Chapter 3: Interdependence and the Gains from Trade

I. A Parable for the Modern Economy

A. Example: two goods—meat and potatoes; and two people—a cattle rancher and a potato farmer (each of whom likes to consume both potatoes and meat). B. Production Possibilities C. Specialization and Trade

Key Points

1. Each person consumes goods and services produced by many other people both in our country and around the world. Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services. 2. There are two ways to compare the ability of two people in producing a good. The person who can produce the good with a smaller quantity of inputs is said to have an absolute advantage in producing the good. The person who has the smaller opportunity cost of producing the good is said to have a comparative advantage. The gains from trade are based on comparative advantage, not absolute advantage. 3. Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage. 4. The principle of comparative advantage applies to countries as well as people. Economists use the principle of comparative advantage to advocate free trade among countries.

Learning Objectives

1. How everyone can benefit when people trade with one another 2. The meaning of absolute advantage and comparative advantage 3. How comparative advantage explains the gains from trade 4. How to apply the theory of comparative advantage to everyday life and national policy

Production Possibilities

1. The farmer and rancher both work eight hours per day and can use this time to grow potatoes, raise cattle, or both. 2. Table 1 shows the amount of time each takes to produce one ounce of either good: 3. The production possibilities frontiers can also be drawn. a. These production possibilities frontiers are drawn linearly instead of being bowed out. This assumes that the farmer's and the rancher's technology for producing meat and potatoes allows them to switch between producing one good and the other at a constant rate. b. As we saw in Chapter 2, these production possibilities frontiers represent the principles of trade-offs and opportunity costs. 4. We will assume that the farmer and rancher divide their time equally between raising cattle and growing potatoes. a. The farmer produces (and consumes) at point A—16 ounces of potatoes and 4 ounces of meat. b. The rancher produces (and consumes) at point B—24 ounces of potatoes and 12 ounces of meat.

Example: two goods—meat and potatoes; and two people—a cattle rancher and a potato farmer (each of whom likes to consume both potatoes and meat).

1. The gains from trade are obvious if the farmer can only grow potatoes and the rancher can only raise cattle. 2. The gains from trade are also obvious if, instead, the farmer can raise cattle as well as grow potatoes, but he is not as good at it and the rancher can grow potatoes in addition to raising cattle, but her land is not well suited for it. 3. The gains from trade are not as clear if either the farmer or the rancher is better at producing both potatoes and meat.

Chapter Outline

I. A Parable for the Modern Economy II. Comparative Advantage: The Driving Force of Specialization III. Applications of Comparative Advantage