To understand why people choose to depend on others for goods and services and how this choice improves their lives, let’s look at a simple economy. Imagine that there are two goods in the world – beef and potatoes. And there are two people in the world – a cattle farmer named Fabia and a market gardener named Marius – each of whom would like to eat both beef and potatoes.
The gains from trade are most obvious if the cattle farmer can produce only meat and the market gardener can produce only potatoes. In one scenario, the farmer and the gardener could choose to have nothing to do with each other.
But after several months of eating beef roasted, boiled, fried and grilled, the cattle farmer might decide that self-sufficiency is not all he expected. The market gar- dener, who has been eating potatoes mashed, fried and baked, would most likely agree. It is easy to see that trade would allow them to enjoy greater variety: each could then have steak and chips.
Although this scene illustrates most simply how everyone can benefit from trade, the gains would be similar if the farmer and the gardener were each capa- ble of producing the other good, but only at great cost. Suppose, for example, that the market gardener is able to rear cattle and produce meat, but that he is not very good at it. Similarly, suppose that the cattle farmer is able to grow pota- toes, but that her land is not very well suited for it. In this case, it is easy to see that the gardener and the farmer can each benefit by specializing in what he or she does best and then trading with the other.
The gains from trade are less obvious, however, when one person is better at producing every good. For example, suppose that the cattle farmer is better at rearing cattle and better at growing potatoes than the market gardener. In this case, should the farmer or gardener choose to remain self-sufficient, or is there still reason for them to trade with each other? To answer this question, we need to look more closely at the factors that affect such a decision.
Production Possibilities
Suppose that the gardener and the farmer each work eight hours a day six days a week (a working week of 48 hours) and take Sunday off. They can spend their time growing potatoes, rearing cattle, or a combination of the two. Table 3.1 shows the amount of time each person takes to produce 1 kilogram of each good. The gardener can produce 1 kilogram of meat in 6 hours and 1 kilogram of potatoes in an hour and a half. The farmer, who is more productive in both
TABLE 3.1
The Production Opportunities of the Gardener and the Farmer
Time needed to make 1 kg of:
Amount of meat or potatoes produced in 48 hours
Meat Potatoes Meat Potatoes
Gardener 6 hrs/kg 1.5 hrs/kg 8 kg 32 kg
Farmer 2 hrs/kg 1 hr/kg 24 kg 48 kg
activities, can produce a kilogram of meat in 2 hours and a kilogram of potatoes in 1 hour. The last columns in Table 3.1 show the amounts of meat or potatoes the gardener and farmer can produce in a 48-hour working week, producing only that good.
Panel (a) of Figure 3.1 illustrates the amounts of meat and potatoes that the gardener can produce. If the gardener devotes all 48 hours of his time to pota- toes, he produces 32 kilograms of potatoes (measured on the horizontal axis) and no meat. If he devotes all his time to meat, he produces 8 kilograms of meat (measured on the vertical axis) and no potatoes. If the gardener divides his time equally between the two activities, spending 24 hours a week on each, he produces 16 kilograms of potatoes and 4 kilograms of meat. The figure shows these three possible outcomes and all others in between.
This graph is the gardener’s production possibilities frontier. As we discussed in Chapter 2, a production possibilities frontier shows the various mixes of out- put that an economy, or in this case an individual, can produce given existing resources. It illustrates one of the Ten Principles of Economics in Chapter 1: people face trade-offs. Here the gardener faces a trade-off between producing meat and producing potatoes. You may recall that the production possibilities frontier in Chapter 2 was drawn bowed out; in that case, the trade-off between the two goods depended on the amounts being produced. Here, however, the gardener’s technology for producing meat and potatoes (as summarized in Table 3.1) allows him to switch between one good and the other at a constant rate. If the gardener devotes an extra hour to producing meat he sacrifices potato production. In Chapter 2 we looked at how to calculate the slope of a straight line. In this case increasing meat production by 1 kilogram leads to a sacrifice of 4 kilograms of potatoes. The ∆y is 1 kilogram and the ∆x is 4 units. The slope is 0.25 which indi- cates the rate at which potatoes are sacrificed for more meat as more time is devoted to meat production. In this case, the production possibilities frontier is a straight line and so the trade-off is a constant rate. Every extra kilogram of meat produced results in a sacrifice of 4 kilograms of potatoes. The converse of
FIGURE 3.1
The Production Possibilities Frontier
Panel (a) shows the combinations of meat and potatoes that the gardener can produce. Panel (b) shows the combinations of meat and potatoes that the farmer can produce. Both production possibilities frontiers are derived from Table 3.1 and the assumption that the gardener and farmer each work 8 hours a day.
4 8
Potatoes (kilograms)
16 32
A
0 Meat (kilograms)
(a) The gardener’s production possibilities frontier
If there is no trade, the gardener chooses this production and
consumption. 12
Potatoes (kilograms) 24
B
0 Meat (kilograms)
(b) The farmer’s production possibilities frontier
48 24
If there is no trade, the farmer chooses this production and consumption.
this is that if the gardener switched from meat production to potato production, then every additional 1 kilogram of potatoes produced would involve a trade-off of ẳ kilogram of meat.
