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CHAPTER
Interdependence and the
Gains from Trade
Economics
PRINCIPLES OF
© 2009 South-Western, a part of Cengage Learning, all rights reserved
In this chapter,
look for the answers to these questions:
 Why do people choose to trade?
 What is absolute advantage?
What is comparative advantage?
How are these concepts similar?
How are they different?
1
Our Example
 Two countries: the U.S. and Japan
 Two goods: computers and wheat
 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
2
Production Possibilities:
 The U.S. has 50,000 hours of labor available for
production, per month.
 Producing one computer requires 100 hours of labor.
 Producing one ton of wheat requires 10 hours of labor.
 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
3
The U.S. PPF
Wheat
(tons)
The U.S. has enough labor
to produce 500 computers,
or 5000 tons of wheat,
or any combination along
the PPF.
5,000
4,000
3,000
2,000
Where will American’s
choose to consume
without trade?
1,000
0
Computers
100
200 300 400
500
4
Japan’s PPF
Wheat
(tons)
Japan has enough labor to
produce 240 computers,
or 1200 tons of wheat,
or any combination
along the PPF.
2,000
1,000
0
Computers
100
200
300
INTERDEPENDENCE AND THE GAINS FROM TRADE
5
Wheat
(tons)
U.S. Production With Trade
5,000
4,000
3,000
2,000
1,000
0
Computers
100
200 300 400
500
6
Japan’s Production With Trade
Wheat
(tons)
Producing 240 computers
requires all of Japan’s 30,000
labor hours.
2,000
So, Japan would produce
0 tons of wheat.
1,000
0
Computers
100
200
300
INTERDEPENDENCE AND THE GAINS FROM TRADE
7
ACTIVE LEARNING
3
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.
8
U.S. Consumption With Trade
Wheat
(tons)
5,000
computers
produced
160
+ imported
110
wheat
3400
0
4,000
– exported
0
700
3,000
= amount
consumed
270
2700
2,000
1,000
0
Computers
100
200 300 400
500
INTERDEPENDENCE AND THE GAINS FROM TRADE
9
Japan’s Consumption With Trade
Wheat
(tons)
produced
+ imported
– exported
= amount
consumed
2,000
computers
240
0
110
wheat
0
700
0
130
700
1,000
0
Computers
100
200
300
INTERDEPENDENCE AND THE GAINS FROM TRADE
10
Trade Makes Both Countries Better Off
U.S.
consumption
without trade
consumption gains from
with trade
trade
computers
250
270
20
wheat
2,500
2,700
200
Japan
consumption
without trade
consumption gains from
with trade
trade
computers
120
130
10
wheat
600
700
100
INTERDEPENDENCE AND THE GAINS FROM TRADE
11
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.
INTERDEPENDENCE AND THE GAINS FROM TRADE
12
Where Do These Gains Come From?
 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
13
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
14
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.
INTERDEPENDENCE AND THE GAINS FROM TRADE
15
Opportunity Cost and
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
16
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.
17
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?
18
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.
19
THE DETERMINANTS OF TRADE
 Equilibrium Without Trade
 Assume:
 A country is isolated from rest of the world and
produces steel.
 The market for steel consists of the buyers and
sellers in the country.
 No one in the country is allowed to import or
export steel.
Figure 1 The Equilibrium without
International Trade
Price
of Steel
Domestic
supply
Consumer
surplus
Equilibrium
price
Producer
surplus
Domestic
demand
0
Equilibrium
quantity
Quantity
of Steel
The World Price and Comparative
Advantage
 If the country decides to engage in international
trade, will it be an importer or exporter of steel?
 The effects of free trade can be shown by
comparing the domestic price of a good without
trade and the world price of the good. The world
price refers to the price that prevails in the world
market for that good.
The World Price and Comparative
Advantage
 If a country has a comparative advantage, then
 the domestic price will be below the world price,
and
 the country will be an exporter of the good.
 If the country does not have a comparative
advantage, then
 the domestic price will be higher than the world
price, and
 the country will be an importer of the good.
Figure 2 International Trade in an
Exporting Country
Price
of Steel
Domestic
supply
Price
after
trade
World
price
Price
before
trade
Exports
0
Domestic
quantity
demanded
Domestic
demand
Domestic
quantity
supplied
Quantity
of Steel
Figure 2 International Trade in an
Exporting Country
Price
of Steel
Price
after
trade
Consumer surplus
surplus
Consumer
after trade
before
trade
Exports
A
BB
Price
before
trade
World
price
D
C
C
Producer surplus
after
before
trade
trade
0
Domestic
supply
Domestic
demand
Quantity
of Steel
How Free Trade Affects Welfare in
an Exporting Country
THE WINNERS AND LOSERS
FROM TRADE
 The analysis of an exporting country yields two
conclusions:
 Domestic producers of the good are better off,
and domestic consumers of the good are worse
off.
