Business and Economics Reading

Chapter 3: Interdependence and the gains from trade

ECW1101
Introductory Microeconomics Your note taking from each chapter should focus on making sure you have an
understanding of the weekly learning objectives.

Week 2: Interdependence and the

gains from trade

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In this part of lecture, we will discover

Learning objectives
answers for following questions:
On completing week 2 lecture you will be able to:
What is trade?
explain how everyone can benefit when
Why do people trade?
people trade with one another
What is absolute advantage?
differentiate between absolute advantage
and comparative advantage What is comparative advantage?
demonstrate how comparative advantage What gives gain from trade?
explains the gains from trade What is Price when it comes to trade?
demonstrate the theory of comparative
advantage to everyday life and national
policy.
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Consumption: Domestic vs. International Interdependence and the gains from trade
product
In Economics we learn how societies
Do people depend on domestic produce and distribute goods to satisfy the
product or international product wants and needs of their members.
for consumption?
We can satisfy these in a global economy by being
either:
economically self-sufficient ; or
specialize and trade with others,
leading to economic interdependence.
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 What is trade Interdependence and the gains from trade
Why is interdependence the norm?
The most important single
central fact about a free market Interdependence occurs because
is that no exchange takes people are better off when they
place unless both parties specialize and trade with others.
benefit (Milton Friedman)
What determines the pattern of production and trade?
Trade is VOLUNTARY exchange between Patterns of production and trade
two or more people that makes ALL
PARTICIPANTS BETTER OFF!
are based upon differences in
opportunity costs.
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Comparative and absolute advantage

Why do people trade?
Differences in costs
Some people have Absolute determine pattern of trade

and/or Comparative
Production Opportunity
Costs Costs
advantage over other in
producing something Absolute Comparative
Advantage Advantage
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Simplified world Suppose, the following is required

PPF example input.
Monica is a cook by Profession
Rachel is a waitress Hours to cook Hours to clean
They live together a meal a room
They needs to cook and clean the flat
They have a spare 12 hours a week after work to do these activities.
Rachel 2 4

Monica 1/2 3

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 Why do people trade? Why do people trade?
Absolute and/or Comparative advantage Absolute and/or Comparative advantage
The question that needs to be addressed is who should cook and who should
do the cleaning?
Absolute advantage
What do you based this decision on? The producer that requires a smaller
quantity of inputs to produce a good is
said to have an absolute advantage in
producing that good

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Absolute advantage Why do people trade?

Absolute and/or Comparative advantage
Monica has
Monica needs 3 hours to
an absolute
advantage
clean a room Should they be self sufficient?
with cleaning Rachel needs 4 hours
or
Monica has Monica needs 1/2 hours
an absolute
advantage
to cook a meal should they specialize and
with cooking Rachel needs 2 hours. trade? If yes, how?

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Why do people trade? Why do people trade?

Absolute and/or Comparative advantage Absolute and/or Comparative advantage

Comparative advantage
To answer this question we The producer that requires a smaller
have to look at opportunity cost of producing a good (that is,
give up less of the alternative) is said to have a
comparative advantage of comparative advantage in producing that good
There are gains from trade if each person
Monica and Rachel specialises in production according to
comparative advantage.

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Steps for calculating comparative advantage Self-Sufficiency
1. Assume total work hour and accordingly calculate
possible output of each person for each option Say Rachel and Monica spend all of
2. Draw PPF for each person their time (12 hours) either on cooking
3. Calculate opportunity cost using following relation or cleaning.
Doing X unit of option 1 = Giving up Y unit of option 2
Hence, Doing 1 unit of option 1 = Giving up Y/X unit of option 2
Here, Y/X is the opportunity cost of doing option 1
4. Comparing the calculated opportunity cost. The option
with lowest opportunity cost has comparative
advantage.

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Hours of work to Hours of work

cook a meal to clean a
room The production opportunities of
Self-Sufficiency Rachel 2 4
No. of
Meals if
No. of
rooms
only cleaned
cooked if only Meal
Monica 1/2 3 Meal cleaned
s 24
s Rachel 6 3

Meals Rooms 6
Monica
Total
24
30
4
7
Product

cleaned 4 A
ion

B
12

Rachel 6 3

Monica 24 4 1 3 Rooms 2 4
Rooms

Rachels cleaned Monica's cleaned

PPF PPF
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Copyright2003 Southwestern/Thomson Learning

Opportunity Opportunity
Calculation of opportunity cost cost of 1 cost of 1
No. of No. of
Meals if rooms

For Rachel, only

cooked
cleaned
if only
meal (in room (in
cleaned

Rachel 6 3 rooms meals

Cooks 6 meals = Giving up 3 Rooms cleaned Monica 24 4
cleaned) foregone)
Total 30 7
No. of No. of
Product
Meals if room if
So, ion only
cooked
only
cleaned

Rachel 1/2 ?
Cooking 1 meals = Giving up 3/6 Rooms Rachel
Monica
6
24
3
4

Total 30 7

= Giving up 1/2 Rooms Product

ion

Hence, opportunity cost of Cooking 1 meal is giving Monica ? ?

up 1/2 rooms cleaned.

