Introduction to Macroeconomics

2. Opportunity Cost, Specialization, and Trade


  1. Introduction
  2. Specialization
    1. Specialization and Division of Labor
    2. Specialization Requires Exchange
    3. Incentive to Specialize - Opportunity Cost
    4. Exchange Prices
    5. Specialization Limited by the Costs of Exchange
    6. Comparative and Absolute Advantage
  3. Production Possibilities Curve (PPC)
    1. Assumptions
    2. Opportunity Cost and the PPC
    3. Comparative and Absolute Advantage
    4. At What Point on the PPC Should We Operate
  4. Applications of the Production Possibilities Curve
    1. Application - Criticism of Protectionism
    2. Application - the Cruel Dilemma Facing Developing Countries
    3. Application - Gains from Specialization and Trade

1. Introduction

In Chapter 1 we introduced the economic principle of opportunity cost. Recall that the combination of limited resources and unlimited wants implies scarcity. Because goods and services are produced from scarce resources, goods and services are also scarce. Scarcity requires choice and implies costs. A scarce resource used to satisfy one need means there is some other need that cannot be satisfied. Opportunity cost represents the highest-valued alternative foregone in making any choice.

In this chapter we will use the principle of opportunity cost to justify the incentive individuals have to specialize in their labor. We will then extend the relationship between opportunity cost and the incentive to specialize to macroeconomic aggregates like nations. To do this we will develop our first economic model: the Production Possibilities Curve.

2. Specialization

  1. Specialization and Division of Labor
  2. How do we get the most out of our personal limited resource - labor? We specialize. We tend to concentrate our labor on one primary activity. 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."

    The greatest improvement in the productive powers of labor..seem to have been the effects of the division of labor.

    [A]n example...the trade of the pin-maker; a workman not educated to this business (which the division of labor has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labor has probably given occasion), could scarce...make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried man draws out the wire, another straights it, a third cuts it...; and of making a pin is...divided into about 18 distinct operations... I have seen a small manufactory of this kind where 10 men only were employed... But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could...make upwards of 48,000 pins in a day.

    Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776)

    But why is specialization efficient? There are several reasons. For example, through specialization we may acquire greater skill from repetition and we may avoid wasting time shifting from one task to another. Adam Smith also emphasized incentives for technological advancement. 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.

    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. Ricardo's theory is the subject of this chapter because it goes beyond explaining specialization by individuals to justify why countries (macroeconomies) also specialize and engage in trade.

  3. Specialization Requires Exchange
  4. 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.

    When the division of labor has been...established, it is but a very small part of a man's wants which the produce of his own labor can supply. He supplies the greater part of them by exchanging that surplus...of his own production, which is over and above his own consumption, for...the produce of other men's labor...Every man thus lives by exchanging, or becomes in some measure a merchant.

    Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776)

    The fundamental method of exchange is barter. With barter no money is used. One good or service is exchanged directly for another. There are several problems with barter:

    But when the division of labor first began to take place, this power of exchanging must...have been [difficult]...The butcher has more meat in his shop than he himself can consume, and the brewer and the baker would each of them be willing to purchase a part of it. But they have nothing to offer in exchange, except the different productions of their respective trades, and the butcher is already provided with all the bread and beer which he has immediate occasion for. No exchange made between them.

    Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776)

    The introduction of money reduced the difficulty or costs of barter. For example, it is no longer necessary to have a coincidence if wants. Money is a common medium of exchange and represents general purchasing power. Money can be used to buy any goods and services offered for sale. Of course the role of money is much more extensive than this, but we will save that for a later chapter.

    [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...

    Many different commodities...were employed for this purpose. In the rude ages of society, cattle are said to have been the common instrument of commerce...The armour of Diomede, says Homer, cost only nine oxen; but that of Glaucus cost an hundred oxen. Abyssinia; a species of shells in some parts of the coast of India ...

    In all countries, however, men seem at give the metals. 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...

    Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776)

    Barter - one good or service is exchanged directly for another.

    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.

  5. Incentive to Specialize - Opportunity Cost
  6. When we specialize we tend to concentrate our labor on one primary activity. The reason is opportunity cost. We act in our rational self-interest by seeking out those activities that minimize our opportunity costs (or equivalently, maximize net benefit).

    We can illustrate the incentive to specialize and exchange with a simple example. You and I are stranded on a tropical island. In one hour I can cut down 12 coconuts or catch 8 fish. In one hour you can cut down 14 coconuts or catch 7 fish. What do we do?

