GAINS FROM TRADE
ETP Economics 101
Lecturer: Jack Wu
RECALL

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.
SHAPE OF PRODUCTION
POSSIBILITIES FRONTIER
Concave curve (bowed outward):
The opportunity cost of producing one good
increases as the production of this good rises.
REASON:
Some resources are better suited to the production
of this good than another good (and vice versa).
 Straight line:
The opportunity cost of producing one good is
constant as the production of this good rises.

NOW

Let’s use the “Production Possibilities Frontier”
to analyze trade problems.
AUTARKY OR TRADE?

How do we satisfy our wants and needs in a
global economy?
We can be economically self-sufficient (Autarky).
 We can specialize and trade
with others, leading to
economic interdependence.

CASE 1
only two goods: potatoes and meat
 only two people: a potato farmer and a cattle
rancher
 Each only works 8 hours/day

What should each produce?
 Why should they trade?

CASE 1 (CONTINUED)
Minutes needed to make 1 ounce of
___________________________________
Meat
Potatoes
___________________________________
Farmer
60min/oz
15min/oz
Rancher
20min/oz
10min/oz

CASE 1 (CONTINUED)
Amounts produced in 8 hours
___________________________________
Meat
Potatoes
___________________________________
Farmer
8 oz
32 oz
Rancher
24 oz
48 oz

THE FARMER’S PRODUCTION POSSIBILITIES FRONTIER
(a) The Farmer ’s Production Possibilities Frontier
Meat (ounces)
8
0
32
Potatoes (ounces)
THE RANCHER’S PRODUCTION POSSIBILITIES FRONTIER
(b) The Rancher ’s Production Possibilities Frontier
Meat (ounces)
24
0
48
Potatoes (ounces)
OPPORTUNITY COST

Opportunity cost
Whatever must be given up to obtain some item
 Measures the trade-off between the two goods that
each producer faces

OPPORTUNITY COSTS
1oz of meat
1oz of potatoes
Farmer
4 oz of potatoes
¼ oz of meat
Rancher
2 oz of potatoes
½ oz of meat
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.

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.
APPLICATION

Should Tiger Woods mow his own lawn?

Woods
Mow his lawn in 2 hours
 Film a TV commercial and earn $10,000 (2 hours)

QUICK QUIZ 1
Who has the absolute advantage?
 The farmer or the rancher?

Who has the comparative advantage?
 The farmer or the rancher?

SPECIALIZATION AND TRADE

Comparative advantage and differences in
opportunity costs are the basis for specialized
production and trade.
QUICK QUIZ 2
What should farmer produce (or specialize in)?
 What should rancher produce (or specialize in)?

BENEFITS OF 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.
SELF-SUFFICIENCY (AUTARKY)

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.

SELF-SUFFICIENCY (AUTARKY)

Assume: Farmer spends 4 hours on meat and 4
hours on potatoes. Rancher spends 4 hours on
meat and 4 hours on potatoes.
WITHOUT TRADE


Production: Farmer produces 4 oz of meat and 16
oz of potatoes. Rancher produces 12 oz of meat
and 24 oz of potatoes.
Consumption: Farmer consumes 4 oz of meat and
16 oz of potatoes. Rancher consumes 12 oz of
meat and 24 oz of potatoes.
THE FARMER’S PRODUCTION AND CONSUMPTION WITHOUT
TRADE
(a) The Farmer’s Production and Consumption
Meat (ounces)
Farmer's
production and
consumption
without trade
8
4
A
0
32
Potatoes (ounces)
16
Copyright©2003 Southwestern/Thomson Learning
THE RANCHER’S PRODUCTION AND CONSUMPTION WITHOUT
TRADE
(b) The Rancher’s Production and Consumption
Meat (ounces)
24
B
12
0
24
Rancher's
production and
consumption
without trade
48
Potatoes (ounces)
Copyright © 2004 South-Western
PROPOSALS FOR SPECIALIZATION
Farmer devotes all his time to growing potatoes.
 Rancher spends 6 hours a day raising cattle and
2 hours growing potatoes.

PRODUCTION WITH TRADE
Farmer’s production with trade: 0 oz of meat and
32 oz of potatoes
 Rancher’s production with trade: 18 oz of meat
and 12 oz of potatoes.

PROPOSAL FOR TRADE

The price of trade


Must lie between the two opportunity costs
Trade deal: Farmer gives rancher 15 oz of
potatoes, and rancher gives farmer 5 oz of meat
in return.
Note: Price of Meat: 2~4 oz of potatoes
 Note: Price of Potatoes: 1/4 oz ~1/2 oz of meat

CONSUMPTION WITH TRADE
Farmer’s consumption with trade: 5 oz of meat
and 17 oz of potatoes
 Rancher’s consumption with trade: 13 oz of meat
and 27 oz of potatoes.

HOW TRADE EXPANDS THE FARMER’S SET OF CONSUMPTION
OPPORTUNITIES
(a) The Farmer’s Production and Consumption
Meat (ounces)
8
Farmer's
consumption
with trade
A*
5
4
Farmer's
production and
consumption
without trade
A
Farmer's
production
with trade
0
32
16
17
Potatoes (ounces)
HOW TRADE EXPANDS THE RANCHER’S SET OF
CONSUMPTION OPPORTUNITIES
(b) The Rancher’s Production and Consumption
Meat (ounces)
Rancher's
production
with trade
24
Rancher's
consumption
with trade
18
13
B*
B
12
0
12
24 27
Rancher's
production and
consumption
without trade
48
Potatoes (ounces)
INTERNATIONAL TRADE

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

Exports—goods produced domestically and sold
abroad
QUICK QUIZ 3

Martha and Stewart each spend 8 hours a day
wallpapering and painting:
Martha
Stewart
Hours needed to Do 1 Room
Paint
Wallpaper
2 hours/room 8 hours/room
4 hours/room 10 hours/room
QUICK QUIZ 4





Suppose that a worker in Cornland can grow either
40 bushels of corn or 10 bushels of oats per year, and
a worker in Oatland can grow either 20 bushels of
corn or 5 bushels of oats per year. There are 20
workers in Cornland and 20 workers in Oatland.
Which of the following statements is true?
a.
Both countries could gain from trade with
each other.
b.
Neither country would gain from trade
because Cornland has an absolute advantage in both
goods.
c.
Neither country would gain from trade
because neither one has a comparative advantage.
d.
Only Oatland could possibly gain from
trade.