3 Chapter 3

3 Chapter 3 - Chapter 3: Interdependence and the Gains from...

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Chapter 3: Interdependence and the Gains from Trade Individuals and nations rely on specialized production and exchange as a way to address problems caused by scarcity. Why is interdependence the norm? Interdependence occurs because people are better off when they specialize and trade with others. What determines the pattern of production and trade? Patterns of production and trade are based upon differences in opportunity costs. A PARABLE FOR THE MODERN ECONOMY Imagine an economic system with only two goods, potatoes and meat and only two people, a potato farmer and a cattle rancher What should each person produce? Why should these people trade? Production Possibilities Suppose the farmer and rancher decide not to engage in trade: Each consumes only what he or she can produce alone. The production possibilities frontier is also the consumption possibilities frontier. Figure 1 The Production Possibilities Frontier 1 Potatoes (ounces) 4 16 8 32 A 0 Meat (ounces) (a) The Farmer ’s Production Possibilities Frontier If there is no trade, the farmer chooses this production and consumption. Potatoes (ounces) 12 24 B 0 Meat (ounces) (b) The Rancher ’s Production Possibilities Frontier 48 24 If there is no trade, the rancher chooses this production and consumption.
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Production and Consumption Without Trade Specialization and Trade Suppose instead the farmer and the rancher decide to specialize and trade… Both would be better off if they specialize in producing the product they are more suited to produce, and then trade with each other. Gains from Trade Figure 2 How Trade Expands the Set of Consumption Opportunities 2 Potatoes (ounces) 4 16 5 17 8 32 A A* 0 Meat (ounces) (a) The Farmer’s Production and Consumption Farmer's production and consumption without trade Farmer's consumption with trade Farmer's production with trade Potatoes (ounces) 12 24 13 27 B 0 Meat (ounces) (b) The Rancher’s Production and Consumption 48 24 12 18 B* Rancher's consumption with trade Rancher's production with trade Rancher's production and consumption without trade
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COMPARATIVE ADVANTAGE Differences in the costs of production determine the following: Who should produce what? How much should be traded for each product? Two ways to measure differences in costs of production: The number of hours required to produce a unit of output (for example, one pound of potatoes). The opportunity cost of sacrificing one good for another. Absolute Advantage The comparison among producers of a good according to their productivity. 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.
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3 Chapter 3 - Chapter 3: Interdependence and the Gains from...

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