Efficiency, Exchange and Comparative Advantage

Value is subjective• The value of a good is subjective and varies with

individual preferences. Values (and our choices) depend on the situation we face.

• Value is in the eye of the chooser – NOT inherent in the product

• This is called: “Subjective theory of value”• Previously: “Labor theory of value” (Marx):

Marx believed that the value of a commodity is only related to the labor needed to produce it

• Question for Thought: Does more labor make something more valuable? (Old Wine, Study Time vs. Exam Grade…)

Value is subjective

Additional water is additional wealth to a farmer who wants to irrigate, it is not wealth to a farmer caught in a flood.

Wealth is subjective

Wealth, in the economic way of thinking, is whatever people value.Example: Bill Gates wants billions of dollars, and has them. Buddha wanted nothing, and had nothing. What can an economist conclude?Gates is wealthy, and so was Buddha

Trade creates Value & Wealth• Mutual gain is the foundation of trade.

Value can be created by exchanges that move goods to individuals who value them more.

• Economic growth consists not in increasing output of things, but increasing the generation of wealth

• Wealth, in the economic way of thinking, is whatever people value. (Fallacy: only something tangible, a product, has true value)

• Ultimately, people do not buy products. They purchase services that those products yield.

The Happiest Place on Earth: Denmark

www.happyplanetindex.org

Question for Thought

– Is it accurate to say that the two goods traded have equal value? (Aristotle believed voluntary trade should be an exchange of equal values)

– No: In a voluntary exchange both parties tend to receive more in value than they give up – Reason: different people value things differently

Efficiency and Values • Technical Efficiency vs. Economic Efficiency• To an engineer - a technical ratio of inputs to outputs.• To an economist - the value of the output to the value of

the input.

• A plan or project is economically efficient if the additional benefits outweigh the additional costs.

• Doing the things right (technical efficiency) vs. doing the right things (economical efficiency)

• Disagreements about values cause disputes over efficiency issues.

Efficiency and Values

• Example: While technical efficiency might be achieved in the production of purple spotted stuffed animals, economic (allocative) efficiency is not achieved if no one actually wants purple spotted stuffed animals and they remain stored in a big purple warehouse.

• Example: It can be perfectly efficient to walk if you prefer to do exercise and get fresh air rather than taking the bus/car.

• Example: Technical efficiency can decide whether it is technically feasible to build a bridge with given material etc.. But whether the bridge should be built at all is a question of economic efficiency.

Conclusion: Do not focus on immediate (visible) outcomes.

Unseen hypothetical outcomes are just as important.

Efficiency and Values

Question for ThoughtWhat is an efficient way to study for an economics exam?

A. Attend every lecture and take notes.B. Read the assigned material once before each class and

once after.C. Form study sessions with others in class.D. Put off everything and instead party the night before the

exam.E. Any of the above might be efficient, depending on

one’s perceived costs and benefits.

The Gains from Specialization and Exchange

• How does International Trade increase “Wealth” and “Efficiency”?

• Adam Smith (1723-1790) was the first person to formalize a model of international trade.

• Absolute Advantage Theory: If our country can produce some set of goods at lower cost than a foreign country, and if the foreign country can produce some other set of goods at a lower cost than we can produce them, then clearly it would be best for us to trade our relatively cheaper goods for their relatively cheaper goods. In this way both countries may gain from trade.

Absolute Advantage

Comparative Advantage• The theory of comparative advantage was

formulated by David Ricardo (1772-1823)• It does not focus on absolute costs, but on

opportunity costs• The ability to make more, in itself, is not a

measure of efficiency. We must compare what is sacrificed against what is gained.

• The principle of comparative advantage is universal as it applies across individuals, firms, regions and countries.

Comparative Advantage• The law of comparative advantage is the guiding principle

for international trade. It provides insight into why and how nations engage in trade. In particular, it indicates why a technologically advanced nation is able to purchase goods produced by a nation with lesser technology. The key to the law of comparative advantage is opportunity cost, the value of foregone production. If very little production is foregone when a good is produced, then the opportunity cost is relatively low. As such, an extremely productive, technologically advanced nation is bound to forego a great deal of production and incur high opportunity cost to produce a given good, while a less productive, less advanced nation can produce the same good at a lower opportunity cost.

