Chapter 3
Exchange and Markets
Consider your typical day
– You wake up to an alarm clock made in Korea.
– You pour yourself orange juice made from
Florida oranges and coffee from beans grown
in Brazil.
– You put on some clothes made of cotton
grown in Georgia and sewn in factories in
Thailand.
– You drive to class in a car made of parts
manufactured in a half-dozen different
countries.
. . . and you haven’t been up for more than two hours yet!
Interdependence and the Gains
from Trade

How do we satisfy our wants and needs in
a global economy?
– We can be economically self-sufficient.
– We can specialize and trade
with others, leading to
economic interdependence.
Interdependence and the Gains
from Trade

Why is interdependence the norm?
– Interdependence occurs because people are
better off when they specialize and trade with
others.

What determines the pattern of
production and trade?
– Patterns of production and trade are based
upon differences in opportunity costs.
 Adam Smith
 In his 1776 book An Inquiry into
the Nature and Causes of the
Wealth of Nations, Adam Smith
performed a detailed analysis of
trade and economic
interdependence.
Adam Smith
1723 -1790
Absolute Advantage

Adam Smith believed that specialization
and trade should be based on absolute
advantage.
Absolute Advantage

The comparison among producers of a
good according to their productivity.
– The producer that requires a smaller quantity
of inputs to produce a good is said to have an
absolute advantage in producing that good.
Example
Minutes needed
to make one
cake
Emily
Boxes
of
cookies
40
30
• Who has an
absolute
advantage in
making
cookies?
Julia
20
60
• Julia
Example
Minutes needed
to make one
cake
Emily
Boxes
of
cookies
40
Julia
20
60
30
• Who has an
absolute
advantage in
making cake?
• Emily
Pattern of specialization and
trade

According to Adam Smith specialization
and trade should be based on absolute
advantage:
– Emily should specialize in making cakes.
– Julia should specialize in making cookies.
Production Possibilities
Assuming for simplicity that time is the only resource and
that each has a total of 8 hours of work
Minutes needed
to make one
Amount
produced in 8 hrs
Box of cake
cookies
Box of cake
cookies
Emily
40
30
Emily
Julia
20
60
Julia
Production Possibilities
Assuming for simplicity that time is the only resource and
that each has a total of 8 hours of work
Minutes needed
to make one
Amount
produced in 8 hrs
Box of cake
cookies
Box of cake
cookies
Emily
40
30
Emily
12
16
Julia
20
60
Julia
24
8
Julia’s Production Possibilities Frontier
cakes
If there is no trade,
Julia chooses
this production and
consumption.
8
4
0
A
12
24
cookies
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Emily’s Production Possibilities Frontier
cakes
16
If there is no trade,
Emily chooses
this production and
consumption.
8
0
A
6
12
cookies
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After Trade

Specialization and Trade results in more
total output. Both are better off
Boxes of
Cookies
Cakes
Total output
before trade
12+6=18
4+8=12
Total output
after trade
24
16
Problems
What if one person has an absolute
advantage in making both goods, will
there be gains from specialization and
trade?
 According to Adam Smith: there will be no
gains from specialization and trade.

 David Ricardo
 In his 1816 book Principles of
Political Economy and Taxation,
David Ricardo developed the
principle of comparative advantage
as we know it today.
David Ricardo
1772-1823
Comparative Advantage
According to Ricardo specialization and
trade should be based on comparative
advantage.
 Even if one person is better at making all
goods, there are still gains from trade.

Example
Consider an
economy with
two people: Fred
and Kate.
 Two goods:
coconut and fish.

Fred’s maximum output in a day if
he produces only
Coconuts
Fish
2
6
Kate’s maximum output in a day if
she produces only
Clearly, Fred is better at
making both goods
Coconuts
Fish
1
1
Fred’s PPC
Fred’s maximum
output in a day if he
produces only
Coconuts
Fish
2
6
Assume that he
works 6 days a
week, we can
construct his PPC
as follows
Coconuts
If there is no trade,
assume Fred chooses
this production and
consumption.
12
A
4
0
24
36
Fish
Copyright©2003 Southwestern/Thomson Learning
Kate’s PPC
Kate’s maximum
output in a day if she
produces only
Coconuts
Fish
1
1
Assume that she
works 6 days a
week, we can
construct her PPC
as follows
Coconuts
6
If there is no trade,
Assume Kate choose
this production and
consumption.
B
1
0
5
6
Fish
Copyright©2003 Southwestern/Thomson Learning
Opportunity Cost and
Comparative Advantage

Opportunity cost is what 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.
?
?
Who has the comparative advantage in the
production of each good?
The Opportunity Cost
Fred’s maximum output in a day if
he produces only
Kate’s maximum output in a day if
she produces only
Coconuts
Fish
Coconuts
Fish
2
6
1
1
• What is the opportunity
cost of one coconut for
Fred?
• 3 Fish
• What is the opportunity
cost of one coconut for
Kate?
• 1 Fish
• Who has a comparative advantage in Coconut?
• Kate
The Opportunity Cost
Fred’s maximum output in a day if
he produces only
Kate’s maximum output in a day if
she produces only
Coconuts
Fish
Coconuts
Fish
2
6
1
1
• What is the opportunity
cost of one fish for Fred?
• 1/3 coconut
• What is the opportunity
cost of one fish for Kate?
• 1 coconut
• Who has a comparative advantage in fish?
• Fred
Rule: Opportunity cost and
slope.
You can calculate the opportunity cost using
the PPF. The opportunity cost of
– the x-axis good = the slope of the PPF.
– the y-axis good equals 1/ the slope of the
PPF.
The opportunity costs
The Opportunity cost of
Who
produces
coconut
cheaper?
Kate has a
comparative
advantage
in coconut
Coconut
Fish
Fred
3 fish
Kate
1 fish
1/3
coconut
1 coconut
Who
produces
fish
cheaper?
Fred has a
comparative
advantage
in fish.
Specialization and Trade

Suppose instead Kate and Fred decide to
specialize and trade…
– Both would be better off if they specialize in
producing the product they are more suited to
produce, and then trade with each other.
Fred produces fish.
Kate produces coconuts.
Specialization and Trade
After specialization, they agreed to trade.
 The terms of trade: 1 fish for ½ coconut.
 Fred gives Kate 10 fish for 5 coconuts

Who will benefit from trade?
How Trade Expands the Set of
Consumption Opportunities
Fred’s Production and consumption
Coconuts
Fred
gives
Kate 10
fish for 5
coconuts.
12
Fred’s
consumption
with trade
A*
5
4
Fred’s
production
with trade
A
0
36
24
26
Fish
Copyright©2003 Southwestern/Thomson Learning
How Trade Expands the Set of
Consumption Opportunities
’
Kate’s Consumption
and Production
Coconuts
Kate
gives
Fred 5
coconuts
for 10
fish.
6
Kate’s
production
With trade
Kate’s
consumption
with trade
Consumption
and Production
without trade
B*
B
1
0
5
6
10
Fish
Copyright©2003 Southwestern/Thomson Learning
Gains from Trade
Coconut
Fish
Fred
1
2
Kate
0
5
Total
1
7
Comparative Advantage and
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.
Comparative Advantage and
Trade
Comparative advantage and differences in
opportunity costs are the basis for
specialized production and trade.
 Whenever potential trading parties have
differences in opportunity costs, they can
each benefit from trade.

APPLICATIONS OF COMPARATIVE
ADVANTAGE
Should the United States trade
with other countries?
 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