Interdependence and Gains From the Trade

7/25/2019 Interdependence and Gains From the Trade

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Interdependence and Gains from the Trade

Economics is the study of how societies produce and distribute goods in an attempt to satisfy the

wants and needs of their members.

How do we satisfy our wants and needs in a global economy?1. We can be economically self-sufficient.2. We can specialize and trade with others, leading to economic interdependence.

3. Indiiduals and nations rely on specialized production and e!change as a way to address

problems caused by scarcity

But this gives rise to two questions:1. Why is interdependence the norm"

2. 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 production and trade?

#atterns of production and trade are based upon differences in opportunity costs.

!arable for the "odern #conomy

In this world for the lielyhood purpose each person is depend upon other, by ma$ing e!change

of goods and serices. %et&s we e!plain it in a simple e!ample.

'ne person who is a cattle rancher and other one is a potato farmer, means while both personswould be li$e to eat both goods but how they can access on both goods" (nswer is e!change or

barter system) trade.

*he +ancher can produce only meet and the armer can produce only potatoes. In one scenario,

both can choose to hae nothing to do with each other. ut after seeral months, the +ancher is

tired of eating meet and the armer is also tired of eating potatoes. oth will be agreed on *rade.*rade would allow them to enoy greater ariety. Each could then hae a stea$ with a ba$ed

potato or a burger with fries.

It shows simply how eeryone can benefit from *rade, the gains would be similar if the +ancher

and the armer were each capable of producing the other good, but only at great cost. /uppose,

for e!ample, that the potato farmer is able to raise cattle and produce meat, but that he is not

ery good at it. /imilarly, suppose that the cattle +ancher is able to grow potatoes but that herland is not ery well suited for it. In this case, the armer and the rancher can each benefit by

specializing in what he or she does best and then trading with the other.


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!roduction !ossibilities/uppose that the farmer and the rancher each wor$ 0 hours per day and can deote this time togrowing potatoes, raising cattle, or a combination of the two.

*he table in fig. 1 shows the amount of time each person reuires to produce the things.*he farmer can produce an ounce of potatoes in 1 minutes and an ounce of meat in 2 minutes.

*he last two coloumns in the table show the amount of meat or potatoes the farmer and the

rancher can produce they wor$ an 0-hour day producing only that good.

#anel b4 of ig. 1 shows the amount of meat and potatoes that the farmer can produce. If the

farmer deotes all 0 hours of his time to potatoes, he produce 32 ounces of potatoesmeasured on

the horizental a!is4 and no potatoes. If the farmer diides his time eually between the twoactiities, spending 5 hours on each, he produces 16 ounces of potatoes and 5 ounces of meat.

*he ig. shows these thrree possible outcomes and all others in between.

*he farmer&s technology for producing meat and potatoes as summarized in ig.14 allows him to

switch between the two goods at a constant rate. Wheneer the farmer spends 1 hour less

producing meat and 1 hour more producing tomatoes, he reduces his output of meat by 1 ounceand raises his output of potatoes by 5 ounces and this is true regardless of how much he is

already producing. (s a result ## is a straight line.

#anel c4 of ig.1 shows the ## for the rancher.

If the rancher deotes all 0 hours of her time to potatoes, she produces 50 ounces of potatoes and

no meat. If she deotes all her time to meat, she produces 25 ounces of meat and no potatoes. If

the rancher diides her time eually, spending 5 hours on each actiity, she produces 25 ouncesof potatoes and 12 ounces of meat. 'nce again, the ## shows all the possible outcomes.

If the farmer and the rancher choose to be self-sufficient rather than trade with each other, then

each consumes e!actly what he or she produces. In this case, the ## is also the consumption

possibilities frontier. *hat is, with out trade, ig.1 shows the possible combinations of meat and

potatoes that the farmer and the rancher can each produce and then consume.

