cost of reading 1 page
of sociology?
 c. What is Maria’s opportunity cost of reading 100
pages of sociology? (compute it using 2 different
ways.)
25
Answer
 a- If Maria spends all 5 hours studying
economics, she can read 100 pages, so that is
the vertical intercept of the production
possibilities frontier. If she spends all 5 hours
studying sociology, she can read 250 pages

26
Answer
 b.

Opportunity cost of 1 page of sociology = 100/250 page

of Economics = 2/5 page of Economics
27
Answer
 c-
 1st method: using b
Opportunity cost of 1 page of sociology = 2/5 page of
Economics.

Opportunity cost of 100 pages of sociology = (2/5)*100

pages of Economics = 40 pages of Economics
 2nd method
It takes Maria 2 hours to read 100 pages of sociology. In
that time, she could read 40 pages of economics. So the
opportunity cost of 100 pages of sociology is 40 pages of
economics.
28
APPLICATIONS OF
COMPARATIVE ADVANTAGE
Canada Trade agreements? (NAFTA
USMCA ?)
[Link]
BkKPI
 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
Each country is exporting the good for which it has the
 Exports—goods produced domestically and sold
comparative advantage (problem 2 in questions set).
abroad
Let’s practise
China United States
Pairs of boots 2 16
produced per
hour
Numbers of 1 10
programs
produced per
hour
1. Which country has a comparative advantage in the production
of boots?

2. Provide the range of the international relative price of program at

which the two countries would trade.

3. Suppose that researchers in US discover a new technology that

doubles the marginal product of labor in boots. Would China
30
and US continue to trade using the same terms?
Answer
 1. O.C of boots (US) = 10/16 programs = 5/8
programs
 O.C of boots (China) = ½ programs lower than O.C
of boots in US so China has a comparative
advantage in the production of boots.
 2. the international relative price of program (P*p)
has to lie between the 2 O.C of programs.
 O.C of programs (US) = 16/10 = 8/5 boots
 = O.C of programs (China) = 2/1 = 2 boots
 8/5 boots < P*p < 2 boots
31
Answer
3. The new table:
China United States
Pairs of boots 2 32
produced per
hour
Numbers of 1 10
programs
produced per
hour

O.C of boots (US) = 10/32 programs = 5/16 programs

O.C of boots (China) = ½ programs greater than O.C of
boots in US so US has a comparative advantage in the
production of boots meaning that US would export boots to
China and import programs from China. 32