    First let's calculate what the opportunity cost is for each of our production options. The opportunity cost for me to cut down 12 coconuts is that I give up the opportunity to catch 8 fish. The opportunity cost of each coconut is 2/3 fish. On the flip side, the opportunity cost for me to catch 8 fish is that I forego cutting down 12 coconuts. The opportunity cost of each fish is 3/2 coconuts. We can demonstrate this mathematically:

         12 coconuts = 8 fish

    Solving for my opportunity cost of each coconut I cut down:

         1 coconut = 8/12 fish
                   = 2/3 fish

    Solving for my opportunity cost of each fish I catch:

         1 fish = 12/8 coconuts
                = 3/2 coconuts

    Your opportunity costs are slightly different:

         14 coconuts = 7 fish
         1 coconut = 1/2 fish
         1 fish = 2 coconuts

    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). Again we ask, what do we do?

    Let's say we don't cooperate at first. We each evenly split our time between cutting down coconuts and catching fish. I get 6 coconuts and 4 fish and you get 7 coconuts and 3.5 fish.

    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. To catch one more fish I reduce my supply of coconuts by 3/2. To cut down two more coconuts you reduce your supply of fish by 1. Our total supply of coconuts increases by 1/2 while our total supply of fish remains the same.

    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. We both have an incentive to specialize and trade. Trade increases total wealth by allowing a person to specialize in those products that he or she produces at a lower opportunity cost than others and trade for those goods that others produce at lower opportunity cost.

    Table 2-1. Production and Consumption on Island

      I produce
    and consume
    You produce
    and consume
    Total production
    and consumption

    Before Specialization and Before Trade
    Coconuts 6 7 13
    Fish 4 3-½ 7-½
    After Specialization, Before Trade
    Coconuts 0 14 14
    Fish 8 0 8
    After Specialization and After Trade
    Coconuts 6-½ 7-½ 14
    Fish 4-¼ 3-¾ 8

    But how do we really know what paid labor to specialize in? Quite simply by what pays you the most for your training and abilities. Individuals seek those jobs they are capable of performing and that pay the highest wage or salary. Market prices (wages) reveal which of your skills is most highly valued.

  7. Exchange Prices
  8. Now that we have established that there is an incentive to specialize and trade the question becomes what will the terms of exchange be? What "price" should I charge for the fish I produce? In our simple economy the price will be some number of coconuts.

    The answer is that the price will fall somewhere between my oportunity cost and your opportunity cost. Let's start with the situation where we are not specializing or trading. If I produce 1 more fish I must give up 1.5 coconuts (my opportunity cost). Would I be willing to give you that fish in exchange for 1 coconut? No, because I would be giving up more (1.5 coconuts) than I would get from you (1 coconut). For me to produce one more fish you must be willing to give me at least 1.5 coconuts. Would you be willing to give me 3 coconuts? No, because you could produce 1 more fish by giving up production of just 2 coconuts (your opportunity cost). You would only be willing to exchange if you could give me less than 2 full cocunuts. Thus the price of fish must lie somewhere between 1.5 and 2 coconuts. The actual price of exchange cannot be determined by our theory since it would depend on each person's negotiating abilities. The same analysis would apply to the exchange price of coconuts. The exchange price should fall between 0.5 fish (your opportunity cost) and 0.67 fish (my opportunity cost).

    When we specialize and exchange we both benefit. Specialization and trade is called a positive sum game because we both are better off after exchange than we were before.

  9. Specialization Limited by Costs of Exchange
  10. Even though money eliminates the costs directly associated with barter there still remain some costs of exchange that reduce the benefits of specialization. These costs of exchange are commonly referred to as transactions costs and include:

    1. Negotiation costs,
    2. Transportation costs, and
    3. Artificial barriers to trade (e.g., import tariffs).

    A reduction in these costs would increase the incentive for specialization, thereby increasing both trade and total wealth. This is a simple explanation why most economists oppose trade barriers (such as tariffs or import quotas) on principle.

  11. Comparative and Absolute Advantage
  12. There are two key terms used to describe the differences in production capabilities of two individuals: absolute advantage and comparative advantage. 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. If I can produce a good or service at a lower opportunity cost than you then I have a comparative advantage.

    Absolute Advantage - a person can produce a good or service with fewer resources than can another person.

