CHAPTER 3

Interdependence and the

Economics
Gains from Trade
PRINCIPLES OF
 N. Gregory Mankiw

Premium PowerPoint Slides

by Ron Cronovich
© 2009 South-Western, a part of Cengage Learning, all rights reserved

In this chapter, look for the answers to

these questions:
 Why do people – and nations – choose to be
economically interdependent?

2
 How can trade make everyone better off?
What is absolute advantage?
What is comparative advantage?
How are these concepts similar?
How are they different?
 Interdependence
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4
 Interdependence
 One of the Ten Principles from Chapter 1:
Trade can make everyone better off.

 We now learn why people – and nations –

choose to be interdependent, and how they
can gain from trade.

Our Example
 Two countries: the U.S. and Japan
 Two goods: computers and wheat

INTERDEPENDENCE AND THE GAINS FROM TRADE 5

 One resource: labor, measured in hours
 We will look at how much of both goods
each country produces and consumes
 if the country chooses to be self-sufficient
 if it trades with the other country
Production Possibilities in the U.S.
 The U.S. has 50,000 hours of labor available
for production, per month.

INTERDEPENDENCE AND THE GAINS FROM TRADE 6

 Producing one computer requires 100 hours
of labor.
Producing one ton of wheat requires 10
hours of labor.

INTERDEPENDENCE AND THE GAINS FROM TRADE 7

 The U.S. PPF

INTERDEPENDENCE AND THE GAINS FROM TRADE 8

 Wheat
(tons) The U.S. has enough labor
5,000 to produce 500 computers,
or 5000 tons of wheat,
4,000
or any combination along
3,000 the PPF.

2,000

1,000

Computers
0
100 200 300 400 500

INTERDEPENDENCE AND THE GAINS FROM TRADE 9

 The U.S. Without Trade
Wheat
(tons)

INTERDEPENDENCE AND THE GAINS FROM TRADE 10

 Suppose the U.S. uses half its labor
5,000
to produce each of the two goods.
4,000 Then it will produce and consume
250 computers and
3,000 2500 tons of wheat.

2,000

1,000

Computers
0
100 200 300 400 500

INTERDEPENDENCE AND THE GAINS FROM TRADE 11

 ACTIVE LEARNING 1
Derive Japan’s PPF
Use the following information to draw Japan’s PPF.
 Japan has 30,000 hours of labor available for
production, per month.
 Producing one computer requires 125 hours of
labor.
 Producing one ton of wheat requires 25 hours
of labor.

INTERDEPENDENCE AND THE GAINS FROM TRADE 12

Your graph should measure computers on the
horizontal axis.
9
 Japan’s PPF
Wheat
(tons)
Japan has enough labor to
produce 240 computers,
2,000 or 1200 tons of wheat,
or any combination
along the PPF.
1,000

0 Computers
100 200 300

INTERDEPENDENCE AND THE GAINS FROM TRADE 14

 Japan Without Trade
Wheat
(tons) Suppose Japan uses half its labor to
produce each good.
2,000 Then it will produce and consume
120 computers and
600 tons of wheat.
1,000

0 Computers
 100 200 300
INTERDEPENDENCE AND THE GAINS FROM TRADE 11

Consumption With and Without Trade

 Without trade,
 U.S. consumers get 250 computers and 2500 tons
wheat. Japanese consumers get 120
computers and 600 tons wheat. We will
compare consumption without trade to
consumption with trade.

 First, we need to see how much of each good is

produced and traded by the two countries.
INTERDEPENDENCE AND THE GAINS FROM TRADE 16
ACTIVE LEARNING 2
Production under trade
1. Suppose the U.S. produces 3400 tons of
wheat. How many computers would the U.S.
be able to produce with its remaining labor?
Draw the point representing this combination of
computers and wheat on the U.S. PPF.
2. Suppose Japan produces 240 computers.
How many tons of wheat would Japan be able
to produce with its remaining labor? Draw this
point on Japan’s PPF.
 13

U.S. Production With Trade

Wheat
(tons)

INTERDEPENDENCE AND THE GAINS FROM TRADE 18

5,000 Producing 3400 tons of wheat
requires 34,000 labor hours.
4,000
The remaining 16,000
3,000 labor hours are used to
produce 160 computers.
2,000

1,000

Computers
0
100 200 300 400 500
 Japan’s Production With Trade

Wheat Producing 240 computers

INTERDEPENDENCE AND THE GAINS FROM TRADE 20

 (tons) requires all of Japan’s 30,000
2,000
So, Japan would produce
0 tons of wheat.
1,000

0 Computers

labor hours.
100 200 300
INTERDEPENDENCE AND THE GAINS FROM TRADE 15
 Basic international trade terms
 Exports:
goods produced domestically and sold abroad
To export means to sell domestically produced
goods abroad.

 Imports:
goods produced abroad and sold domestically
To import means to purchase goods produced
in other countries.
ACTIVE LEARNING 3

INTERDEPENDENCE AND THE GAINS FROM TRADE 22

Consumption under trade
Suppose the U.S. exports 700 tons of wheat to
Japan, and imports 110 computers from Japan.
(So, Japan imports 700 tons wheat and exports
110 computers.)

