Specialization and Exchange

Overheads

SpecializationSpecialization - A method of production in which each agent (firm) concentrates on a limited number of activities

Specialization and exchangeSpecialization and exchange

ExchangeExchange - The act of trading with others to obtain what we desire

Specialization and Exchange

There are gains to specializing in a small number of tasks

and trading the products we produce as compared to

doing it all ourselves

Steak and eggs

Examples

Beef and laying hens

Medical care and automobile care

Hair styling and plumbing

Principle of specialization and exchange

Specialization and exchange enable us to enjoygreater production and higher living standardsthan would otherwise be possible

As a result, all economies have been characterizedby high degrees of specialization and exchange

WHY?

Why specialization and exchange make us better off

1. Time to learn & acquire skills / learning by doing

3 reasons specialization pays

Finish carpenter

X- ray technician

Electrical engineer

MIS consultant

2. Set-up and switching time

Triplets in the copy shop

Fire brigade

Ice cream sundaes

Wooden pallet construction

Adam Smith and Pins

3. Comparative advantage

1. Time to learn & acquire skills / learning by doing

2. Set-up and switching time

3. Comparative advantage

Why specialization and exchange make us better off

What is comparative advantage?

Comparative advantage is the ability toproduce a good or service at alower opportunity cost than other producers

The track coach’s dilemma

Two runners (A & W) are projected to place 1-2in 400 meter hurdles, and 2-5 in the 400 meter dash

Scoring is as follows:Place Points 1 7 2 5 3 4 4 3 5 2 6 1

Only one of the runners can run each race

What should he do?

Hurdles Place Points Dash Place Points Total Points

A W

Figure it out

W A

Place Points 1 7 2 5 3 4 4 3 5 2

A will be 1st in hurdles, 2nd in dash

W will be 2nd in hurdles, 5th in dash

1 7 4 3 10

1 7 2 5 12

Absolute versus comparative advantage

An individual producer has an absolute advantage in the production of a product if he has the ability to produce the good or service using

fewer resources than other producers use.

An individual producer has a comparative advantage in the production of a product if she has the ability to produce the good or service at a

lower opportunity costthan other producers.

The Flintstone Economy

Wilma

Fred

Turnips Mastodons

20 1

80 2

Output per hour

This data is output per unit of input data

Tons per acre

Cars per day

Shirts per hour

Returns per dollar invested

Turnips or mastodons per hour

Who has the advantage in what?

Wilma has an absolute advantage inturnip gathering and in mastodon hunting

Wilma is more efficient at both activities!!

Comparative Advantage is Measuredin TermsTerms of Opportunity Cost

The The opportunity costopportunity cost of any choice of any choice

is is what we give upwhat we give up when we make when we make

that choicethat choice

What does Fred give up to get a mastodon?What does Fred give up to get a mastodon?

Fred gives up 20 turnips to get one mastodonFred gives up 20 turnips to get one mastodon

1 mastodon costs 20 turnips1 mastodon costs 20 turnips

Wilma

Fred

Turnips Mastodons

20 1

80 2Output per hour

Wilma

Fred

1 Turnip 1 Mastodon

20 turnips

Opportunity Cost of:

Pricing in the Flintstone economywith turnips as the unit of exchange

Fred 1 mastodon costs 20 turnips

Individual Opportunity Cost

If Fred could pick up 40 ants per hour then

20 / 1 = 20

20 /40 = 1/2

Fred 1 ant costs 1/2 turnip

What about Wilma?What about Wilma?

Wilma gives up 40 turnips per mastodonWilma gives up 40 turnips per mastodon

1 mastodon costs 40 turnips1 mastodon costs 40 turnips

80 / 2 = 4080 / 2 = 40

Wilma

Fred

Turnips Mastodons

20 1

80 2Output per hour

Wilma

Fred

1 Turnip 1 Mastodon

20 turnips

40 turnips

Opportunity Cost of:

Who has the lowest opportunity cost for mastodons?

20 t

40 tWilma

Fred

Turnips Mastodons

Fred has a comparative advantage in mastodon hunting!

Pricing in the Flintstone economywith turnips as the unit of exchange

Fred 1 mastodon costs 20 turnips

Individual Opportunity Cost

Wilma

Fred has a comparative advantage in mastodon hunting!

1 mastodon costs 40 turnips

Fred gives up less turnips for a mastodon

The good that is the unit of comparison

The numerairenumeraire good is used as a way ofmeasuring the opportunity costopportunity cost of other goods,

in an economy is called thenumerairenumeraire good

(or exchange)(or exchange) (or account)(or account)

or how many units of the numeriarenumeriare must begiven up

for one unit of a given good

In our example so far, turnips were theunit of exchange or numeraire

Wilma

Fred

Turnips Mastodons

20 t

40 t

Now make mastodons the unit of exchange

What does Fred give up to get a turnip?What does Fred give up to get a turnip?

