Chapter II
Gains from Trade and Division of
Labor
Interdependence versus Subsistence
J.F. O’Connor
1/25/05
Main Points
• Voluntary trade or exchange is mutually
beneficial
• Specialization and division of labor can
increase total output of a community
• Comparative advantage (opportunity cost)
is a key factor in determining the best
pattern of specialization
• International trade is generally beneficial in
the long run
Our Approach
• Show that voluntary exchange or trade is mutually
beneficial.
• Show that two bases for such trade are different
endowments and different valuations.
• Introduce the Principle of Comparative Advantage
(lower opportunity cost).
• Show that specialization in accordance with the
principle of comparative advantage can increase
joint or community output or production.
• Introduce the Production Possibilities Frontier
(PPF).
Our Approach (contd.)
• Show how the Principle of Comparative
Advantage is used to obtain the PPF.
• Discuss the main features of the PPF model.
• Apply the PPF model to analyze questions
about economic growth:
– Why are some countries better off than others?
– How can countries improve standard of living?
Bases for Trade or Exchange
• Trade in the Absence of Production:
– Differences in endowments
– Differences in valuations
• Trade in the Presence of Production:
– Comparative advantage (opportunity
cost)
Different Endowments
• Shirley and Kim are interested in old
bicycles. Their valuations are identical.
They value having the first bike at $500, a
second at $300, and the third at $200. At
present Shirley has one bike and Kim has
three bikes. Is there a trade that will make
both better off?
Different Valuations
• Joe and Mike are also interested in bicycles.
Joe’s valuations are $500 for the first bike,
$300 for the second and $260 for the third.
Mike’s valuations are $400 for the first
bike, $200 for the second, and $150 for the
third.
• At present, each has two bikes. Is there a
basis for trade?
Two Bases for Trade
• If two persons have identical valuations,
what would cause them to trade?
• If two persons have identical endowments,
is there any basis for trade?
• In all cases, if the valuation (reservation
price) of the person having the good is less
that the valuation of a potential buyer, there
is a basis for a trade.
Gains from Trade
• Key point of the foregoing discussion is that
voluntary trade is mutually beneficial. It
makes both parties to the trade better off.
We say that voluntary trade is a positivesum game.
• What is an example of involuntary trade or
exchange?
Should a Physician do her
Typing?
• Joan is a physician and also an excellent
typist ( 100 wpm error free). As a physician,
she earns $90 an hour. She has also been
doing her own typing but that reduces the
number of patients that she can see. Joan
advertises the position. The best person
available is Mary who types 60 wpm and is
willing to work for $8 per hour.
Comparative Advantage
• Mary, while being a less efficient typist than
Joan, has a comparative advantage in typing
because the opportunity cost of Joan’s
typing is her best alternative which is seeing
patients at $90 an hour while opportunity
cost of Mary doing the typing is $16. (It
takes Mary twice the time for a given job.)
Comparative Advantage
• A person has a comparative advantage in
producing a particular good or service if:
– That person is relatively more efficient at
producing it than other people. That is, the
person has a lower opportunity cost than others.
• The question is: How does the person’s OC
compare with that of others?
Absolute vs.Comparative
Advantage
• A person has an absolute advantage over
another in performing a task if:
– That person takes fewer hours to perform a task
than the other person.
• A person has a comparative advantage over
another in performing a task if:
– That person’s opportunity costs of performing
the task is lower than the other person’s
opportunity cost.
Sources of Absolute Advantage
• Individuals
– Possibly inborn talent
– More often due to education, training, or
experience
• Countries
– Difference in natural resources
– Difference in cultures--incentives of institutions
Gains from Specialization
• Mike and Paddy own and operate a stereo
and television repair shop. Mike can repair
a stereo in one hour while it takes Paddy
two hours. Mike can repair a TV in four
hours while it takes Paddy five hours.
• Each works 40 hours per week. At present
each spends half his time repairing stereos
and the other half repairing TVs. They
repair 30 stereos and 9 TVs per week.
• Can they do better?
Mike and Paddy’s Repair Shop
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4
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O
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P
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20
10
30
T
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5
4
9
Demonstration of Gains
• Mike repairs one less TV while Paddy
repairs one more TV. Mike can then repair
4 more stereos while Paddy can repair 2.5
fewer stereos. The result is a total of 31.5
stereos and 9 TVs, a gain in output of 1.5
stereo repairs.
• What would happen if Mike repaired one
more TV while Paddy repaired one less?
Understanding the Gains
• Initially, each was producing efficiently as an
individual.
• Mike is better at both tasks. Yet, output can be
increased by having Paddy do more TV repairs.
• Key is that the Opportunity Cost of Paddy
repairing another TV is 2.5 stereo repairs while
the OC for Mike is 4 stereo repairs. Paddy has a
Comparative Advantage in TV repair.
Continuing the Gains
• Every time Mike does one less TV repair and
Paddy does one more, output is increased by 42.5 = 1.5 stereo repairs while holding constant
TV repairs at 9.
• Continuing to have Paddy do more TV repairs
and Mike do fewer, one ends up with Paddy
spending all his time on TV repairs, doing 8.
Mike does one TV repair and 36 stereo repairs.
• We observe the Principle of Comparative
Advantage in action!
Gains from Specialization
• Specialization produces gains for all, even
when one person enjoys an absolute
advantage in both tasks.
• Specialization:
– Uses differences in individual skills
– Deepens skills via practice
– Breaking tasks into simple steps multiplies
the productivity of workers
Size of the Gain
• No gain from specialization when OCs are
equal
• Gain increases as differences in opportunity
costs increase
• The two people wish to consume equal
amounts of the two goods. Consider the
gain when the opportunities are (56,56) and
(56,56) compared to (56,8) and (8,56).
