Opportunity Cost and the Root of Trade
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Opportunity Cost and the Root of Trade Efficiency Pareto Optimality Comparative Advantage Root of Trade and Markets. Trade – Core of Economic Decision Making Why do people engage in trade?

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Opportunity Cost and the Root of Trade Efficiency Pareto Optimality Comparative Advantage

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Opportunity Cost and the Root of Trade


Pareto Optimality

Comparative Advantage

Root of Trade and Markets

Trade – Core of Economic Decision Making

Why do people engage in trade?

Trade and exchange is one of the oldest parts of human society – trade existed long before written history. In a modern market economy, most of a society’s economic decisions are made through the process of trade. In addition, trade is not just a central part of modern economics systems, it is a cornerstone of a large amount of human interaction.

Recognizing the root cause of trade and the reasons for the continuation of this economic system for making individual and social decisions is an important part of understanding economics.

Built on this understanding is an evaluation about whether trade is an appropriate system to use to make economic decisions about what is produced and how that produce is distributed within society.

Criteria for Judging an Economic System

From a social perspective, economics describes how a society decides how to turn the resources at its disposal into the things it wants. Throughout history, societies have used many different systems to do this. Comparing these systems can be difficult for a number of reasons that involve messy cultural judgments – economists try to say away from many of these normative issues of morals, justice and so forth. Instead, of focusing on judgment based outcomes, economists set their criteria for judging an economic system based on its efficiency. The question they as is, “Is the economic system both productively and allocatively efficient?

Productive efficiency means society turns its resources into the goods it wants in a manner that costs the least.

Allocative efficiency means that the produced output will be distributed in such a way as to meet the maximum wants of the people in society.

Productive Efficiency

The idea of productive efficiency is shown by the production possibilities curve. The basic idea is that society has limited resources and there are limits to what it can produce – to reach those limits, it needs to be efficient in how it turns those resources into goods.

The production possibilities curve also clearly shows the opportunity costs involved in production. When producing at the efficient limits the only way to produce more of one good is to produce less of another good.

The production possibilities curve represents the idea that the only way for a society to get more goods in total is to get more resources or become more efficient. However, there is another way to get more and that is through trade.

Allocative Efficiency

Allocative efficiency is a measure of how the goods a society produces are distributed to people in society. The economic goal is to get the goods to the people who most want them – this would create the greatest material benefit in society.

Economist use the concept of Pareto Efficiency or Pareto Optimality to describe the point of highest allocative efficiency. Pareto Optimality describes a situation in which the allocation of goods is such that the only way to make one person better off is to make another person worse off.

The difficulty is that it is impossible to really know how much anyone really wants a good. It is impossible to know if the benefit created by giving a good to one person is greater than the harm created by taking it away from somebody else. The only way to see whether any allocation of goods really creates the maximum material benefit is to get people to reveal their preferences for goods. People do this when they trade because trade involves selling goods that they value less for those that they value more.

Efficiency of Economic Systems

Throughout history societies have used a variety of economic systems to make production and allocation decisions and often they have been less efficient than the systems that have free trade at their core.

Perhaps the most straight forward system is one in which the leader will order people to do their jobs and decide who gets what. This is the basic structure of a command economy. In a basic sense, any totalitarian country (either communist or fascist) is a larger version of this type of decision-making.

While command economies do function, they are not very productive and the people that live in them are generally oppressed. In other words, while this type of economy can be productive enough to suffice in meeting people’s needs, it is not productively or allocatively efficient. The reality that these economies are riddled with shadow or black markets indicates that they are not allocatively efficient.

An economy run on authoritarian principles is inefficient. However this does not mean that an economy run on democratic principles would be more successful.

On the surface, an economy based on democratic principles would seem to be more fair a centrally planned system. However, a democratic system would also involve coercion at some point. Consider the problem of how the majority in any decision would get the minority to live by the decision? Democracy could devolve into a “tyranny of the majority”, where the majority uses its legal power to capture economic benefits from the minority population. At an extreme point, a majority population could simply enslave a minority population or take all the property of a minority population.

In the absence of rights to protect the minority population from the majority population, the minority population would be less productive, and the result would be a poorer society.

A third system is the market economy. In this situation, in which each survivor was free to produce whatever they wanted however they wanted. On its surface, this system would appear to be anarchy – which generally is not thought of as efficient.

However, there would be an underlying order that the only power given to the leader is to enforce property rights – that is to protect people’s private property. If people cannot resort to theft, the only way to get something is to produce it themselves or trade with other somebody else.

The question is how can an system where people will only think about their own well being (be self interested) result in an economically efficient system?

Enter Adam Smith and his “invisible hand”.

Opportunity Cost – Origin of Trade Benefits

People are different – some people are good at one thing and other people are good at something else. This means that people have different opportunity costs. These differences create an opportunity for people to specialize in doing the thing they are good at and trade for what they want but are not good at doing.

Consider a world with two people, one who is tall and the other who strong, in which there are two good, apples that need to be picked from trees and potatoes that need to be dug out of the ground. While both people can pick apples and dig potatoes and could be self-sufficient, they would most likely be better off if they specialized and traded. But how would this work?

First, each person would choose to produce the thing for which they have the lowest opportunity cost. The tall person can pick a lot of apples compared to the number of potatoes they can dig. This means each apple has a low opportunity cost. The opposite is true for the strong person. The prospect of gaining from trade would be a motivation to be productive. This would be a productively efficient system.

