Mankiw: Brief Principles of
Macroeconomics, Second Edition
(Harcourt, 2001)
Ch. 3: Interdependence and the Gains
From Trade
Why Do People Trade With Each
Other?
• If one person produces bread and another butter, they
would be both better off exchanging some of their
produce with the other and have a variety in their diet.
• If they can both produce bread and butter, they each
will have a PPF.
• The total output of bread and butter would be much
higher if each specialized on the product s/he can
produce more.
Econ 202
Dr. Ugur Aker
2
Bread and Butter Production
Bread Butter
6
10
4
20
2
30
0
Farmer A
7
6
5
Butter
0
4
3
2
1
0
0
5
10
Bread Butter
15
5
10
10
5
15
0
25
30
35
Farmer B
16
14
12
Butter
0
15
20
Bread
10
8
6
4
2
0
0
5
10
Bread
Econ 202
Dr. Ugur Aker
15
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3
Opportunity Costs
• What is the implied price of butter for
Farmer A?
– Each time FA increases her butter production
she has to give up 5 breads.
• What is the implied price of butter for
Farmer B?
– Each time FB increases his butter production he
has to give up 1 bread.
Econ 202
Dr. Ugur Aker
4
Combined Production
• Suppose both are producing only bread.
How many breads will be produced?
• Suppose they decide to reduce bread
production by 10 and allocate that effort to
butter production. Who should be the one
to produce butter? How much butter will be
produced?
Econ 202
Dr. Ugur Aker
5
PPF
25
20
Butter
Bread Butter
0 21
5 20
10 19
15 18
20 17
25 16
30 15
35 10
40 5
45 0
15
10
5
0
0
10
20
Bread
30
40
50
Suppose that the rest of the world is willing to trade 2 breads for 1 butter. How would each
farmer decide what to do?
Econ 202
Dr. Ugur Aker
6
Bread Butter
0 30
30 15
60 0
PPF with Trade
40
Butter
30
20
10
0
0
10
20
30
40
50
60
70
Bread
Econ 202
Dr. Ugur Aker
7
Total Production
• If Farmer A produced 15 breads and 3
butters, and Farmer B produced 10 breads
and 5 butters, their combined consumption
would be 25 breads and 8 butters.
• If Farmer A specialized in bread and Farmer
B specialized in butter, their combined
production would be 30 breads and 15
butters.
Econ 202
Dr. Ugur Aker
8
Specialization and Trade
• If the price of butter were 2 breads, what
strategy would be advantageous for both
farmers?
• Farmer A can only acquire 1 butter for 5 breads
when she is self-sufficient. She would be better
off producing bread and exchanging for butter.
• Farmer B can only acquire 1 bread for 1 butter
when he is self-sufficient. He would be better
off producing butter and exchanging for bread.
Econ 202
Dr. Ugur Aker
9
Consumption After Trade
• If Farmer A gave up 6 breads out of the 30 she
produced, she can get 3 butters. Her
consumption would be 24 breads and 3 butters.
• If Farmer B gave up 5 butters out of the 15 he
produced, his consumption would be 10 breads
and 10 butters.
• They are both better off than what they were
consuming under self-sufficiency.
Econ 202
Dr. Ugur Aker
10
Bread and Butter Production
Bread Butter
6
10
4
20
2
30
0
Farmer A
7
6
Consumption
after trade
5
Butter
0
4
Consumption
before trade
3
2
1
0
0
5
10
Bread Butter
15
5
10
10
5
15
0
25
30
35
Farmer B
16
14
12
Butter
0
15
20
Bread
Consumption
after trade
10
8
Consumption
before trade
6
4
2
0
0
5
10
Bread
Econ 202
Dr. Ugur Aker
15
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11
Absolute and Comparative
Advantage
• The example before showed absolute
advantage because FA was more productive
in bread production and FB was more
productive in butter production.
• What if FA were more productive in both
bread and butter production? Would there
be a reason to trade?
Econ 202
Dr. Ugur Aker
12
Comparative Advantage
Farmer A
40
Butter
Bread Butter
0
30
10
20
20
10
30
0
30
20
10
0
0
10
15
20
Bre ad
25
30
35
Farmer B
10
8
Butter
Bread Butter
0
9
5
6
10
3
15
0
5
6
4
2
0
0
5
Econ 202
Dr. Ugur Aker
10
Bre ad
15
20
13
PPC
50
40
Butter
Bread Butter
0 39
5 36
10 33
15 30
20 25
25 20
30 15
35 10
40 5
45 0
30
20
10
0
0
10
20
Bread
Econ 202
Dr. Ugur Aker
30
40
50
14
Opportunity Costs
• Farmer A can produce either 30 breads or
30 butters. Her opportunity cost is 1br=1bt.
• Farmer B can produce 15 breads or 9
butters. His opportunity cost is 1br=0.6bt.
• As long as different opportunity costs exist,
there is room for specialization, trade and
improvement of well being.
Econ 202
Dr. Ugur Aker
15
Trade
• If the “world” exchange rate (price) were
1br=0.8bt, FA would be interested in giving up
butter to get bread and FB would be interested in
giving up bread to get butter.
• Start at self-sufficiency for both. Pick a point on
the PPF of each to show consumption before
specialization and trade. Allow full specialization
and exchange some of the production for the
production of the other farmer. Show that they are
both better off.
Econ 202
Dr. Ugur Aker
16
Bread Butter
0 42
15 30
45 6
PPC with Trade
50
Butter
40
30
20
10
0
0
10
20
Econ 202
Dr. Ugur Aker
Bread
30
40
50
17
US Foreign Trade
• US is more productive than Mexico and
China in many products. Yet it engages in
trade, freeing resources to be put to use in
products where US has a comparative
advantage. This way all countries can enjoy
a higher standard of living.
Econ 202
Dr. Ugur Aker
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Assignment
• American and Japanese workers can each produce 4
cars a year. An American worker can produce 10 tons
of grain a year, a Japanese worker can produce 5 tons of
grain a year. Each country has 100 million workers.
– Graph the PPF for both countries.
– Make a table showing the opportunity costs.
– If half of the workers in each country is working on cars, how
many cars and how many tons of grain are produced?
– How could both countries be better off through trade? What
range of world prices would bring this outcome?
– Suppose world price is 2 tons of grain for 1 car. Show
numerically that specialization and trade improves both
Japanese and American societies.
Econ 202
Dr. Ugur Aker
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