*The game referenced in this article is ‘The Tribez‘ offered by Game Insight UAB.
Trade is the exchange of one resource for another, and it forms one of the four key stages of resource management.
While the benefits (and costs) of trade are numerous, economists tend to prioritize three key “gains” that the economy receives from domestic and global trade.
Trade Improved the Lives of People With Different Interests.
A previous article about Value Creation (Link) showed how value can be created through trade. Remember that value is defined by what a person is willing to sacrifice to possess something.
A simple example is where Timmy has a bird, but isn’t attached and only values it at about $10. Sarah has a turtle, but doesn’t want it and only values it at about $8.
This means Timmy would be willing to keep his bird unless someone offers him more than $10, and Sarah will keep her turtle unless someone offers her more than $8.
Conversely, Timmy really enjoys learning about turtles in classes and is very interested in getting on. He has been saving up money and is willing to buy a turtle for $15.
Sarah loves listening to the bird sing every morning and has visited the local pet store frequently. She is willing to spend about $14 on buying one.
Before trading, the total value of these two animals between Timmy and Sarah is about $18.00. After trading, the total value of these two animals increases to $29 and both children are happier and more satisfied than before.
In this way, value is created and the lives of people improve through trade.
Another example: In the business above, the worker is interested in money (a salary) and the buyer wants to purchase food. With trade, both the worker and the buyer become happier than they were before.
Notice three things:
- This only works as long as the two people involved have different interests. It would not work nearly as well if Timmy and Sarah both wanted turtles. . . . there are some resources that are not as easy to trade — power, money, highly valuable resources. When the two people cannot resolve competing desires for the same resources, the trade may fail.
- This only works as long as the two people involved are willing to trade with one another. Negotiations is an important business strategy that seeks to bring people together and find a mutual ground on which they can identify different interests and a willingness to work together for mutual gain. If negotiations fail, the trade may not be completed. This can happen when personal interests, ethical issues, or social interests make the trade undesirable — for example, a consumer may refuse to trade for a product if they feel it was produced with child slave labor regardless of how much value it create for them personally.
- This only works as long as the two people involved both feel that value is created through the trade — their interests must be aligned. If Timmy still didn’t really care about his turtle but preferred a dog instead, Sarah would be in trouble. When one person does not believe the trade improves their situation, it will not succeed.
Trade Allows Companies to Increase Productivity through Specialization and Shared Knowledge.
Specialization (专门) is the situation where a worker focuses on producing one specific produce or handling one specific job until they master it as a professional.
In the ‘Wild Wild West’, people often became something of a Jack-of-all-Trades, which means they had to do multiple jobs in order to meet their needs. One person may be both teacher and seamstress, baker and butcher, veterinarian and doctor. This is because the popular was incredibly small at first and resources rarely available for trade.
The result of trying to do everything is that you are excellent at nothing. . . consider a Doctor who is also responsible for finding and creating his own food, house, wagons, machines, tools, books, etc. He would be mediocre at best simply because he has no time to LEARN or PRACTICE medicine in the ways necessary to improve.
In the modern world, we prefer to specialize, which allows us to make use of both the learning curve and the experience curve. Each person takes on a specific job and devotes all of their professional time to learning that job and gaining more experience.
Specialization importantly allows us to:
- Take advantage of the learning curve to improve output and quality
- Take advantage of the experience curve to decrease costs and improve efficiency
- Share newly found knowledge and research to expand those benefits globally.
The learning curve is a graph that shows a direct (positive) relationship between the time spent learning something and the overall performance (quality & quantity of output).
Generally, someone unfamiliar with a job is slow, uses up a lot of unnecessary resources, and makes many mistakes. The production is slow, of poor quality. As the person learns and practices their task, they begin to improve. They can produce more in the same amount of time and of better quality.
The piano is an excellent example — when first learning, the songs mastered in a week are few and of simple notes. After years mastering the piano, songs that can be memorized and performed within a week are of a higher number and of greater difficulty.
