"This unit asks a very fundamental question: Why do people cooperate in producing things? To get an idea, let us make some very simple assumptions. Assume there are two tasks to be done, say the production of food and cloth. To produce these goods, only labor is required, which is measured in hours of work or number of workers. In a primitive non-cooperative economy each worker will produce food and cloth individually. Now let us assume that one worker is better at producing food while the other is better at producing cloth. Here better means that the first worker can produce more food in one hour than the second worker. However, she produces less cloth per hour than the second.
In other words, the first worker has higher labor productivity in producing food, while the other has higher productivity in producing cloth. Labor productivity is the ratio between output and input. In this example labor productivity is measured by output of food (cloth) per hour worked in the production of food (cloth). The labor productivities of two workers in two different occupations are given in table 1.1.
Table 1.1: Labor productivities
|Production of food||Production of cloth|
|Worker 1||2 units of food per hour||1 sq. meter per hour|
|Worker 2||1 unit of food per hour||2 sq. meters per hour|
If both workers spend half of the week producing food and the other half producing cloth, then
|worker 1||produces 40 units of food (= 2 x 20 hours) and
20 sq. meters cloth (= 1 x 20 hours);
|worker 2||produces 20 units of food (= 1 x 20 hours) and
40 sq. meters cloth (=2 x 20 hours
It is common sense that in this case the persons can produce more by working together than by working alone. The first worker will specialize in the production of food and the second one in the production of cloth. By specializing, they can produce together 80 units of food and 80 sqm of cloth. If they exchange 1 unit of food for one sq. meter of cloth they could both consume 40 units of food and 40 sq. meters of cloth each, which is more than they could consume working alone.
We speak of an absolute advantage if one worker is more productive in one activity and the other in a second activity. Although this can explain the gains from cooperation in some cases, it is not a principle that is valid in general. It is apparent that in the real world there are people who lack any absolute advantage. They have an absolute disadvantage in everything.
In the following, we will show that gains from collaboration also exist if one worker is less productive than the other in producing both goods. The principles we are discussing do not apply only to people but also to countries. How can a country gain from trade even though it needs more labor than the other country for the production of goods?
Let us consider two countries, East and West, which only produce food and cloth. Each country has 40 workers whose productivity is given in the following table 1.2.
Table 1.2: Production opportunities
per unit of output
|Amount produced by
|food||Cloth||food||cloth||1 unit food||1 sqm of cloth|
The upper left part of table 1.2 shows the labor needed to produce one unit of the commodity. To produce one unit of food East needs 1/3 of a worker while West can do the same with 0,2 of a worker. Similarly, the production of one sq. meter of cloth requires in the West less (0.3333 of a worker) than in the East (1 worker). Clearly, West is better at producing both goods. The bottom two rows provide the same information, but this time in terms of labor productivity. Labor productivity is just the reciprocal of the labor requirement per unit of output. It says how much output one worker can produce. In East a worker can produce 3 units of food, or one sq. meter of cloth. West does better, producing 5 units of food or 3 sq. meters cloth per worker. The labor productivity in both types of production is higher in West than in East.
The middle columns show the maximal production if all workers in each country produce exclusively cloth or food. For example, all 40 workers in East can produce 40 sq. meters cloth (= 1 x 40). Production is given by the labor productivity times the number of workers.
The last two columns introduce the concept of opportunity costs. They are given by the amount you have to give up in one good in order to produce one unit more of the other good. To produce one more unit of food West has to sacrifice 0.6 sq. meter of cloth. Since one unit of food requires 0.2 of a worker in West, this amount of work has to be taken from the production of cloth. This reduces the production of cloth by 0.6 (=3/5) sq. meters (= 3 x 0.2). The opportunity cost of cloth in West (5/3) is given by the fraction of the unit labor requirements of food to cloth (0.333/0.2) or the relation of labor productivities in cloth to food production (5/3).
In the example, West has a comparative advantage in the production of cloth, because the opportunity cost is less than in East (green figure in table 1.2). East has lower opportunity cost and a comparative advantage in the production of food (3/1 versus 5/3). Although East has an absolute disadvantage in both of the products, it has a comparative advantage in the production of one good (food). Except for the case that both countries have exactly the same opportunity costs, any country has a comparative advantage in the production of one good.
We are now going to show that for both countries trade is better than autarky. Let us now suppose that each country specializes in the production of that good in which it has a comparative advantage. While without trade each country produced both goods, if trade is possible each country will specialize completely in the production of one good. Exchanging its own production for the good of the other country, both of the countries can consume more of both goods than in autarky.
Table 1.3: Gains from trade
|production = consumption||30||30||75||75||105||105|
|price ratio: 1 cloth =2 units food or 1 food = 0,5 cloth|
|trade (ex -/ im +)||-80||+40||+80||-40||0||0|
|gains from trade||10||10||5||6||15||12|
Let us assume the regions produced and consumed in autarky the amounts given in the 4th row. Let us arbitrarily assume that the countries want to have a “balanced diet” between food and cloth. It can be seen that this is possible to achieve given the numbers in table 1.2. In East 30 workers produce cloth and 10 produce food. In West 15 people work in food production and 25 in the cloth industry. The last two columns state the world production, i.e. the production of East plus West.
Assume the countries start trading with each other. With trade, consumption can differ from production. If East specializes completely in the production of food and West produces solely cloth, world production will be higher than in the case of autarky. But for both countries to be better off we require that each of the countries can consume more than before. Assume that one 1sqm. cloth can be traded for 2 units of food. East would definitely like the situation because in autarky it gets less for 1 unit food namely 1/3 sqm of cloth. Therefore, it will produce food and exchange it for cloth at the given price ratio of 2. West will do the opposite; produce cloth and trade it for food. West gets 2 units of food for one sq. meter of cloth, which is better than the situation in autarky, when it would receive the opportunity cost of 1.66 units of food. If both countries trade at this ratio, they can consume the amounts given in the row labeled consumption. Consumption is equal to production minus trade, where export (ex) is given with a negative and import (im) with a positive sign. The consumption of both goods is higher in both countries than it was in autarky. These differences in consumption are the gains from trade (bottom row). In addition, East’s export has to be equal to the import from West and vice versa. East will give (export) 80 units of food and will get (import) 40 units of cloth.
The example shows that both countries can gain from cooperation and specialization. It demonstrates the gains from free trade, which constitutes the most forceful theorem of economics. This type of reasoning is the background for the creation of various international institutions which have fostered free trade and free-trade policy in the last decades. Expanding international trade is an important source of growth and prosperity.
So far we have not discussed why the countries have different levels of productivity in producing goods. Two sources of the comparative advantages are:
Volkardt Vincentz: 1st Chapter of Unit 1: Gains from Cooperation. © East European Studies Online; 2010.