Specialization and Exchange

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Specialization and Exchange
Overheads
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Specialization and exchange
Specialization - A method of production in which
each agent (firm) concentrates on a limited
number of activities
Exchange - The act of trading with others to
obtain what we desire
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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
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Examples
Steak and eggs
Beef and laying hens
Medical care and automobile care
Hair styling and plumbing
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Principle of specialization and exchange
Specialization and exchange enable us to
enjoy greater production and higher living
standards than would otherwise be possible
WHY?
As a result, all economies have been
characterized by high degrees of specialization
and exchange
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Why specialization and exchange make us better off
3 reasons specialization pays
1. Time to learn acquire skills / learning by
doing
Finish carpenter
X- ray technician
Electrical engineer
MIS consultant
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2. Set-up and switching time
Triplets in the copy shop
Fire brigade
Ice cream sundaes
Wooden pallet construction
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Adam Smith and Pins
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3. Comparative advantage
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Why specialization and exchange make us better off
1. Time to learn acquire skills / learning by
doing
2. Set-up and switching time
3. Comparative advantage
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What is comparative advantage?
Comparative advantage is the ability to produce
a good or service at a lower opportunity cost
than other producers
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The track coachs dilemma
Two runners (A W) are projected to place 1-2 in
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?
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Figure it out
A will be 1st in hurdles, 2nd in dash
W will be 2nd in hurdles, 5th in dash
Hurdles Place Points Dash Place Points Total
Points
A W
1
7
4
3
10
W A
1
7
2
5
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Place Points 1 7 2 5 3
4 4 3 5 2
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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 cost than other producers.
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The Flintstone Economy
Output per hour
Turnips
Mastodons
1
20
Fred
Wilma
2
80
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This data is output per unit of input data
Turnips or mastodons per hour
Cars per day
Tons per acre
Shirts per hour
Returns per dollar invested
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Who has the advantage in what?
Wilma has an absolute advantage inturnip
gathering and in mastodon hunting
Wilma is more efficient at both activities!!
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Comparative Advantage is Measured in Terms of
Opportunity Cost
The opportunity cost of any choice is what we
give up when we make that choice
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What does Fred give up to get a mastodon?
Fred gives up 20 turnips to get one mastodon
1 mastodon costs 20 turnips
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Opportunity Cost of
20 turnips
Fred
Wilma
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Pricing in the Flintstone economy with turnips as
the unit of exchange
Individual Opportunity Cost
Fred 1 mastodon costs 20 turnips
20 / 1 20
If Fred could pick up 40 ants per hour then
Fred 1 ant costs 1/2 turnip
20 /40 1/2
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What about Wilma?
Wilma gives up 40 turnips per mastodon
80 / 2 40
1 mastodon costs 40 turnips
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Opportunity Cost of
1 Turnip
1 Mastodon
20 turnips
Fred
Wilma
40 turnips
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Who has the lowest opportunity cost for mastodons?
20 t
40 t
Fred has a comparative advantage in mastodon
hunting!
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Pricing in the Flintstone economy with turnips as
the unit of exchange
Wilma
1 mastodon costs 40 turnips
Fred gives up less turnips for a mastodon
Fred has a comparative advantage in mastodon
hunting!
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The good that is the unit of comparison
(or exchange)
(or account)
in an economy is called the numeraire good
The numeraire good is used as a way of measuring
the opportunity cost of other goods,
or how many units of the numeriare must be given
up for one unit of a given good
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In our example so far, turnips were the unit of
exchange or numeraire
Now make mastodons the unit of exchange
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What does Fred give up to get a turnip?
Fred gives up 1/20 of a mastodon per turnip
1 turnip costs 1/20 of a mastodon
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Opportunity Cost of
1 Turnip
1 Mastodon
1/20 mastodon
20 turnips
Fred
Wilma
40 turnips
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What about Wilma?
Wilma gives up 1/40 mastodon per turnip
2 / 80 1/40
1 turnip costs 1/40 of a mastodon
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Opportunity Cost of
1 Turnip
1 Mastodon
1/20 mastodon
20 turnips
Fred
Wilma
40 turnips
1/40 mastodon
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Who has the lowest opportunity cost for turnips?
Wilma has a comparative advantage in turnip
digging!
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Pricing in the Flintstone economy with mastodons
as the unit of exchange (numeraire)
Individual Opportunity Cost
Fred 1 turnip costs 1/20 of a mastodon
Wilma 1 turnip costs 1/40 of a mastodon
Wilma gives up less mastodons for a turnip
Wilma has a comparative advantage in turnip
digging!
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How to determine who has the comparative
advantage in what
1. Determine the output per period of each agent
2. Make an opportunity cost table (agents by
goods)
3. For each good (column) choose a unit of
exchange
4. Determine the opportunity cost of each good in
terms of the unit of exchange by dividing the
production of the unit of exchange by the
production of the other good
5. The person with the lower opportunity cost has
a comparative advantage in the production of
each good
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Example Computation
4 c
1/4 f
3 c
1/3 f

• Cassava is unit of exchange for fish
• Fish is unit of exchange for cassava

4. Fill in comparative advantage table (unit of
exchange per unit of good)
5. Friday has the comparative advantage in fish
production
5a. Crusoe has the comparative advantage in
cassava production
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What is comparative advantage?
Comparative advantage is the ability to produce
a good or service at a lower opportunity
cost than other producers
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Utilizing comparative advantage leads to more
total output
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Output before specialization
Hours Digging Turnips Hours Hunting
Mastodons Fred 6 120 2 2 Wilma 6
480 2 4 Total 12 600 4 6
Output after specialization Hours Digging
Turnips Hours Hunting Mastodons Fred 0
0 8 8 Wilma 8 640
0 0 Total 8 640 8 8
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Total production of every good and service will
be greatest when individuals specialize
according to their comparative advantage.
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The three problems of resource allocation
1. Which goods and services should be produced
with societys resources?
2. How should the goods and services be produced?
3. Who should get these goods and services?
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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
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Three methods of resource allocation
Tradition
Command
Market
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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.
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Prices are a signal
for resource allocation
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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
buy more 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.
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Example
Gas-powered model airplanes
Patent on nerve gas antidote
Terrorists start setting off nerve gas
Income of patent owner
He likes to fly model airplanes
Production of airplanes
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Three systems of resource ownership
resources owned in common
Communism -
Socialism -
resources owned by the state
resources owned privately
Capitalism -
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Types of Economic Systems
Resource Allocation
Market
Command
Centrally Planned Capitalism
Market Capitalism
Private
Resource Ownership
Centrally Planned Socialism
Market Socialism
State
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The End