Chapter 2 Markets, Specialisation and Economic Efficiency

A human being should be able to change a diaper, plan an invasion, butcher a hog, conn a
ship, design a building, write a sonnet, balance account, build a wall, set a bone, comfort the
dying, take orders, give orders, cooperate, act alone, solve equations, analyze a new problem,
pitch manure, program a computer, cook a tasty meal, fight efficiently, die gallantly.
Specialization is for insects. Robert A. Hein

Introduction:

Developed countries, such as are characterized by a much higher degree of

specialization than under-developed countries in the organization of economic life
In richer economies: consuming of goods which were not produced and producing of
goods which will not be consumed is more common
i.e. household skills got replaced over the years by goods and services outside the
household (cleaning, pizza, clothes) and bought in out of earnings derived from what
the household produces and sells to other economic entities
vertical disintegration of production trend towards separate production of parts
from the assembly of those parts into final goods
positive correlation between income levels and specialization and exchange across
countries and over time within countries
economic systems based on specialization and the exchange of goods and services
far more productive than those with less specialization
people in poorer countries do not provide their own services because they are poor
less specialization wider variety of skills, less comparative advantage: A person has
a comparative advantage at producing a particular good or service if that person is
relatively more efficient at producing the specific good/service than at producing other
goods and services
production possibilities curve (PPC) = graphical method of describing the
combinations of goods and services that an economy can produce
size of the market, transport infrastructure, training/skills and capital in form of
dedicated equipment determines the limits to the benefits from the specialized
division of labour chicken and egg problem; specialization increases the value
of goods and services being produced , but the incentive to specialize may depend on
the existing size of the economy (development economics)

EXCHANGE AND OPPORTUNITY COST

Scarcity Principle reminds us that the opportunity cost of spending more time on any one
activity is having less time available to spend on others. This explains why everyone can do
better by concentrating on those activities at which they perform best relative to others.
The Principle of comparative Advantage
absolute advantage = one person has an absolute advantage over another if an hour spent in
performing a task earns more than the other person can earn in an hour at the task
comparative advantage = one person has a comparative advantage over another in a task if
his or her opportunity cost of performing a task is lower than the other persons opportunity
cost
Time to update a web page
Paula
Beth

20
30

Time to complete a bycicle

repair
10
30

Beths opportunity cost of updating a web page is one bicycle repair

Paulas opportunity cost of updating a web page is two bicycle repair twice as high
Beth has a comparative advantage over Paula at programming, she is relatively
more productive at programming than Paula
Similarly, Paula has a comparative advantage over Beth in bicycle repair

the total number of bicycle repairs and web updates accomplished if Paula and Beth both
spend part of their time at each activity will always be smaller than the number accomplished
if each specializes in the activity in which she has a comparative advantage:
The Principle of Comparative Advantage = everyone does best when each person (or each
country) concentrates on the activities for which her opportunity cost is lowest

Comparative advantage makes specialization worthwhile even if one trading partner is

more productive than others, in absolute terms, in every activity
The gains made possible from specialization based on comparative advantage
constituted the rationale for market exchange, gains from exchange are possible if
trading partners have comparative advantages in producing different goods and
services

Sources of comparative advantage

Individual level: result of inborn talent, education, training or experience

National level: differences in natural resources or differences in society, culture,
climate, non-economic factors (i.e. English as world-language)

COMPARATIVE ADVANTAGE AND PRODUCTION POSSIBILITIES

Production possibility curves

Production possibilities curve (PPC) = a graph that describes the maximum amount of one
good that can be produced for every possible level of production of the other good

The slope of the PPF at any point represents the opportunity cost of coconuts at that
point, expressed in kg of fish, Crusoes opportunity cost of an additonal coconut is 0.5
fish (since slope is -0.5), OCfish = 2 coconuts
Occoconuts = Loss in fish/Gain in coconuts, Ocfish = loss in coconuts/gain in fish
Downward slope illustrates the Scarcity Principle

attainable point = any combination of goods that can be produced using currently available
resources (points on or within/under the curve)
unattainable point = any combination of goods that cannot be produced using currently
available resources (points over the curve)
inefficient point = any combination of goods for which currently available resources enable
an increase in the production of one good without a reduction in the production of the other
(points under the curve)
efficient point = any combination of goods for which currently available resources do not
allow an increase in the production of one good without a reduction in the production of the
other (points on the curve)
How individual productivity affects the slope and position of the PPC:

Principle of Comparative Advantage is a relative concept - one that makes sense only
when the productivities of two or more people (countries) are being compared

The gains from specialization

Point B (8/8) = output of each person if they divide their time so as to produce the same
quantity of nuts and coffee
Point E (12,12) = not drawn here, consumption of each person if Tom specializes in nuts
and Susan specializes in coffee and they split up the output evenly

Gain from specialization (8/8)->(12,12)

The solid lines constitute their production possibility curve (PPC) or procuction possibility
frontier (PPF) = describes the maximum amount of one good that can be produced for every
possible level of production of the other good

A PPF for a many-person economy

Opportunity cost of producing nuts increases

as the economy produces more of them
this pattern of increasing opportunity cost
persists over the entire length of the PPF

The Principle of Increasing Opportunity

Cost (Low-Hanging-Fruit Principle) =
In expanding the production of any good,
first employ those resources with the lowest
opportunity cost, and only afterwoods turn to
resources with higher opportunity costs
(picking the most accessible fruit first)

Take advantage of your most favourable

opportunities first

FACTORS THAT SHIFT THE ECONOMYS PPF

The PPF confronts every society with trade-offs: the only way people can produce
and consume more nuts is to produce and consume less coffee
BUT: in the long-run it is often possible to increase the production of all goods
through economic growth. Reasons for economic growth:
1. increases in the amount of productive resources available can result
from investment (i.e. workers have more and better equipment)
2. improvement in knowledge or technology higher output through
increased specialization result indirectly from increases in education
3. Population growth also causes an economys PPF curve to shift outwards
though cannot by itself raise countrys standard of living (also problems:
i.e. availability of land)

Many of these differences which lead to economic growth can act reinforcing which
leads to even bigger differences between economies

Adam Smith was the first to recognize the gains made by the division and specialization of
labour

Why have some countries been slow to specialise?

population density is an important precondition for specialization

extreme isolation
laws and customs that limit peoples freedom to transact freely with one another
size of the market its worth doing only if a significant quantity of output is to be
produced

Again: chicken and egg problem for poor countries

Can we have too much specialization?

Specialization also entails costs

Most people enjoy variety in the work they do

COMPARATIVE ADVANTAGE AND THE GAINS FROM INTERNATIONAL TRADE

Nations can benefit from exchange based on comparative advantage, even though
one may be generally more productive than another in absolute terms!
the greater the difference between domestic opportunity cost and world opportunity
cost, the more a nation benefits from exchange with other nations
BUT expansion in trade does not guarantee that each individual citizen will do better.
In particular unskilled workers in high-wage countries may be hurt in the short run by
the reduction of barriers to trade with low-wage nations

(book summary page 54)