To catch one more fish I reduce my supply of coconuts by 3/2. Greenspan did not mention any specific industries or products. Let's say that in one hour I can still cut down 12 coconuts or catch 8 fish. To produce capital goods the country must reduce production of consumption goods. In option A all available resources are dedicated to the production of clothing. You can then see that Country A has the flattest slope and the lowest opportunity cost and comparative advantage. But we can still use the PPC model for economic analysis, i.e., comparative advantage. Would you be willing to give me 3 coconuts? When specialization occurs it is when one person does one aspect of a job and voluntary exchange is when buyers and sellers engage in market transactions. Japan, for example, imports scarce natural resources and uses its skilled labor force and technology to produce many products at comparative advantage to other countries. Just as individuals are limited by the scarcity of time and other personal resources, societies are also constrained in their capacity to produce goods and services from their available resources of land, labor, and real capital. For the country to become self-sustaining it must shift its PPC outward. If I specialize in teaching economics I would starve unless I was able to exchange the service I provide for food produced by someone else who specializes in farming. Metals can not only be kept with as little loss as any other commodity...but they can likewise, without any loss, be divided into any number of parts, as by fusion those parts can easily be reunited again... General Purchasing Power - the characteristic of money or currency where it can be used as a medium of exchange for any good or service produced in an economy. For example, a strike in one part of the factory can halt the whole production process. For example, the production of artifacts in one region and exchange to another may be considered regional specialization, although artifacts were manufactured by every household. But there are other options such as job retraining programs, extension of unemployment benefits, etc. In the figure below we can see that the PPC falls below the subsistence level. Let's start with the situation where we are not specializing or trading. We can illustrate these many combinations with a graph of the production possibilities curve. One of the most important choices any society (and individual) makes deals with the tradeoff between enjoying consumption today and investing for a greater level of consumption tomorrow. We can continue this logic and show in Table 2-1 that the total supply and consumption of coconuts and fish is greatest when we specialize and I only catch fish and you only cut down coconuts and we trade. Relationship Between Specialization and Trade. If I produce 1 more fish I must give up 1.5 coconuts (my opportunity cost). Our second assumption requires the full and efficient use of all available resources. If there is an improvement in technology we can also produce more or everything. Comparative advantage, specialization, and gains from trade. It is most often applied to systems of mass-production and is one of the basic organizing principles of the assembly lines. In the early 19th century, David Ricardo developed a different justification for specialization based on the concept of opportunity cost, which may vary across individuals because of differences in abilities. CONTENTS. Scarcity requires choice and implies costs. The Food-Clothing Production Possibilities Curve, Figure 2-2. The first resources transferred from clothing to food production will likely be those that are best suited for food production. Specialization and trade is called a positive sum game because we both are better off after exchange than we were before. All of these forms of specialization imply an exchange economy. We can apply the microeconomic concepts of opportunity cost and specialization to entire countries with our first macroeconomic model - the Production Possibilities Curve (PPC). Savings and investment represent the engine of economic growth. But why is specialization efficient? specialization exists because of voluntary exchanges. For example, Maldives specialises in tourism and fishing products, Sri Lanka and India specialises in the production of tea. We both have an incentive to specialize and trade. While economists may feel comfortable with the argument that specialization with free trade would make everyone better off, politics is not so lucky. Greenspan acknowledged that increased competition can cause an "adjustment process [that] is wrenching to an existing work force made redundant largely through no fault of their own." Recall that the combination of limited resources and unlimited wants implies scarcity. Poor countries with a hungry population may be unable to pay that cost and may be forever locked into poverty. Nevertheless, the simple model we have presented is sufficient to address some questions. Money can be used to buy any goods and services offered for sale. Specialization and trade is called a positive sum game because we both are better off after exchange than we were before. If we decide to produce some food we must give up some production of clothing. As we calculated above, the opportunity cost for me to catch 1 fish is 3/2 coconuts while the opportunity cost for you is 2 coconuts. of nuts Then the consumptions are: Susan: 15 lb. Adam Smith recognized that the increased productivity of labour after division happens due to the following reasons. Finally, there is regional and local specialization. For comparative advantage in fish production you must rotate the graph 90 degrees so that fish production is on the horizontal axis. He pointed out that a worker will be able to make 20 pins a day if he were to do all the tasks of pin production himself. This is a simple explanation why most economists oppose trade barriers (such as tariffs or import quotas) on principle. 