The idea of trade-offs is one of the most basic principles in economics, that in order to have more of one thing, you have to accept having less of something else. This principle disciplines us to use resources efficiently and without waste, and also makes us alert to new resources that can satisfy our wants. At the microeconomic level, we each specialize in producing goods and services for which we need to give up the least; that is, for which we are the lowest opportunity cost producers. We trade goods that are cheapest for us to provide to get things that would require more effort, cost, or resources for us to produce ourselves. Our trading partners give up things that cost them the least to produce to obtain things that would have cost them more, but which we have produced more efficiently and at lower cost. Compared with producing everything ourselves, we not only get more goods at lower cost by trading with others, but this gives us access to a wider variety of goods and services than we could produce on our own. Trading creates a higher standard of living because it results in each person specializing in the goods they can produce best and with the lowest opportunity cost—that is, requiring each of us to sacrifice the least and use the fewest resources.
At the macroeconomic level, trade-offs determine what a country produces for international trade. The nature of trade-offs explains why we import goods that can be produced more cheaply and efficiently in other countries, and export goods that can be produced more cheaply and efficiently here. Adam Smith was among the first in a long succession of economists who argued in favor of trade among nations. As he saw it, England’s trading with France had the same beneficial impact on the standards of living in both countries, as the contrast between isolated peasants trying to eke out a miserable subsistence by producing everything they consumed, compared with the more abundant and diverse diet the same peasants could achieve just by specializing in growing different crops and trading with each other. As Smith put it, international trade expands “the extent of the market,” or more explicitly, “the division of labour is limited by the extent of the market. This is because it is by the exchange that each person can be specialised in their work and yet still have access to a wide range of goods and services.”
We specialize in producing whatever is easiest for us to produce; that is, whatever is cheapest for us to produce; that is, whatever we can produce better than others. We use the surplus produce, the amount which exceeds our own needs, to trade with others for what they have produced more efficiently than we could. This principle of specialization in trade or comparative advantage applies equally well for trade between individuals as for trade between countries. Comparative advantage explains why people specialize in producing certain products at the microeconomic level, and why countries export certain goods at the macroeconomic level.
Roger Garrison illustrates macroeconomic trade-offs by assuming a two-good world where the two goods are consumer goods, which satisfy people’s wants directly, and producer goods, also called capital or investment goods. Producer goods only satisfy people’s wants indirectly, over time, and only potentially. Producer goods include tools, factories, and equipment that are used in part to produce consumer goods. Normally, to illustrate trade-offs, introductory textbooks oversimplify by assuming two goods like guns and butter, but dividing production into the two broad categories of producer and consumer goods actually captures everything that gets produced in the real world. Consumer goods can satisfy wants immediately, but producer goods only satisfy them with a delay, and subject to some uncertainty. That means that at the individual level, the mix of consumer and producer goods is determined by individuals’ willingness to wait to satisfy their wants, a quantity known as time preference, normally expressed as a rate of interest. People with very high time preference don’t want to wait to satisfy their wants and require a high return to defer consumption by saving part of their income. People with lower time preference consume less and save more.
From a macroeconomic perspective, consumer goods are used up relatively quickly, so they have to be produced on a continuous basis. Producer goods last longer, but wear out over time—in other words, they depreciate. This ongoing process of physical depreciation means that businesses have to buy various producer goods just to maintain production at current levels. Spending exclusively on consumer goods would maximize the satisfaction of wants in the short run, but is not sustainable, because depreciation would eventually result in all producer goods—tools, equipment, and factories—wearing out. Thus, trying to enjoy too much today leads to having too little in the future.
The combination of consumer and producer goods people choose determines a country’s future economic growth. The economy can run in place—operating at a steady state—if people choose a combination of consumer and producer goods that allows for replacing existing producer goods just as fast as they wear out. If their choice is skewed toward consumer goods, the economy shrinks. If it’s skewed toward producer goods, the economy grows, and the more biased toward producer goods, the faster the growth.
When economists talk about macroeconomic trade-offs, they generally assume that combinations of consumer and producer goods are optimal. That means that what really matters is not the amount of consumer goods, but also that the composition of mouthwash versus canned soup versus deodorant, etc., is precisely what gives each consumer the greatest satisfaction of his wants. For producer goods, it is also not just the total that matters, but the composition best suited to produce the precise composition of consumer goods that consumers most desire. Since consumer wants change over time, there is also a benefit from choosing flexible producer goods that can be used to produce a variety of different outputs as preferences change.
So far, we have assumed that the population and state of technology are both fixed. Since technology advances over time, this changes the way output is produced as well as the kinds of products most desired by consumers. Technological progress makes producer goods increasingly more versatile, productive, flexible, and substitutable. However, technological progress also makes production processes more intricate, time-consuming, and path-dependent—and in that sense less flexible. As the population grows, more output is needed just to maintain a constant standard of living, but more labor also becomes available to operate the producer goods. These real-world complications highlight the limits of applying the basic idea of trade-offs in economics, but even with these complications, understanding this one basic economic principle offers powerful insights into consumer choice, economic growth, and international trade.
