Chapter 2

Efficiency,
Exchange, and
Comparative
Advantage

Outline

Goods and Bads

The Myth of Material Wealth
Trade Creates Wealth
Is It Worth It? Efficiency and Values
Recognizing Trade-Offs: Comparing
Opportunity Costs of Production
The Gains from Specialization and Exchange

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Outline - continued
Why Specialize?
From Individual Trade to International
Trade, and Back Again
Transactions Costs
Incentives to Reduce Transactions Costs:
Middlemen
Markets as Discovery Processes
The Big Picture: First Thoughts on
Economic Growth

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Introduction
This chapter explores these questions:
Who profits from trading?
Is trade productive?
What are production possibilities?
What is wealth?
What is economic growth?

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Good and Bads

A commodity is a good if more of it is
preferred to less
A commodity is a 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 eye of the chooser

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Trade Creates Wealth

The myth of material wealth: economic
growth consists not in increasing output of
things, but increasing the generation of
wealth
wealth equals material things is not a valid
claim, as it omits key aspects of economic
life like specialization and exchange in
Adam Smiths 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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Involves exchange to gain

more of what people value

Involves exchange
of unequally valued goods

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Trade Creates Wealth

example:
does
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 less valued
good for a more valued good
every choice entails a trade-off
The cost of obtaining a good is the value
placed on whatever is sacrificed to buy it
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

Values

The efficiency of any process

can change with changes
in valuation

value of output
Efficiency =
value of input
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Recognizing Trade-Offs: 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=S
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Brown:
4S=3L
therefore
1 S = cost L
and
1 L = 4/3 S
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Recognizing Trade-Offs: Comparing

Opportunity Costs of Production
Production possibilities before specialization and trade

lager

lager
Jones

Brown

10
3

stout

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stout
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Recognizing Trade-Offs: Comparing

Opportunity Costs of Production
Who produces lager at a relatively lower
cost?
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

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Recognizing Trade-Offs: Comparing

Opportunity Costs of Production
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
gallons of lager
Note that Jones can produce more of both
stout (S) and lager(L)

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Table 21

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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 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=S

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Brown:
4 S= 3 L therefore
1 S = cost L and
1 L = 4/3 S

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Recognizing Trade-Offs: 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, due to lower opportunity cost
The tables show that Jones has a
comparative advantage in L, while Brown
has a comparative advantage in S

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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:
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 Trade
At full production: Jones produces 10 Lager
and Brown produces 4 Stout
They trade 1 for 1: 3 Lagers for 3 Stouts
Jones now has 7L & 3S Brown has 1S & 3L
Both have more from specializing and trading

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The Gains from Specialization

and Exchange

Wealth has been increased

for both through
specialization
and trade

Both can now consume

more than they could
individually
produce

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Gains from specialization and

exchange
Production possibilities after specialization and trade
Figure 21 Simple production possibilities frontiers

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Why Specialize?
Specialization is a synonym for following
ones comparative advantage
Producers specialize so that they can expand
their possibilities (wealth) by trading for
something that is more costly to produce on their
own
This is referred to as the Law of Comparative
Advantage

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From Individual to International

Trade, and Back Again
Specialization and exchange occur between
cities, regions and across political borders
Each group pay for its imports with their
exports
The same idea applies at an individual level

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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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Incentives to Reduce Transaction

Costs: Middlemen
Middlemen help interested parties find
one another
e.g., stockbrokers, wholesalers, job
placement agencies, realtors
Middlemens comparative advantage is to
generate quality information at a low cost
They lower the hurdles that can impede
exchange

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Markets as Discovery Processes

To enhance wealth, people pursue their
comparative advantage
Comparative advantage is discovered
through market exchanges of property
rights
In doing so, people continuously coordinate
the processes of cooperative interaction that
comprise the economy

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Explaining 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
Everyone exchanges

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Encouraging Specialization and

Exchange
Market specialization / Division of labor
creates the conditions for economic
growth
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 goods versus scarce goods
opportunity cost
wealth = whatever people value
comparative advantage

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Once Over Lightly

Middlemen
comparative advantage
market specialization
division of labor
trade between nations

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