12. Present consumption is the opportunity cost of investing to increase future consumption. It satisfies both the producer and consumer. Higher output: the total output of goods and services will increase and the quality of goods and services produced will increase. Another reason is that, time is saved by eliminating the constant need to move from one operation to the next by the worker. Consumption Versus Investment Trade-Off, Figure 2-6. Relationship Between Specialization and Trade. Ceramic production and community specialization 73 Craft specialization can be organized under direct state control (as demonstrated through archaeological examples such as the Inka empire: Earle 1987) or outside the domain of administrativeproduction at the household or community level. Federal Reserve Chairman Alan Greenspan arguing that free trade raises living standards, yesterday deplored recent politically driven actions to protect various industries from foreign competition. This country faces the cruel dilemma that it cannot invest in the equipment needed to boost future productivity and consumption without letting more people go hungry today. If I can produce more of a good or service using all of my available resources than you can, I have an absolute advantage in producing that good or service. Breaking down the work process into simple, repetitive tasks eliminates the unnecessary workers on an assembly line and limits the handling of different tools and parts of different workers. The bottom line is that a solution to this question is possible but only if we develop a more complex macroeconomic model, which is beyond the scope of this course. For some reason, however, many people deny that international specialization in production and the consequent exchange of products are beneficial. both parties gain as a result of voluntary exchange. Smith suggested that if more of my time is spent on one activity, then I have an incentive to invest my resources to develop specialized tools or machines to aid me in that activity. You have absolute advantage in coconut production. Explain what happens to the Supply Curve when Economic Profits are above normal. Specialization is related to another economic concept, division of labor, discussed at great length by Adam Smith, the 18th-century … Increasing opportunity costs is a reflection of the specialized characteristics of resources. The exchange price should fall between 0.5 fish (your opportunity cost) and 0.67 fish (my opportunity cost). There are many advantages and disadvantages to specialisation, which became common place during the industrial revolution with the creation of factories and the use of division of labour. answer choices . So, why did we emphasize that specialization should be based on opportunity cost, i.e. Since specialization is predicated upon the existence of linkages between groups engaged in producing different items, which allow them to exchange their products, variation in degrees of specialization can best be understood through an examination of exchange networks themselves. ! The exchange price should fall between 0.5 fish (your opportunity cost) and 0.67 fish (my opportunity cost). Example, the specialisation of teachers in different subjects in CHSE. We each evenly split our time between cutting down coconuts and catching fish. In our simple economy the price will be some number of coconuts. The definition of specialization allows for certain ambiguities, as issues of scale and context impinge. Those people may also be ill-trained to find work in industries that enjoy a comparative advantage. Specialization and the Gains From Trade Now assume that Susan trades 3 lb. Unfortunately, many poor nations don't have the luxury of making this choice. Since I'm the economics instructor I get the bright idea that if I shift some of my time to catching one more fish and you shift some of your time to cutting down two more coconuts we will both be better off. Then we apply the basic production possibilities curve to the unfortunate dilemma facing poor countries in their ability to feed their people. This in turn may greatly speed up the individual jobs which are automated. The opportunity cost for me to cut down 12 coconuts is that I give up the opportunity to catch 8 fish. The exchange of products will take place between the countries and it leads to an increase in sales volume and profits in trade. No exchange can...be made between them. Resources are not perfectly adaptable to alternative uses. In this economics lesson, students will examine the relationship between specialization and trade. Declining industries means some must lose their jobs. Some automation (use of specialised machinery) may arise from the division of the general manufacturing process into small, separate and simple tasks. There is one distinction we should make. Although division of labour can lead to considerable gains in the productivity and quality of production, division of labour can also have negative effects on the production for the following reasons. Generally we assume an increase in available resources raises the production capacity of both goods. For example, it is no longer necessary to have a coincidence if wants. In this example Island A has absolute advantage in fish while Island B has absolute advantage in coconuts. voluntary exchange negates the need for specialization. The gains that arise from such specialization in production and market exchanges are the same whether we consider two individuals, the citizens of two dries, the citizens of two states, or, just as important, the citizens of two nations. The PPC for