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Division of Labor and Free Trade – Comparative advantage

How hard would it be for one man to live if he had to do everything by himself? Let me rephrase the question. Imagine if the Econ Clips team would fly you by a helicopter to a secluded place, leaving you armed only with a knife in the middle of a forest. How long would it take you to build a smartphone from scratch and send us your holiday picture? Most probably you would be too busy looking for water and food, and trying to build a primitive shelter, while we would die of boredom waiting for your message. What enables a group of people to do much more than they would acting alone is the division of labor. You may think that geniuses often changed the world for the better using nothing but their minds. Remember though, that someone else provided them with food, clothes, a roof over their heads, and even bedding. Stripped of these things, even a genius would be too busy meeting his basic needs to be able to do any creative work. The division of labor allows people to focus on the field of work that suits them best. When people specialize in their areas, they can exchange any surplus they produce. And any free and voluntary exchange of goods always benefits the parties involved.

Imagine two countries. One up far North, and the other in the sunny South. People of both countries need oranges and spruce wood. The Northerners have plenty of spruce trees, so they produce spruce planks famous all over the world for their quality. Unfortunately, they don’t have any oranges. Surely there’s a chance they will be able to grow oranges by themselves. They could build greenhouses, use fertilizers, and install special lamps imitating sunlight. Likewise Southerners, given proper effort and stubbornness, could grow the spruce trees they need, even though they now waste a lot of uneaten oranges. But therein lies a problem, you see. Northerners attempting to grow oranges would need not only to spend a lot of money to build proper infrastructure, but they would also need to spend less time doing what they do best: working with spruce trees. The cost of growing oranges instead of woodworking may be losing, say, five planks to get one orange. The same goes for Southerners if they want to sacrifice a part of their growth of oranges to get some spruces. You just can’t do everything at once, because resources like time and land are scarce.

Let’s put it in numbers:

Suppose that each Northerner and Southerner works 10 hours a day producing either oranges or planks. A typical Northerner spends 6 hours producing 3 tons of planks, and then 4 hours to reap 1 ton of oranges. Meanwhile, an average Southerner spends 5 hours to reap 4 tons of oranges and then 5 hours to produce 1 ton of planks. This means that Northerners have absolute advantage over Southerners in producing spruce planks, while Southerners have absolute advantage over Northerners in reaping oranges.

Such a pattern of production allows for production of 4 tons of planks and 5 tons of oranges in the economy.

Now what would happen if both peoples decided to specialize? Being as productive as they are, in 10 hours Northerners would produce 5 tons of planks, while Southerners would produce 8 tons of oranges. The result would be additional 1 ton of planks and 3 tons of oranges in the economy.

You probably already figured out that both peoples would do better focusing on a kind of production that they have advantage in. Northerners should produce spruce planks, and exchange some for oranges. Southerners should do the opposite. If both do, then there will be more oranges and more planks in the economy for everyone to enjoy. Both peoples will gain because of trade and division of labor.

But what if someone is better than anyone else at everything? What will happen then? To tackle with this problem, we need to understand how comparative advantage works.

Imagine two people: The first one is a brilliant opera singer. The second one is a cleaner whose only ability, and therefore his only possible contribution to the operation of an opera house, is wiping its floors. The singer is better than the cleaner in everything he does. He is smarter and better organized. Not only that he sings better (obviously), but he is also more able at every other task there is to be done at the opera. He is better at playing musical instruments, managing the opera’s staff, or writing plays. He would even upstage the cleaner at cleaning the opera’s floors. So tell me, who would be more likely to get a job as a cleaner if the opera started recruiting? The Singer, right? Nope. Although the singer has an absolute advantage in cleaning (among other things), he wouldn’t even bother applying for the job, as he would have to forgo its alternative cost, that is singing, which earns him a lot of money. Consider that he got used to a costly standard of living, and he would therefore demand an absurdly high wage for simple act of wiping floors. Although it takes the cleaner more time to wipe the floors, other people value the singer’s singing more than his ability to wipe the floors a bit faster. This valuation is reflected in the difference in earnings between the two jobs. As a result, the cleaner has a better chance of getting a floor-cleaning job than the singer, who would only lose money by getting it. This is why the cleaner has a comparative advantage over the singer in cleaning. If the singer were to accept the cleaner’s job, the economy would be worse off, because we would be left with comparatively cleaner floors, a poorer singer, and an unemployed cleaner (or a horrible singer if the cleaner got the job). But we don’t want the singer to swipe floors. We want him to sing, as it adds more value to society. We want the cleaner to clean the floors, because no one else is better than him at this, comparatively speaking. Thanks to their respective comparative advantages, we have clean floors and an employed cleaner, a rich singer, and a satisfied aesthetic need of listening to opera music. Everyone gains in this arrangement.

The same principle works for a manufacturer who is best at producing everything, but will still benefit from trade with another manufacturer who produces everything less efficiently. Thanks to the less efficient manufacturer the more effective one will devote more time to the most profitable avenue of production. It is better to focus on the most profitable production possible and to buy the rest from others, than to spread oneself too thin.

You can find a link to the article about comparative advantage on our website.[1] We recommend reading it, as it provides a clear explanation of comparative advantage, building on a specific case with concrete calculations.

Moreover, comparative advantage suggests an answer to a following question about international trade: “What if one country is better at everything than another country?”

First of all, countries do not trade with each other – individuals do. Suppose that every individual in some country is more productive than all other people in another country. Because of the comparative advantage, it would still be better for the more productive individuals to focus on their respective most profitable production processes, and just buy other things with money they earned. The less productive individuals would still be able to compete with more productive ones, as their opportunity costs of producing the aforementioned other things are lower.

We will talk more about exports, imports, and tariffs in the next episode.

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[1] mises.org/library/cooperation-how-free-market-benefits-everyone

2018-07-24T20:07:09+00:00