Panel (b) of Figure 3.1 shows the production possibilities frontier for the farmer. If the farmer devotes all 48 hours of her working week to potatoes, she pro- duces 48 kilograms of potatoes and no meat. If she devotes all of her time to meat production, she produces 24 kilograms of meat and no potatoes. If the farmer divides her time equally, spending 24 hours a week on each activity, she produces 24 kilograms of potatoes and 12 kilograms of meat. Once again, the production pos- sibilities frontier shows all the possible outcomes. In this case, reducing meat pro- duction by one unit means that potato production can increase by 2 units. The slope of this production possibilities frontier is, therefore, 0.5. Conversely, if she devotes more time to producing potatoes then the rate of sacrifice of meat will be 2 kilograms of meat for every 1 kilogram of potatoes.
If the gardener and farmer choose to be self-sufficient, rather than trade with each other, then each consumes exactly what he or she produces. In this case, the production possibilities frontier is also the consumption possibilities frontier.
That is, without trade, Figure 3.1 shows the possible combinations of meat and potatoes that the gardener and farmer can each consume.
Although these production possibilities frontiers are useful in showing the trade-offs that the gardener and farmer face, they do not tell us what the gar- dener and farmer will actually choose to do. To determine their choices, we need to know the tastes of the gardener and the farmer. Let’s suppose they choose the combinations identified by points A and B in Figure 3.1: the gardener produces and consumes 16 kilograms of potatoes and 4 kilograms of meat, while the farmer produces and consumes 24 kilograms of potatoes and 12 kilograms of meat.
Specialization and Trade
After several years of feeding her family on combination B, the farmer gets an idea and she goes to talk to the gardener:
FARMER: Marius, have I got a deal for you! I know how to improve life for both of us. I think you should stop producing meat altogether and devote all your time to growing potatoes. According to my calculations, if you devote all of your working week to growing potatoes, you’ll produce 32 kilograms of potatoes. If you give me 15 of those 32 kilograms, I’ll give you 5 kilograms of meat in return. You will have 17 kilograms of potatoes left to enjoy and also 5 kilograms of meat every week, instead of the
16 kilograms of potatoes and 4 kilograms of meat you now make do with. If you go along with my plan, you’ll have more of both foods. [To illustrate her point, the farmer shows the gardener panel (a) of Figure 3.2.]
GARDENER: (sounding sceptical) That seems like a good deal for me, Fabia, but I don’t understand why you are offering it. If the deal is so good for me, it can’t be good for you too.
FARMER: Oh, but it is, Marius! Suppose I spend 12 hours a week growing potatoes and 36 hours rearing cattle. Then I can produce 12 kilograms of potatoes and 18 kilograms of meat. You will give me 15 kilograms of your potatoes in exchange for the 5 kilograms of my meat. This means I end up with 27 kilograms of potatoes and 13 kilograms of meat. So I will also be able to consume more of both foods than I do now. [She points out panel (b) of Figure 3.2.]
GARDENER: I don’t know, Fabia.… This sounds too good to be true.
FARMER: It’s really not as complicated as it seems at first. Here – I’ve summa- rized my proposal for you in a simple table. [The farmer hands the gardener a copy of Table 3.2.]
GARDENER: (after pausing to study the table) These calculations seem correct, but I am puzzled. How can this deal make us both better off?
FARMER: We can both benefit because trade allows each of us to specialize in doing what we do best. You will spend more time growing potatoes and less time rearing cattle. I will spend more time rearing cattle and
FIGURE 3.2
How Trade Expands the Set of Consumption Opportunities
The proposed trade between the gardener and the farmer offers each of them a combination of meat and potatoes that would be impossible in the absence of trade. In panel (a), the gardener consumes at pointA*rather than pointA.
In panel (b), the farmer consumes at pointB*rather than pointB. Trade allows each to consume more meat and more potatoes.
4 5 8
Potatoes (kilograms)
16 17
32 A
A*
0 Meat (kilograms)
(a) The gardener’s production and consumption
Gardener's production and consumption without trade Gardener's
consumption with trade
Gardener's production with trade
12 13
Potatoes (kilograms) 24
12 27
B
0 Meat (kilograms)
(b) The farmer’s production and consumption
48 24
18
B*
Farmer's consumption with trade Farmer's
production with trade
Farmer's production and consumption without trade
TABLE 3.2
The Gains from Trade: A Summary
Gardener Farmer
Meat Potatoes Meat Potatoes
Without trade:
Production and consumption 4 kg 16 kg 12 kg 24 kg
With trade:
Production 0 kg 32 kg 18 kg 12 kg
Trade Gets 5 kg Gives 15 kg Gives 5 kg Gets 15 kg
Consumption 5 kg 17 kg 13 kg 27 kg
Gains from trade:
Increase in consumption +1 kg +1 kg +1 kg +3 kg
less time growing potatoes. As a result of specialization and trade, each of us can consume more meat and more potatoes without working any more hours.
Quick Quiz Draw an example of a production possibilities frontier for Hasani, who is stranded on an island after a shipwreck and spends his time gathering coconuts and catching fish. Does this frontier limit Hasani’s con- sumption of coconuts and fish if he lives by himself? Does he face the same limits if he can trade with natives on the island?