Economics plays a role in all societies, both developed and undeveloped.  Even during the beginning of our time, goods have been produced, and even traded.  Thus to understand a simple economy, consider the following scenario: there are two people who each live on an isolated island.  James is one person, and Michelle is the other.  In order to survive, each person must produce and consume potatoes or chickens.  Both persons may produce any combination limited to their resources.

            Within each economy, there are opportunity cost, what you must give up in order to get (Krugan, Wells, 2009, p. 8), which applies to James and Michelle’s scenario.  Given that James may produce either 80 pounds of potatoes or 40 chickens per year, what are his opportunity costs for potatoes?  What are his opportunity costs for chickens?  See the below calculations:

James opportunity costs for 1 potato: 80 potatoes = 40 chickens== > 80/80 potatoes = 40/80 potatoes == > 1 Potato = 1/2 Chicken.

James opportunity costs for 1 chicken: 40 chickens = 80 potatoes== > 40/40 Chickens = 80/40 Chicken == > 1 Chicken = 2 Potatoes.

Summary for James: Opportunity cost of 1 potato is 1/2 chicken. Opportunity cost of 1 chicken is 2 potatoes.  Note, we cannot assume that James can produce a fraction of a chicken (1/2 chicken), only we calculate this to determine the opportunity cost for a potato.
 

Michelle, if devoted all of her time, she can grow 200 pounds of potatoes each year.  If she were to raise chickens, she could grow 50 chickens per year.  What are her opportunity costs for potatoes?  What are her opportunity costs for chickens?  See the below calculations:

Michelle’s opportunity costs for 1 potato: 200 potatoes = 50 chickens== > 200/200 potatoes = 50/200 Potato == > 1 Potato = 1/4 Chicken.

Michelle’s opportunity costs for 1 chicken: 50 chickens = 200 Potato== > 50/50 Chickens = 200/50 Chicken == > 1 Chicken = 4 Potatoes.

Summary for Michelle: Opportunity cost for 1 potato is 1/4 chicken.  Opportunity cost for 1 chicken is 4 potatoes.  Note, we cannot assume that Michelle can produce a fraction of a chicken (1/4 chicken), only we calculate this to determine the opportunity cost for a potato.
 

            Now that we understand what James and Michelle can produce and their opportunity costs, let’s take a look at who has the advantages.  Obviously Michelle, can produce more potatoes, or chickens, than James throughout the year.  Due to this, she has the absolute advantage, an activity if he or she can do better than other people (Krugan, Wells, 2009, p. 33).  Moving on, to comparative advantages, producing a good or service if the opportunity cost of producing the good or service is lower for that individual than for other people (Krugan, Wells, 2009, p. 31).  Michelle has the lower opportunity cost for potatoes, ¼ chicken, based on the previous calculations. James has the lower opportunity cost for chickens, 1/2 potato, based on the previous calculations.  Due to these comparative advantages, Michelle should specialize on potato production where as James should specialize on chickens.

            Suppose if Michelle and James specialized on their comparative advantages and decided to trade their resources at a rate of 2.5 pounds of potatoes per 1 chicken.  How would this affect their economy?  See below calculations:

Before trade = Michelle = 25 chickens = 100 Potatoes == James = 20 chickens = 40 potatoes

Specialization = Michelle = 200 potatoes == James = 40 chickens

Math for Michelle = 25 x 2.5 = 62.5 == 200 – 62.5 = 137.5

Math for James = 40/2.5 = 16 == 40 – 16 = 24

After trade = Michelle = 25 chickens = 137.5 potatoes == 24 chickens = 40 potatoes

            Based on the calculations, each person would be better off if they conducted a trade in their specialized product.  Each person would work less to get more, and result in profit from trade.

            In conclusion, societies, large or small, developed or undeveloped, an economy exists regardless the situation or at least wherever there are resources involved.  Relative to James and Michelle’s situation, everything begins with opportunity costs.  From that point on, absolute and comparative advantages can be calculated in order to determine what this person or that person should specialize in producing if they consider to trade.  It is logical that economies across the world will trade due to the different locations of limited resources such as oil, iron, food, etc.  and how each are able to produce them.

            Krugan, Wells. (2009). Economics (2^nd Ed.).

            Worth Publishers. AIU Online Version