“The Economic
Way of Thinking”
11th Edition
Chapter 2
Efficiency,
Exchange, and
Comparative
Advantage
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
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
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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
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Introduction
• This chapter explores these questions
–
–
–
–
Who profits from trading?
Does trade increase wealth?
Is trade productive?
What are production possibilities?
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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.
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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.
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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”
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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?
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Trade Creates Wealth
Trade:
Voluntary
Exchange:
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More of what
people want.
Involves exchange
of unequal values.
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Trade Creates Wealth
Jack
Value of glove
1
Value of ball
Jim
Value of ball
1
Value of glove
Question:
Does an exchange
of a ball for a
glove, between two
people,
affect wealth?
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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.”
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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
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Is It Worth It?
Efficiency and Value
The efficiency of any process
can change with changes
in valuation
value of output
Efficiency =
value of input
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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
1L=½S
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Brown:
4 S = 3 L therefore
1 S = cost ¾ L and
1 L = 4/3 S
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Recognizing Tradeoffs:
Comparing Opportunity Costs of Production
Production possibilities before Specialization and Trade
Lager
Jones
Brown
10
3
5
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4
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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.
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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
1L=½S
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Brown:
4 S= 3 L therefore
1 S = cost ¾ L and
1 L = 4/3 S
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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
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Brown:
4 S= 3 L therefore
1 S = cost ¾ L and
1 L = 4/3 S
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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.
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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.
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Jones can enjoy
7 lager and 3 stout
Brown can enjoy
3 lager and 1 stout.
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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
Both can now consumeand trade.
Jones can enjoy
more than they could
7 lager and 3 stout
individually
Brown can enjoy
produce.
3 lager and 1 stout.
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The Gains from Specialization and
Exchange
Production Possibilities after specialization and trade
Lager
10
Lager
Jones
Brown
3
3 5
Stout
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4
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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.
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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.
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Transaction Costs
• Transaction costs are costs of arranging
contracts and agreements – trades in general
among interested parties.
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Transaction Costs: Middlemen
• Middlemen help interested parties find one
another.
– Stockbrokers, wholesalers, job placement agencies,
etc.
• They create more desirable options for us.
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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.
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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.
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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
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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
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Once Over Lightly
• Exchange of Property Rights
• A Good – more preferred to less
• Free Good...Scarce Good
• Opportunity Cost
• Wealth = Value
• Comparative Advantage
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Once Over Lightly
• Information and the Middlemen
• Middlemen and Comparative Advantage
• Market Specialization
• Division of Labor
• Wealth and Nations
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End of Chapter 2
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