$igure %

&a' !roduction (pportunities


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If there is no trade,the farmer choosesthis production andconsumption.

s Production Possibilities Frontier


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Farmer'sproductionwith trade

)peciali*ation and Trade

/uppose instead the farmer and the rancher decide to specialize and trade7

oth would be better off if they specialize 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+


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Rancher's

production and

consumption

without trade

(C) The Gains from Trade: ASummary


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,omparative dvantage

8ifferences in the costs of production determine the following91. Who should produce what"2. :ow much should be traded for each product"

*wo ways to measure differences in costs of production1. *he numbers of hours reuired to produce a unit of output or e!ample, one pound of

potatoes4.2. *he opportunity cost of sacrificing one good for another.

bsolute dvantage

The comparison among producers of good according to their productivity+

1. 8escribes the productiity of one person, firm, or nation compared to that of another.

2. *he producer that reuires a smaller uantity of inputs to produce a good is said to haean absolute adantage in producing that good.

The ranchor needs only %- minutes to produce an ounce of potatoes. whereas the

farmer needs %/ minutes

The rancher needs only %- minutes to produce an ounce of meat. whereas the

farmer needs 0- minutes+

ased on this information, we can conclude that the rancher has the lower cost of producingpotatoes, if we measure cost by the uantity of inputs.

(pportunity cost and ,omparative dvantages

,ompares producers of a good according to their opportunity cost. that is. what

must be given up to obtain some item+

The producer who has the smaller opportunity cost of producing a good is said tohave a comparative advantages in producing that good+

Who has the comparative advantage in the production of each good?


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,omparative dvantage and Trade

!otato costs11. *he armer&s opportunity cost of an ounce of potatoes is ; is an ounce of meat.

2. *he +ancher&s opportunity cost of an ounce of potatoes is < an ounce of meat.

"eat costs1

1. *he farmer&s opportunity cost of a pound of meat is 5 ounces of potatoes.2. *he rancher&s opportunity cost of an ounce of meat is 2 ounces of potatoes.

7so, the rancher has a comparatie adantage in the production of meat but the farmer has acomparatie adantage in the production of potatoes.

=omparatie adantage and differences in opportunity costs are the basis for the

specialized production and trade. Wheneer potential trading parties hae differences in opportunity costs, they can each

benefit from trade.

In our e!ample, rancher has a comparatie adantage in the production of meat. *his

means that he will specialize in the production of meat, i.e., he will produce only meatand will not produce any potatoes, he will buy potatoes from the farmer.

*he farmer has a comparatie adantage in the production of potatoes. *his means that he

will specialize in the production of potatoes, i.e., he will produce only potatoes and will

not produce any meat, he will buy meat from the rancher.

*he ne!t factor to be determined is the price at which the farmer and the rancher will

e!change meat for potatoes. *his will be determined by the negotiations between the two

indiidual.

%et us assume that they negotiate a price of 1oz of meat for 3oz of potatoes. We will hae

to show that the farmer and the rancher will benefit by trading at this price.

%et us consider the farmer, who specializes in the production of potatoes, and buys meat

from the rancher. efore he started trading, for each ounce of meat he produced, he

would hae to gie up 5 oz of potatoes. :oweer, once he starts trading, for each ounceof meat he now gies up only 3 oz of potatoes.

*he price the farmer pays for the meat he buys from rancher is less than what it would

cost him to produce the meat if he did no trade. *herefore the farmer is better off when he

trades with the rancher.

%et us consider the rancher, who specialize in the production of meat, and buys potatoesfrom the farmer. efore he started trading, for each ounce of potatoes he produced, he

would hae to gie up < of meat. :oweer, once he starts trading, for each ounce ofpotatoes he now gies up only 1)3 oz of meat 1oz of meat for 3oz of potatoes is the

same as 1oz of potatoes for 1)3 oz of meat4.

*he price the rancher pays for the potatoes he buys from the farmer is less than what it

would cost him to produce the potatoes if he did not trade.


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*herefore the rancher is better off when he trades with the farmer.

*rade can benefit eeryone in a society because it allows people to specialize in actiities in

which they hae a comparatie adantage.

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Interdependence and Gains From the Trade