• The United States, for example, has the technology and resources to produce athletic shoes. However, it imports athletic shoes from Indonesia, which are produced at lower opportunity cost. The United States foregoes highly valuable production when using resources to produce athletic shoes and thus incurs relatively high opportunity cost. Indonesia, in contrast, foregoes less valuable production when producing athletic shoes and thus incurs relatively lower opportunity cost.

Comparative Advantage

Specialization and Division of Labor

• Specialization according to comparative advantage leads to increased global production, which means better living standards for everyone. Exchange creates the momentum for more specialization, which creates the momentum for more exchange and so on…

• Specialization is a synonym for ‘following one’s comparative advantage’

• The benefits of specialization can only be reaped when people are able to trade with each other

Division of Labor• Specialization and the division of labor

increase output for several reasons:

• Specialization permits individuals to take advantage of their existing skills.

• Specialized workers become more skilled with time.

• Division of labor allows for the adoption of mass-production technology/automation (less time wasting between switching tasks).

Division of Labor

Disadvantages?

• Monotony• Loss of skill• Kills creativity• Risk of Unemployment• Checks Development of Personality• Increases Dependence

Division of Labor

Transaction Costs – A Barrier to Trade

• Mutual gain is the foundation of trade.• Value can be created by exchanges that move goods

to individuals who value them more.

• Transactions costs:

are costs of arranging contracts and agreements – (trades in general) among interested parties• Transactions costs reduce our ability to produce gains

from potential trades.• How does the Internet reduce transactions costs and

thereby enhance trade?• Examples: eBay, iTunes, Amazon.com.

Trade and the Middleman• Middleman:

A person who buys and sells, or arranges trades.• Middlemen reduce transactions costs. They help

interested parties find one another.• Example:

your local grocer reduces the transactions costs of your acquiring vegetables from farmers, milk from diaries, and other products from food manufacturers.

• Stockbrokers, Real Estate Agents, Auto Dealers, Wholesalers, Job Placement Agencies…

Markets as Discovery Processes

Markets help you find out where your comparativeadvantage lies:

• to enhance wealth, people pursue their comparative advantage

• comparative advantage is discovered through market exchanges of property rights

• A social system with clear property rights and few restrictions on exchange generates money prices that help people who are pursuing their comparative advantage to discover in exactly which direction their advantage lies.

Markets as Discovery Processes

Which wages can we demand at different tasks?Prices are signals that tell us what we have to do in order to be useful to other people…

The Importance of Property Rights• When an exchange occurs, in many cases it is really the property

rights of the item that changes hands. (Example: Real Estate)• Therefore private property rights need to be protected and enforced.

• Private ownership is a key to prosperity as it provides people with a

strong incentive to take care of things and develop resources in ways that are valued by others.

• Private owners can gain by using their resources in ways beneficial to others.

• They have a strong incentive to care for and manage what they own.

• They have an incentive to conserve for the future (especially if the property’s value is expected to rise).

• In contrast, commonly owned property will be poorly maintained and over-utilized rather than conserved for future use.

The Importance of Property Rights

• When private property rights are protected and enforced, permission of the owner is required for use of a resource.

• If you want to use a good or resource, you must either buy or lease it from the owner.

• Individuals and firms are faced with the cost of using scarce resources.

• Market prices provide a strong incentive for private owners to consider the desires of others and to use and develop resources that are highly valued by others.

Question for Thought

• Does a 60 year old tree farmer have an incentive to plant and care for trees that will not reach optimal cutting size for 50 years? Explain.

Recommended Literature• The Economic Way of Thinking; Heyne/Boettke/Prychitko; 12th ed.

Prentice Hall – Chapter 2• The Wealth of Nations; Adam Smith; Book 1, Chapter 1 “Of the

Division of Labor”• I, Pencil. My Family Tree as told to Leonard E. Read, Foundation for

Economic Education

HISTORY OF POLITICAL AND ECONOMIC THOUGHT

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