Interdependence and the Gains from Trade

Interdependence

Rely on many people from around the world, most of whom you’ve never met

• To provide you with goods and services

• And they get something in return

Exports

Goods produced domestically and sold abroad

Imports

Goods produced abroad and domestically

Absolute advantage 

The ability to produce a good using fewer inputs than another producer 

Two measures of the cost of a good

Absolute advantage

Opportunity cost: the opportunity cost of one airplane = the amount of soybeans that could be produced using the labor needed to produce one airplane

Comparative advantage

The ability to produce a good at a lower opportunity cost than another producer

Principle of comparative advantage

Each good should be produced by the individual who has the smallest opportunity cost of producing that good 

Specialize according to comparative advantage

Comparative advantage and trade

Gains from trade: arise from comparative advantage (Differences in opportunity costs)

When each country specializes in the goods in which they have a comparative advantage

• Total production in all countries is higher 

• The world’s “economic pie” is bigger 

• All countries can gain from trade 

The price of the trade

The price of trade must lie between their opportunity costs

In our example, 22 airplanes were traded for 40 tons of soybeans

• Greater than Japan’s opportunity cost of 1 airplane (25 tons of soybeans)

• Lower than the U.S opportunity cost of 1 airplane (50 tons of soybeans)