The Joy of Economics:  Making Sense out of Life
 Robert J. Stonebraker, Winthrop University
 

How to Produce

            Waste not, want not.
                                    ...anonymous proverb

            To reach our production-possibilities curve (PPC) we must get the most we can from our limited resources. If we waste resources or use them inefficiently, we will produce less than we possibly could and drop inside or beneath our PPC.  In other words, we need to produce with technical efficiency, that is, we need to use the least-cost methods of production. Using $5 of resources to produce what could have been made with $4 of resources is throwing away the potential output we could have gotten from the wasted resource.

            What method is best?  There is no so single answer.  It will depend upon the particular good and particular resources in question.  However, the best methods almost always will involve significant specialization. 

            We are very specialized producers.  For example, I specialize in economic lectures.  I produce lectures, earn income from doing so, and use my income to trade for goods and services produced by others.  This specialization makes us all interdependent.  We need others to produce the goods that we do not make ourselves.

            Why do we choose to specialize and trade with others rather than being self-sufficient?  Simple.  Specialization and trade raise our standard of living.  We reap gains from specialization and trade for two major reasons.

            First, specialization allows us to practice and learn to become more proficient.  If we spread our time and effort trying to play all sports, we never become expert in any one. If we specialize in baseball we can practice baseball skills repetitively.  The practice helps us improve. The saying “practice makes perfect” certainly exaggerates, but practice does make us better.

            Second, specialization allows us to take advantage of our particular talents.  People differ. Specialization allows us to concentrate on what we do best.  Some of this is obvious.  If Annie excels at cleaning and Laurie at cooking; it makes intuitive sense that Annie should specialize in cleaning and Laurie in cooking.  If Annie can then trade some of her cleaning efforts to Laurie in return for Laurie’s cooking, both women should gain.

            For example, suppose Annie and Laurie can produce either good A or good B in the amounts listed below.

                        A                                  B

Annie               8 units/day                    8 units/day
Laurie              2 units/day                  10 units/day

            Because Annie can produce eight units of good per day compared to Laurie’s two, Annie has an absolute advantage in the production of A.  Similarly, Laurie has an absolute advantage over Annie in the production of B. 

            Restate this is terms of opportunity costs.  Annie can produce equal amounts of goods A or B in a day; she produces them in a one-to-one ratio.  That means that the opportunity cost to Annie of producing a unit of A is one unit of B, and her opportunity cost of producing one unit of B is one unit of A.  The ratios for Laurie differ. Laurie can produce five times more B per day than A.  For Laurie, the opportunity cost of producing one A is five units of B and her cost to produce one unit of B is 1/5 unit of A.  Annie has the lower opportunity cost of producing one unit of A (one B for Annie compared to five B for Laurie) and Laurie has the lower cost of producing one unit of B (1/5 of an A for Laurie compared to one A for Annie).  To get least-cost production, Annie should specialize and produce A, while Laurie specializes and produces B. 

            Specialization requires trade.  Annie is not likely to want to consume only good A, nor is Laurie likely to want only good B.  There must be a way for Annie to trade some of her extra A to Laurie and get some of Laurie’s B in return.  What sorts of trades are mutually beneficial?

            By herself Annie can get one unit of B for every unit of A she gives up.  She will gain from specialization and trade if it enables her to get more than one unit of B per A.  By herself Laurie must sacrifice five units of B to get an A.  Laurie will gain from specialization and trade if she can get a unit of A for less than five units of B. 

            What trade ratio might help both women?  Any trade ratio between 1A to 1B and 1A to 5B will work.  Pick a ratio of 1 to 3.  That is, suppose Annie agrees to trade a unit of A for three units of B and Laurie agrees to trade three units of B for one unit of A.  Annie gains.  She now gets three units of B per unit of a through trade, but could only get one unit of B per A by herself.  Laurie also gains.  By herself she needed to sacrifice five units of B to get an A.  Now, by specializing and trading B to Annie, she needs to give up only three units of B to get a unit of A.

            Is this exciting, or what?  Wait, it gets even better!  It turns out that absolute advantages are not needed for this to work.  Only comparative advantages matter.  Check the example below.  In this new example, Annie has an absolute advantage over Laurie in both products.  She can produce ten units of A per day to Laurie’s five and five B per day to Laurie’s one.

                        A                                 B

Annie               10                                5
Laurie                5                                1

            Despite Annie’s across-the-board absolute edge, both women still will gain from specialization and trade.  The key is that Annie’s advantage over Laurie is relatively bigger for good B than for good A.  Annie can produce five times more B per day than can Laurie (five compared to one).  Annie can also produce more A per day than Laurie, but only twice as much (ten compared to five).  Therefore, Annie’s relative or comparative advantage is in producing B.  Similarly, Laurie is at an absolute disadvantage in both, but she can produce one-half as much a as Annie and only one-fifth as much B as Annie.  Laurie has a relative or comparative edge at good A.

            Think in terms of opportunity costs.  Annie can produce one-half as much B as A per day.  Her opportunity cost for producing one unit of A is 1/2 of a B while her cost of producing one B is 2 units of A.  For Laurie, the cost of producing one unit of A is 1/5 of a B and her cost of producing one unit of B is five units of A. 

Opportunity Costs        Cost of one A    Cost of one B

    Annie                                1/2 B                2A
    Laurie                               1/5 B                5A

            Do you see it?  Least-cost production still requires specialization.  It is cheaper to have Annie produce the B (her cost is 2A compared to Laurie’s cost of 5A) and to have Laurie produce the A (her cost of 1/5 B is less than Annie’s cost of 1/2 B). Even though Laurie cannot produce as A per day as can Annie, Laurie is still the low-cost producer.  The opportunity cost of producing A is lower for Laurie than Annie.  Even though Annie can produce A in less time than can Laurie, it costs her more.  Annie must sacrifice 1/2 of a B to get an A, Laurie sacrifices only 1/5 of a B.

            What trades will complete the gains?  In the example, Annie can produce twice as much A as she can produce B in a day (a 2A per B ratio) and Laurie can produce five times more A than B in a day (a 5A per B ratio).  Any trade using a ratio between 2A per B and 5A per B works.  For example, a ratio of three A for one unit of B will work for both.  This 3:1 ratio allows Annie to get three units of A per B through specialization and trade with Laurie while she could get only two units of A per B by herself.  Similarly, the 3:1 ratio allows Laurie to get a B for three units of A through specialization and trade while it would have cost her five units of A to get a B by herself. 

            Think about it. Even when Annie has an absolute advantage in the production of both goods, she still benefits by specializing and trading with Laurie.  Opportunity costs are driven by relative or comparative abilities, not by absolute abilities.  Because their relative or comparative abilities to produce A vs. B differ, their opportunity costs must also differ. As long as the ratio of possible production of the two goods differs for Annie and Laurie, there will be a ratio between them at which the women can engage in mutually beneficial trade. 

            Is it magic?  No, it’s merely gains from trade.

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Testing Yourself

To test your understanding of the major concepts in this reading, try answering the following:

1.         Explain the concept of technical efficiency.

2.         Explain two reasons why specialization tends to be efficient.

3.         Given productivity data for two individuals (or two countries),

a.      calculate opportunity costs.

b.      identify absolute and comparative advantages and explain.

c.      identify mutually beneficial trade ratios.

d.      clearly explain how such trade ratios benefit both.

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