Ann produces chopped vegetables because her opportunity cost of producing vegetables, at half of one hors d’oeuvre, is lower than Bob’s. When one good has a lower opportunity cost over another, it is said to have a comparative advantageCondition that exists when one good has a lower opportunity cost over another.. That is, Ann gives up less to produce chopped vegetables than Bob, so in comparison to hors d’oeuvres, she has an advantage in the production of vegetables. Since the cost of one good is the amount of another good forgone, a comparative advantage in one good implies a comparative disadvantageCondition that exists when one good has a higher opportunity cost over another.—a higher opportunity cost—in another. If you are better at producing butter, you are necessarily worse at something else—and, in particular, the thing you give up less of to get more butter.
To illustrate this point, let’s consider another party planner. Charlie can produce one hors d’oeuvre or 1 ounce of chopped vegetables per minute. His production is strictly less than Ann’s; that is, his production possibilities frontier lies inside of Ann’s. However, he has a comparative advantage over Ann in the production of hors d’oeuvres because he gives up only 1 ounce of vegetables to produce an hors d’oeuvre, while Ann must give up 2 ounces of vegetables. Thus, Ann and Charlie can still benefit from trade if Bob isn’t around.
When one production possibilities frontier lies outside another, the larger is said to have an absolute advantageCondition that exists when one production possibilities frontier can produce more of all goods than another.—it can produce more of all goods than the smaller. In this case, Ann has an absolute advantage over Charlie—she can, by herself, have more—but not over Bob. Bob has an absolute advantage over Charlie, too; but again, not over Ann.
Diminishing marginal returns implies that the more of a good that a person produces, the higher the cost is (in terms of the good given up). That is to say, diminishing marginal returns means that supply curves slope upward; the marginal cost of producing more is increasing in the amount produced.
Trade permits specialization in activities in which one has a comparative advantage. Moreover, whenever opportunity costs differ, potential gains from trade exist. If Person 1 has an opportunity cost of c1 of producing good x (in terms of y, that is, for each unit of x that Person 1 produces, Person 1 gives up c1 units of y), and Person 2 has an opportunity cost of c2, then there are gains from trade whenever c1 is not equal to c2 and neither party has specialized.If a party specialized in one product, it is a useful convention to say that the marginal cost of that product is now infinite, since no more can be produced. Suppose c1 < c2. Then by having Person 1 increase the production of x by Δ, c1Δ less of the good y is produced. Let Person 2 reduce the production of x by Δ so that the production of x is the same. Then there is c2Δ units of y made available, for a net increase of (c2 – c1)Δ. The net changes are summarized in Table 6.1 "Construction of the gains from trade".
Table 6.1 Construction of the gains from trade
|Change in x||+Δ||–Δ||0|
|Change in y||–c1Δ||c2Δ||(c2 – c1)Δ|
Whenever opportunity costs differ, there are gains from reallocating production from one producer to another, gains which are created by having the low-cost producers produce more, in exchange for greater production of the other good by the other producer, who is the low-cost producer of this other good. An important aspect of this reallocation is that it permits production of more of all goods. This means that there is little ambiguity about whether it is a good thing to reallocate production—it just means that we have more of everything we want.If you are worried that more production means more pollution or other bad things, rest assured. Pollution is bad, so we enter the negative of pollution (or environmental cleanliness) as one of the goods we would like to have on hand. The reallocation dictated by differences in marginal costs produces more of all goods. Now with this said, we have no reason to believe that the reallocation will benefit everyone—there may be winners and losers.
How can we guide the reallocation of production to produce more goods and services? It turns out that, under some circumstances, the price system does a superb job of creating efficient production. The price system posits a price for each good or service, and anyone can sell at the common price. The insight is that such a price induces efficient production. To see this, suppose we have a price p, which is the number of units of y that one has to give to get a unit of x. (Usually prices are in currency, but we can think of them as denominated in goods, too.) If I have a cost c of producing x, which is the number of units of y that I lose to obtain a unit of x, I will find it worthwhile to sell x if p > c, because the sale of a unit of x nets me p – c units of y, which I can either consume or resell for something else I want. Similarly, if c > p, I would rather buy x (producing y to pay for it). Either way, only producers with costs less than p will produce x, and those with costs greater than p will purchase x, paying for it with y, which they can produce more cheaply than its price. (The price of y is 1/p—that is, the amount of x one must give to get a unit of y.)
Thus, a price system, with appropriate prices, will guide the allocation of production to ensure the low-cost producers are the ones who produce, in the sense that there is no way of reallocating production to obtain more goods and services.