3 - Interdependence and the Gains from Trade

A Parable for the Modern Economy

This parable involves a simple economy where the only goods in the world are meat and potatoes. The only two people in this world are a cattle rancher named Ruby and a potato farmer named Frank. Ruby and Frank would both like to eat a diet of both beef and potatoes.

Production Possibilities

Now suppose that Frank and Ruby each work 8 hours per day and can use this time to engage in some combination of growing potatoes or raising cattle. Note that each of them might produce the two goods at different levels of productivity.

A production possibilities frontier shows the mixes of output that an economy can produce.

Specialization and Trade

Trade allows for producers to receive products beyond their production frontiers.

3.2 - Comparative Advantage: The Driving Force of Specialization

Absolute Advantage

Absolute advantage is used to compare the productivity of persons, firms, or nations. The producer that requires a smaller input to produce a good is said to have an absolute advantage in producing that good.

Opportunity Cost and Comparative Advantage

The opportunity cost is the next best alternative, or what you give up to get something. When one thing is produced, the other is given up.

Comparative advantage describes the opportunity costs faced by two producers.

Comparative Advantage and Trade

When people produce goods in which they have the comparative advantage, total production rises.

The Price of Trade

For both parties to benefit from trade, the price at which they trade must lie between their opportunity costs.