Lesson 1: The Basics Still Apply: Domestic or International, A Market Is a Market

Download IIT Lesson 1 Guide.

Concepts

scarcity	incentives	specialization
rational choice	voluntary exchange	comparative advantage
opportunity cost

Content Standards

Standard 1: Productive resources are limited. Therefore, people cannot have all the goods and services they want; as a result, they must choose some things and give up others.

• Scarcity is the condition of not being able to have all of the goods and services one wants. It exists because human wants for goods and services exceed the quantity of goods and services that can be produced using all available resources.
• Like individuals, governments and societies experience scarcity because human wants exceed what can be made from all available resources.
• Choices involve trading off the expected value of one opportunity against the expected value of its best alternative.
• The choices people make have both present and future consequences.
• The evaluation of choices and opportunity costs is subjective; such evaluations differ across individuals and societies.

Standard 4:  People respond predictably to positive and negative incentives.

• Responses to incentives are predictable because people usually pursue their self-interest.
• Changes in incentives cause people to change their behavior in predictable ways.
• Acting as consumers, producers, workers, savers, investors, and citizens, people respond to incentives in order to allocate their scarce resources in ways that provide the highest possible returns to them.

Standard 5: Voluntary exchange occurs only when all participating parties expect to gain. This is true for trade among individuals or organizations within a nation, and among individuals or organizations in different nations.

• Students will be able to use this knowledge to: Negotiate exchanges and identify the gains to themselves and others. Compare the benefits and costs of policies that alter trade barriers between nations, such as tariffs and quotas.
• Free trade increases worldwide material standards of living.
• Voluntary exchange among people or organizations in different countries gives people a broader range of choices in buying goods and services.
• When imports are restricted by public policies, consumers pay higher prices and job opportunities and profits in exporting firms decrease.

Standard 6: When individuals, regions, and nations specialize in what they can produce at the lowest cost and then trade with others, both production and consumption increase.

• Students will be able to use this knowledge to: Explain how they can benefit themselves and others by developing special skills and strengths.
• Like trade among individuals within one country, international trade promotes specialization and division of labor and increases output and consumption.
• As a result of growing international economic interdependence, economic conditions and policies in one nation increasingly affect economic conditions and policies in other nations.
• Individuals and nations have a comparative advantage in the production of goods or services if they can produce a product at a lower opportunity cost than other individuals or nations.
• Comparative advantages change over time because of changes in factor endowments, resource prices, and events that occur in other nations.

Overview

There is a temptation, even among good students who demonstrate proficiency in applying the fundamental precepts of economic reasoning, to abandon those precepts when attention shifts from the domestic scene to issues of international trade. A reminder is thus in order: the tools of economic analysis are neither place, time, nor circumstance- specific. Their power lies in their ability to transcend context, to facilitate our understanding of human economic interaction with not just our neighbors across town, but also those around the globe.

This lesson outline provides a brief summary of the way in which fundamental economic principles of scarcity, choice, opportunity cost, and incentives apply to the study of issues of international trade.

Key Points

Need and desire for trade among people has existed almost since the beginning of time – and there seem to have been arguments about the proper role of trade for just as long. In even the most basic cultures, people quickly learn that they and their neighbors do different things well, and that by trading some of what they do well, they can obtain some of what they don’t do as well. It’s somewhat surprising, then, that the universal urge to trade has been almost as universally accompanied by suspicion of trading partners. Once people have entered into trade, they worry whether or not they were taken advantage of or came out the winner. A better understanding of the mutually beneficial nature of voluntary trade and of the wealth-enhancing potential of specialization based on comparative advantage would go a long way to undermining such suspicion.

1. Scarcity is universal.

• Just as all individuals face the constraints of limited resources, so do all economies.
• The necessary result of scarcity is choice.

2. Rational Choice – Economics asserts that human choices are rational, meaning that individuals always choose the alternatives that they perceive to have the greatest benefits over costs.

• At the individual level, we use our time, talent, knowledge and other personal resources to produce wealth.
  • In its broadest sense, wealth includes all facets of our personal well-being: money, lifestyle, time, health, pleasure, etc.
  • The mix that comprises each person’s wealth is based on personal values and available alternatives.
• Because economies are the outgrowth or expression of the accumulated decisions of individuals, nations’ decisions about production and consumption reflect this rational bias: the chosen alternatives are those with the greatest benefits over costs.