Property Rights & Trade

After production (picking and digging), the strong person has a lot of potatoes and the tall person has a lot of apples. Suppose both people want to eat both potatoes and apples and they have to respect each others property rights. Then, the only way they can get both apples and potatoes is to trade apples for potatoes.

The difficulty is knowing what would make a good rate of exchange and the way they would discover the apple for potato price would be through negotiating with each other. Assuming both people are rational and self interested, they will only agree to a price if the rate of exchange benefits them as individuals – therefore all agreed to trades must be at a mutually beneficial rate of exchange.

For both people, trade only benefits them if it makes them better off than they would have been had they tried to produce both goods on their own. Both sides will agree to exchange rate that is better than their opportunity cost – i.e. the tall person will trade away their apples for more potatoes than they could have dug on their own. They will trade until the point where they cannot gain from any more trade – a Pareto Optimal outcome.

Clearly, it is better for both people to produce one product and trade for the other product. Here is the key point – not only are they better off, but they are more productive. Economist call this “specialization of labor” – people chose to work at one thing and then trade for anything else they want.

The effect of different opportunity cost on trade can explain the patterns of trade within the United States. For example, Silicon Valley has a high concentration of people skilled in computers and is a center of the computer industry while Kansas has lots of open land good for growing food and is the center of agricultural industry

It would be foolish to have people in Silicon Valley to trying to grow their own food and to have people in Kansas could trying to write the code for their computers because the opportunity cost for both would be very high.

Both regions are wealthier because they specializing in producing the good for which they have the lower opportunity cost and trading with the other.

There is Always an Opportunity to Gain from Trade

Go back to the two person world of apples and potatoes. This time one person is tall but the other person is tall and strong. In this situation it would seem as if there would be no reason to trade because the person who is tall and strong can get apple just as easily as the person who is only tall and the tall and strong person is better at digging potatoes.

However, the person who is tall and strong still faces the issue of opportunity cost – every apple they pick costs them so many potatoes. Because of the opportunity cost between the two people, the tall and strong person could still benefit from specializing in digging potatoes and trading for apples because they can get a better rate of exchange than is better than their own opportunity cost.

For example, Bill Gates and (the late) Steve Jobs most likely do not repair their own computers because their time is too valuable. Instead they hire somebody else (who has a lower opportunity cost) to do the work.

  • Trade is Based on Advantage

  • Economists use two terms when describing trade:

  • Absolute Advantage – A person can use a smaller amount of resources to produce a good or service. Specifically, it can produce a good or service at a lower cost than other person.

  • Comparative Advantage – A person can produce a good or service at a lower opportunity cost than another person.

  • Trade is based on comparative advantage – goods and services should be produced where they have the lowest opportunity cost.

  • Why not have trade based on Absolute Advantage?

  • At first the ability to produce at the lowest cost would seem to be the most economical. However, if the resources used in production could be use even more efficiently producing something else (which is opportunity cost) then simply having the lowest cost may not be the best use of the resources.

Comparative Advantage Drives Trade

The existence of opportunity cost creates a situation where each person has a comparative advantage. The term “comparative advantage” means “who has the productive advantage based on a comparison of opportunity costs”.

It means that if each person specializes in the activity in which they have a lower opportunity cost and engage in trade, they will both be better off.

Nineteenth century British economist David Ricardo first recognized the concept of comparative advantage – which he used to argue for free trade between nations.

The connection of comparative advantage to trade is one of the few places where economic logic is counter-intuitive. This is one of the reasons many people deny the reality that free trade is mutually beneficial.

Distribution of the Benefits of Trade

While trade is mutually beneficial, it is important to recognize that trade may not benefit everyone equally.

This inequality causes people to think that trade is bad because it involves one person taking advantage of somebody else. While the benefits may not be equal, the important fact is that both parties are better off than they would have been on their own.

Remember, if both parties freely agreed to a trade then both sides should see the deal as beneficial – if it was not beneficial, they would not have agreed to trade.

Related to this is the idea that trade is a “zero-sum game” in which one person’s gain is the result of another person’s loss. In any specific transaction this may be true, but if you consider the process beginning with the decision to specialize in production and the benefits from that decision, then both parties have benefited from the larger amount of output created.

Trade is Good for the Poor

The full implication of trade based on comparative advantage is that free trade benefits those with less productive advantages – which is the poor. Trade provides one of the few ways for people to escape their poverty. A good example is the changes in China over the past four decades.

Comparative advantage, if applied to international trade, says that even if a country is less productive (because of, say, older technology or a poor endowment of natural resources) than other countries in producing every single product that it produces, it would still have a lower opportunity cost in the production in at least one of those products, and could profitably export that product (or those products) in international markets in sufficient amounts to pay for its imports of other products. In other words, even poor underdeveloped countries can benefit from open global trade.

The economist Hernando de Soto claims that trade is a tool for the less well off to improve their condition. He says that barriers to trade and poor property rights are one of the largest barriers to development in many poor countries.

Free Trade – Economists Like Markets

Free trade involves people making individual decisions to best use their resources to produce at the lowest opportunity cost (efficiently use resources in production) and distribute it to best meet their needs until there are no further gains possible from trade (Pareto efficient).

Economists support free trade because it is productively efficient, allocatively efficient and in confers benefits on participants.

Paul Krugman described this when he said, “If there were an Economist’s Creed, it would surely contain the affirmations “I believe in the Principle of Comparative Advantage” and “I believe in Free Trade.”

This process of specialized production and free trade is the root of the market system.

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