Principle #4: Voluntary and informed exchange benefits the traders
Objectives:
Identify the tradeoff between efficiency and self-sufficiency
Explain the relationship between differing opportunity costs and the Law of Comparative Advantage
Why do you want to learn this?
You learned that one way to increase society’s well-being with no additional resources is to exchange. In this lesson you will discover another way to increase society’s wealth with no additional resources – specialization in production.These two concepts are the basis for domestic and international trade. Since you are, or soon will be voting on these issues, you probably want to know what production and trade are all about. Pretty neat, huh?
Efficiency or self-sufficiency?
When you go to work outside the home, you use your human capital to do whatever you do at work and you exchange the money that you receive from work for other goods and services that you want. Most people don’t make their own automobiles, computers or shoes or grow their own coffee, tea, or bananas. There are two reasons that we are not self-sufficient – it is not practical and it is not efficient. I can’t produce an automobile. I don’t have the physical capital to do so and I don’t have the human capital to do so. It is not practical. Even if I were able to complete the car, it would take a tremendous amount of resources to do so; the opportunity cost would be very high. General Motors or Toyota can do the same thing with far fewer resources per car. Besides all the equipment, they have workers who have been trained and who have experience doing this sort of work. We all produce some goods or services and exchange them for other goods and services; virtually no one that I know makes everything they consume. So the question is, “What should I produce to exchange for all the other goods and services I want, in order to get the most from my scarce resources?”
In what activities are you most efficient or in what activities are you least inefficient?
We all know people who are good at lots of things. In fact, they are so good at so many things that people often say about them, “Is there anything Sharon can’t do? She can do everything and do it better than everyone else. So the question is “Should Sharon do everything or should she specialize in one thing and exchange that one thing for everything else that she wants. Let’s assume that a star professional athlete is a Sharon; she can do everything better than everyone else. So should she grow all her own food, clean her house, do her own laundry, recognizing that all of these activities will take her away from practicing and playing her sport? Probably not.
The tale of the cabinetmaker and the high school student
On sports teams, the athlete who is obviously college material has an absolute advantage over the other players on the team in all positions. Absolute advantage compares one individual’s production capabilities to another individual’s production capabilities; how does Quinton compare to other team members at each position. In this case, we are making the claim that he is better than other players at every position.
But he can’t play all positions. So now the question is, “In which position is he most better?” In which position is his advantage over the other players the greatest? The coach has to decide where his comparative advantage lies, just as the coach must decide where the worst athlete on the team has a comparative advantage, i.e. in which position does he have an advantage compared to all other positions… where is he likely to do the least harm? The beauty of this is that every player has a comparative advantage somewhere. Comparative advantage compares an individual’s advantage in production of one product to another product.
Let’s put some numbers on this so we can see the gains from specialization and exchange. Assume that a cabinetmaker is very good at making cabinets and specializes in doing that. She uses about two hours of her human capital to making a cabinet. Assume further that she averages about $50 per hour making and selling her cabinets. She owns a nice home and has lawns that have to be mowed and leaves and other debris that have to be raked. It would take her about two hours to do the yard work.
There is a teenager down the street who is very good at mowing lawns and raking yards and he specializes in doing that. He uses about three hours of his human capital to do a fair sized yard and he charges $10 per hour. He would like a cabinet for his bedroom and could make it himself. It would take him about 20 hours of human capital.
The cabinetmaker is better both at making cabinets and mowing and raking than is the teenager. If the cabinetmaker is better at both activities, is there any way that both the cabinetmaker and the lawnmower could benefit from specialization and exchange? Should the cabinetmaker hire the teenager to mow and rake, to make cabinets, both, neither?
The question can be answered by answering another question. Even though the cabinetmaker is better at both activities, is she “more better” at one activity than another? Does she have a comparative advantage in one activity? And does the teenager have a comparative advantage in one activity?
Hours to Make Cabinet | Hours to Mow and Rake Yard | |
Cabinetmaker | 3 | 2 |
Teenager | 20 | 3 |
Cabinetmaker advantage over teenager | 3/20 = 15% | 2/3 = 67% |
Teenager disadvantage | 20/3 = 6.67 | 3/2 = 1.5 |
Yes, they do. The cabinetmaker can make a cabinet using 15% of the human capital it takes the teenager to make a cabinet and she can do the yard work using 67% of the human capital it takes the teenager. Her advantage is greater in making cabinets than in doing yard work. She should specialize in cabinets and hire the teenager to do her yard work. She has a greater (or comparative) advantage in cabinets as opposed to yard work. She is “more better” in cabinetmaking than in yard work.
But won’t the teenager get ripped off? Well, no actually. The teenager has a smaller disadvantage in yard work (1.5) compared to cabinetmaking (6.67), and so economists say that he has a comparative advantage in yard work. In comparing yard work to cabinetmaking, her disadvantage is smallest in yard work. When discussing comparative advantage, it is important to realize that the comparison is not between the two workers, but between the two activities. Compared to cabinetmaking, the teenager is “less ungood” in yard work. While the language is certainly inelegant, the point is, hopefully, clear.
Let’s see who gains when both parties specialize. The table below helps illustrate the situation. This table is based on the assumptions that the cabinetmaker earns $50 per hour and the teenager earns $10 per hour.
Cabinetmaker | Teenager | |
Time to make cabinet | 20 hours | |
Hourly pay | $10 | |
Cost to make cabinet | $200 | |
Cost to buy cabinet | $150 | |
Saving by buying cabinet | $50 | |
Time to do yard work | 2 hours | |
Hourly pay | $50 | |
Cost to do yard work | $100 | |
Cost to buy yard work | $30 | |
Saving by buying yard work | $70 |
Who gains what depends upon the opportunity cost of both individuals. It will cost the cabinetmaker two hours of human capital to mow and rake the lawn. The opportunity cost of using her human capital to do yard work is valued at $100 since she would be using her human capital in those two hours to be making a cabinet. If she hires the teenager, it will cost $30. It is in her best interest to specialize in making cabinets. She is ahead by $70. The teenager could build his own cabinet, but that would take 20 hours of human capital, which is valued at $200. If he buys the cabinet, it will cost $150. It is in the cabinetmaker’s best interest to specialize in cabinets and the teenager’s to specialize in mowing and raking. Even though the cabinetmaker is better at both making cabinets and mowing and raking, because the two have different opportunity costs, it benefits both parties to specialize and exchange. In an exchange between two parties, even if one party is better at both activities, both parties can benefit from specialization and exchange. That is the law of comparative advantage.
In an efficient economy, people become teachers, plumbers, carpenters, engineers or nurses if they have a comparative advantage in that field. The more this rule is followed, the greater the efficiency of the economy and the more goods and services society will produce from its scarce resources.
Bottom Line: The more people specialize in production and exchange with others, the more they will get from their scarce resources.
1. A nation that attempts to produce all of its own products, closing its borders to imports, gives up:
a. Self-sufficiency
b. National independence
c. Efficiency
d. All of the above
2. If Fran is better at cooking and cleaning than Jacob, which of the following is true?
a. Fran should do both.
b. Jacob should do both.
c. Fran should do that which she does “more better.”
d. Jacob should do that which he does “more worse.”
3. The Law of Comparative Advantage depends upon:
a. The first exchange principle
b. The second exchange principle
c. Different opportunity costs
d. All of the above