Interdependence and

the Gains from Trade

19
Copyright©2014 Cengage
 INTERNATIONAL TRADE
How do we satisfy our wants and needs in a
global economy?
• We can be economically self-sufficient.
OR
• We can specialize and trade with others, leading
to economic interdependence.
 A Parable for the Modern Economy

Imagine
• only two goods in an economy: potatoes and meat
• only two people: a market gardener and a cattle farmer
What should each produce?
Why should they trade?
A Parable for the Modern Economy
Obvious gains if:
• The market gardener can only grow potatoes and
the farmer can only raise beef cattle.
• The market gardener can raise cattle as well as
grow potatoes, but he is not as good at it, and the
farmer can grow potatoes in addition to raising
cattle, but her land is not well suited for it.
o Each faces different opportunity costs
Differences in the costs of production
determine the following:
• Who should produce what?
• How much should be traded for each product?

Who can produce potatoes at a lower

cost--the gardener or the farmer?
Table 1 The Production Opportunities of the Farmer
and Farmer

Copyright©2014 Cengage
Absolute Advantage

The comparison among producers of a good

according to their productivity—absolute
advantage
• Describes the productivity of one person, firm, or
nation compared to that of another.
• The producer that requires a smaller quantity of
inputs to produce a good is said to have an
absolute advantage in producing that good.
Absolute Advantage

The farmer needs only 1 hour to produce a

kilogram of potatoes, whereas the gardener
needs 1.5 hours.
The farmer needs only 2 hours to produce a
kilogram of meat, whereas the gardener
needs 6 hours.

The farmer has an absolute advantage in

the production of both meat and potatoes.
Opportunity Cost and Comparative
Advantage
Compares producers of a good according to
their opportunity cost.
• Whatever must be given up to obtain some item
The producer who has the smaller opportunity
cost of producing a good is said to have a
comparative advantage in producing that good.
Comparative Advantage and Trade

Who has the absolute advantage?

• The farmer or the gardener?

Who has the comparative advantage?

• The farmer or the gardener?
 Table 3 The Opportunity Cost of Meat
and Potatoes

Opportunity cost of:

1 kilogram of 1 kilogram of
meat potatoes

Gardener 4kg of potatoes 0.25kg of meat

Farmer 2 kg of potatoes 0.5kg of meat

Comparative Advantage and Trade

The farmer’s opportunity cost of a kilo of

potatoes is ½ of a kilo of meat, whereas the
gardener’s opportunity cost of a kilo of
potatoes is ¼ a kilo of meat.

The farmer’s opportunity cost of a kilo of meat

is only 2 kilos of potatoes, while the
gardener’s opportunity cost of a kilo of meat is
4 kilos of potatoes...
Comparative Advantage and Trade

…so, the farmer has a

comparative advantage in the
production of meat but the
gardener has a comparative
advantage in the production of
potatoes.
Production Possibilities

Self-Sufficiency
• By ignoring each other:
o Each consumes what they each produce.
o Without trade, economic gains are diminished.
Specialization and Trade

The gardener and the farmer decide to

specialize and trade
• Each would be better off if they specialized in
producing the product they are more suited to
produce, and then trade with each other.

The gardener should produce

potatoes.
The farmer should produce meat.
Table 2 The Gains from Trade:
A Summary
(production totals in 24h)

Copyright©2014 Cengage
Comparative Advantage and Trade

Comparative advantage and differences in

opportunity costs are the basis for specialized
production and trade.
• Whenever potential trading parties have
differences in opportunity costs, they can each
benefit from trade.
Benefits of Trade
• Trade can benefit everyone in a society because it
allows people to specialize in activities in which
they have a comparative advantage.
 The Legacy of Adam Smith and
David Ricardo
Adam Smith
• In his 1776 book An Inquiry into the Nature and
Causes of the Wealth of Nations, Adam Smith
performed a detailed analysis of trade and
economic interdependence, which economists still
adhere to today.
David Ricardo
• In his 1816 book Principles of Political Economy
and Taxation, David Ricardo developed the
principle of comparative advantage as we know it
today.
 Equilibrium Without Trade

Assume:
• A country is isolated from rest of the world and
produces olive oil.
• The market for olive oil consists of the buyers and
sellers in the country.
• No one in the country is allowed to import or export
olive oil.
Figure 7. The Equilibrium without International Trade

Price
of olive oil

Domestic
supply

Consumer
surplus
Equilibrium
price Producer
surplus

Domestic
demand
0 Equilibrium Quantity
quantity of olive oil
Copyright©2014 Cengage
The Equilibrium Without International Trade

Equilibrium Without Trade

• Results:
o Domestic price adjusts to balance demand and
supply.
o The sum of consumer and producer surplus measures
the total benefits that buyers and sellers receive.
The World Price and Comparative Advantage

If the country decides to engage in

international trade, will it be an importer or
exporter of olive oil?
The World Price and Comparative Advantage