    Comparative Advantage - a person can produce a good or service with lower opportunity cost than can another person.

    Let's use our tropical island example to identify who has absolute and comparative advantage in the production of fish and coconuts. You and I are stranded on a tropical island. In one hour I can cut down 12 coconuts or catch 8 fish. In one hour you can cut down 14 coconuts or catch 7 fish.

    Absolute Advantage. If we both spend all our time catching fish, I can catch 8 fish in one hour while you catch 7 fish. Since I can catch more fish I have absolute advantage in catching fish. If on the other hand we both spend all our time cutting down coconuts, I can cut down 12 in one hour and you can cut down 14. You have absolute advantage in coconut production.

    Comparative Advantage. 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. I have comparative advantage over you in catching fish because my opportunity cost is lower. In coconut production you have comparative advantage because your opportunity cost is lower.

    So, why did we emphasize that specialization should be based on opportunity cost, i.e. comparative advantage, and not the simpler concept of absolute advantage? It may be easier to demonstrate by slightly changing the example. Let's say that in one hour I can still cut down 12 coconuts or catch 8 fish. But let's change your capabilities to cutting down 10 coconuts or catching 5 fish in one hour. Now I have absolute advantage in both coconut and fish production since I can cut down more coconuts and catch more fish in one hour than you can. Does that mean I should do both? No. Notice that the opportunity costs have not changed. I have comparative advantage in catching fish and you still have comparative advantage in cutting down coconuts. I should specialize in fish and you should specialize in coconuts. (The details of this calculation are provided in the sample problems for this chapter.)

    The bottom line is that it is comparative advantage (opportunity cost) and not absolute advantage that yields an incentive for specialization and trade. Just because I am better than you at everything doesn't mean I should do everything.

3. Production Possibilities Curve (PPC)

Specialization is not only a characteristic of individuals but also of macroeconomic aggregates like regions or nations. 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.

The quantity and quality of available human and nonhuman resources usually determines the competitive relationship between countries (i.e., who has comparative advantage in what products). These resource factors include:

The availability of natural resources is of course a major determinant of comparative advantage. The Middle East countries have abundant crude oil reserves and the United States has rich agricultural lands. But a country can also pursue comparative advantage despite a lack of natural resources. 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.

We can apply the microeconomic concepts of opportunity cost and specialization to entire countries with our first macroeconomic model - the Production Possibilities Curve (PPC). To illustrate the concept of the production possibilities curve, assume that we live on an island that has only two industries -- food and clothing. Table 2-2 below shows different combinations of the maximum possible quantities that can be produced with the resources that are available on our island:

Table 2-2. Production Possibilities for Island Economy

Option Food Clothing


The table identifies six production possibilities, options A through F. Each option represents the amount of food and clothing that our island economy can produce given full and efficient utilization of our available resources. In option A all available resources are dedicated to the production of clothing. If we decide to produce some food we must give up some production of clothing. Options B through F represent progressively increasing output of food and decreasing output of clothing.

Actually there are many more possible production combinations than indicated in the table. We can illustrate these many combinations with a graph of the production possibilities curve.

The Food-Clothing Production Possibilities Curve
Figure 2-1. The Food-Clothing Production Possibilities Curve


Production Possibilities Curve - a graph that indicates all the possible combinations of two goods or services (or aggregates of goods and services) that can be produced within an economy given the full and efficient use of all available resources.

The production possibilities curve is often referred to as a "Frontier". The PPC represents all possible combinations of two goods or services that can be produced given available resources and technology. 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.

However, you can operate inside the production possibilities curve (below and/or to the left of the PPC). But this represents the undesirable situation of an underutilization of resources. For example, if there is a higher than normal level of unemployment, then our economy is not producing at its full capacity.

Underutilization of Resources
Figure 2-2. Underutilization of Resources

  1. Assumptions
  2. There are four assumptions that must be satisfied to construct a production possibilities curve:

    1. Only 2 goods or services (or aggregates of goods or services) are produced.
    2. Full and efficient use of all available resources.
    3. Supplies of resources (i.e., land, labor, and capital) are fixed.
    4. Technology is held constant.

    By satisfying these four assumptions, the production possibilities curve identifies all combinations of the maximum amount of any two goods or services that can be produced by a given economy.

