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Opportunity Cost, Specialization, and Trade: Introduction To Macroeconomics
Opportunity Cost, Specialization, and Trade: Introduction To Macroeconomics
1. Introduction
In Chapter 1 we introduced the economic principle of opportunity cost. Recall that the combination of
limited resources and unlimited wants implies scarcity. Because goods and services are produced from
scarce resources, goods and services are also scarce. Scarcity requires choice and implies costs. A
scarce resource used to satisfy one need means there is some other need that cannot be satisfied.
Opportunity cost represents the highest-valued alternative foregone in making any choice.
In this chapter we will use the principle of opportunity cost to justify the incentive individuals have to
specialize in their labor. We will then extend the relationship between opportunity cost and the incentive
to specialize to macroeconomic aggregates like nations. To do this we will develop our first economic
model: the Production Possibilities Curve.
2. Specialization
A. Specialization and Division of Labor
How do we get the most out of our personal limited resource - labor? We specialize. We tend to
concentrate our labor on one primary activity. Adam Smith was one of the first economists to
explicitly identify the productive benefits of specialization, which he referred to as the "division of
labor."
The greatest improvement in the productive powers of labor..seem to have been the effects of the division of labor.
[A]n example...the trade of the pin-maker; a workman not educated to this business (which the division of labor has
rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the
same division of labor has probably given occasion), could scarce...make one pin in a day, and certainly could not
make twenty. But in the way in which this business is now carried on...one man draws out the wire, another
straights it, a third cuts it...; and the...business of making a pin is...divided into about 18 distinct operations... I have
seen a small manufactory of this kind where 10 men only were employed... But though they were very poor, and
therefore but indifferently accommodated with the necessary machinery, they could...make upwards of 48,000 pins
in a day.
Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776)
But why is specialization efficient? There are several reasons. For example, through
specialization we may acquire greater skill from repetition and we may avoid wasting time shifting
from one task to another. Adam Smith also emphasized incentives for technological
advancement. Smith suggested that if more of my time is spent on one activity, then I have an
incentive to invest my resources to develop specialized tools or machines to aid me in that
activity.
In the early 19th century, David Ricardo developed a different justification for specialization based
on the concept of opportunity cost, which may vary across individuals because of differences in
abilities. Ricardo's theory is the subject of this chapter because it goes beyond explaining
specialization by individuals to justify why countries (macroeconomies) also specialize and
engage in trade.
When the division of labor has been...established, it is but a very small part of a man's wants which the produce of
his own labor can supply. He supplies the greater part of them by exchanging that surplus...of his own production,
which is over and above his own consumption, for...the produce of other men's labor...Every man thus lives by
exchanging, or becomes in some measure a merchant.
Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776)
The fundamental method of exchange is barter. With barter no money is used. One good or
service is exchanged directly for another. There are several problems with barter:
But when the division of labor first began to take place, this power of exchanging must...have been [difficult]...The
butcher has more meat in his shop than he himself can consume, and the brewer and the baker would each of them
be willing to purchase a part of it. But they have nothing to offer in exchange, except the different productions of
their respective trades, and the butcher is already provided with all the bread and beer which he has immediate
occasion for. No exchange can...be made between them.
Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776)
The introduction of money reduced the difficulty or costs of barter. For example, it is no longer
necessary to have a coincidence if wants. Money is a common medium of exchange and
represents general purchasing power. Money can be used to buy any goods and services
offered for sale. Of course the role of money is much more extensive than this, but we will save
that for a later chapter.
[T]o avoid the inconvenience of such situations, every prudent man...must have at all times by him, besides the
peculiar produce of his own industry, a certain quantity of some one commodity...such as he imagined few people
would be likely to refuse in exchange...
Many different commodities...were employed for this purpose. In the rude ages of society, cattle are said to have
been the common instrument of commerce...The armour of Diomede, says Homer, cost only nine oxen; but that of
Glaucus cost an hundred oxen. Salt...in Abyssinia; a species of shells in some parts of the coast of India ...
