Chapter
3
Interdependence and the
Gains from Trade
Why Trade – PPF Model of Trade
• DEFINITION of 'Production Possibility
Frontier - PPF' A curve depicting all maximum
output possibilities for two or more goods
given a set of inputs (resources, labor, etc.).
The PPF assumes that all inputs are used
efficiently.
• A production-possibility frontier is a budget
constraint presented by the limitation of
available factors of production.
2
• The production--possibility frontier (PPF) is
an expository figure for representing scarcity,
cost, and efficiency.
3
How People Interact
Chapter
Principle 5: Trade can make everyone better off
• Trade
– Specialization
• Allows each person/country to specialize in the
activities he/she does best
– People/countries can buy a greater variety of
goods and services at lower cost
4
A Parable for the Modern Economy
• Two goods: meat and potatoes
• Two people: rancher and farmer
• If rancher produces only meat
– And farmer produces only potatoes
– Both gain from trade
• If both rancher and farmer produce both
meat and potatoes
– They still gain from specialization and trade
5
Figure 1
The production possibilities frontier (a)
(a) Production Opportunities
Minutes needed to
Make 1 ounce of:
Farmer
Rancher
Amount produced in
8 hours
Meat
Potatoes
Meat
Potatoes
60 min/oz
20 min/oz
15 min/oz
10 min/oz
8 oz
24 oz
32 oz
48 oz
Panel (a) shows the production opportunities available to the
farmer and the rancher.
6
Figure 1
The production possibilities frontier (b, c)
(b) The farmer’s production
Meat (oz) possibilities frontier
If there is no trade, the farmer
chooses this production and
consumption.
(c) The rancher’s production
Meat (oz) possibilities frontier
24
8
12
4
0
If there is no trade, the
rancher chooses this
production and consumption.
B
A
16
Potatoes (oz)
32
0
24
48
Potatoes (oz)
Panel (b) shows the combinations of meat and potatoes that the farmer can
produce. Panel (c) shows the combinations of meat and potatoes that the rancher
can produce. Both production possibilities frontiers are derived assuming that the
farmer and rancher each work 8 hours per day. If there is no trade, each person’s
production possibilities frontier is also his or her consumption possibilities frontier
7
Figure 1
The opportunity cost of meat and potatoes
Opportunity cost of:
Farmer
Rancher
1 oz of Meat
1 oz of Potatoes
4 oz potatoes
2 oz potatoes
¼ oz meat
½ oz meat
8
A Parable for the Modern Economy
• Specialization and trade
– Farmer – specialize in growing potatoes
• More time growing potatoes
• Less time raising cattle
– Rancher – specialize in raising cattle
• More time raising cattle
• Less time growing potatoes
– Trade
• Willing to trade: 3 oz of meat for 1 oz potatoes
• Final trade -5 oz of meat for 15 oz of potatoes
9
Farmer’s Gains From Trade
Farmer
Potatoes
Meat
No Trade
With
32
32
0
28
29
1
24
26
2
20
23
3
16
20
4
12
17
5
8
14
6
4
11
7
0
8
8
35
30
25
20
Taters - No Trade
15
Taters - Trade
10
5
0
0
1
2
3
4
5
6
7
8
10
Rancher’s Gains From Trade
80
70
60
50
Taters - No Trade
40
Taters - Trade
30
20
10
0
24
22
20
18
16
14
12
10
8
6
4
2
0
11
Figure 2
Greg’s Final Solution (text)
(a) The farmer’s production
Meat (oz) and consumption
Farmer's
production and
consumption
without trade
8
Farmer's
consumption
with trade
0
A
16 17
Farmer's
production
with trade
32
18
B*
13
12
0
Rancher’s
production and
consumption
without trade
Rancher’s
production
with trade
24
A*
5
4
(b) The rancher’s production
Meat (oz) and consumption
Rancher’s
consumption
with trade
B
12
27
24
48
Potatoes (oz)
Potatoes (oz)
Farmer and Rancher agree to trade 5 oz of Meat for 15 oz of Potatoes (3:1)
Start at corners (specialization)
12
Figure 2
How trade expands the set of consumption opportunities (c)
(c) The gains from trade: A summary
Farmer
Without trade:
Production and consumption
With trade:
Production
Trade
Consumption
GAINS FROM TRADE:
Increase in consumption
Rancher
Meat
Potatoes
Meat
Potatoes
4 oz
16 oz
12 oz
24 oz
0 oz
Gets 5 oz
5 oz
32 oz
Gives 15 oz
17 oz
+1 oz
+1 oz
18 oz
12 oz
Gives 5 oz Gets 15 oz
13 oz
27 oz
+1 oz
+3 oz
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Comparative Advantage
• Absolute advantage
– Produce a good using fewer inputs than
another producer
– Rancher: 20 min/1 oz M; 10 min/1 oz P
– Farmer: 60 min/ 1 oz M; 15 min/ 1 oz P
• Opportunity cost
– Measures the trade-off between the two
goods that each producer faces
– Rancher -1 oz M -> 2 oz P
– Farmer: 3 oz P -> -1 oz M
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Table
1
The opportunity cost of meat and potatoes
Opportunity cost of:
Farmer
Rancher
1 oz of Meat
1 oz of Potatoes
4 oz potatoes
2 oz potatoes
¼ oz meat
½ oz meat
15
Comparative Advantage
• Comparative advantage
– Produce a good - lower opportunity cost than
another producer
– Reflects - relative opportunity cost
• Principle of comparative advantage
– Each good - produced by the individual that
has the smaller opportunity cost of producing
that good
16
Comparative Advantage
• One person
– Can have absolute advantage in both goods
– Cannot have comparative advantage in both
goods
• For different opportunity costs
– One person - comparative advantage in one
good
– The other person - comparative advantage in
the other good
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Comparative Advantage
• Opportunity cost of one good
– Inverse of the opportunity cost of the other
• Gains from specialization and trade
– Based on comparative advantage
– Total production in economy rises
• Increase in the size of the economic pie
• Everyone – better off
18
Comparative Advantage
• Trade can benefit everyone in society
– Allows people to specialize in activities
• Have a comparative advantage
• The price of trade
– Must lie between the two opportunity costs
• Principle of comparative advantage explains:
– Interdependence
– Gains from trade
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Applications of Comparative Advantage
• Should the U.S. trade with other countries?
– Imports
• Goods produced abroad and sold domestically
– Exports
• Goods produced domestically and sold abroad
• Principle of comparative advantage
– Each good – produced by the country
• Smaller opportunity cost of producing that good
• Specialization and trade
• All countries – greater prosperity
20