Economics

Trade, both within and between countries, enhances our quality of life by increasing the efficiency of production. In modern economies, goods and services are produced by individuals who specialize in their production. For example, your professor spent years mastering economics. Similarly, the engineers who work for Apple have extensive training in their particular line of work. An Apple engineer can’t produce insightful economics research or teach an economics course. Likewise, an economics professor can’t design a miniaturized circuit board and a high throughput factory to manufacture it. In a market system, people choose occupations that suit their talents and interests. Then they develop specialized skills in their chosen industry and trade with others. Trade exploits gains from specialization, which are the economic gains that society obtains by having some workers specialize in specific productive activities.

Specialization won’t work without trade. Economics professors can’t eat economic ideas or live in them. Economists teach, and then get paid with money, and then use the money to buy food and shelter. Apple engineers love the iPhone, but they can’t sleep on it or drive it to work. Engineers get paid so they can buy what they want. Without opportunities for trade, life is bleak. If your economics professor were stranded on an island, he or she would have no students to teach and no policymakers to advise. The professor would have little or no way to put economic knowledge to use. Despite all of that knowledge, day-to-day life would resemble that of a Stone Age hunter-gatherer.

Absolute Advantage and Comparative Advantage

To gain a deeper understanding of how trade works, consider the late Steve Jobs, the visionary chief executive officer (CEO) of Apple. Jobs was famous for being a great marketer and a brilliant designer. Because of his knowledge of and love for Apple products, Jobs was a much better salesperson than most of Apple’s employees. To illustrate this point, let’s assume that Jobs could sell twice as many computers (per time period) compared to the typical Apple storeclerk. In this sense, Jobs had an absolute advantage at selling computers. A producer has an absolute advantage in producing a good or service if the producer can produce more units per hour than other producers. Of course, selling computers isn’t the only skill that Jobs had. As CEO, he designed revolutionary new products. Relative to a typical salesclerk, Jobs was a superstar designer. Let’s assume that if Jobs allocated his time to design, he would generate 1,000 design ideas per year. If a typical salesclerk worked on design, he would generate only one design idea per year. Exhibit 1 reports the estimated productivity of Jobs in the first column of data and the estimated productivity of the salesclerk, John Clerk, in the final column. By looking across the rows of Exhibit 1, we see that Jobs has an absolute advantage in both tasks: Jobs was capable of producing twice as many sales per year (relative to Clerk) and Jobs was capable of producing 1,000 times as many useful design ideas per year (relative to Clerk).

Exhibit 1.

Which task should Apple have asked him to do? To answer this question, let’s calculate the opportunity cost per unit of production or, more precisely, the opportunity cost of a design idea in terms of forgone sales. This calculation will answer the following question: how many sales are given up to produce a design idea? A worker has a comparative advantage in design when the opportunity cost of the worker’s design idea is lower than the opportunity cost of other workers’ design ideas. More generally, a worker has a comparative advantage in producing a good (or service) when he has a lower opportunity cost per unit produced compared to other producers. Exhibit 1 implies that Steve Jobs forgoes 2,000 sales for every 1,000 design ideas that he generates, or 2,000/1,000 = 2 forgone sales per design idea. On the other hand, John Clerk forgoes 1,000 sales for every design idea that he generates. With that calculation in mind, we can determine how production should be optimally organized. Apple can produce design ideas by allocating Jobs to design, with an opportunity cost of 2 forgone sales per design idea. Or Apple can produce design ideas from Clerk with an opportunity cost of 1,000 forgone sales per design idea. Since Jobs has a lower opportunity cost for each design idea (2 forgone sales for Jobs versus 1,000 forgone sales for Clerk), Jobs has a comparative advantage in design ideas. Hence, Apple should allocate Jobs to work on design and Clerk to work on sales (as long as it needs both types of activities).

Text credits: Acemoglu, D., Laibson, D. & List, J. (2016) Macroeconomics. Pearson Education Limited.