Trade and Interdependence
Consider the Production Productivity Frontiers of a
Farmer and a Rancher…
Assume: Nobody else in the economy, each can work only 8 hours a day and the only two goods they can produce
are beef and potatoes
Minutes
needed
to make
AmountPossibilities
producedFrontier
in 8 if
Note that the Production
Possibilities
Frontier
is also the Consumption
the two farmers do not trade.
oneWhy?
ounce of:
hours:
• The straightness of the curves show that the trade-off of one good for the other is constant for
Meatgoods. Why?Potatoes
Meat
Potatoes
these producers and these
• These trade-offs are also the opportunity costs of producing one good rather than the other:
Farmer
min/oz. Cost to15themin/oz.
8 oz.
32 oz.
• What is the60
Opportunity
Farmer of one ounce
of meat?
• What is the20
Opportunity
Rancher of one ounce
of meat?
Rancher
min/oz. Cost to10themin/oz.
24 oz.
48 oz.
•
Farmer’s PPF
Rancher’s PPF
Meat
Meat
Without trade, the
farmer chooses this
level (4oz. Meat, 16 oz.
potato)
8
Without trade, the
farmer chooses this level
(12 oz. Meat, 24 oz.
potatoes)
24
1:2
1:4
32
Potatoes
48
Potatoes
To trade or not to
trade, that is the
question…
Suppose the farmer agrees
to produce only potatoes
(32 oz.) and the rancher
produces 18 oz. meat and
only 12 oz. of potatoes –
they trade 5 meat for 15
potatoes
Farmer
Rancher
Note that with trade,
both
and
Meat
Potatoes farmer
Meat
Potatoes
Without
Trade
16
12
24
rancher
are able to4 consume
more
meat
With Trade
and
potatoes than0 they could
producing
Production
32
18
12
onTrade
their own: They
able
consume
Gets 5 are
Gives
15 to
Gives
5
Gets 15
Consumption (P + T)
5
27
outside of
their17PPFs. 13
Gains from Trade (C – WT)
+1
+1
+1
+3
Both side, in this case, gain meat and potatoes from trading. Why?
Trade allowed both sides to specialize and do what they do best, producing more of their specialty (at
less opportunity cost)
Meat
Meat
After trade,
farmer gains
outside of
PPF alone
24
No trade
No trade
After trade,
rancher gains
outside of
PPF alone
13
8
5
Rancher production
with trade
Farmer production
with trade
4
16
17
32
Potatoes
12
48
24
27
Potatoes
To fully understand why the rancher (who produces
both products better than the farmer) gains from trade,
we must compare their relative costs of production:
Absolute and Comparative Advantage
Minutes needed to make one ounce
of:
Amount produced in 8 hours:
Meat
Potatoes
Meat
Potatoes
Farmer
60 min/oz.
15 min/oz.
8 oz.
32 oz.
Rancher
20 min/oz.
10 min/oz.
24 oz.
48 oz.
The producer who uses fewer resources/inputs (in this case time) to produce a
good has an absolute advantage over the other:
Who has the absolute advantage in producing potatoes?
(Rancher: 10 min/oz. – 15 min/oz. OR 48 oz. – 32 oz. per 8 hours)
Who has the absolute advantage in producing meat?
(Rancher: 20 min/oz. – 60 min/oz. OR 24 oz. – 8 oz. per 8 hours)
Absolute Advantage is the ability to produce a good using fewer resources
(inputs) than other producers of that good.
Minutes needed to make one ounce
of:
Amount produced in 8 hours:
Meat
Potatoes
Meat
Potatoes
Farmer
60 min/oz.
15 min/oz.
8 oz.
32 oz.
Rancher
20 min/oz.
10 min/oz.
24 oz.
48 oz.
The producer who has a lower opportunity cost (smaller trade-off)
for producing a good has a comparative advantage over the other:
Opportunity Cost of:
1 oz. of meat
1 oz. of potatoes
Farmer
4 oz. potatoes
¼ oz. meat
Rancher
2 oz. potatoes
½ oz. meat
1. For the farmer, 1 oz. of potatoes takes 15 minutes, time that can’t be spent on meat. Since it
Sotakes
whohim
has60
theminutes
comparative
advantage
(the
smallest
opportunity
costs): costs him ¼ an
for an ounce
of meat,
a loss
of 15 minutes
for potatoes
ounce
of meat.
Similarly,
1 oz.
meat (1/4
takesoz.)
60 minutes,
time that
be spent
• The
farmer
gives up
lessofmeat
for an ounce
of can’t
potatoes,
he on
has the
potatoes. Since 15 minutes are needed for an oz. of potatoes, 1 oz. of meat costs 4 potatoes.
comparative advantage for potatoes.
1. For
rancher,
1 oz.
of potatoes
10 minutes.
Since
takes 20ofminutes
forhas
an ounce
• the
The
rancher
gives
up lesstakes
potatoes
(2 oz.) for
anitounce
meat, he
the
of meat,
a loss of 10advantage
minutes forfor
potatoes
comparative
meat.costs ½ oz. of meat. Similarly, 1 oz. of meat takes
20 minutes. Since potatoes take 10 minutes, each ounce of meat costs 2 potatoes.
So who cares?
Gains from trade come from comparative advantage (not
absolute advantage). Here’s why:
• When each person/nation specializes in the goods for which they
have a comparative advantage, they produce more with less
opportunity cost.
• This raises the production in the entire economy
• All thing equal, more production (output) helps everyone (makes
the economic pie bigger)
•
In the deal between the farmer and the rancher, the farmer gave 15 oz. potatoes for 5 oz. of meat – 1 oz. of
Rule
Thumb:
Trade
benefitscost,
both
sidesis 4when
the price
lays
meatof
cost
3 oz. potatoes.
His opportunity
however,
oz. potatoes
for 1 oz.of
of the
meat.trade
Since his
price
(3 for 1) is less than his opportunity
(4 for
1), opportunity
he wins!!
betweencostthe
two
costs
•
•
•
•
The rancher gave 5 oz. meat for 15 oz. potatoes – 3 oz. potatoes cost 1 oz. of meat. His opportunity cost,
OC
(Farmer):
potato
= 1 meatfor 1 oz.
Trade
Price:
3 potato
= 1(1meat
Rancher:
2 potato = 1cost
meat
however,
is 24 oz.
of potatoes
meat.
Since
his price
for 3) is OC
less than
his opportunity
(1 for
2), he wins too!!
If the price was 1 oz. potato for 1 oz. meat, both would be meat buyers, since the price would
be less than their opportunity cost. (Price < OC for both) – no trade would happen
If the price was 5 oz. potato for 1 oz. meat, both would be meat sellers, since price would be
above their opportunity cost. (Price > OC for both) – no trade would happen
Trade happens when both have goods they can buy and sell for a price less than their
opportunity costs.