Interdependence and the gains from Trade

Consider an individual’s typical day. He wakes up in the morning, and pour for himself juice from oranges grown in Florida and coffee from beans grown in Brazil. Over breakfast, he watches a news program broadcast from New York on his television made in Japan. Then he gets dressed in clothes made of cotton grown in Georgia and sewn in factories in Thailand. He drives to his office in a car made of parts manufactured in more than a dozen countries around the world. Then at office he opens up some hand books for reference compiled by an author living in Massachusetts, published by a company located in Ohio, and printed on paper made from trees grown in Oregon.

Every day, we rely on many people from around the world, most of whom we do not know, to provide us with the goods and services that all of us enjoy. Such interdependence is possible because people trade with one another. Those people who provide the goods and services are not acting out of generosity or concern for our welfare. Nor is some government agency directing them to make what others want and give it to them. Instead, people provide the consumers with the goods and services they produce because they get something in return.

We will examine how our economy coordinates the activities of millions of people with varying tastes and abilities. As a start in point for this analysis, here we consider the reasons for economic interdependence. This principle explains why people trade with their neighbors and why nations trade with other nations. We examine this principle more closely. What exactly do people gain when they trade with one another? Why do people choose to become interdependent?

A parable for the Modern Economy:

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: meat and potatoes. And there are two people in the world – a cattle rancher and a potato farmer – each of whom would like to eat both meat and potatoes.

The gains from trade are most obvious if the rancher can produce only meat and the farmer can produce only potatoes. In one scenario, the rancher and the farmer could choose to have nothing to do with each other. But after several months of eating beef roasted, boiled, broiled and grilled, the rancher might decide that self-sufficiency is not all it’s cracked up to be. The farmer, who has been eating potatoes mashed, fried, baked and scalloped, would likely agree. It is easy to see that trade would allow them to enjoy greater variety: Each could then have a steak with a baked potato or a burger with fries.

Although this scene illustrates most simply how everyone can benefit from trade, the gains would be similar if the rancher and the farmer were each capable of producing the other good, but only at great cost. Suppose, for example, that the potato farmer is able to raise cattle and produce meat, but that he is not very good at it. Similarly, suppose that the cattle rancher is able to grow potatoes but that her land is not very well suited for it. In this case, it is easy to see that the farmer and the rancher can reach benefit by specializing in what he or she does best and then trading with the other.