Introduction to Macroeconomics

2. Opportunity Cost,
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
s
pecialize 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
A.
Specialization and Division of Labor
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 ident
ify 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 labo
r 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
on...one man draws out the wire, another
straights it, a third cuts it...; and the...business 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 tech
nological
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.
B.
Specialization Requires Exchange
If I specialize in teaching economics I would starve unless I was
able to exchange the service I
provide for food produced by som
eone 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 ow
n 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:
o
requires a "
coincidence of wants
"
-
each individual engaged in barter must have a
product that the other wants.
o
indivisibility
-
some goods cannot be broken down into small tradable
quantities. For
example, a house must be purchased in one transaction and not
in pieces. If I produce
wheat it would likely be impossible to find someone wi
lling to exchange a house for the
quantity of wheat that would be required in exchange.
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
brea
d and beer which he has immediate
occasion for. No exchange can...be 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 t
his, 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 imag
ined few people
would be likely to refuse in exchange...