the United States would dwarf that of the island economy. These resource factors include: The availability of natural resources is of course a major determinant of comparative advantage. Ofcourse, this exactly allowed Victorian factories (UK) to grow throughout the nineteenth century and develop themselves and their country simultaneously. Specialization is not only a characteristic of individuals but also of macroeconomic aggregates like regions or nations. The article is organized as follows: Section 2 presents stylized facts of African international trade and defines a specialization rule. 1. If the PPCs were bowed outwards then we would have the situation of increasing opportunity costs. I have comparative advantage over you in catching fish because my opportunity cost is lower. The opportunity cost of each coconut is 2/3 fish. In coconut production you have comparative advantage because your opportunity cost is lower. The actual price of exchange cannot be determined by our theory since it would depend on each person's negotiating abilities. Production Possibilities for Island Economy, Table 2-3. Consequently it is impossible to produce outside the production possibilities curve (above and/or to the right of the PPC) because of scarcity of resources. For me to produce one more fish you must be willing to give me at least 1.5 coconuts. If country B has comparative advantage in coconut production, country A must have comparative advantage in fish production. We can illustrate this problem with a PPC. According to Adam Smith, “Wealth of nations”, the economic growth(ie. Many different commodities...were employed for this purpose. Similarly, if resources are not efficiently used we could increase output of one good without sacrificing output of the other good. But how do we really know what paid labor to specialize in? Division of labour refers to the separation of a work process into a number of simple and separate tasks, with each task being performed by a separate person or a group of people. Of course there are many thousands of goods and services that are supplied in any economy. To produce more food, resources employed in clothing production must be transferred to food production. For example, we start with a simple application of the concept of opportunity cost when considering government policy decisions on import quotas or tariffs. Supplies of resources (i.e., land, labor, and capital) are fixed. There are several reasons. One political response as mentioned is to protect the jobs. In some of the examples and sample problems in this chapter we assume the PPC is a straight line. The concepts of comparative and absolute advantage also apply to macroeconomic aggregates such as regions or nations. both parties gain as a result of fraudulent exchange. Competition and lower prices: Increased competition for domestic producers acts as an incentive to minimize costs and to be innovative to remain competitive. One good or service is exchanged directly for another. It is comparative advantage that reveals incentives to specialize. Review graphs of two countries with different PPCs. In one hour you can cut down 14 coconuts or catch 7 fish. How do we get the most out of our personal limited resource - labor? We can demonstrate this mathematically: Solving for my opportunity cost of each coconut I cut down: Solving for my opportunity cost of each fish I catch: Your opportunity costs are slightly different: I have the lower opportunity cost of catching fish (I give up only 3/2 coconuts for each fish while you must give up 2 coconuts for each fish) and you have the lower opportunity cost of cutting down coconuts (my 1/2 fish for each coconut versus your 2/3 fish for each coconut). Key Concepts: Benefits of Trade, Trade, Exchange and Interdependence 45 mins A country should specialize in the good in which it has comparative advantage. For example, increasing food production from 0 units to 10 units requires only a small reduction in clothing production. Who has absolute advantage? Let's use our tropical island example to identify who has absolute and comparative advantage in the production of fish and coconuts. Third, specialization allows businesses to take advantage of economies of scale, which means that for many goods, as the level of production increases, the average cost of producing each individual unit declines. People are allowed to pick and choose which specialization they … Comparing absolute advantage for two countries requires the additional assumption that the resources available to each country are identical. Let's say we don't cooperate at first. For example, if there is a higher than normal level of unemployment, then our economy is not producing at its full capacity. of nuts Tom: 3 lb. Meaning of Exchange Inter relationship Between Among Production, Specialization and Exchange. There is no gain from trade; exchange simply makes possible the specialization of labor, which is the source of increased production. Absolute Advantage. The country whose production possibilities curve crosses each axis at the farthest point has absolute advantage. Exchange is only possible because of production and specialization, production which is the creation of utility in the aspect of goods and services can be enhance through the breaking down of jobs into different segment, division of labor and specialization therefore leads to increase or excess in production, this excess therefore needs to be exchange for what others have also produced, for instance a producer of shoes can exchange … Assuming there is no increase in available resources this can only be accomplished by increases in productivity through investment in capital goods (such as the purchase of new farm machinery). However, this is not an important feature of the model for two