What is specialization and trade? Explanation and Overview.

In this article, we're gonna talk about specialization and trade. Specialization and trade are a way to consume outside of the Production Possibilities Frontier. Let's say we've got our PPF for an economy where you can produce food or bicycles and we think about being limited with their current level of resources to all the points along that curve. We can't currently produce outside these points and they are not currently feasible given our current level of resources.

By specializing in producing a good in which your country or economy has a comparative advantage or if you have a comparative advantage in one good you can specialize and produce only that good (food), and then trade with another country to get the bicycles or something you don't have a comparative advantage in producing, you can actually consume at a point beyond the PPF.

So you're not expanding the PPF. It's not like when we get new technology or capital accumulation we're not expanding the PPF. What you're doing is you're specializing in something where you have a comparative advantage. You're trading with another economy and you're getting to consume at one of those points that aren't otherwise feasible. 

So I want to give you an example, let's say that you are stranded on an island after a plane crash with only your economics professor, exciting, I know. You can collect two coconuts per hour. You have to climb trees or whatever, you get two coconuts an hour or you can collect half a liter of water. Let's say there's a spring and you can go and collect some freshwater. For one hour's work, you could either collect two coconuts or half a liter of water.

Your professor can also collect coconuts and water but he or she can only collect one coconut per hour and also half a liter of water per hour. So you each can get half a liter of water per hour but if you decide to use that hour to collect coconuts you're gonna do a lot better job you have an absolute advantage of producing coconuts.

Let's pretend that you each worked for eight hours.  After eight hours you spent four hours collecting coconuts so you get eight coconuts and then you spend the other four hours producing water so four times half a liter of water per hour is two liters of water and then your professor also spends four hours doing coconuts and four hours doing water so it ends up with four coconuts and two liters of water.

This is just one combination of goods it doesn't have to be this way, you could spend six hours doing coconuts and two hours getting water but I'm just trying to give you an example of a combination of goods that you and your professor could produce.

Now your production possibilities frontier is going to be linear in this example usually a PPF we see is a bow-shaped familiar curve because resources are not generally equally productive in all uses but let's just say here we've got this linear PPF. For example, if you produced zero liters of water you could produce 16 coconuts and if you produce zero coconuts then you could produce four liters of water etc. 

So each red point along here along the PPF is efficient in production meaning that at any given point let's say the point eight coconuts and two liters of water point is efficient in production what does that mean? That means that you cannot give your current level of resources produced the point 10 coconuts and 2 liters of water. 

This is not feasible with the current level of resources but let's think about the following you might be able to trade with your professor and actually get to that point (10, 2). You might think that's crazy how can I consume at a point beyond my PPF, those points aren't feasible. Well, that's where this idea of comparative advantage becomes important. So your opportunity cost of produce 
1 coconut is 0.25 liters of water 
So think about it you can get 2 coconuts an hour otherwise you could spend an hour collecting 0.5 liters of water. So if we divide this by 2 that gives us 0.25 liters of water, because now the opportunity cost of producing 1 coconut for you is 0.25 liters of water.

To produce one coconut you give up a quarter-liter of water that you could have collected. Now your opportunity cost of producing 
1 liter of water is 4 coconuts.
The time that you could have spent collecting one liter of water could have been spent collecting four coconuts. That's the idea, now we could do the same thing for your professor. Your professor's opportunity cost of producing one coconut (because he or she does one coconut an hour and a half a liter of water an hour) is half a liter of water. So 0.5 liters of water is the opportunity cost of getting one coconut.

Conversely, the opportunity costs that one liter of water is going to be two coconuts because it takes your professor two hours to get one liter of water because he/she do half liter of water per hour. So we look at these opportunity costs. We compare them and we see that for you, the coconuts cost you less. which is only a quarter-liter of water for you to get a coconut that you're giving up but your professor is giving up half a liter of water.

So you have a comparative advantage in coconuts it costs you less to go get a coconut because you're really good at producing coconuts, you're really good to climb in those trees and so to get one liter of water you're giving up four coconuts. Where your professors only giving up two coconuts to get one liter of water so your professor has a comparative advantage in producing water or in collecting water.

That might seem weird to you. You might think "Hey we both collect a half-liter of water an hour why is it that my professor has a comparative advantage?" Well, what we're noticing here is even though you both collect water at the same 0.5 liters of water per hour but you have a different opportunity cost of producing water because you are really good at producing coconuts. 

So you're giving up a lot more to produce the water. That's a comparative advantage. Now what we want is for each of you to specialize where you have a comparative advantage and then you can trade and each be better off.

For example, let's say you take 8 hours and you just do coconuts and you would end up with 16 coconuts because you do 2 coconuts an hour. Now your professor spends 8 hours and ends up with 4 liters of water. Now comes the trade. You need to trade and there are a number of trades you could do here but let me just give you the one that we were talking about. So we are talking about could you consume at the point (10, 2)? where you have 10 coconuts and 2 liters of water.

So for that to happen you could give 6 coconuts because you want to have 10 coconuts and 2 liters of water Whice is also beyond the PPF. So you could give six of these to your professor and then your professor could give you two liters of water. So your professor is at 6 coconuts 2 liters of water. So in a way, we were actually able to consume at a point that was beyond the PPF. By specializing in trading.

Post a Comment

Previous Post Next Post