Fred gives up 1/20 of a mastodon per turnipFred gives up 1/20 of a mastodon per turnip

1 turnip costs 1/20 of a mastodon1 turnip costs 1/20 of a mastodon

Wilma

Fred

Turnips Mastodons

20 1

80 2Output per hour

Wilma

Fred

1 Turnip 1 Mastodon

1/20 mastodon 20 turnips

40 turnips

Opportunity Cost of:

What about Wilma?What about Wilma?

Wilma gives up 1/40 mastodon per turnipWilma gives up 1/40 mastodon per turnip

Wilma

Fred

Turnips Mastodons

20 1

80 2

2 / 80 = 1/402 / 80 = 1/40

1 turnip costs 1/40 of a mastodon1 turnip costs 1/40 of a mastodon

Wilma

Fred

1 Turnip 1 Mastodon

1/20 mastodon 20 turnips

40 turnips

Opportunity Cost of:

1/40 mastodon

Who has the lowest opportunity cost for turnips?

Wilma has a comparative advantage in turnip digging!

20 t

40 tWilma

Fred

Turnips Mastodons

1/20 m

1/40 m

Pricing in the Flintstone economywith mastodons as the unit of exchange (numeraire)

Fred 1 turnip costs 1/20 of a mastodon

Individual Opportunity Cost

Wilma 1 turnip costs 1/40 of a mastodon

Wilma has a comparative advantage in turnip digging!

Wilma gives up less mastodons for a turnip

How to determine who has the comparative advantage in what

2. Make an opportunity cost table (agents by goods)

1. Determine the output per period of each agent

5. The person with the lower opportunity cost has a comparative advantage in the production of each good

3. For each good (column) choose a unit of exchange

4. Determine the opportunity cost of each good in termsof the unit of exchange by dividing the production ofthe unit of exchange by the production of the other good

Example Computation

3. Cassava is unit of exchange for fish Fish is unit of exchange for cassava

5. Friday has the comparative advantage in fish production

5a. Crusoe has the comparative advantage in cassava production

4. Fill in comparative advantage table (unit of exchange per unit of good)

Friday

Crusoe

Fish Cassava

5 20

8 24 Friday

Crusoe

Fish Cassava

4 c

3 c

1/4 f

1/3 f

What is comparative advantage?

Comparative advantage is the abilityto produce a good or serviceat a lower opportunity costthan other producers

Utilizing comparative advantageleads to more total output

Output before specialization

Hours Digging Turnips Hours Hunting MastodonsFred 6 120 2 2Wilma 6 480 2 4Total 12 600 4 6

Output after specialization

Hours Digging Turnips Hours Hunting MastodonsFred 0 0 8 8Wilma 8 640 0 0Total 8 640 8 8

Total production of every good and service

will be greatest

when individuals specialize

according to their comparative advantage.

The three problems of resource allocation

1. Which goods and services should be produced with society’s resources?

2. How should the goods and services be produced?

3. Who should get these goods and services?

Resource allocation is ...

the method used to determine

which goods and services will be produced,

how they will be produced,

and who will get them

Three methods of resource allocation

Tradition

Command

Market

What is a price?

The price of a product is the amount of money that must be paid to a seller

to obtain a good or service.

Prices are a signal

for resource allocation

How prices lead to changes in resource allocation

An increase is the desire for product will cause consumers to bid up the price of the product.

A higher price for a product will encourage sellers to produce (obtain) and then sell more of the product.

To produce more of the product, sellers will buymore of the resources needed to produce it.

The owners of these resources will have a higher income.

The owners of these resources will now have more influence on what is produced.

ExampleExample

Gas-powered model airplanesGas-powered model airplanes

Patent on nerve gas antidotePatent on nerve gas antidote

Terrorists start setting off nerve gasTerrorists start setting off nerve gas

Income of patent ownerIncome of patent owner

Production of airplanesProduction of airplanes

He likes to fly model airplanesHe likes to fly model airplanes

Three systems of resource ownership

Communism - resources owned in common

Socialism - resources owned by the state

resources owned privatelyCapitalism -

Types of Economic Systems

MarketCapitalism

MarketSocialism

CentrallyPlannedCapitalism

CentrallyPlannedSocialism

ResourceOwnership

Resource Allocation

Private

State

Market Command

The End