 Trade raises the economic well-being of the
nation as a whole.
The Gains and Losses of an
Importing Country
 International Trade in an Importing Country
 If the world price of steel is lower than the
domestic price,
 the country will be an importer of steel when
trade is permitted.
 domestic consumers will want to buy steel at the
lower world price.
 domestic producers of steel will have to lower
their output because the domestic price moves to
the world price.
Figure 3 International Trade in an
Importing Country
Price
of Steel
Consumer surplus
before trade
Domestic
supply
A
Price
before trade
Price
after trade
B
C
D
Imports
Producer surplus
before trade
0
World
price
Domestic
demand
Quantity
of Steel
Figure 3 International Trade in an
Importing Country
Price
of Steel
Consumer surplus
after trade
Domestic
supply
A
Price
before trade
Price
after trade
0
BB
C
D
Imports
Producer surplus
after trade
World
price
Domestic
demand
Quantity
of Steel
How Free Trade Affects Welfare in
an Importing Country
The Gains and Losses of an
Importing Country
 How Free Trade Affects Welfare in an Importing
Country
 The analysis of an importing country yields two
conclusions:
 Domestic producers of the good are worse off,
and domestic consumers of the good are better
off.
 Trade raises the economic well-being of the
nation as a whole because the gains of
consumers exceed the losses of producers.
The Effects of a Tariff
 A tariff is a tax on goods produced abroad and
sold domestically.
 Tariffs raise the price of imported goods above
the world price by the amount of the tariff.
Figure 4 The Effects of a Tariff
Price
of Steel
Domestic
supply
Equilibrium
without trade
Price
with tariff
Tariff
Price
without tariff
0
Imports
with tariff
S
Q
S
Domestic
demand
D
Q
Q
Imports
without tariff
D
Q
World
price
Quantity
of Steel
Figure 4 The Effects of a Tariff
Price
of Steel
Consumer surplus
Producer surplus
Domestic
supply
A
Deadweight Loss
B
Price
with tariff
Tariff
C
D
Price
without tariff G
0
E
F
Imports
with tariff
S
Q
S
Domestic
demand
D
Q
Q
Imports
without tariff
D
Q
World
price
Quantity
of Steel
The Effects of a Tariff
 A tariff reduces the quantity of imports and
moves the domestic market closer to its
equilibrium without trade.
 With a tariff, total surplus in the market
decreases by an amount referred to as a
deadweight loss.
FYI: Import Quotas: Another Way to
Restrict Trade
 The Effects of an Import Quota
 An import quota is a limit on the quantity of a
good that can be produced abroad and sold
domestically.
 Because the quota raises the domestic price
above the world price, domestic buyers of the
good are worse off, and domestic sellers of the
good are better off.
 License holders are better off because they
make a profit from buying at the world price and
selling at the higher domestic price.
The Effects of an Import Quota
Price
of Steel
Consumer surplus after quota
Surplus for firms
with licenses
Domestic
supply
Equilibrium
without trade
Quota
A
Isolandian
price with
quota
Price
World
without =
price G
quota
0
Producer surplus
after quota
B
C
E'
D
Equilibrium
with quota
F
E"
Imports
with quota
S
Q
Domestic
supply
+
Import supply
S
Domestic
demand
D
Q
Q
Imports
without quota
D
Q
World
price
Quantity
of Steel
FYI: Import Quotas: Another Way to
Restrict Trade
 With a quota, total surplus in the market
decreases by an amount referred to as a
deadweight loss.
 The quota can potentially cause an even larger
deadweight loss, if a mechanism such as
lobbying is employed to allocate the import
licenses.
The Lessons for Trade Policy
 Both tariffs and import quotas . . .
 raise domestic prices.
 reduce the welfare of domestic consumers.
 increase the welfare of domestic producers.
 cause deadweight losses.
The Lessons for Trade Policy
 Other Benefits of International Trade
 Increased variety of goods
 Lower costs through economies of scale
 Increased competition
 Enhanced flow of ideas
THE ARGUMENTS FOR
RESTRICTING TRADE





Jobs Argument
National-Security Argument
Infant-Industry Argument
Unfair-Competition Argument
Protection-as-a-Bargaining-Chip Argument