Specialization and Exchange Overheads

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

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

Examples Steak and eggs Beef and laying hens Medical care and automobile care Hair styling and plumbing

WHY? 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

3 reasons specialization pays 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

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

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

What is comparative advantage? Comparative advantage is the ability to produce a good or service at a lower opportunity cost than other producers

What should he do? The track coach’s 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?

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

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.

The Flintstone Economy Output per hour Turnips Mastodons 20 1 Fred Wilma 80 2

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

Who has the advantage in what? Wilma has an absolute advantage in turnip gathering and in mastodon hunting Wilma is more efficient at both activities!!

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

What does Fred give up to get a mastodon? Wilma Fred Turnips Mastodons 20 1 80 2 Output per hour Fred gives up 20 turnips to get one mastodon 1 mastodon costs 20 turnips

Opportunity Cost of: 1 Turnip 1 Mastodon 20 turnips Fred Wilma

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

Wilma gives up 40 turnips per mastodon What about Wilma? Wilma Fred Turnips Mastodons 20 1 80 2 Output per hour Wilma gives up 40 turnips per mastodon 80 / 2 = 40 1 mastodon costs 40 turnips

Opportunity Cost of: 1 Turnip 1 Mastodon Fred Wilma 20 turnips

Who has the lowest opportunity cost for mastodons? Wilma Fred Turnips Mastodons 20 t 40 t Fred has a comparative advantage in mastodon hunting!

Pricing in the Flintstone economy with turnips as the unit of exchange Fred 1 mastodon costs 20 turnips Individual Opportunity Cost Wilma 1 mastodon costs 40 turnips Fred gives up less turnips for a mastodon Fred has a comparative advantage in mastodon hunting!

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

In our example so far, turnips were the unit 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? Wilma Fred Turnips Mastodons 20 1 80 2 Output per hour Fred gives up 1/20 of a mastodon per turnip 1 turnip costs 1/20 of a mastodon

Opportunity Cost of: 1 Turnip 1 Mastodon Fred Wilma 1/20 mastodon 20 turnips Fred Wilma 40 turnips

Wilma gives up 1/40 mastodon per turnip What about Wilma? Wilma Fred Turnips Mastodons 20 1 80 2 Wilma gives up 1/40 mastodon per turnip 2 / 80 = 1/40 1 turnip costs 1/40 of a mastodon

Opportunity Cost of: 1 Turnip 1 Mastodon Fred Wilma 1/20 mastodon 20 turnips Fred Wilma 1/40 mastodon 40 turnips

Who has the lowest opportunity cost for turnips? Wilma Fred Turnips Mastodons 1/20 m 1/40 m Wilma has a comparative advantage in turnip digging!

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!

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

Example Computation 5 20 8 24 4 c 1/4 f 3 c 1/3 f Friday Crusoe Fish Cassava 5 20 8 24 Friday Crusoe Fish Cassava 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

What is comparative advantage? Comparative advantage is the ability to produce a good or service at a lower opportunity cost than other producers

Utilizing comparative advantage leads to more total output

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

according to their comparative advantage. 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 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.

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

Three systems of resource ownership Communism - resources owned in common Socialism - resources owned by the state Capitalism - resources owned privately

Types of Economic Systems Resource Allocation Market Command Centrally Planned Capitalism Private Market Capitalism Resource Ownership Centrally Planned Socialism Market Socialism State

The End