Interdependence and Trade

1
Chapter 3
Interdependence and the Gains From Trade Ratna
K. Shrestha
2
Changes in What Canadian Produce

• Over the past 50 years, the number of Canadians
  who produce farm goods have decreased, while the
  number who produce services has expanded.
• Yet Canadians now enjoy a greater
  varieties/quantities of farm goods than before.
• What explains this seemingly paradoxical outcome
  ?

3
Changes in What Canadian Produce
4
Overview

• A Parable for the Modern Economy
• Principle of Comparative Advantage
• Application of Comparative Advantage

5
How Do We Satisfy Our Needs?

• Economics studies how society produces and
  distributes goods and services so that wants and
  needs are satisfied.
• We can be economically Self-Sufficient.
• Or
• We can specialize and trade with others, leading
  to Economic Interdependence.

6
Interdependence
0

• Every day you rely on many people from around
  the world, most of whom you do not know, to
  provide you with the goods and services you
  enjoy.

7
Interdependence Trade

• A general observation
• Individuals and nations rely on specialized
  production (they produce only certain goods and
  not all) and exchange as a way to address
  problems caused by scarcity.
• This gives rise to two questions.
• Why is interdependence the norm?
• What determines production trade?

8
Interdependence Trade

• Why is interdependence the norm?
• Interdependence occurs because people are better
  off when they specialize (in the goods which they
  can produce at lower costs) and trade with
  others.
• What determines the pattern of production
  trade?
• The differences in opportunity costs. You produce
  the good which you can produce at a lower
  opportunity cost.

9
Interdependence and Trade A Parable for the
Modern Economy

• Imagine...
• only two goods (potatoes and meat)
• ..only two people (farmer and rancher)
• What should each produce?
• Why should they trade?

10
Productivity Table

• Note that based on the Productivity Tableabove
  the Rancher is more productive inproducing both
  of the products.
• Yet, we will see that both the Rancher and the
  Farmer can gain from trade ...

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PPF(Assuming an 8 hour day)
Rancher
Farmer
64
PPF
PPF
8
Meat in Kg
Meat in Kg
8
16
Potatoes in Kg
Potatoes in Kg
12
A World of Self-Sufficiency

• Suppose with no trade, the Farmer produces and
  consumes combination A, while the Rancher is at
  combination B

64
Rancher
Farmer
B
48
8
Meat in Kg
Meat in Kg
A
6
4
2
8
16
Potatoes in Kg
Potatoes in Kg
13
Specialization and Trade

• If the farmer and the rancher were to specialize
  in producing the product that they were best
  suited to produce, and then trade with each
  other, they would be better off.
• Farmer should produce potatoes.
• Rancher should produce meat.
• Farmer and Rancher should trade.
• In the next slide, farmer produces 8 potatoes and
  no meat. Similarly, rancher 16 meat and no
  potatoes.

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Specialization and Trade

• In this example, farmer trades 5 Kg Potatoes
  for 10 Kg Meat

Rancher
Farmer
64
Atrade
54
Btrade
10
48
B
8
Meat in Kg
Meat in Kg
6
A
4
5
2
8
16
3
Potatoes in Kg
Potatoes in Kg
15
Specialization and Trade
With trade theFarmer is at A
With trade theRancher is at B
Rancher
Farmer
64
Atrade
54
Btrade
10
48
B
8
Meat in Kg
Meat in Kg
6
A
4
2
5
8
16
3
Potatoes in Kg
Potatoes in Kg
16
Examples of Specialization
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The Principle of Comparative Advantage

• What determines who should produce what? And how
  much should be traded for each product?
• It depends on the opportunity costs of production
  for each trading partner.
• Not on the total amount of resources required for
  production by each partner.

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Comparative and Absolute Advantage

• The producer that requires a smaller quantity of
  inputs to produce a good is said to have an
  absolute advantage in producing that good.
• The producer that has a lower opportunity cost in
  producing a good is said to have a comparative
  advantage in producing that good.

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Productivity Table

• Who has the Absolute Advantage in eachproduct?
  Rancher, in both products.
• Yet, both the Rancher and the Farmer can gain
  from trade. Why?

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What is the Problem with this Picture?
21
The Principle of Comparative Advantage

• Comparative advantage is the basis for
  specialized production and trade.
• Whenever potential trading parties have
  differences in opportunity costs, they can each
  benefit from trade.

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Opportunity Cost Table

• The Rancher has the Comparative Advantage in
  producing Meat (lower opportunity cost).
• The Farmer has the Comparative Advantage in
  producing Potatoes (lower opportunity cost).

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Applications of Comparative Advantage

• Should Canada trade with Other countries (e.g.
  Japan or USA)?
• Who has a comparative advantage in producing
  lumber Canada or US?
• Comparative advantage depends on Opportunity
  Costs and it determines the nature of trade who
  Imports or Exports.

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Trade Canada and Japan
Food
Food
4
Japan
Canada
2
2
2
Cars
Cars
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Opportunity Cost Sacrifice Food Production for
Car Production
Food
4
Canada

• Opportunity Cost
• Slope of PPF 2/1
• (2 Units of food given up to get 1 Unit of a car)

2
1
2
Cars
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Opportunity Cost Sacrifice Food Production for
Car Production
Food
Japan
2

• Opportunity Cost
• Slope of PPF 1/1
• 1 Unit of food given up to get 1 Unit of a car

2
Cars
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Who should produce Cars/Food? Trade ratio
between 2 and 1
Food
Food
Canada
4
Japan
2.5
2
1.5
2
1
1
2
Cars
Cars
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Conclusion

• Interdependence and trade are desirable because
  they allow everyone to enjoy a greater quantity
  and variety of goods and services.
• Founded upon the. . .
• Principle of Comparative Advantage
• (developed by David Ricardo in his 1816 book
  Principle of Political Economy and Taxation)

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Should Joe Sakic Mow His Own Lawn?

• Joe Sakic is a great hockey player.
• Perhaps he can also mow his lawn faster than
  anyone else.
• Does that mean he should mow his own lawn?

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Specialization and Trade

• Suppose Rancher wants to consume more than 8
  Potatoes that the Farmer can possibly produce.
  In this case, Rancher has to produce some of the
  potatoes on its own (even though Farmer has the
  comparative advantage in producing it).
• For example, if the Rancher wants 9 potatoes,
  then she/he can get 5 from the farmer and produce
  4 on its own.

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Specialization and Trade
Rancher
64
Farmer
Btrade
48
Atrade
38
10
32
8
B
Meat in Kg
6
A
4
9
8
2
8
16
3
Potatoes in Kg
Potatoes in Kg