reasons. This is specialisation at national level. Adam Smith was one of the first economists to explicitly identify the productive benefits of specialization, which he referred to as the "division of labor.". With barter no money is used. Conversely, if there is a reduction in available resources (e.g., workers leave the country or a natural disaster strikes) the PPC would shift inwards. [T]o avoid the inconvenience of such situations, every prudent man...must have at all times by him, besides the peculiar produce of his own industry, a certain quantity of some one commodity...such as he imagined few people would be likely to refuse in exchange... Table 2-1. In one hour you can cut down 14 coconuts or catch 7 fish. Below normal. A more complex model should not change the results of that analysis so we apply Occam's Razor and try to keep it simple. The answer is that the price will fall somewhere between my oportunity cost and your opportunity cost. ... One might assume that the country that is most efficient at the production of a good would choose to specialize in that good, but this isn't always the case. Our total supply of coconuts increases by 1/2 while our total supply of fish remains the same. thank you very much for the topic ..really helpful, Basic economic problem: choice and the allocation of resources, The allocation of resources: how the market works; market failure, Advantages and disadvantages of the market system, The private firm as producer and employer, Changes in the structure of business organisations, Determinants of demand for factors of production, Labour-intensive and capital-intensive production, Total and average cost, fixed and variable cost, Relationship between average cost and output, Profit maximisation as a goal of business organisations, Pricing and output policies in perfect competition and monopoly, Main reasons for the different sizes of firms, The individual as producer, consumer and borrower, Functions of central banks, stock exchanges, commercial banks, Factors affecting an individual’s choice of occupation, Changes in an individual's earnings over time, differences in earnings between different groups of workers, Trade unions and their role in an economy, Expenditure patterns of different income groups, The government’s influence on private producers, Measures and indicators of comparative living standards, How a consumer prices index/retail prices index is calculated, Changing patterns and levels of employment, Why some countries are classified as developed and others are not, Consequences of population changes at different stages of development, The effects of changing size and structure of population on an economy, Benefits and disadvantages of specialisation at regional and national levels, Structure of the current account of the balance of payments, Competitive Markets- How they work and why they fail, Determining the Price, Functions of Prices, Consumer/Producer Surplus, Wage rate determination in labour markets, How governments attempt to correct market failure, Glossary of Unit 2 : Managing the economy, Determining the price level and equilibrium level of real output, Causes, costs and constraints on economic growth, Demand-Side Macroeconomic Policy Instruments, Business Economics and Economic Efficiency, Comparing the monopolist and perfect competition, Government intervention to promote competition, Basic economic ideas and resource allocation, The margin: decision making at the margin, Social costs and benefits; cost-benefit analysis, Movements along and shifts of a demand curve, Price, income and cross-elasticities of demand, Equilibrium and Disequilibrium in the market, The workings/functions of the price mechanism, Direct provision of goods & services by the government, Green Capitalism – How it can save our planet, The American Iceberg: Debt, Inflation, and Money – By Bob Blain, Modern Economic Problems by Frank A. Fetter, The Principles of Political Economy, and Taxation by David Ricardo, Political economy by William Stanley Jevons, The Wealth of the People: Your Wealth By Fernando Urias, The Wealth of the People: Your Neighbor’s Wealth By Fernando Urias, The Wealth of the People: The Wealth of the Market By Fernando Urias, Economics of Freedom : What Your Professors Won’t Tell You. We frequently read about the government imposing import restrictions or providing tax breaks to industries that are in decline. the increase in the value of goods produced in a country in a year) of a county lies in the concept of division of labour. The opportunity cost of each fish is 3/2 coconuts. The work is divided among many different workers and each worker becomes a cog in a large machine. There are two key terms used to describe the differences in production capabilities of two individuals: absolute advantage and comparative advantage. I should specialize in fish and you should specialize in coconuts. These less-developed countries (LDCs) may find it necessary to devote all of their resources to feeding their population, and that still may not be enough. But now let's assume we are talking about two Caribbean islands with essentially the same population and natural resources. The PPC represents all possible combinations of two goods or services that can be produced given available resources and technology. In the long-term, this may lead to unemployment, a type of structural unemployment where the worker is replaced by a machine, and because the worker’s skill is no longer required, the worker has trouble finding employment, because he is not trained in anything else. This, in turn, may lead to the general workforce acquiring narrow skills. The fact that labourers do not have to switch tasks during the say further saves time and money. 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