In all countries, however, men seem at last...to give the preference...to metals. Metals can not only be kept with as
little loss as any other commodity...but they can likewise, without any loss, be divided into any number of parts, as
by fusion those parts can easily be reunited again...
Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776)
General Purchasing Power - the characteristic of money or currency where it can be used as a medium of
exchange for any good or service produced in an economy.
We can illustrate the incentive to specialize and exchange with a simple example. You and I are
stranded on a tropical island. In one hour I can cut down 12 coconuts or catch 8 fish. In one hour
you can cut down 14 coconuts or catch 7 fish. What do we do?
First let's calculate what the opportunity cost is for each of our production options. The
opportunity cost for me to cut down 12 coconuts is that I give up the opportunity to catch 8 fish.
The opportunity cost of each coconut is 2/3 fish. On the flip side, the opportunity cost for me to
catch 8 fish is that I forego cutting down 12 coconuts. The opportunity cost of each fish is 3/2
coconuts. We can demonstrate this mathematically:
12 coconuts = 8 fish
14 coconuts = 7 fish
1 coconut = 1/2 fish
1 fish = 2 coconuts
I have the lower opportunity cost of catching fish (I give up only 3/2 coconuts for each fish while
you must give up 2 coconuts for each fish) and you have the lower opportunity cost of cutting
down coconuts (my 1/2 fish for each coconut versus your 2/3 fish for each coconut). Again we
ask, what do we do?
Let's say we don't cooperate at first. We each evenly split our time between cutting down
coconuts and catching fish. I get 6 coconuts and 4 fish and you get 7 coconuts and 3.5 fish.
Since I'm the economics instructor I get the bright idea that if I shift some of my time to catching
one more fish and you shift some of your time to cutting down two more coconuts we will both be
better off. To catch one more fish I reduce my supply of coconuts by 3/2. To cut down two more
coconuts you reduce your supply of fish by 1. Our total supply of coconuts increases by 1/2 while
our total supply of fish remains the same.
We can continue this logic and show in Table 2-1 that the total supply and consumption of
coconuts and fish is greatest when we specialize and I only catch fish and you only cut down
coconuts and we trade. We both have an incentive to specialize and trade. Trade increases total
wealth by allowing a person to specialize in those products that he or she produces at a lower
opportunity cost than others and trade for those goods that others produce at lower opportunity
cost.
But how do we really know what paid labor to specialize in? Quite simply by what pays you the
most for your training and abilities. Individuals seek those jobs they are capable of performing
and that pay the highest wage or salary. Market prices (wages) reveal which of your skills is most
highly valued.
D. Exchange Prices
Now that we have established that there is an incentive to specialize and trade the question
becomes what will the terms of exchange be? What "price" should I charge for the fish I produce?
In our simple economy the price will be some number of coconuts.
The answer is that the price will fall somewhere between my oportunity cost and your opportunity
cost. Let's start with the situation where we are not specializing or trading. If I produce 1 more fish
I must give up 1.5 coconuts (my opportunity cost). Would I be willing to give you that fish in
exchange for 1 coconut? No, because I would be giving up more (1.5 coconuts) than I would get
from you (1 coconut). For me to produce one more fish you must be willing to give me at least 1.5
coconuts. Would you be willing to give me 3 coconuts? No, because you could produce 1 more
fish by giving up production of just 2 coconuts (your opportunity cost). You would only be willing
to exchange if you could give me less than 2 full cocunuts. Thus the price of fish must lie
somewhere between 1.5 and 2 coconuts. The actual price of exchange cannot be determined by
our theory since it would depend on each person's negotiating abilities. The same analysis would
apply to the exchange price of coconuts. The exchange price should fall between 0.5 fish (your
opportunity cost) and 0.67 fish (my opportunity cost).
When we specialize and exchange we both benefit. Specialization and trade is called a positive
sum game because we both are better off after exchange than we were before.
1. Negotiation costs,
2. Transportation costs, and
3. Artificial barriers to trade (e.g., import tariffs).
A reduction in these costs would increase the incentive for specialization, thereby increasing both
trade and total wealth. This is a simple explanation why most economists oppose trade barriers
(such as tariffs or import quotas) on principle.
