So long as both A and B produce at the same cost, each sacrificing the same number of working hours for the same quantity of the same product, no exchange takes place between A and B no matter how different their individual relative valuations of apples and pears may be. Production simply follows the demand and consumption of the individual producers. But if the production costs of A and B differ, exchange will take place as soon as they are no longer isolated from each other but able to exchange goods.
As an isolated producer, A could produce 5 pears only by exchanging 15 apples with nature, since his production costs for pears are those shown by curve S2 in Figure 4 (1 pear for 3 apples). It would obviously be advantageous for him to produce no pears at all but only apples, and to exchange some of the latter for pears with B, whose production costs for pears are those shown by curve S3 (1 pear for 1/3 apple). So-called division of labor would be the result. No one any longer produces everything. Labor is divided according to what is to be produced. It should be noted that in our example both A and B produce apples at the same cost. What differs is the production cost of pears in terms of apples. It is the difference in the relative production cost of apples and pears which makes exchange advantageous.
How could an exchange of products between A and B be made under the cost condition described? We see that A produces 1 pear in the time it takes him to produce 3 apples, and that B produces 3 pears in the time it takes him to produce 1 apple. The most advantageous exchange for A would be to receive 3 of B's pears in exchange for each of his own apples; and the most advantageous exchange for B would be to receive 3 of A's apples in exchange for each of his own pears. Both exchanges are possible, but in either case only one of the producers would gain; by an exchange at any level in between both producers could gain.
If A gives less than 3 apples for each pear he receives, he gains by the exchange, for his production costs are such that he must sacrifice 3 apples for every pear he produces. On the other hand, if B receives more than 1 apple for every 3 pears, he also gains by the exchange, for in his own orchard he must sacrifice 1 apple for every 3 pears he produces. The range within which exchange is advantageous for both producer A and producer B is therefore between 1/3 and 3 apples per pear, or between 3 and 1/3 pears per apple.
The actual exchange rate of apples for pears at which the deal will go through depends, in our two-producer economy in which there are no competing parties in the market, upon the respective bargaining ability of A and B. All that can be stated with certainty is that the rate is bound to be within definite limits, and even that is contingent upon a rational behavior of both producers—meaning that both try to maximize the advantages to be obtained.
Let us assume that the price of pears expressed in apples will be somewhere between the two extremes, say 1 apple for 1 pear. How many apples and pears will A and B produce and eventually consume? According to Figure 4 producer A obtained his 5 pears by sacrificing 15 apples. The possibility of exchange with B, whose production cost of pears in terms of apple production time is lower, makes it advantageous for A to obtain his 5 pears by exchange with B rather than to produce them himself. He will produce only apples—50 as before. Of these he exchanges 5 for 5 of B's pears. Besides his 5 pears he will now have 45 apples, instead of 35 as before. He is better off by 10 apples.
Producer B got his 28 pears, according to Figure 4, by sacrificing just over 9 apples. He now exchanges 5 of his pears for 5 apples. He has 23 pears and 46 apples, instead of 28 pears and 41 apples. He, too, gains by the exchange because he could have produced the additional 5 apples himself only by sacrificing 15 pears—instead of 5 as he now does.
Some effects of exchange become immediately evident:
(1) Producer A now produces only apples and gets all his pears through exchange with B; division of labor is complete as far as he is concerned. Producer B still produces 41 apples himself, even though his productivity is much greater for pears than for apples. The reason is that A offers him no more apples at a price of 1:1. Owing to his lower average productivity A is too poor to buy more pears from B.
(2) The division of labor resulting from differences of productivity in turn increases differences and degree of productivity by specialization of production and work.
(3) The living standard of both A and B has risen. This is due to the fact that each producer's own more expensive production has been replaced by the other's cheaper production. In the same way international trade raises the living standard when expensive domestic production is replaced by less expensive foreign production. More expensive production of all goods, on the other hand, does not lead to increased exchange of goods either in internal or in foreign trade, but merely causes a fall in the living standard.
(4) The reward for the work done by both A and B has risen as a result of exchange. The labor demand curve (cf. Figure 1) moves up. Ceteris paribus the number of work-hours will be greater. Thus exchange increases the total output not only through increased productivity due to division of labor, but also through an increase in the amount of work done, due to its higher remuneration.