Interdependence and the Gains from Trade,Chapter 3,Interdependence and Trade,Consider your typical day:You wake up to an alarm clock made in Korea.You pour yourself some orange juice made from oranges grown in Florida.You put on some clothes made of cotton grown in Georgia and sewn in factories in Thailand.You watch the morning news broadcast from New York on your TV made in Japan.You drive to class in a car made of parts manufactured in a half-dozen different countries. and you havent been up for more than two hours yet!,Interdependence and Trade,Remember, economics is the study of how societies produce and distribute goods in an attempt to satisfy the wants and needs of its members.,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 Trade,A general observation . . .Individuals and nations rely on specialized production and exchange as a way to address problems caused by scarcity.,Interdependence and Trade,But, this gives rise to two questions:Why is interdependence the norm?What determines production and 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.,Imagine . . .only two goods: potatoes and meatonly two people: a potato farmer and a cattle rancherWhat should each produce?Why should they trade?,A Parable for the Modern Economy,The Production Opportunities of the Farmer and the Rancher,Self-Sufficiency,By ignoring each other:Each consumes what they each produce.The production possibilities frontier is also the consumption possibilities frontier.Without trade, economic gains are diminished.,Production Possibilities Frontiers,Potatoes (pounds),Meat (pounds),4,2,(a) The Farmers Production Possibilities Frontier,0,Production Possibilities Frontiers,Potatoes (pounds),Meat (pounds),5,40,(b) The Ranchers Production Possibilities Frontier,0,The Farmer and the Rancher Specialize and Trade,Each would be better off if they specialized in producing the product they are more suited to produce, and then trade with each other.,The farmer should produce potatoes. The rancher should produce meat.,The Gains from Trade: A Summary,The Gains from Trade: A Summary,Trade Expands the Set of Consumption Possibilities,Potatoes (pounds),Meat (pounds),4,2,2,1,(a) How Trade Increases the Farmers Consumption,0,A,3,3,A*,Trade Expands the Set of Consumption Possibilities,Potatoes (pounds),Meat (pounds),5,2.5,40,20,(b) How Trade Increases The Ranchers Consumption,0,B,21,3,B*,The Gains from Trade: A Summary,The Principle of Comparative Advantage,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?,Differences in the costs of production determine the following:,Differences in Costs of Production,The number of hours required to produce a unit of output. (for example, one pound of potatoes)The opportunity cost of sacrificing one good for another.,Two ways to measure differences in costs of production:,Absolute Advantage,Describes the productivity of one person, firm, or nation compared to that of another.The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good.,Comparative Advantage,Compares producers of a good according to their opportunity cost.The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good.,Specialization and Trade,Who has the absolute advantage?The farmer or the rancher?Who has the comparative advantage?The farmer or the rancher?,Absolute Advantage,The Rancher needs only 8 hours to produce a pound of potatoes, whereas the Farmer needs 10 hours.The Rancher needs only 1 hour to produce a pound of meat, whereas the Farmer needs 20 hours.,The Rancher has an absolute advantage in the production of both meat and potatoes.,The Opportunity Cost of Meat and Potatoes,Comparative Advantage,The Ranchers opportunity cost of a pound of potatoes is 8 pounds of meat, whereas the Farmers opportunity cost of a pound of potatoes is 1/2 pound of meat.The Ranchers opportunity cost of a pound of meat is only 1/8 pound of potatoes, while the Farmers opportunity cost of a pound of meat is 2 pounds of potatoes.,Comparative Advantage,so, the Rancher has a comparative advantage in the production of meat but the Farmer has a comparative advantage in the production of potatoes.,The Principle of Comparative Advantage,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.,