Absolute Advantage - a person can produce a good or service with fewer resources than can another person.
Comparative Advantage - a person can produce a good or service with lower opportunity cost than can another
person.
Let's use our tropical island example to identify who has absolute and comparative advantage in
the production of fish and coconuts. You and I are stranded on a tropical island. In one hour I can
cut down 12 coconuts or catch 8 fish. In one hour you can cut down 14 coconuts or catch 7 fish.
Absolute Advantage. If we both spend all our time catching fish, I can catch 8 fish in one hour
while you catch 7 fish. Since I can catch more fish I have absolute advantage in catching fish. If
on the other hand we both spend all our time cutting down coconuts, I can cut down 12 in one
hour and you can cut down 14. You have absolute advantage in coconut production.
Comparative Advantage. As we calculated above, the opportunity cost for me to catch 1 fish is
3/2 coconuts while the opportunity cost for you is 2 coconuts. I have comparative advantage over
you in catching fish because my opportunity cost is lower. In coconut production you have
comparative advantage because your opportunity cost is lower.
So, why did we emphasize that specialization should be based on opportunity cost, i.e.
comparative advantage, and not the simpler concept of absolute advantage? It may be easier to
demonstrate by slightly changing the example. Let's say that in one hour I can still cut down 12
coconuts or catch 8 fish. But let's change your capabilities to cutting down 10 coconuts or
catching 5 fish in one hour. Now I have absolute advantage in both coconut and fish production
since I can cut down more coconuts and catch more fish in one hour than you can. Does that
mean I should do both? No. Notice that the opportunity costs have not changed. I have
comparative advantage in catching fish and you still have comparative advantage in cutting down
coconuts. I should specialize in fish and you should specialize in coconuts. (The details of this
calculation are provided in the sample problems for this chapter.)
The bottom line is that it is comparative advantage (opportunity cost) and not absolute advantage
that yields an incentive for specialization and trade. Just because I am better than you at
everything doesn't mean I should do everything.
The quantity and quality of available human and nonhuman resources usually determines the competitive
relationship between countries (i.e., who has comparative advantage in what products). These resource
factors include:
• labor (with consideration of the education and skills of the workforce and the extent of
specialization),
• natural resources such as fertile fields, minerals, navigable waterways, forests, etc., and
• technology and real capital.
The availability of natural resources is of course a major determinant of comparative advantage. The
Middle East countries have abundant crude oil reserves and the United States has rich agricultural lands.
But a country can also pursue comparative advantage despite a lack of natural resources. Japan, for
example, imports scarce natural resources and uses its skilled labor force and technology to produce
many products at comparative advantage to other countries.
We can apply the microeconomic concepts of opportunity cost and specialization to entire countries with
our first macroeconomic model - the Production Possibilities Curve (PPC). To illustrate the concept of
the production possibilities curve, assume that we live on an island that has only two industries -- food
and clothing. Table 2-2 below shows different combinations of the maximum possible quantities that can
be produced with the resources that are available on our island:
A 0 50
B 10 48
C 20 42
D 30 33
E 40 19
F 50 0
The table identifies six production possibilities, options A through F. Each option represents the amount of
food and clothing that our island economy can produce given full and efficient utilization of our available
resources. In option A all available resources are dedicated to the production of clothing. If we decide to
produce some food we must give up some production of clothing. Options B through F represent
progressively increasing output of food and decreasing output of clothing.
Actually there are many more possible production combinations than indicated in the table. We can
illustrate these many combinations with a graph of the production possibilities curve.
Production Possibilities Curve - a graph that indicates all the possible combinations of two goods or
services (or aggregates of goods and services) that can be produced within an economy given the full and efficient
use of all available resources.
The production possibilities curve is often referred to as a "Frontier". The PPC represents all possible
combinations of two goods or services that can be produced given available resources and technology.
Consequently it is impossible to produce outside the production possibilities curve (above and/or to the
right of the PPC) because of scarcity of resources.
However, you can operate inside the production possibilities curve (below and/or to the left of the PPC).
But this represents the undesirable situation of an underutilization of resources. For example, if there is a
higher than normal level of unemployment, then our economy is not producing at its full capacity.