    Our first assumption that only 2 goods or services are produced allows us to illustrate our model as a graph with the output of one economic good plotted against the output of a second economic good. Of course there are many thousands of goods and services that are supplied in any economy. We are not limited to analyzing the tradeoff between two specific goods. For example, we can plot the production of that one good against an aggregate measure of all other goods and services supplied in the economy. There are other aggregated combinations that reveal interesting tradeoffs such as all consumer goods versus all capital goods.

    Our second assumption requires the full and efficient use of all available resources. As we noted above if resources are not fully utilized we are operating inside the PPC. The application of the model with respect to opportunity cost and comparative advantage requires that we are operating at some point on the PPC. For example, if we have a situation of large scale unemployment and factories are sitting idle we can increase output with no opportunity cost to society. In other words we can produce more of one good without requiring any sacrifice of production of the other good. Similarly, if resources are not efficiently used we could increase output of one good without sacrificing output of the other good.

    You should recognize that this is not a model of economic growth. The application of the model with respect to opportunity cost and comparative advantage requires a stable PPC, i.e. a curve that does not shift. If there is an increase in the resources available (e.g., an increase in the size of the labor force) we can produce more. If there is an improvement in technology we can also produce more or everything. Economic growth arising from an increase in productive capacity through an increase in resources or an improvement in technology implies the PPC shifts outward (Figure 2-3). 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.

    There is one distinction we should make. Generally we assume an increase in available resources raises the production capacity of both goods. An improvement in technology, however, may be specific to one product. In this situation the PPC shifts outward only along one axis (Figure 2-4).

    Resource and Technology Growth Both Goods
    Figure 2-3. Resource and/or Technology Growth That Benefits Both Goods/Services
    Resource and Technology Growth One Good
    Figure 2-4. Resource and/or Technology Growth That Benefits Only One Goods/Service

  3. Opportunity Cost and the PPC
  4. The production possibilities curve illustrated above has two significant characteristics:

    1. The PPC slopes downward and to the right. This represents the opportunity cost of increasing the output of one good at the expense of the second good. An increase in food production requires a reduction in the production of clothing. The slope of the PPC is negative at all points on the curve. Opportunity cost is measured by the slope of the PPC (the change in along y-axis divided by the change along the x-axis). As production of food increases, production of clothing declines and vice versa.
    2. The PPC is "bowed outward" (concave) from the origin. This represents increasing opportunity cost. For example, increasing food production from 0 units to 10 units requires only a small reduction in clothing production. A futher increase from 10 to 20 requires a larger sacrifice. Finally increasing from 40 to 50 requires the largest sacrifice. The opportunity cost of producing more food increases as we move to the right in the graph. The slope of the PPC becomes more negative as we move from left to right on the curve.

      Increasing Opportunity Cost - As more scarce resources are used to increase production of one good or service, production of another good or service falls by larger and larger amounts.

      Why are there increasing opportunity costs? To produce more food, resources employed in clothing production must be transferred to food production. The first resources transferred from clothing to food production will likely be those that are best suited for food production. For example, the most fertile land is first transferred from raising sheep to growing food. As more resources are transferred those resources are progressively less well suited to food production. Increasing opportunity costs is a reflection of the specialized characteristics of resources. Resources are not perfectly adaptable to alternative uses.

      In some of the examples and sample problems in this chapter we assume the PPC is a straight line. This implies opportunity costs are constant. While this assumption is made as a convenient simplification, it is not necessarily unrealistic. For example, if the tradeoff considered is between making automobile engines versus motorcycle engines, the resources employed may be equally suitable in the production of either good.

  5. Comparative and Absolute Advantage
  6. The concepts of comparative and absolute advantage also apply to macroeconomic aggregates such as regions or nations. We can easily use the production possibilities curves of two countries to identify which has absolute and/or comparative advantage.

    1. Absolute Advantage - can produce a good with fewer resources.
    2. Comparative Advantage - if two agents (countries) have different opportunity costs of producing a good or service, the agent with the lowest opportunity cost has comparative advantage in that good or service.

    Comparing absolute advantage for two countries requires the additional assumption that the resources available to each country are identical. But we are not really interested in absolute advantage. It is comparative advantage that reveals incentives to specialize. We do not need to assume the countries are the same size to determine who has comparative advantage using the PPC model.

    Review graphs of two countries with different PPCs.

