In economies we distinguish amongst three kinds of productive situations: the market period, in which the amount of goods is fixed and cannot respond to price incentives; the short-run period, in which producers can use current stock to produce more for consumers; and the long-run period, in which the supply of productive goods -- machines, labor, etc. -- can be altered in response to price.
Production occurs when the physical characteristics of a resource are improved toward higher-valued uses. For example, it can be using steel to make cars or even just moving water from a well into a home.
Gains from Specialization: A Preview
The source of gains from cooperative specialization can be suggested in a very simple example. Suppose I could type 6 letters or make 100 bricks in ah hour, whereas you could type 12 letters or make 150 bricks. You are 2x as good a typist and 1.5x as good a brick-maker than I am. But, if we want to build a brick wall and type letters, we should look at relative costs. My cost to make bricks is .06 letters per brick, and your cost is .08 letters per brick. I should make the bricks since I can do so more cheaply.
In other words, though you have an absolute advantage over me in bricks and letters, specialization must be considered. The comparison should be between relatively abilities-- or comparative advantages. You have the absolute advantage in both, which determines sheer wealth, but I have a lower cost to making bricks. In this example we see both the reason for specialization and how costs play a role.
Specialization, Marginal Costs, and Trade
Corporations, labor unions, credit buying, shopping centers, factories, and all other institutions through which economic activity is conducted help the organization of production. While the economy seems complex, if we notice that the methods of coordinating specialization of production are the same, we notice the source of gains from trade.
In the previous example we held the marginal cost of each producer constant (a brick would always cost the same number of letters), however, we will abandon that assumption and notice that the tradeoff typically depends on how intensively we engage in an activity.
A Two-Person Economy
Suppose we have two people, A and B. A's resources can produce 10 X's per day or $14.50 worth of Y's per day, and for 1 unit of X produced, $1 of Y is sacrificed. However, for 2 X's it costs A an extra $1.10. Thus the marginal cost increase is $1.10. Since the meaning of cost is understood, it is easy to see that minimizing the cost of any output is the same as maximizing the value of the other output one can also produce.
Suppose that A's marginal costs go up by an extra 10 cents per unit or X. This means the average cost per each unit will be the total cost divided by the total units produced (always a bit lower than the marginal cost here). Now imagine the person B, who is not as productive as A in producing X or Y, but whose marginal costs start lower and rise more rapidly.
Achieving Production Efficiency by Equalizing Marginal Costs
Imagine A is self-sufficient, producing (and thus consuming) 2 X's and $12.40 worth of Y each day. Next, B produces 2 X (at the marginal cost of 70 cents) and making $8.40 worth of Y. Certainly A is richer, but they both couldn't change their production since they must consume 2 X per day.
The crucial feature is that A and B are producing outputs at which their marginal costs are not equal. If they were to specialize, A would produce more Y than he needs but only 1 X and B would produce 3 X then trade for some of A's Y. The important concept to remember is that producers should always keep the marginal costs as close as possible to equality so that one won't have a lower marginal cost for another unit than any other party; all resources are being allocated to their highest-valued uses.
{insert figure 7-6}
Here, \(MC _{A + B}\) is the industry supply curve, which is the sum of the horizontal distances of all the individual outputs with equal marginal costs. In other words, it represents the minimum cost of producing X for each producer. Below will demonstrate the gains from specialization and exchange with interdependence, if A and B decide to trade with one another:
In this, the aggregate demand and supply curves are horizontal summations of the individual demand curves and the individual marginal cost curves (essentially supply curves). If there is communication and a market price, B will be incentivized to produce more X since A's has a higher marginal personal value for X and A would buy the extra by trading some of Y. Market prices serve as both coordinating guides and incentives to producers and consumers. The institutional features for such a system of control and coordination are: an accessible, reliable marketplace in which prices of exchangeable goods are revealed, and there is private-property ownership of resources.
Some Misunderstandings of Costs
- Time is not a cost. Notice, the person who specializes in one good is not the one who can produce the most in a day. Time is never saved, it is merely used for something else. The forsaken best alternative use of that time -- not the time itself -- is the cost.
- Everyone has a lower marginal cost in some activity. Since, by the definition of costs, a marginal cost depends on a tradeoff of resources, each producer much have some output at which his or her marginal costs are lower than someone else's.
- Quality and cost are directly proportional. Costs can be reduced by lowering quality. It is not necessarily to continue lowering costs if quality decreases more than the cost saving, or vice versa.
More Producers: Net Gains or Transfers
Resource transfers in trade produce net gain through which other parties share in the lower prices of goods now more abundantly produced. Nevertheless, the major part of new entry (C) accrues mostly to C. There are several consequences of C's entry into the market:
- C, the newcomer, obtains most of the total gain in output
- Consumers of what the newcomer produces gain because its price falls
- The prior producers of the good produced by the newcomer lost some income to their customers
- Some social gain is provided everyone by the release of some resources by former producers of the good.
It is important to recognize that the total increase in output is large enough to make everyone better off; always the admission of a newcomer increases the social total above what it would be if they were excluded from the market and some of this gain is the income transfer through lower prices (produced by all consumers) whereas the newcomer adds real output gain.
Interestingly, even higher-cost producers can enter the market if there is an increase in demand for the good. In this case, consumers will benefit from increased output and lower prices than otherwise, and even though producers will argue that they could have met that input, we know if would have been at a higher price.
Short-Run Price and Output Adjustments
Almost all productive resources have some degree of specificity (can only be used for certain outputs) so it is costly to switch. Furthermore, with each new invention, the old outputs are devalued. These are transition costs and creative destruction costs.
Some of these costs incentivize current producers to bar entrants to their market. These are called monopoly restraints, usually in the form of protective legislation. the major difference between trade across and trade within national boundaries is that international trade involves two kinds of money, necessitating financial arrangements. Otherwise, benefits and costs are the same with net gains.
Are Specialization and Efficient Production "Good"?
For all its benefits, it may seem to increase risks over those of self-sufficiency. However, there is much uncertaintly and more risk in self-sufficiency than we usually can see. The future is always uncertain.
Marx argued that the system of specialization alienated producers from understanding their social role and interrelationships with other people. Each worker-producer felt that he or she was producing solely in response to impersonal market prices rather than satisfy others wants. (Of course, prices merely reflect these.) His primary contention was that "persons exist for one another primarily as representatives of, and therefore as owners of, commodities. The process of production has the mastery over man instead of being controlled by him" (Capital).
However, he called for central planning as if society were a single huge factory, which he believed would somehow eliminate alienation. The important question to as is, "What is the right amount of alienation (or sweat or toil) in view of what we get from bearing those risks and ills?" Unfortunately, everything is a matter of degree-- with tradeoffs.