Figure 2-2. Underutilization of Resources
A. Assumptions
There are four assumptions that must be satisfied to construct a production possibilities curve:
By satisfying these four assumptions, the production possibilities curve identifies all combinations
of the maximum amount of any two goods or services that can be produced by a given economy.
Our first assumption that only 2 goods or services are produced allows us to illustrate our model
as a graph with the output of one economic good plotted against the output of a second economic
good. Of course there are many thousands of goods and services that are supplied in any
economy. We are not limited to analyzing the tradeoff between two specific goods. For example,
we can plot the production of that one good against an aggregate measure of all other goods and
services supplied in the economy. There are other aggregated combinations that reveal
interesting tradeoffs such as all consumer goods versus all capital goods.
Our second assumption requires the full and efficient use of all available resources. As we noted
above if resources are not fully utilized we are operating inside the PPC. The application of the
model with respect to opportunity cost and comparative advantage requires that we are operating
at some point on the PPC. For example, if we have a situation of large scale unemployment and
factories are sitting idle we can increase output with no opportunity cost to society. In other words
we can produce more of one good without requiring any sacrifice of production of the other good.
Similarly, if resources are not efficiently used we could increase output of one good without
sacrificing output of the other good.
You should recognize that this is not a model of economic growth. The application of the model
with respect to opportunity cost and comparative advantage requires a stable PPC, i.e. a curve
that does not shift. If there is an increase in the resources available (e.g., an increase in the size
of the labor force) we can produce more. If there is an improvement in technology we can also
produce more or everything. Economic growth arising from an increase in productive capacity
through an increase in resources or an improvement in technology implies the PPC shifts outward
(Figure 2-3). Conversely, if there is a reduction in available resources (e.g., workers leave the
country or a natural disaster strikes) the PPC would shift inwards.
Figure 2-3. Resource and/or Technology Figure 2-4. Resource and/or Technology
Growth That Benefits Both Growth That Benefits Only One
Goods/Services Goods/Service
1. The PPC slopes downward and to the right. This represents the opportunity cost of
increasing the output of one good at the expense of the second good. An increase in food
production requires a reduction in the production of clothing. The slope of the PPC is
negative at all points on the curve. Opportunity cost is measured by the slope of the PPC
(the change in along y-axis divided by the change along the x-axis). As production of food
increases, production of clothing declines and vice versa.
2. The PPC is "bowed outward" (concave) from the origin. This represents increasing
opportunity cost. For example, increasing food production from 0 units to 10 units
requires only a small reduction in clothing production. A futher increase from 10 to 20
requires a larger sacrifice. Finally increasing from 40 to 50 requires the largest sacrifice.
The opportunity cost of producing more food increases as we move to the right in the
graph. The slope of the PPC becomes more negative as we move from left to right on the
curve.
Increasing Opportunity Cost - As more scarce resources are used to increase production of one good
or service, production of another good or service falls by larger and larger amounts.
3. Why are there increasing opportunity costs? To produce more food, resources employed
in clothing production must be transferred to food production. The first resources
transferred from clothing to food production will likely be those that are best suited for
food production. For example, the most fertile land is first transferred from raising sheep
to growing food. As more resources are transferred those resources are progressively
less well suited to food production. Increasing opportunity costs is a reflection of the
specialized characteristics of resources. Resources are not perfectly adaptable to
alternative uses.
4. In some of the examples and sample problems in this chapter we assume the PPC is a
straight line. This implies opportunity costs are constant. While this assumption is made
as a convenient simplification, it is not necessarily unrealistic. For example, if the tradeoff
considered is between making automobile engines versus motorcycle engines, the
resources employed may be equally suitable in the production of either good.
C. Comparative and Absolute Advantage
The concepts of comparative and absolute advantage also apply to macroeconomic aggregates
such as regions or nations. We can easily use the production possibilities curves of two countries
to identify which has absolute and/or comparative advantage.
Comparing absolute advantage for two countries requires the additional assumption that the
resources available to each country are identical. But we are not really interested in absolute
advantage. It is comparative advantage that reveals incentives to specialize. We do not need to
assume the countries are the same size to determine who has comparative advantage using the
PPC model.