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 Opportunity Opportunity Comparative advantage
cost of 1 cost of 1
meal (in room (in Rachel has a Rachel's opportunity cost of
rooms meals comparative cleaning is 2 meals
cleaned) foregone) advantage Monica's opportunity cost of
with cleaning cleaning is 6 meals
Rachel 1/2 2
Monica has a Rachels opportunity cost of
comparative cooking is 1/2 room
advantage Monica's opportunity cost of
Monica 1/6 6 with cooking cooking is 1/6 rooms

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Comparative advantage and trade

Hence Rachel should specialize in
Often comparative advantage and differences
in opportunity costs are the basis for Cleaning and Monica should specialize
specialized production and trade. in Cooking they GAIN from trade
Whenever potential trading parties have
differences in opportunity costs, they can
each benefit from trade.
What is this gain?
A good example on Absolute advantage and
comparative advantage:
http://www.youtube.com/watch?v=Vvfzaq72wd0

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Self-Sufficiency
Lets remember the input pattern
Remember they have 12 hours: again
Say Rachel spend 8 hours for Hours of work Hours of work
Cleaning and 4 hours for Cooking. cook a meal to clean a
room
Monica spends half of his time (6
hours) on cleaning and half of his Rachel 2 4

time (6 hours) on cooking. (This is just 1

assumption out of many possible combinations) Monica 1/2 3

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Self-Sufficiency POSSIBLE OUTPUT Say Rachel spend 8 hours for cooking and 4 hours for cleaning. Monica spends
Self-Sufficiency POSSIBLE OUTPUT
half of her time (6 hours) on cleaning and half of her time (6 hours) on cooking.
(This is just 1 assumption out of many possible combinations)

Hours of work Hours of work

to cook to clean
Cook Clean cook Clean
Rachel 2 4

Monica 1/2 3

Rachel 4 1 Rachel 4 1
Monica ? ? Monica 12 2
Total ? ? Total 16 3

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Specialization and trade

Specialization and trade
Here we claim that Rachel and Monica should specialize
and trade (that means, share the gain). Now, suppose Rachel spends ALL
Each would be better off if they specialized in his time for cleaning and Monica
producing the product they are more suited to
produce and then trade with each other (or, share spends spent most of her time for
the gain). cooking.
Rachel should Clean.

Monica should Cook.

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Specialization and trade POSSIBLE OUTPUT Now, suppose Rachel spends ALL her time for cleaning and Monica spends nine
Specialization and trade POSSIBLE OUTPUT
hours cooking with the rest cleaning.

Hours of work
to cook a meal
Hours of work
to clean a
room Meal Room Meal Room
Rachel 2 4

Monica 1/2 3

Rachel 0 3 Rachel 0 3
Monica ? ? Monica 18 1
Total ? ? Total 18 4
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 Specialization and trade
How trade expands the set of consumption
So where did the extra 2 meals and 1 room come from? opportunities Meal
s 24
Monicas gain
By specializing according to opportunity cost, Meal with
s Rachels gain specialization
people can produce more. Then by trading they 6
with
B*
can all be better off. 5
A* specialization 13
12
A
4
B

For example, Rachel and Monica could share the

benefit of trade equally.

2 2 1/2 4
1 1 1/2 3 Rooms Rooms
cleaned
Rachels
cleaned
Monicas
PPF PPF
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Copyright2003 Southwestern/Thomson Learning

The market system

The Gains from trade: A summary
Without With trade Adam Smith described the invisible
trade: hand metaphor in the 1700s.
production
and Production Trade Consumption Gains from
Consumption trade
Buyers and sellers act in their
Rachel 4 meals 0 meals Gets 5 meals 5 meals 1 meal own interest but end up
unknowingly taking into account
1 room 3 rooms For 1 rooms 1 rooms rooms
the social costs of their actions.
Monica 12 meals 18 meals Gives 5 meals 13 meals 1 meal
Prices thus guide decision
makers to outcomes that tend to
2 rooms 1 rooms For 1 rooms 2 rooms rooms maximize the welfare of society
as a whole.

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Comparative advantage (different opportunity More information about Malaysian trade policy
costs)

If two people have different opportunity TRADE POLICY REVIEW - the WTO
costs then specialization in production and Secretariat
trade can make them both better off.

Trade Policy Review Malaysia 2010

David Ricardo

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 Summary Summary
People consume goods produced domestically
and overseas. The gains from trade are often based on
comparative advantage.
Interdependence and trade mean more goods and
services are available in increased variety.
Trade makes everyone better off because
Absolute advantage people specialize in those activities in which they
lies with the person who can produce a good with the have a comparative advantage.
least quantity of inputs.
The principle of comparative advantage applies
Comparative advantage to countries as well as people.
lies with the person who can produce a good with the
smaller opportunity cost.
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Next Week
The Market forces of Demand and
Supply
Chapter 4

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