Principles of Economy-Chapter 3

Interdependence and the Gains from Trade

1

A Parable for the Modern Economy
• Only two goods
– Meat
– Potatoes

• Only two people
– Rancher
– Farmer

2

A Parable for the Modern Economy
• If rancher produces only meat
– And farmer produces only potatoes
– Both gain from trade

• If both rancher and farmer produce both meat and potatoes
– Both gain from specialization and trade

• Production possibilities frontier
– Various mixes of output that an economy can produce
3

Figure 1

The Production Possibilities Frontier (a)

Panel (a) shows the production opportunities available to the farmer and the rancher.

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Figure 1

The Production Possibilities Frontier (b, c)
(b) The farmer’s production possibilities frontier
Meat (oz)
If there is no trade, the farmer chooses this production and consumption. (c) The rancher’s production possibilities frontier
Meat (oz)
24

8
12
4

0

If there is no trade, the rancher chooses this production and consumption.

B

A

16

32
Potatoes (oz)

0

24

48
Potatoes (oz)

Panel (b) shows the combinations of meat and potatoes that the farmer can produce. Panel (c) shows the combinations of meat and potatoes that the rancher can produce. Both production possibilities frontiers are derived assuming that the farmer and rancher each work 8 hours per day. If there is no trade, each person’s production possibilities frontier is also his or her consumption possibilities frontier.
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A Parable for the Modern Economy
• Specialization and trade
– Farmer – specialize in growing potatoes
• More time growing potatoes
• Less time raising cattle

– Rancher – specialize in raising cattle
• More time raising cattle
• Less time growing potatoes

– Trade: 5 oz of meat for 15 oz of potatoes
– Both gain from specialization and trade
6

Figure 2

How Trade Expands the Set of Consumption Opportunities (a, b)
(a) The farmer’s production and consumption
Meat (oz)
Farmer's production and consumption without trade

8
5
4

0

A*
A
16 17

(b) The rancher’s