Overheads

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

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

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

Why specialization and exchange make us better off
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

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

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

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
1
2
3
4
5
6
Points
7
5
4
3
2
1
Only one of the runners can run each race
What should he do?

Figure it out
A will be 1st in hurdles, 2 nd in dash
W will be 2nd in hurdles, 5th in dash
Hurdles Place Points Dash Place Points Total Points
A 1 7 W 4 3 10
W A 12 1
Place
1
2
3
4
5
7 2
Points
7
5
4
3
2
5

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.

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

Fred
Opportunity Cost of:
1 Turnip 1 Mastodon
20 turnips
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

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

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

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

Pricing in the Flintstone economy with turnips as the unit of exchange
Individual Opportunity Cost
Fred
Wilma
1 mastodon costs 20 turnips
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
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
Turnips Mastodons
20 t
Fred
40 t
Wilma
Now make mastodons the unit of exchange

What does Fred give up to get a turnip?
Turnips Mastodons
20 1
Fred
Output per hour
Wilma
80 2
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
1/20 mastodon 20 turnips
Wilma
40 turnips

What about Wilma?
Turnips Mastodons
20 1
Fred
Wilma
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
1/20 mastodon 20 turnips
Wilma
1/40 mastodon 40 turnips

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

Pricing in the Flintstone economy with mastodons as the unit of exchange (numeraire)
Individual
Fred
Wilma
Opportunity Cost
1 turnip costs 1/20 of a mastodon
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.
3.
4.
Make an opportunity cost table (agents by goods)
For each good (column) choose a unit of exchange
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

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

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

Output before specialization
Fred
Wilma
Total
Hours Digging Turnips Hours Hunting Mastodons
6 120 2 2
6
12
480
600
2
4
4
6
Output after specialization
Fred
Wilma
Total
Hours Digging Turnips Hours Hunting Mastodons
0 0 8 8
8
8
640
640
0
8
0
8

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?

the method used to determine which goods and services will be produced, how they will be produced, and who will get them

Tradition
Command
Market

The price of a product is the amount of money that must be paid to a seller to obtain a good or service.

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.

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
Private Market
Capitalism
Centrally
Planned
Capitalism
Resource
Ownership
State
Market
Socialism
Centrally
Planned
Socialism