Chapter 3
Interdependence
and the
Gains From Trade
Ratna K. Shrestha
Changes in What Canadian Produce
Over the past 50 years, the number of
Canadians who produce farm goods have
decreased, while the number who produce
services has expanded.
 Yet Canadians now enjoy a greater
varieties/quantities of farm goods than
before.
 What explains this seemingly paradoxical
outcome ?

Changes in What Canadian Produce
Overview
A Parable for the Modern Economy
 Principle of Comparative Advantage
 Application of Comparative Advantage

How Do We Satisfy Our Needs?
Economics studies how society produces and
distributes goods and services so that wants
and needs are satisfied.
 We can be economically Self-Sufficient.
Or
 We can specialize and trade with others,
leading to Economic Interdependence.
Interdependence
Every day
you rely on
many people
from around
the world,
most of whom
you do not know,
to provide you
with the goods
and services
you enjoy.
hair gel from
Cleveland, OH
cell phone
from Korea
dress shirt
from China
coffee from
Brazil
Interdependence & Trade
A
general observation
– Individuals and nations rely on specialized
production (they produce only certain goods
and not all) and exchange as a way to
address problems caused by scarcity.
 This gives rise to two questions.
– Why is interdependence the norm?
– What determines production & trade?
Interdependence & Trade
Why is interdependence the norm?
 Interdependence occurs because people
are better off when they specialize (in the
goods which they can produce at lower
costs) and trade with others.
 What determines the pattern of production &
trade?
 The differences in opportunity costs. You
produce the good which you can produce at
a lower opportunity cost.

Interdependence and Trade:
“A Parable for the Modern Economy”
Imagine...
…only two goods (potatoes and meat)
..only two people (farmer and rancher)
What should each produce?
Why should they trade?
Productivity Table
 Note
that based on the Productivity Table
above the Rancher is more productive in
producing both of the products.
 Yet, we will see that both the Rancher and the
Farmer can gain from trade ...
PPF(Assuming an 8 hour day)
Rancher
Farmer
PPF
8
8
Potatoes in Kg
Meat in Kg
Meat in Kg
64
PPF
16
Potatoes in Kg
A World of Self-Sufficiency
64
Farmer
8
6
A
2
8
Potatoes in Kg
Meat in Kg
Meat in Kg
Suppose with no trade, the Farmer produces and
consumes combination A, while the Rancher is at
combination B
48
Rancher
B
4
16
Potatoes in Kg
Specialization and Trade
 If
the farmer and the rancher were to
specialize in producing the product that they
were best suited to produce, and then trade
with each other, they would be better off.
– Farmer should produce potatoes.
– Rancher should produce meat.
– Farmer and Rancher should trade.
 In the next slide, farmer produces 8 potatoes
and no meat. Similarly, rancher 16 meat and
no potatoes.
Specialization and Trade
In this example, farmer trades 5 Kg Potatoes for
10 Kg Meat:
Rancher
10
8
6
A*trade
A
2 3
8
Potatoes in Kg
Meat in Kg
Meat in Kg
Farmer
64
54
48
B*trade
B
4 5
16
Potatoes in Kg
Specialization and Trade
Farmer
A*trade
10
8
6
A
2 3
8
Potatoes in Kg
With trade the
Rancher is at B*
Meat in Kg
Meat in Kg
With trade the
Farmer is at A*
64
54
48
Rancher
B*trade
B
4 5
16
Potatoes in Kg
Examples of Specialization
The Principle of
Comparative Advantage
 What
determines who should produce what?
And how much should be traded for each
product?
 It
depends on the opportunity costs of
production for each trading partner.
 Not on the total amount of resources required
for production by each partner.
Comparative and Absolute Advantage

The producer that requires a smaller
quantity of inputs to produce a good is said
to have an absolute advantage in producing
that good.
 The
producer that has a lower opportunity
cost in producing a good is said to have a
comparative advantage in producing that
good.
Productivity Table
A m o u n t P ro d u ced In O n e H o u r
(in K ilo g ra m s)
M ea t
P o ta to es
F a rm er
1 Kg
1 Kg
R a n ch er
8 Kg
2 Kg
 Who
has the Absolute Advantage in each
product? Rancher, in both products.
 Yet, both the Rancher and the Farmer can gain
from trade. Why?
What is the Problem with this Picture?
The Principle of
Comparative Advantage
 Comparative
advantage is the basis for
specialized production and trade.
 Whenever
potential trading parties have
differences in opportunity costs, they can
each benefit from trade.
Opportunity Cost Table
C ost of 1 K g of each p rod u ct in real term s
1 K g of M eat C osts
1 K g of P otatoes costs
F arm er
1 K g of P otatoes
1 K g of M eat
R an ch er
.25 K g of P otatoes
4 K g of M eat
 The
Rancher has the Comparative Advantage in
producing Meat (lower opportunity cost).
 The Farmer has the Comparative Advantage in
producing Potatoes (lower opportunity cost).
Applications of Comparative
Advantage
 Should
Canada trade with Other countries
(e.g. Japan or USA)?
 Who has a comparative advantage in
producing lumber: Canada or US?
 Comparative
advantage depends on
Opportunity Costs and it determines the
nature of trade: who Imports or Exports.
Trade: Canada and Japan
4
Food
Food
Japan
Canada
2
Cars
2
Cars
2
Opportunity Cost: Sacrifice Food
Production for Car Production
Food
4
Canada
Opportunity Cost =
Slope of PPF = 2/1
(2 Units of food given up to
get 1 Unit of a car)
2
1
Cars
2
Opportunity Cost: Sacrifice Food
Production for Car Production
Food
2
Japan
Opportunity Cost
Slope of PPF =1/1
1 Unit of food given up
to get 1 Unit of a car
Cars
2
Who should produce Cars/Food?
Trade ratio = between 2 and 1
Food
4
Food
Canada
Japan
2.5
2
1.5
1
Cars
2
1
Cars
2
Conclusion

Interdependence and trade are desirable
because they allow everyone to enjoy a
greater quantity and variety of goods and
services.

Founded upon the. . .
Principle of Comparative Advantage
(developed by David Ricardo in his 1816
book “Principle of Political Economy and
Taxation)
Should Joe Sakic Mow His Own Lawn?
 Joe Sakic is a great hockey player.
 Perhaps he can also mow his lawn faster
than anyone else.
 Does that mean he should mow his own
lawn?
Specialization and Trade
 Suppose Rancher wants to consume more
than 8 Potatoes that the Farmer can possibly
produce. In this case, Rancher has to produce
some of the potatoes on its own (even though
Farmer has the comparative advantage in
producing it).
 For example, if the Rancher wants 9 potatoes,
then she/he can get 5 from the farmer and
produce 4 on its own.
Specialization and Trade
Rancher
64
Meat in Kg
Farmer
10
8
6
A*trade
B*trade
48
38
32
B
A
2 3
8
Potatoes in Kg
4
89
16
Potatoes in Kg