Gains From Trade
Reference: Chapter 3, Principles of Economics, G. Mankiw, 10th edition
Md. Nazmul Hossain
Assistant Professor of Economics, University of Dhaka
Going to cover
• Why do people – and nations – chose to be economically
interdependent?
• How can trade make everyone better off?
• What is absolute advantage?
• What is comparative advantage?
• The answers to these questions are key to understanding the
global economy.
• Most countries today import from abroad many of the goods and services
they consume, and they export to foreign customers much of what they
produce.
Assumptions
• Two People:
• Farmer (Frank) and Rancher (Ruby)
• Two goods:
• Potato and Meat
• Each works 8 hours per day.
• Poduce potato or meat or combination of both.
• Assume that opportunity costs for each individual remain same
for all levels of production.
• So, PPF will be linear/straight line.
Assumptions
• Farmer
• produces an ounce of meat in 60 minutes and
• an ounce of potatoes in 15 minutes.
• Rancher
• can produce an ounce of meat in 20 minutes and
• an ounce of potatoes in 10 minutes.
• Who is better at chicken production and who is better at potato production?
Production Possibility Frontier
• Farmer
• can produce 8 ounces of meat in 8 hours (and no potatoes).
• can produce 32 ounces of potatoes in 8 hours (and no meat).
• Rancher
• can produce 24 ounces of meat in 8 hours (and no potatoes).
• can produce 48 ounces of potatoes in 8 hours (and no meat).
Production Possibility Frontier
Production Possibility Frontier
No Trade
• Frank and Ruby remain self-
sufficient instead of trading
with each other.
• Each consumes exactly what
he or she produces.
• Frank decides to produce and
consume 16 ounces of
potatoes and 4 ounces of
meat.
• Ruby decides to produce and
consume 24 ounces of
potatoes and 12 ounces of
meat.
Negotiation for Trade
• Farmer will produce only potatoes.
• So, 32 ounces of potatoes (in 8 hours).
• Rancher will produce
• 18 ounces of chicken (in 6 hours).
• 12 ounces of potatoes (in 2 hours).
• Farmer will give 15 ounces of potatoes to Rancher.
• Rancher will give 5 ounces of chicken to Farmer.
After Trade
Gains From Trade
Driving Force for Specialization
• Recall the answer to the question:
• Who is better at meat production and who is better at potato production?
• Answer: Ruby the rancher is better at both goods’ production.
• Puzzle:
• If Ruby is better at both, how can Frank ever specialize in potato
production?
• To solve this puzzle:
• We need to look into the question:
• Who can produce potato at lower cost – Frank or Ruby?
• We can answer the question in TWO ways.
Absolute Advantage
• The ability to produce a good using fewer inputs than another
producer.
• Ruby has aboslute advantage in both meat and potato production.
• For 1 ounce meat, Ruby needs 20 minutes where Frank needs 60 minutes.
• For 1 ounce potato, Ruby needs 10 minutes where Frank needs 15
minutes.
Comparative Advantage
• The ability to produce a good at a lower opportunity cost than another producer.
• Suppose Ruby wants 1 ounce of meat.
• Ruby needs 60 minutes for 1 ounce of meat.
• In 60 minutes, Ruby can produce 4 ounces of potatoes.
• To get 1 ounce of meat Ruby give up 4 ounces of potatoes.
• Hence, for Ruby, opportunity cost of 1 ounce of meat is 4 ounces of potatoes.
Comparative Advantage
• Ruby has comparative advantage in meat production.
• For meat, Ruby’s opportunity cost is lower
• Frank has comparative advantage in potato production.
• For potato, Frank’s opportunity cost is lower.
• Although it is possible for a person to have an absolute advantage in both
goods (as Ruby does in our example), it is impossible for a person to have a
comparative advantage in both goods.
Gains from Trade and Comparative Advantage
• The gains from specialization and trade are based on comparative
advantage.
• Trade can benefit everyone because it allows people to specialize
in the activities in which they have a comparative advantage.
Should Sakib Al Hasan wash his own clothes?