An Especially Useful Division of
Labor
Principle of Comparative
Advantage
• Society does best when each person (or
each country) concentrates on the activities
for which his or her opportunity cost is
lowest.
• Output is increased when we all focus on
those tasks in which we are relatively more
productive; together we can produce much
more than if we were all self-sufficient.
Production Possibilities Frontier
• If Mike and Paddy want to produce 9 TV
repairs, the maximum number of stereo
repairs is 36, given their current resources.
• The combination of 9 TV and 36 stereo
repairs is a point on the Production
Possibilities Frontier (PPF).
• The PPF gives the maximum output of one
good for each output of the other good. It is
the locus of efficient combinations.
Efficient Joint Production
• How should Mike and Paddy organize
production so as to maximize the output of
stereo repairs for each level of output of TV
repairs? Use the Principle of Comparative
Advantage!
• The PPF is drawn up using CA. Start where
both are devoting all their resources to
stereo repair. If they want to increase TV
repair by one unit, who should do it? Paddy!
Obtaining the PPF
• Each unit increase in TV repair reduces
stereo repair by 2.5 units until Paddy is
doing only TV repair. Then output is 8 TV
repairs and 40 stereo repairs.
• From then on, a unit increase in TV repair
reduces stereo repair by 4 units until both
are working only TV repair, doing 18 stereo
repairs.
• We now have the points on the PPF:
(0 TV, 60 Stereo), (8 TV,40 Stereo), and
(18 TV, 0 Stereo). We plot them.
Production Possibilities Frontier
for Mike and Paddy's Repair Shop
60
50
O. C. of TV repair = 2.5 stereo repairs
Stereo Repair
40
30
O. C. of TV repair = 4 stereo repairs
20
10
0
0
2
4
6
8
10
TV Repair
12
14
16
18
Properties of PPF
• Negative slope reflects scarcity.
• Absolute value of slope measures
opportunity cost.
• Steeper slope for 8 or more TV repairs
shows Principle of Increasing Opportunity
Cost or Low Hanging Fruit Principle.
• Next graph shows how to get PPF from
individual PPFs.
Production Possibilities Frontier
for Mike and Paddy's Repair Shop
60
50
O. C. of TV repair = 2.5 stereo repairs
Stereo Repair
40
30
Mike's PPF
O. C. of TV repair = 4 stereo repairs
20
Paddy's PPF
10
0
0
2
4
6
8
10
TV Repair
12
14
16
18
Deriving the PPF Geometrically
• Move the individual PPF with the smaller
slope up to the point on the vertical axis
where both persons are producing only the
good on the vertical axis.
• Then move the second PPF out until its
highest value connects with the low point of
the first PPF. They should meet at the output
values where each is specializing.
Terminology
• Attainable combination - can be produced with
current resources. All points on and inside PPF.
• Unattainable combination – cannot be produced
with current resources. Outside PPF.
• Efficient – attainable and on the PPF, including
end points.
• Inefficient - attainable but inside the PPF. E.g.
(9,30). Can increase output of one good without
reducing the output of the other.
Principle of Increasing
Opportunity Cost
• AKA “The Low Hanging-Fruit Principle”
– In expanding the production of any good, first
employ those resources with the lowest
opportunity cost, and only afterward turn to
resources with higher opportunity costs.
Factors Affecting the PPF
• In deriving the PPF, the plant and
equipment available, the techniques of
repair, the number of hours worked were
given for Mike and Paddy’s repair shop.
• In economic terms, both the amount and
quality of capital and labor and the
technology of production were fixed.
• How would a change in these factors affect
the PPF?
Increasing Factor Endowments
Paddy and Mike decide to work 60 hours
instead of 40 per week.
• They hire an additional worker.
• They acquire a second machine for
diagnosing problems in TVs.
• They acquire more space which allows
them to work faster.
Improving Input Quality
• Paddy takes a course on TV repair which
improves his productivity from 5 hours to 4
hours for repairing a TV. It would not affect
the possibilities when only stereos are bring
repaired but it reduces the opportunity cost
of TV repair from 2.5 to 2 stereos, and shifts
the curve to the right.
• A better machine for testing TV circuits is
purchased
Technological Advance
• If an improved diagnostic method useful on
both stereos and TVs became available it
could shift the PPF out in all directions.
• As a result of experience, they figure out
easier and faster ways of diagnosing and
repairing stereos and TVs.
Applying the PPF
•
•
•
•
•
•
Grocery store
Ford Motor company
University
Clothing store
Allocating your time
Allocating your budget
Application to the Economy
• The amounts of goods and services that can
be produced in any given year is limited by
the amount and productivity of the land,
labor, and capital goods available. Choices
have to be made regarding the composition
of output. How much national defense,
food, clothing, automobiles, education,
drugs, health care, capital goods, etc. The
PPF can be used to capture the choices.
Why are we rich and they poor?
• Why is income or output per capita higher
in the U.S than in Haiti? Look at the factors
discussed in the PPF model!
• Differences in the quality of inputs,
techniques of production, and capital per
worker.
• How did this happen?
Comparative Advantage for
Regions and Countries
• Does the principle of comparative
advantage apply to regions and countries?
• Some examples:
–
–
–
–
–
Eastern Kentucky and Bluegrass
Colorado and Iowa
U.S and Haiti
U.S. and Mexico
U.S and Japan
PPC for a Large Economy
Smoothly Bowed PPC
• Smooth because of a large population
• Downward-sloping
– Shows scarcity principle
• Increasing Opportunity Cost
– Greater production of one good results in rising
opportunity cost of producing more of that
good.
Comparative Advantage and
International Trade
• Each trading partner can benefit from trade,
even if one partner is absolutely more
productive.
• Without trade, the opportunity cost of
producing is higher than it would be if trade
occurred, hence output is lower.