Opportunity cost is the key calculation standing behind productive trade
We trade so frequently that we don’t even think about it any longer. It’s just mundane, and indeed, if you’re reading this, you’re probably unfamiliar with a world in which you don’t carry a pocket supercomputer that allows you to buy essentially anything you want and have it shipped to your doorstep in a few days.
Trade creates wealth. Recall that wealth is whatever people value. This means you can create wealth without creating new stuff, just by getting the old stuff into new hands. You’ve heard the aphorism “one person’s trash is another person’s treasure.” Trade turns trash into treasure by getting it out of one set of hands and into another.
Think about it this way. Have you ever gotten a great deal on something really cool at a thrift store? I went to a thrift store with my wife the night before I gave a macroeconomics exam in Fall Semester of 2017. I found a vintage Birmingham Barracudas t-shirt from 1995. If you don’t know who the Barracudas are, you’re not alone. They were Birmingham’s entry into the Canadian Football League’s ill-fated, 1990s venture south of the border. They lasted one season. I think I paid $2 for the shirt. I would’ve gladly paid $5. We didn’t make any new clothes, but when I bought the Barracudas shirt, society’s wealth increased.
Importantly, someone got paid for it. Thrift stores are a little bit different because they’re usually nonprofit organizations, but the people at the thrift store created value by having something I wanted, when I wanted it. The income the store’s managers and employers earned comes from their contribution to wealth creation. Getting things from those who value them less to those who value them more is an important way trade creates wealth.
Here’s a simple-ish example that illustrates another way trade creates wealth and explains why hulking Jason Momoa has bodyguards. There are two people, Han and Lando. They can produce two goods: apples and oranges. In a year, Han could produce 100,000 apples or 50,000 oranges. Lando could produce 200,000 apples or 400,000 oranges. The important word here is or. It isn’t and. If Han decides to produce more apples, he has to produce fewer oranges, and vice versa. The same is true for Lando.
Lando looks like an especially gifted farmer. He can produce more apples than Han. He could produce more oranges than Han. He has what economists call an absolute advantage in apples (he can produce more in a year) and an absolute advantage in oranges (he can produce more in a year).
This is where many public commentators stop, if they even get this far. Lando has nothing to gain from trading with Han, because he has an absolute advantage in both apples and oranges. If there were a whole society of high-productivity Landos and another society of low-productivity Hans, many commentators would infer that the Hans are, if anything, a threat to the Landos.
But they’re not. What you’re about to see should absolutely rock your world, as it does mine almost daily.
Let’s see what it costs Lando to produce apples and oranges and what it costs Han to produce apples and oranges.
This is where we get real insight. We need to calculate opportunity cost, which is the opportunity it costs you if you decide to do one thing and not another. In our example, the opportunity cost of apples is oranges, and the opportunity cost of oranges is apples. Since we have numbers for Han and Lando’s production possibilities, we can be precise about this.
Opportunity cost is what you give up to get something. To find Han’s opportunity cost of growing an orange, divide the number of apples he gives up by the number of oranges he gets. He gives up 100,000 apples to get 50,000 oranges, so each orange costs Han two apples. Han’s opportunity cost of growing apples is calculated the same way. Divide the 50,000 oranges he would give up to get 100,000 apples. This shows you that Han’s opportunity cost of producing an apple is half an orange.
We can do the same calculation for Lando. He gives up 400,000 oranges to get 200,000 apples, so each apple costs him two oranges. He gives up 200,000 apples to get 400,000 oranges, so each orange costs him half an apple.
We now have both their opportunity costs, so let’s compare. Han’s opportunity cost of growing an orange is two apples. Lando’s opportunity cost of growing an orange is half an apple. Lando has the lowest cost, which means he has a comparative advantage in orange growing. Conversely, Han’s opportunity cost of growing an apple is half an orange while Lando’s opportunity cost of growing an apple is two apples. In this case, Han has the lowest cost of growing apples and therefore has a comparative advantage in apples.
By agreeing to trade, Han and Lando can get more apples and more oranges than they could get by working alone, or they can get a given number of apples and oranges for less effort than they would exert if they didn’t trade.
When we know opportunity costs, we can figure out the prices at which each would be willing to trade. Think about Han as the seller of apples (for oranges) and Lando as the buyer of apples (with oranges).
Now suppose Lando wants apples. Let’s think about his decision. He could grow them himself. In that case, it would cost him two oranges for every apple he grows.
His alternative is to focus his time, energy, and attention on apple-growing and then trade some of the apples he grows for the oranges Han has grown. If he can get Han to agree to a price lower than two apples per orange, he will be able to get cheaper oranges than he would if he just produced them himself.
But that’s going to take some doing. After all, Han doesn’t want to get ripped off, right? But here’s the thing: Han won’t get ripped off as long as Lando offers him the right price.
And what, you ask, is the right price? Han’s opportunity cost of each apple is half an orange. If Lando offers him anything above half an orange per apple, Han would be better off because of the trade. Suppose Lando offered him one orange for an apple. Han produces an apple at a cost of half an orange, then he trades that apple for one orange. On net, he’s better off to the tune of half an orange.
But why would Lando be willing to make this offer? Remember how much it costs him to grow his own apples. Every apple would cost him two oranges. If, instead, he produces an orange and trades it to Han for an apple, then he has saved an apple by specializing in oranges and trading for apples, rather than growing apples himself.
Han, the apple grower, has more apples and oranges to show for his effort because he can trade with Lando. Lando, the apple buyer, has more apples and oranges to show for his effort because he can trade with Han.
There’s no trick, no sleight of hand, no mysterious new apple-growing technology nor genetic change. We’re just bringing together two people who can now trade, and they’re able to accomplish more together than they could apart.
Which price will they agree on? Any “orange price” of apples between 0.5 and 2 will be advantageous for both of them. In a competitive market with a lot of buyers and a lot of sellers, competition will determine which prices emerge.
This illustrates four important points:
- Sellers compete with other sellers for the privilege of cooperating with buyers: Han competes with all the other sellers for Lando’s business. Lando has a powerful right: the right to say no, which means Han has to hustle if he wants Lando to buy his apples.
- Buyers compete with other buyers for the privilege of cooperating with sellers. Lando competes with all the other buyers for Han’s goods. In a free market, Han has the same powerful right Lando has: the right to say no, which means Lando has to hustle if he wants Han’s apples.
- You enlist strangers on your behalf by working on their behalf. In other words, you persuade them to look after your interests by looking after theirs.
- The One Lesson of Business: People create value by moving resources from lower-value to higher-value uses. In this case, Han creates value by moving more of his time into apple production and Lando creates value by moving more of his time into orange production.
Eventually, the market for apples reaches equilibrium, and it stays there—that is until an innovator comes along and upsets the apple cart.
Originally published by the American Institute for Economic Research. Republished with permission under a Creative Commons Attribution 4.0 International License.
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