Interdependence and Trade
Remember, economics is the
study of how societies produce
and distribute goods to best
satisfy the wants and needs of
its members.
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Interdependence is the
norm
People
are better off when they
specialize and trade with others.
Patterns of production and trade
are based on differences in
opportunity costs.
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A Textbook Economy
 Imagine
...
only two goods: potatoes
and meat
only two people: a farmer
and a rancher
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Production Possibilities
Frontiers
Meat
(pounds)
(a) The Farmer’s Production
Possibilities Frontier
2
1
0
A
2
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4
Potatoes (pounds)
Meat 40
(pounds)
Production Possibilities
Frontiers
(b) The Rancher’s Production
Possibilities Frontier
B
20
0
2.5
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5
Potatoes (pounds)
The Principle of
Comparative Advantage
Differences in the costs of
production determine
 Who
should produce what?
 How much should be traded for each
product?
Who can produce potatoes at a lower
cost--the farmer or the rancher?
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The Opportunity Cost
of Meat and Potatoes
Opportunity Cost of:
1 lb of Meat
1 lb of Potatoes
Farmer
2 lb potatoes
½ lb meat
Rancher
1/8 lb potatoes
8 lb meat
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Opportunity costs and
willingness to trade
The farmer would gladly trade 1 pound
of potatoes for ½ pound of meat or more.
 The rancher would gladly trade as much
as 8 pounds of meat for 1 pound of
potatoes.
 Suppose the “terms of trade” settle at 3
pounds of meat per pound of potatoes.

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Trade Expands Consumption Possibilities
The Farmer specializes in potatoes and trades
1 lb of potatoes for 3 lbs of meat.
Meat
(pounds)
Farmer’s
consumption
with trade
A*
3
Farmer’s
consumption
without trade
2
1
0
A
2
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3
4
Potatoes (pounds)
Trade Expands Consumption
Possibilities: The Rancher
Meat 40
(pounds)
21
20
produces 24 lbs of meat and 2 lbs of
potatoes. He trades 3 lbs of meat
for an additional lb of potatoes.
B*
B
Rancher’s
consumption
with trade
Rancher’s
consumption
without trade
0
2.5 3
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5
Potatoes (pounds)
The Gains from Trade:
A Summary
Farmer
Rancher
The Outcome
With Trade:
What They
Produce
0 lbs meat
4 lbs potatoes
24 lbs meat
2 lbs potatoes
What They
Trade
Gets 3 lbs meat
for 1 lb potatoes
Gives 3 lbs meat
for 1 lb potatoes
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What They
Consume
3 lbs meat (A*)
3 lbs potatoes
21 lbs meat (B*)
3 lbs potatoes
Absolute Advantage and
Comparative Advantage
 The
producer who requires a smaller
quantity of inputs to produce a good has an
absolute advantage in producing that good.
 The producer who has the lower opportunity
cost producing a good has a comparative
advantage in producing that good.
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Who
has the absolute advantage?
The farmer or the rancher?
Who
has the comparative advantage?
The farmer or the rancher?
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Trade can benefit everyone in a
society because it allows people
to specialize in activities in
which they have a comparative
advantage.
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Summary
Interdependence
and trade allow
people to enjoy a greater quantity
and variety of goods and services.
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Summary
The
gains from trade are based on
comparative advantage, not absolute
advantage.
Comparative advantage applies to
countries as well as to people.
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Graphical
Review
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Production Possibilities
Frontiers
Meat
(pounds)
(a) The Farmer’s Production
Possibilities Frontier
2
1
0
A
2
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4
Potatoes (pounds)
Meat 40
(pounds)
Production Possibilities
Frontiers
(b) The Rancher’s Production
Possibilities Frontier
B
20
0
2.5
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5
Potatoes (pounds)
Trade Expands the Set of
Consumption Possibilities
(a) How Trade Increases the
Farmer’s Consumption
Meat
(pounds)
Farmer’s
consumption
with trade
A*
3
Farmer’s
consumption
without trade
2
1
0
A
2
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3
4
Potatoes (pounds)
Meat 40
(pounds)
Trade Expands the Set of
Consumption Possibilities
(b) How Trade Increases The
Rancher’s Consumption
21
20
B*
B
Rancher’s
consumption
with trade
Rancher’s
consumption
without trade
0
2.5 3
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5
Potatoes (pounds)