Conclusion: Learning improves productivity and quality.
The experience curve is a graph that demonstrates the indirect (negative) relationship between your experience at a task and the marginal cost of producing each unit.
Generally, an inexperienced person improves as they repeat the job over and over. . . becoming faster, wasting fewer resources, finding cheaper ways to do the task, and generally decreasing the cost of production.
In a best case scenario, the worker will achieve economies of scale — the situation where the more you produce / work, the lower the average cost of each unit. Buy in bulk, use machines to mass produce, produce higher quality with less waste. . . .
Conclusion: Experience decreases costs and improves efficiency.
Specialization & Trade
When the doctor is able to specialize — to focus on learning and increasing his experience by devoting his time to one task, he will find that his:
- Average and Marginal Costs decrease
- Speed of Production increases
- Quality improves
- Output increases
However, this will only work if the doctor is able to devote himself to that one job — which is possible only where his other needs are able to be met through trade with other specialists (shoes, food, security, etc.).
When the doctor is able to learn and experience more, eventually he will be able to both A) create innovative techniques new to the industry and B) share his new knowledge and skills with others.
As knowledge is passed from doctor to doctor, it is combined and forms even greater innovative strides in improving productivity and efficiency. The power of many minds is better than one. . . . just as products can be traded, so too can knowledge.
Conclusion: Trade, specialization and shared communication of information can increase productivity and efficiency.
Trade Can Allow Countries to Increase Global Productivity by Capitalizing on Their Comparative Advantage.
In 1776, Adam Smith published a famous economic book known as “The Wealth of Nations” and it introduced an important concept — Absolute Advantage.
Absolute Advantage is the advantage a company or country has over competitors when it can produce a product at the lowest cost. By which we mean, they product products using fewer (or cheaper) resources than the competition. They can produce the highest output for the same cost, which means they are maximizing efficiency.
You might recognize this graph as a Production Possibility Frontier (PPF) model similar to the one covered in a previous article (link). A PPF is a graph demonstrating the maximum combination of products that can be produced where resources are limited and are completely utilized.
For example, you have $100 to spend (no more -> it’s limited) and all $100 must be spent on producing Shoes 👞, Shirts 👚, or Both.
In the chart above, both Bulgaria and Canada are given $100.00 to spend on production. They can produce Shoes 👞, Shirts 👚, or a combination of both. The cost of each combination of products on the line is the same.
For Bulgaria, the cost of producing 5 Shoes (👞) and 18 Shirts (👚) is the virtually $100.00. The same cost as producing 20 Shoes (👞) and 9 Shirts (👚).
Based on this graph, we can figure out a few things about the two countries
- Bulgaria can produce either 21 Shirts 👚 or 30 Shoes 👞 for $100.
- The Cost of producing 1 Shirt 👚 must be ($100 ÷ 21 = $4.76)
- The Cost of producing 1 Shoe 👞 must be ($100 ÷ 30 = $3.33)
- Canada can produce either 18 Shirts 👚 or 40 Shoes 👞 for $100.
- The Cost of producing 1 Shirt 👚 must be ($100 ÷ 18 = $5.56)
- The Cost of producing 1 Shoe 👞 must be ($100 ÷ 40 = $2.50)
- Comparing the two countries:
- Bulgaria can produce Shirts 👚 at a lower cost in resources than Canada. Bulgaria has an absolute advantage in producing shirts.
- Canada can produce Shoes 👞 at a lower cost in resources than Bulgaria. Canada has an absolute advantage in producing shoes.
The theory of absolute advantage says that both Bulgaria and Canada can increase productivity and efficiency if they each specialize in their own product and then trade with one another. In this way, every buys shirts at the lower price Bulgaria can afford and shoes at the lower price Canada can afford.
In 1817, David Ricardo took the theory of absolute advantage and modified it into something known as the theory of comparative advantage.
