“The Economic Way of Thinking” 11 th Edition

“The Economic Way of Thinking” 11th Edition Chapter 2Efficiency, Exchange, and Comparative Advantage

Chapter 2 Outline • Introduction • Goods and Bads • The Myth of Material Wealth • Trade Creates Wealth • Is it Worth It? Efficiency and Values • Recognizing Tradeoffs: Comparing Opportunity Costs of Production • The Gains from Specialization and Exchange

Chapter 2 Outline • Why Specialize? • From Individual Trade to International Trade and Back Again • Transactions Costs • Incentives to Reduce Transactions Costs: Middlemen • Middlemen Create Information • Markets as Discovery Processes • Appendix – Economic Growth

Introduction • This chapter explores these questions • Who profits from trading? • Does trade increase wealth? • Is trade productive? • What are production possibilities?

Good and Bads Something is Good if …… more of it is preferred to less. Something is Bad if … less of it is preferred to more. A Free Good can be acquired without sacrifice. A Scarce Good requires sacrifice.

The Myth of Material Wealth • Of what does wealth consist? • Wealth, in the economic way of thinking, is whatever people value. • Value is in the eyes of the chooser.

The Myth of Material Wealth • Economic growth consists not in increasing production of things, but increasing the production of wealth. • “Wealth = Material things” is not a valid claim. It blocks an understanding of such aspects of economic life like “specialization and exchange” • Specialization and trade are the heart of Adam Smith’s “Commercial Society”

Trade Creates Wealth • Questions: • What do we gain from trading? • Is it accurate to say that the two goods traded have equal value? • Does trade add value, wealth? • Is trading efficient?

More of what people want. Involves exchange of unequal values. Trade Creates Wealth Trade: Voluntary Exchange:

Jack Jim Trade Creates Wealth Question: Does an exchange of a ball for a glove, between two people, affect wealth?

Trade Creates Wealth • With trade each party trades a scarce and valuable good for a more valued good. • Any choice entails a “trade-off.” • The cost of obtaining anything is the value placed on whatever must be sacrificed in order to obtain it. • In economics that cost is referred to as the “opportunity cost.”

Is It Worth It?Efficiency and Values • Efficiency changes with valuations. • Efficiency compares the ratio of the value of the output to the value of the input. • Increased Efficiency • Leads to lower production costs

Is It Worth It?Efficiency and Value The efficiency of any process can change with changes in valuation

Recognizing Tradeoffs:Comparing Opportunity Costs of Production A “Production Possibilities Frontier” illustrates maximum combinations of products that can be produced using a given set of resources and talent. Jones: 5 S = 10 L therefore 1 S = cost 2 L and 1 L = ½ S Brown: 4 S = 3 L therefore 1 S = cost ¾ L and 1 L = 4/3 S

Lager Lager Jones Brown 10 3 4 5 Stout Stout Recognizing Tradeoffs:Comparing Opportunity Costs of Production Production possibilities before Specialization and Trade

Recognizing Tradeoffs:Comparing Opportunity Costs of Production • Who produces lager at a relatively lower cost? • Note that Jones is more efficient at producing both stout and lager. • If Jones produces only lager he can make 10 gallons but sacrifices the opportunity to make 5 gallons of stout. If he makes only stout he sacrifices the opportunity to make 10 gallons of lager. • If Brown produces only stout she can make 4 gallons but gives up the opportunity to make 3 gallons of lager. For every gallon of stout she sacrifices ¾ gallons of lager.

Recognizing Tradeoffs:Comparing Opportunity Costs of Production The tables show that Jones has a lower relative cost producing lager, he only sacrifices ½ S for each gallon of L, while Brown must forego 4/3 S for each gallon of L. Jones: 5 S= 10 L therefore 1 S = cost 2 L and 1 L = ½ S Brown: 4 S= 3 L therefore 1 S = cost ¾ L and 1 L = 4/3 S

Recognizing Tradeoffs:Comparing Opportunity Costs of Production The tables show that Brown has a lower relative cost producing lager, she only sacrifices ¾ L for each gallon of S, while Jones must forego 2 L for each gallon of S. Jones: 5 S= 10 L therefore 1 S = cost 2 L and 1 L = ½ S Brown: 4 S= 3 L therefore 1 S = cost ¾ L and 1 L = 4/3 S

Recognizing Tradeoffs:Comparing Opportunity Costs of Production • Who produces lager at a relatively lower cost? • The least cost producer of a product has a comparative advantage over other producers. Least cost producers have a lower opportunity cost. • The tables show that Jones has a comparative advantage in brewing lager, while Brown has a comparative advantage in stout production.

The Gains from Specialization and Exchange If Brown and Jones agree to trade one for one in the product of their comparative advantage: Both can now consume more than they could individually produce. Jones can enjoy 7 lager and 3 stout Brown can enjoy 3 lager and 1 stout.

The Gains from Specialization and Exchange If Brown and Jones agree to trade one for one in the production of their comparative advantage: Wealth has been increased for both through specialization and trade. Both can now consume more than they could individually produce. Jones can enjoy 7 lager and 3 stout Brown can enjoy 3 lager and 1 stout.

Lager Lager Brown Jones 10 3 1 3 4 5 Stout Stout The Gains from Specialization and Exchange Production Possibilities after specialization and trade

Why Specialize? • Specialization is a synonym for “Following one’s comparative advantage.” • People specialize so that they can increase their wealth. • Specialization allows producers to expand their possibilities (wealth) by trading for something that is more costly to produce on their own. • The phenomenon is referred to as the “Law of Comparative Advantage” in Economics.

Individual to International Trade and Back Again • The terms of trade at the individual level are the exchange rates at the international level. • People pay for their imports with their exports. • Specialization and exchange occur between individuals, regions, and across political borders.

Transaction Costs • Transaction costs are costs of arranging contracts and agreements – trades in general among interested parties.

Transaction Costs: Middlemen • Middlemen help interested parties find one another. • Stockbrokers, wholesalers, job placement agencies, etc. • They create more desirable options for us.

Middlemen Create Information • Middlemen generate high quality information at a low cost which is their comparative advantage. • They are specialists in organizing markets. • They lower the hurdles that will impede exchange.

Markets as Discovery Processes • In the real world people pursue their comparative advantages by choosing the most attractive option. • Comparative advantages are discovered thru real market exchanges of property rights. • In doing so people continuously coordinate these processes of cooperative interaction and mutual accommodation that comprise the economy.

Appendix: Economic Growth • Adam Smith determined that wealth came from huge increases in production which resulted in the division of labor. • Economic growth is a consequence of the evolution of commercial society… • Everyone specializes and • Lives by exchanges

Appendix: The Evolution of Rules That Encourage Specialization and Exchange • Market Specialization / Division of Labor • Creates the conditions for economic growth • The Rule of Law – Private Property Rights • Allows freedom of exchange • Provides incentives to specialize in activities of comparative advantage

Once Over Lightly • Exchange of Property Rights • A Good – more preferred to less • Free Good...Scarce Good • Opportunity Cost • Wealth = Value • Comparative Advantage

Once Over Lightly • Information and the Middlemen • Middlemen and Comparative Advantage • Market Specialization • Division of Labor • Wealth and Nations

End of Chapter 2

“The Economic Way of Thinking” 11 th Edition