3. Opportunity Cost – All choices impose opportunity costs.

• When an individual makes a choice about how to use his resources, he gives up the opportunity to use those resources in different ways.
  • A list of the many alternative uses of a resource must eventually be narrowed to two. One is chosen and the other refused or foregone. This “next-best” alternative, the opportunity that could have been selected but wasn’t, is the opportunity cost.
• Opportunity cost is a powerful tool in analyzing choices that individuals and groups of people (even groups as large as nations) make about production and trade.
  • The resources of all nations are scarce, which necessitates choices among the alternative uses of those resources.
  • In making choices about consumption, production, and trade, nations inevitably bear opportunity costs – the next-best alternatives that could have been pursued, but weren’t.

4. People respond to incentives, and prices are very powerful incentives.

• Prices of goods and services and of resources (like labor) allocate goods, services, and resources to their most highly valued uses.
  • Prices provide incentives for people to specialize in that production for which they have a comparative advantage (least opportunity cost).
  • In order to specialize, people must be willing to accept interdependence – and therefore, to trade.

5. Voluntary trade creates wealth – because PEOPLE trade.

• It is important to realize that in international trade, as in domestic trade, it is people, not nations, who trade.
  • An American drinking French wine, a German company using American computer software, and a Canadian restaurant serving Russian caviar are all the result of trades between people or organizations of people.
  • National laws and polices will influence trade, but ultimately trade is the accumulated exchanges of individuals.
• Voluntary trade between people takes place internationally for the same reasons that voluntary trade between people takes place domestically – because people anticipate that they will be better off if they trade.
  • A voluntary trade will not take place unless both parties believe that they will gain from the trade.
    • If a person values what she has more than she values what is offered in exchange, she will not trade.
  • If an individual trades something he values less for something he values more, his wealth has increased – and so, by the same reasoning, has the wealth of his trading partner.
• (Caveat – saying trade creates wealth is not the same as saying that trade among nations makes all people wealthier. There is no guarantee that the gains from trade will be distributed evenly or equitably; the only guarantee is that there will be gains.)

6. Comparative advantage – Specialization lowers the opportunity cost of production in both domestic and international trade.

• Because all production entails opportunity cost, and because each producer commands a unique combination of (limited) resources, there is a strong incentive for producers to search for the product and production process with the lowest opportunity cost.
• In our domestic economy, we readily accept that we are better off overall if individuals specialize in one area of production and trade for (purchase) goods and services produced by other specialists.
  • Gregarious, outgoing, “mathphobic” individuals are likely to earn larger incomes in occupations – like service or sales – where their social personalities increase their productivity. If they choose, instead, to be tax accountants, they may find that their outgoing natures are less likely than their math deficiencies to have an impact on productivity. So the friendly customer service representative is led naturally to lower his opportunity cost of production by working for the cable company and hiring others to do the things he does less well – including filing his tax return.
• We also readily accept the logic of specialization and comparative advantage in trade among states.
  • Given the climate, land conditions, and his expertise, a grower in Washington state can easily grow apples. Arguably, he could also, with a good greenhouse and lots of care, grow oranges. But, if he specializes in growing apples and trades for or purchases oranges from growers in California or Florida, he can have more of both apples and oranges than if he grows the oranges himself.
  • This same principle applies in manufacturing and other economic pursuits even though the differences are less stark and the advantages of specialization more subtle.
  • The key to specialization is to find the least opportunity cost production.  (See Visual 1 in download attached above.)

7.  Historical Development of the Principle of Trade Based on Comparative Advantage

• International trade based on comparative advantage increases wealth.
• Before 1817 and the writings of David Ricardo, a mercantilist view of international trade prevailed.
  • Because they believed that the amount of wealth in the world was finite, nations sought to accumulate gold and silver through very restrictive trade policies.
  • Exports were encouraged because they brought the gold and silver of foreigners into the country.
  • Imports were discouraged because they sent domestic gold and silver to foreign sellers.
  • In 1817, David Ricardo argued that free international trade would increase the wealth of nations far faster and more effectively than restrictive trade policies.
    • Ricardo explained the principle of comparative advantage, arguing that what people intuitively understood in domestic trade was also true of international trade – that a nation will be better off if it specializes in the goods and services for which it has low opportunity costs and trades for goods and services for which it has high opportunity costs.

Lesson 1 Activities:

• The Magic of Markets
• Tag Check