This theory argues that the advantage belongs instead to the company or country who can produce the product at a lower opportunity cost than competitors. *You can find an introduction to opportunity costs here (link).
When we use a resource to produce shoes 👞, the resource is consumed and is no longer available to produce shirts 👚. The lost shirts we could have produced are known as the opportunity cost.
Consider the same graph as before. . .
The formula (Y = MX + B) of these two lines is as follows:
- Y = -0.7X + 21 (Bulgaria)
- Y = -0.45X + 18 (Canada)
The slope (M = ΔY ÷ ΔX ) refers to the number of shirts👚 (Y) sacrificed each time one new shoe 👞 (X) is produced. It is known as the marginal opportunity cost of shoes 👞.
The reciprocal of M ( ΔX ÷ ΔY ) is the marginal opportunity cost of shirts 👚.
- -0.7 = Marginal Opportunity Cost of Shoes
- (1 ÷ – 0.7) = 1.43 = Marginal Opportunity Cost of Shirts
- -0.45 = Marginal Opportunity Cost of Shoes
- (1 ÷ – 0.45) = 2.22 = Marginal Opportunity Cost of Shirts
Belgium can produce Shirts 👚 at a lower opportunity cost (-1.43 shoes) and has the comparative advantage in shirts.
Canada can produce Shoes 👞 at a lower marginal opportunity cost (-0.45 shirts) and has the comparative advantage in shoes
A easy tip to calculating Opportunity Costs is as follows. . . .
- Identify the maximum quantities a country can produce of both products.
- Bulgaria can produce for the same $100
- 21 Shirts 👚
- 30 Shoes 👞
- Canada can produce for the same $100
- 18 Shirts 👚
- 40 Shoes 👞
- Bulgaria can produce for the same $100
- Remember both options are worth $100 so equate them.
- 21 Shirts 👚 = 30 Shoes 👞
- 18 Shirts 👚 = 40 Shoes 👞
- Calculate the Margins
- 1 Shirt 👚 = 1.43 Shoes 👞
- 0.7 Shirts 👚 = 1 Shoe 👞
- 1 Shirt 👚= 2.22 Shoes 👞
- 0.45 Shirts 👚 = 1 Shoe 👞
- Bulgaria has the comparative advantage in shoes
- Canada has the comparative advantage in shirts
We have identified what makes a comparative advantage, but not how it improves productivity.
Let’s assume the same example as before. . . we already calculated the actual cost of shoes and shirts when finding the absolute advantage above:
Without Trade or Specialization
Assume for simplicity’s sake that both Bulgaria and Canada will split their resources equally between shoes ($50) and shirts ($50).
Now assume that both countries focus on specialization and produce where they have a comparative advantage.
Without Trade / With Specialization
Together, Bulgaria and Canada have actually increased global output by 1.52 Shirts 👚 and 4.98 Shoes 👞!
Of course, this is good for global output but it leaves Bulgaria without shoes and Canada without shirts unless the TRADE.
With Trade & Specialization
Notice that (compared to without trade)
- Global Output still increased
- Bulgaria has more Shoes overall
- Canada has more Shirts overall
Conclusion: Trade allows the use of comparative advantage to increase productivity.
There are many reasons why countries may choose not to trade even where a competitive advantage would improve global productivity. . . .
- The products being created are of national security and are not trusted if imported.
- The products being created are key national products that provide substantial domestic employment and giving it up would decrease jobs.
- The two countries are not necessarily allies or do not trust one another completely to be always open to trade
- Trade becomes impossible do to trade barriers or natural trade disruptions (e.g. the COVID-19 pandemic)
- The comparative advantage is entirely lopsided. . . where one country has an advantage in BOTH goods and is not particularly low on resources (e.g. China).
- It is not cheap or feasible to easily shift production from product A to product B (e.g. moving people from fishing to finance is not a simple switch).
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