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.
The World Price and Comparative Advantage

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 8 International Trade in an Exporting Country

Price
of olive oil

Price Domestic
after supply
trade World
price
Price
before
trade

Domestic
Exports demand
0
Domestic Domestic Quantity
quantity quantity of olive oil
demanded supplied
Copyright©2014 Cengage
Figure 9a How Free Trade Affects Welfare in an Exporting
Country

Price
of olive oil

Domestic
Price supply
after A Exports
trade World
B D price
Price
before
C
trade

Domestic
demand

0 Quantity
of olive oil
Copyright©2014 Cengage
Figure 9b How Free Trade Affects Welfare in an Exporting
Country

Price
of olive oil
Consumer surplus
before trade Domestic
Price supply
after A Exports
trade World
B D price
Price
before
C
trade
Producer surplus
before trade Domestic
demand

0 Quantity
of olive oil
Copyright©2014 Cengage
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 olive oil is lower than the
domestic price, the country will be an importer of
olive oil when trade is permitted.
• Domestic consumers will want to buy olive oil at
the lower world price.
• Domestic producers of olive oil will have to lower
their output because the domestic price moves to
the world price.
Figure 10 International Trade in an Importing Country

Price
of olive oil

Domestic
supply
Price
before
trade

Price World
after price
trade
Domestic
Imports
demand
0 Domestic Domestic Quantity
quantity quantity of olive oil
supplied demanded Copyright©2014 Cengage
 Figure 11a How Free Trade Affects Welfare in an Importing
Country

Price
of olive oil

Domestic
supply

A
Price
before trade B D
Price World
after trade C price
Imports
Domestic
demand
0 Quantity
of olive oil
Copyright©2014 Cengage
 Figure 11b How Free Trade Affects Welfare in an Importing
Country

Price
of olive oil
Consumer surplus
before trade Domestic
supply

A
Price
before trade B
Price World
after trade C price

Producer surplus Domestic

before trade demand
0 Quantity
of olive oil
Copyright©2014 Cengage
 Figure 11c How Free Trade Affects Welfare in an Importing
Country

Price
of olive oil
Consumer surplus
after trade Domestic
supply

A
Price
before trade B D
Price World
after trade C price
Imports
Producer surplus Domestic
after trade demand
0 Quantity
of olive oil
Copyright©2014 Cengage
The Gains and Losses of 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:
o Domestic producers of the good are worse off, and
domestic consumers of the good are better off.
o Trade raises the economic well-being of the nation as
a whole because the gains of consumers exceed the
losses of producers.
 RESTRICTIONS ON TRADE
Restrictions on trade come in the form of:
• Tariffs
• Quotas
• Non-tariff barriers
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 12 The Effects of a Tariff

Price
of olive oil

Domestic
supply

Equilibrium
without trade

Price
with tariff Tariff
Price World
without tariff Imports price
Domestic
with tariff
demand
S S D D
0 Q Q Q Q Quantity
of olive oil
Imports
without tariff Copyright©2014 Cengage
 Figure 12a The Effects of a Tariff

Price
of olive oil

Consumer surplus
before tariff Domestic
supply

Producer
surplus Equilibrium
before tariff without trade

Price World
without tariff price
Domestic
demand
S D
0 Q Q Quantity
of olive oil
Imports
without tariff Copyright©2014 Cengage
Figure 12b The Effects of a Tariff

Price
of olive oil

Consumer surplus
with tariff Domestic
supply

A
Equilibrium
without trade
B
Price
with tariff Tariff
Price World
without tariff Imports price
Domestic
with tariff
demand
S S D D
0 Q Q Q Q Quantity
of olive oil
Imports
without tariff Copyright©2014 Cengage
Figure 12c The Effects of a Tariff

Price
of olive oil

Domestic
supply

Producer
surplus Equilibrium
after tariff without trade

Price
with tariff C Tariff
Price World
without tariff G Imports price
Domestic
with tariff
demand
S S D D
0 Q Q Q Q Quantity
of olive oil
Imports
without tariff Copyright©2014 Cengage
Figure 12d The Effects of a Tariff

Price
of olive oil

Domestic
supply

Tariff Revenue

Price
with tariff Tariff
E
Price World
without tariff Imports price
Domestic
with tariff
demand
S S D D
0 Q Q Q Q Quantity
of olive oil
Imports
without tariff Copyright©2014 Cengage
Figure 12e The Effects of a Tariff

Price
of olive oil

Domestic
supply

A
Deadweight Loss
B
Price
with tariff C Tariff
D E F
Price World
without tariff G Imports price
Domestic
with tariff
demand
S S D D
0 Q Q Q Q Quantity
of olive oil
Imports
without tariff Copyright©2014 Cengage
The Effects of a Tariff
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.

Similar effects if instead of Tariff, the

government were to impose an import quota (a
limit on the quantity of a good that can be
produced abroad and sold domestically.)
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