    1. Straight-line PPCs (constant opportunity cost) - each country completely specializes
    2. Bowed outwards PPCs (increasing opportunity cost) - degree of specialization depends on other market factors (i.e., demands and prices) - not covered in text

  7. At What Point on the PPC Should We Operate?
  8. Given that we satisfy our assumptions and are operating somewhere on our production possibilities curve, where on the curve should we be? We suggested that individuals and nations have an incentive to specialize but should they concentrate on producing only 1 product? We can't answer that question without more information - specifically people's preferences. With additional information about the tastes and preferences of the consumers in our economy we can determine what combination of output maximizes our total satisfaction. For example, consider a simple agricultural economy that can produce only corn or wheat. If the majority of consumers prefer corn products to wheat products, then the economy should probably produce more corn than wheat. 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. Nevertheless, the simple model we have presented is sufficient to address some questions. A more complex model should not change the results of that analysis so we apply Occam's Razor and try to keep it simple.

Applications of the Production Possibilities Curve

We've saved examples of applications for last to show how the theory developed in this chapter can be applied at different levels. This is probably a source of frustration for many new college students. The questions and problems we face are seldom the same. Each problem often requires the unique application of some part of the theory. For example, we start with a simple application of the concept of opportunity cost when considering government policy decisions on import quotas or tariffs. Then we apply the basic production possibilities curve to the unfortunate dilemma facing poor countries in their ability to feed their people.

  1. Application - Criticism of Protectionism
  2. We frequently read about the government imposing import restrictions or providing tax breaks to industries that are in decline. For example, during the 1970s many blamed the plight of the economy on the slow decay of some heavy industries such as steel. The economist would say that the opportunity cost to society for taking resources from expanding industries (such as computer technology) to invest in declining industries may be so high that the use of antiquated machinery by declining firms is perfectly efficient.

    "Greenspan Criticizes U.S. Protectionism"

    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.

    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." But protectionist efforts designed to avoid such dislocations are "unwise and surely self-defeating" because they make the U.S. economy less productive.

    Greenspan did not mention any specific industries or products. But he pointed to anti-dumping complaints and the imposition of so-called countervailing duties on imports as examples of anti-competitive actions.

    John M. Berry, Washington Post (Washington, DC: April 17, 1999) pp. E1-E2.

    While economists may feel comfortable with the argument that specialization with free trade would make everyone better off, politics is not so lucky. There is still a human element (voters) that can't be ignored. Declining industries means some must lose their jobs. Those people may also be ill-trained to find work in industries that enjoy a comparative advantage. One political response as mentioned is to protect the jobs. But there are other options such as job retraining programs, extension of unemployment benefits, etc.

  3. Application - the Cruel Dilemma Facing Developing Countries
  4. 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. Savings and investment represent the engine of economic growth. In general, countries that have larger investments in capital goods are wealthier and have greater economic growth rates.

    Unfortunately, many poor nations don't have the luxury of making this choice. 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. Their economy may be operating at or below the subsistence level (the barest means in terms of food, clothing, and shelter needed to sustain life). 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.

    We can illustrate this problem with a PPC. Assume the country produces only two goods: consumption goods and capital goods. In the figure below we can see that the PPC falls below the subsistence level. If the country devoted all of its resources to consumption today it still would not satisfy the basic minimal needs of its population. Humanitarian aid would be required.

    For the country to become self-sustaining it must shift its PPC outward. 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). To produce capital goods the country must reduce production of consumption goods. Present consumption is the opportunity cost of investing to increase future consumption. Poor countries with a hungry population may be unable to pay that cost and may be forever locked into poverty.

    Consumption Versus Investment Trade-Off
    Figure 2-5. Consumption Versus Investment Trade-Off

  5. Application - Gains from Specialization and Trade
  6. We can illustrate the gains from specialization and trade that arise from differences in comparative advantage using production possibilities curve. This example is identical to the problem faced by our island castaways that we discussed above. But now let's assume we are talking about two Caribbean islands with essentially the same population and natural resources.

    Cultural differences originating half a century ago (one island was colonized by the Dutch, the other by the Spanish) have led to one island being better at fishing and the other island being better at farming. Their annual production capabilities are represented in Table 2-3:

    Table 2-3. Production Possibilities for Island Economies

    Country A Country B

    (million pounds)
    (million pounds)
    (million pounds)
    (million pounds)

    0 12 0 14
    4 6 3.5 7
    8 0 7 0

    These production possibilities can be graphed as production possibilities curves:

    Production Possibilities for Islands
    Figure 2-6. Production Possibilities for Islands

    There are several things you should observe from the graph:

File last modified: May 1, 2003

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