Economics 7: comparative advantage, markets and money

by George Hatjoullis

A foundation concept of modern economics is comparative advantage. It is a simple concept and easily illustrated with an arithmetic example and a few totally unrealistic assumptions (this is the way with economics). Assume two self-sufficient communities each producing milk and corn. Both have fixed resources so there is a trade-off between the two possible goods that can be produced. Community A can either produce 1000 bushels of corn or 500 gallons of milk. Community B can produce either 500 bushels of corn or 300 gallons of milk. One simplifying assumption is that the production relationship is such in both communities that the opportunity cost is linear. Hence if A wants one more gallon of milk it must give up 2 bushels of corn. However, if B wants one more gallon of milk it need only give up 5/3 bushels of corn. The opportunity cost of milk in B is lower than in A so B is said to have a comparative advantage in the production of milk. So what, you may ask?

Assume that both are initially splitting their resources between the two goods. A is producing 500 bushels of corn and 250 gallons of milk. B is initially producing 250 bushels of corn and 150 gallons of milk. Total corn production is 750 bushels and total milk production is 400 gallons. If B were to produce 30 gallons more of milk (180 gallons) it would have to give up 50 bushels of corn leaving it with only 200 bushels. What if A produced 30 gallons less of milk ( leaving it with 220 gallons)? It could produce 60 bushels more of corn, giving it 560 bushels. A quick bit of arithmetic will reveal that total corn production by A and B is now 760 bushels but milk production is unchanged. A little bit of specialisation has increased the total corn available to both communities. For economists this is sufficient to justify free trade. The specialisation is Pareto efficient because community A could compensate community B and leave them no worse off and yet A would still have some corn left over. Modern economics is happy to leave the issue here but most of us are curious as to what happens to the extra 10 bushels and how much does A need to persuade B to co-operate.

First, note that trade opens up a mutual dependency. This moves the two communities into a power relationship and the terms of the trade that takes place will in part depend upon this power relationship. There is no definitive answer as to how the trade relationship will develop or who will get the benefits of trade. The fact that trade can be mutually beneficial does not automatically mean that it will be. Moreover, if one party realises that the other is gaining more from the trade relationship it may refuse to co-operate and trade may decline. GDP production is clearly not independent of distribution! Second, note that externalities may arise and there may be no ‘state’ to make an adjustment. The carbon footprint comes to mind. We have said nothing about transport costs etc and in particular the carbon footprint of trade versus no trade. The only cost accounted for in our simple example is opportunity cost. If the impact on carbon emissions is also taken into account then it may be that trade is not deemed beneficial. Making carbon emissions a consideration has stressed global national co-operation. Finally, what if non-material factors are important? Taken to its logical extreme, the above example maximises GDP by community B mainly producing milk and getting much of its corn from community A. The mixed farming approach may have made some non-material contribution to ‘happiness’. It is now lost.

Modern economic theory goes to considerable lengths to identify the conditions under which individuals (and communities) pursuing their own self-interest will lead to an outcome that maximizes ‘social welfare’. They never quite get there and students find themselves delving into such things as externalities, monopolies and the like and public policy, driven by this theory, is forever trying to adjust reality to meet the impossible conditions defined by economic theory (e.g. anti-trust policy to combat monopoly). Moreover, social welfare is almost always equated with GDP. Economic theory rarely even tries to address, in a useful way, the social issues that arise from GDP maximizing policies. Bear this in mind when listening to economists. This series of lessons will return to this theme again (and again).

Trade of course requires the invention of money and markets (oh yes). If individuals and communities are going to specialise, they need some way of organising exchange (otherwise you may end up with too much milk or corn). Markets enable people who have specialised and have a lot of one thing to exchange it for all the other things they need. They could barter but this quickly becomes impractical even in a slightly complex economic structure. The simplest solution is to invent money. You price your goods in money. Its serves as a unit of account. You give and accept money for goods. It serves as a medium of exchange. You can hang on to it and buy tomorrow. It serves as a store of wealth. The important characteristic of money is that everyone is happy to use it. Note you acquire money in exchange for goods or services performed. So whoever produces it can get goods in exchange. If trade is bustling and there is not enough money around, then people will offer more goods (GDP) to get a unit of money. This is a deflation. The price of money in terms of goods is rising. If there is too much money about for the level of trade then people will be less keen to offer goods to acquire money and price of money in terms of goods could be falling. This is inflation. Producing money is not costless. Seigniorage is the difference between the cost of producing it (in terms of GDP units) and the GDP units that it will buy.

An interesting modern example is Bitcoin. It can be produced by solving some algorithms on a computer. It takes up computer time and electricity. The rising price of Bitcoin makes such activity quite profitable. Bitcoin is a form of money that exists outside of any national jurisdiction. This is a problem as all people and all trading activities fall within some national jurisdiction. However, if we ignore this serious question we can see that Bitcoin fulfills all the necessary conditions of a money. To the extent that transactions with Bitcoin can be conducted anonymously, then it also approximates cybercash. The development of Bitcoin (or otherwise) provides an interesting case study into the nature of money and has been followed in one section of the Gestaltz blogs. The growing acceptance of Bitcoin in exchange for goods and services has confirmed its status as money.

To recap:

1. The economists justification for trade and specialisation is the concept of comparative advantage.

2. Comparative advantage illustrates why trade and specialisation can be mutually beneficial but says nothing about whether it will be mutually beneficial. Economics has little useful to contribute to the social consequences of mutual dependency in trade relations.

3. Trade necessitates the existence of markets and money. People acquire money in exchange for goods.

4. Bitcoin provides an interesting case study of the development of a modern (private) money.

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