How much of each good is consumed in the

U.S.? Plot this combination on the U.S. PPF.
How much of each good is consumed in
Japan? Plot this combination on Japan’s PPF.

17
 U.S. Consumption With Trade

INTERDEPENDENCE AND THE GAINS FROM TRADE 24

 Wheat
(tons) computers wheat
5,000 produced 160 3400
+ imported 110 0
4,000 – exported 0 700
= amount
3,000 270 2700
consumed
2,000

1,000

Computers
0
100 200 300 400 500
 Japan’s Consumption With Trade
computers wheat
Wheat produced 240 0
(tons)
+ imported 0 700
2,000 – exported 110 0
= amount
130 700
consumed

1,000

0 Computers
100 200 300

INTERDEPENDENCE AND THE GAINS FROM TRADE 26

Trade Makes Both Countries Better Off
U.S.
consumption consumption gains from
without trade with trade trade
computers 250 270 20
wheat 2,500 2,700 200
Japan
consumption consumption gains from
without trade with trade trade
computers 120 130 10
wheat 600 700 100

INTERDEPENDENCE AND THE GAINS FROM TRADE 27

 Where Do These Gains Come From?
 Absolute advantage: the ability to produce a
good using fewer inputs than another producer
The U.S. has an absolute advantage in
wheat: producing a ton of wheat uses 10 labor
hours in the U.S. vs. 25 in Japan.

 If each country has an absolute advantage in

one good and specializes in that good, then
both countries can gain from trade.

Where Do These Gains Come From?

INTERDEPENDENCE AND THE GAINS FROM TRADE 28

 Which country has an absolute advantage in
computers?

 Producing one computer requires 125 labor

hours in Japan, but only 100 in the U.S.

 The U.S. has an absolute advantage in both

goods!

So why does Japan specialize in computers?

Why do both countries gain from trade?

INTERDEPENDENCE AND THE GAINS FROM TRADE 29

 Two Measures of the Cost of a Good
 Two countries can gain from trade when each
specializes in the good it produces at lowest cost.

 Absolute advantage measures the cost of a good

in terms of the inputs required to produce it.
Recall:
Another measure of cost is opportunity
cost.In our example, the opportunity cost of a
computer is the amount of wheat that could be
produced using the labor needed to produce one
computer.
INTERDEPENDENCE AND THE GAINS FROM TRADE 30
 Opportunity Cost and
Comparative Advantage
 Comparative advantage: the ability to produce
a good at a lower opportunity cost than another
producer

 Which country has the comparative advantage in

computers?

 To answer this, must determine the opp. cost of a

computer in each country.
Opportunity Cost and

INTERDEPENDENCE AND THE GAINS FROM TRADE 31

 Comparative Advantage
 The opp. cost of a computer is
 10 tons of wheat in the U.S., because producing
one computer requires 100 labor hours, which
instead could produce 10 tons of wheat.

 5 tons of wheat in Japan, because producing one

computer requires 125 labor hours, which instead
could produce 5 tons of wheat. So, Japan has
a comparative advantage in computers. Lesson:
Absolute advantage is not necessary for
comparative advantage!

INTERDEPENDENCE AND THE GAINS FROM TRADE 32

 Comparative Advantage and Trade
 Gains from trade arise from comparative
advantage (differences in opportunity costs).

 When each country specializes in the good(s)

in which it has a comparative advantage, total
production in all countries is higher, the
world’s “economic pie” is bigger, and all
countries can gain from trade.

 The same applies to individual producers (like

the farmer and the rancher) specializing in
different goods and trading with each other.
INTERDEPENDENCE AND THE GAINS FROM TRADE 33
 ACTIVE LEARNING 4
Absolute & comparative advantage
Argentina and Brazil each have 10,000 hours of
labor per month. In Argentina,
 producing one pound coffee requires 2 hours
 producing one bottle wine requires 4 hours In
Brazil,
 producing one pound coffee requires 1 hour
 producing one bottle wine requires 5 hours
 Which country has an absolute advantage in the
production of coffee? Which country has a
comparative advantage in the production of wine? 27

ACTIVE LEARNING 4
Answers
Brazil has an absolute advantage in coffee:
 Producing a pound of coffee requires only one
labor-hour in Brazil, but two in Argentina.
Argentina has a comparative advantage in wine:
 Argentina’s opp. cost of wine is two pounds of
coffee, because the four labor-hours required to
produce a bottle of wine could instead produce
two pounds of coffee.
 Brazil’s opp. cost of wine is five pounds of coffee.
28

Unanswered Questions….
 We made a lot of assumptions about the quantities
of each good that each country produces, trades,
and consumes, and the price at which the
countries trade wheat for computers.
  In the real world, these quantities and prices would
be determined by the preferences of consumers
and the technology and resources in both
countries.

 We will begin to study this in the next chapter.

For now, though, our goal was merely to see
how trade can make everyone better off.
INTERDEPENDENCE AND THE GAINS FROM TRADE 29

 Interdependence and trade allow everyone to

enjoy a greater quantity and variety of goods &
services.
CHAPTER SUMMARY

 Comparative advantage means being able to

produce a good at a lower opportunity cost.
Absolute advantage means being able to produce
a good with fewer inputs.
 When people – or countries – specialize in the
goods in which they have a comparative
advantage, the economic “pie” grows and trade
can make everyone better off.