Specialization and Voluntary Exchange

Lesson Purpose:
To develop a full understanding of trade, one must first divorce politicians’ and the media’s descriptions of trade from economists’ understanding, especially as it relates to the ‘benefits of trade.’  Politicians traditionally say they favor trade, but only as long as their constituencies are not adversely affected.  Economists favor voluntary, or free trade, without that political caveat, because it leads to resources being used in their most highly valued ways and thereby to general, widespread increases in standards of living. 

Many students see the win-win model of voluntary exchange as abstract, a textbook construct and simulation artificiality that doesn’t fit the real world where trade affects jobs, the environment, and relationships between nations. The economic consensus on the importance of voluntary trade is an extension of their recognition of the benefits of voluntary exchange among individuals and businesses. Teachers can best build students’ understanding of how trade creates wealth by taking the time to establish a firm grounding in the key economic reasoning tools – specialization, division of labor, productivity, and comparative advantage – and by applying them to trade within a nation before leaping into trade among nations.

The basics, as always, come back to scarcity and opportunity cost.  Natural and human resources are not equally distributed throughout the world, or even, indeed, throughout a nation. One of the most important functions of trade is to redistribute resources – from those who value them less to those who value them more. Improvements in technology and transportation have heightened the power of trade to redistribute incomes and wealth, and in the process, to raise standards of living.

This lesson focuses on how wealth is created as specialization and division of labor facilitate trade based on comparative advantage.  It also looks at what inhibits trade, from transaction costs to trade policy.  Together, these basic tools prepare students to deal with the issues of international trade in Topic 14.

Key Terms:

voluntary exchange	mutual benefit	trade barriers	specialization
opportunity cost	quota	tariff	division of labor
comparative advantage	productivity	subsidy
transaction costs	embargo	quota

 Content Standards:

Standard 5: Students will understand that: 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.

Benchmarks:
grade 8:

• Free trade increases worldwide material standards of living.
• Despite the mutual benefits from trade among people in different countries, many nations employ trade barriers to restrict free trade for national defense reasons or because some companies and workers are hurt by free trade.
• Voluntary exchange among people or organizations in different countries gives people a broader ranger of choices in buying goods and services.

grade 12:

• When imports are restricted by public policies, consumers pay higher prices and job opportunities and profits in exporting firms decrease.

Standard 6:  Students will understand that:  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.

Benchmarks:
grade 4:

• Economic specialization occurs when people concentrate their production on fewer kinds of goods and services than they consume.
• Specialization and division of labor usually increase the productivity of workers.

grade 8:

• Like trade among individuals within one country, international trade promotes specialization and division of labor and increases output and consumption.

grade 12:

• Transaction costs are costs (other than price) that are associated with the purchase of a good or service.  When transaction costs decrease, trade increases.
• 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.

Session Objectives:

• Identify and discuss the “mutual benefit” characteristic necessary for voluntary exchange.  (Based on bag trading game.)
• Emphasize:  Trade is based on perceived value, with price being only one factor considered.
• Emphasize the importance of information in individual traders’ decision-making
• Emphasize the importance of information in the efficient operation of markets.
• Introduce the concept of “transaction cost” and its importance in trade.
• Discuss specialization and division of labor as the basis for trade.
• Explain the trade-off associated with specialization and division of labor:  increased productivity and output vs. decreased self-sufficiency, and how this trade-off is mitigated by growing interdependence.
• Develop the concept of comparative advantage in trade between individuals and organizations (not countries) by relating back to earlier discussions of opportunity cost.
• Make the case that the basis for trade between individuals and organizations is the same regardless of whether the individuals are in the same local area, different regions, the same country, or different countries.
• Develop an example of trade between states in the U.S. and then substitute nations for the states.
• Provide examples of trade patterns and dispel the notion that most trade is back-and-forth.
• Provide examples of how comparative advantage changes and causes trade patterns to change.
• Differentiate between trade and trade policy:  individuals and organizations trade; nations create trade policy that restricts or shapes trade (and may, therefore, change the win-win nature of voluntary exchange).
• Differentiate among various trade barriers:  embargoes, sanctions, quotas, subsidies, etc.
• Explain and provide examples of how trade barriers distort trade patterns and reduce productivity growth and wealth.
• Explain and provide examples of how trade barriers change the win-win nature of voluntary exchange so that there are winners and losers.
• Discuss the difference between “free trade” and “fair trade.”

Key Content:

• Voluntary exchange is based on the mutual perception of benefit. 
• Voluntary exchange leads to increases in specialization, division of labor, productivity, and output.
• Comparative advantage (sellers’ identification of their least-opportunity cost alternative) is the basis for wealth-enhancing trade, whether among individuals and businesses within a country or among individuals and businesses in different countries.
• People and organizations trade; countries do not.  (Countries do set trade policy.)
• Barriers that reduce the flow of trade slow down the overall creation of wealth. 
• Trade barriers include direct barriers like tariffs, quotas, and embargos, and indirect barriers like subsidies.
• Individuals and businesses are affected differently by barriers to trade; some “lose,” and some “win.”

Mythconceptions:

• Countries trade.
• Countries are better off being self-sufficient.
• Trade makes some countries rich at the expense of other countries.
• Trade is based solely on the price of items.
• Most trade is bilateral, back-and-forth or this-for-that trade.
• Barriers to trade, such as tariffs and quotas, protect and strengthen a nation’s economy.
• Other countries won’t react when a nation establishes trade barriers.
• Once established, trading patterns among countries don’t change.

Frequently Asked Questions:

• Why do we trade with other countries?
• Do we benefit from trade?  How?
• Do those we trade with benefit?  How?
• Why do some people dislike/protest against international trade? How do they perceive that we or that people in developing countries will be hurt by trade?
• Isn’t international trade fundamentally different from trade within our country?
• How does our economy change when we trade with others?
• Aren’t tariffs, quotas, and embargos necessary to protect our economy?
• Aren’t we the “winners” when we establish trade barriers?
• How can subsidies provided by our government to industries within our country (farmers, for example) be considered trade barriers by developing countries?

Classroom Activity Options

• “The Magic of Markets” - Often known simply as “the bag game,” this trading simulation is an engaging, effective way to have students experience the wealth-enhancing effects of trade.  This activity is included in several FTE curriculum packages.  It is available on the FTE website at:

http://fte.org/teachers/programs/efl/lessons/mon/eflmon2.htm