Federal Reserve Chairman Alan Greenspan arguing that free trade raises living standards, yesterday deplored recent
politically driven actions to protect various industries from foreign competition.
Greenspan acknowledged that increased competition can cause an "adjustment process [that] is wrenching to an
existing work force made redundant largely through no fault of their own." But protectionist efforts designed to
avoid such dislocations are "unwise and surely self-defeating" because they make the U.S. economy less productive.
Greenspan did not mention any specific industries or products. But he pointed to anti-dumping complaints and the
imposition of so-called countervailing duties on imports as examples of anti-competitive actions.
John M. Berry, Washington Post (Washington, DC: April 17, 1999) pp. E1-E2.
While economists may feel comfortable with the argument that specialization with free trade
would make everyone better off, politics is not so lucky. There is still a human element (voters)
that can't be ignored. Declining industries means some must lose their jobs. Those people may
also be ill-trained to find work in industries that enjoy a comparative advantage. One political
response as mentioned is to protect the jobs. But there are other options such as job retraining
programs, extension of unemployment benefits, etc.
Unfortunately, many poor nations don't have the luxury of making this choice. These less-
developed countries (LDCs) may find it necessary to devote all of their resources to feeding their
population, and that still may not be enough. Their economy may be operating at or below the
subsistence level (the barest means in terms of food, clothing, and shelter needed to sustain life).
This country faces the cruel dilemma that it cannot invest in the equipment needed to boost future
productivity and consumption without letting more people go hungry today.
We can illustrate this problem with a PPC. Assume the country produces only two goods:
consumption goods and capital goods. In the figure below we can see that the PPC falls below
the subsistence level. If the country devoted all of its resources to consumption today it still would
not satisfy the basic minimal needs of its population. Humanitarian aid would be required.
For the country to become self-sustaining it must shift its PPC outward. Assuming there is no
increase in available resources this can only be accomplished by increases in productivity
through investment in capital goods (such as the purchase of new farm machinery). To produce
capital goods the country must reduce production of consumption goods. Present consumption is
the opportunity cost of investing to increase future consumption. Poor countries with a hungry
population may be unable to pay that cost and may be forever locked into poverty.
Country A Country B
0 12 0 14
4 6 3.5 7
8 0 7 0
There are several things you should observe from the graph:
o The production possibilities curves for both islands are straight lines. This implies
the opportunity costs are constant at all points on the curves. Usually this is not the
case but this is a convenient assumption for this example. If the PPCs were bowed
outwards then we would have the situation of increasing opportunity costs.
o Who has absolute advantage? The country whose production possibilities curve
crosses each axis at the farthest point has absolute advantage. In this example Island A
has absolute advantage in fish while Island B has absolute advantage in coconuts.
However, this is not an important feature of the model for two reasons. First, which island
has absolute advantage tells us nothing about the economic incentives to specialize.
Absolute advantage may give bragging rights but that's all. Second, what if we were to
compare a small island economy to the United States? In this situation absolute
advantage has no meaning. The PPC for the United States would dwarf that of the island
economy. But we can still use the PPC model for economic analysis, i.e., comparative
advantage.
o Who has comparative advantage? Comparative advantage is based on opportunity
cost. In a graph of the PPC the opportunity cost of the good represented on the
horizontal axis is measured as the slope on the PPC. The country that has the lowest
opportunity cost for producing coconuts is the one with the flattest curve -- Country B. As
country B increases production of coconuts it sacrifices the smaller volume of fish
production.
For comparative advantage in fish production you must rotate the graph 90 degrees so
that fish production is on the horizontal axis. You can then see that Country A has the
flattest slope and the lowest opportunity cost and comparative advantage. But it's not
necessary to go through this exercise. One country can not have comparative advantage
in both goods. If country B has comparative advantage in coconut production, country A
must have comparative advantage in fish production.
o Who should specialize in what? A country should specialize in the good in which it
has comparative advantage. As described earlier, total world production and
consumption can be increased through specialization and trade.