Arto's Notes re: economics

Specialization and the Division of Labor

The Law of Comparative Advantage

"[Adam] Smith pointed out that it made no sense, for example, for Scotland to try to manufacture wine, although through the use of greenhouses it undoubtedly could do so. If Scotland produces wool and Spain makes wine, and the citizens of the two countries trade for the goods not available from domestic industry, both countries' inhabitants will be better off. But what of the case where one country, perhaps due to geographical disadvantage and an uneducated populace, is worse at producing everything than some other country is? Shouldn't the more backward nation erect trade barriers, allowing domestic industry to develop? How can it possibly offer the more advanced nation anything in trade?

"The answer to this problem is Ricardo's law of comparative advantage, named after English economist David Ricardo. Although the initial application of the law was to trade, it is a universal law applying to all human cooperation. Because of the broad applicability of the law, Mises felt it was better named the law of association. In fact, it is easiest to understand this law at a personal level, after which its implications for trade become clear.

"Let's use as an example a great athlete: Michael Jordan. Jordan's physical skills are truly extraordinary. There is little doubt that should he choose to apply them to, for instance, house painting, that he could be one of the best house painters in the world.

"Yet it's doubtful that Jordan paints his own house. Although he could probably, with a little practice, do so far better than anyone he can hire, he still finds someone else to paint it for him. How can we explain that fact?

"The law of comparative advantage is the answer. Although Jordan is better than his painter at both basketball and house painting, Jordan has a comparative advantage in basketball, while his painter has a comparative advantage in house painting. It's easiest to comprehend that arithmetically, by using wage rates as a basis for the comparison.

"Let's say that Jordan can hire a house painter for $20 per hour. With a little practice, Jordan could be twice as efficient a painter as the man he has hired. We will imagine that he could market his own house-painting services for $40 per hour.

"However, by playing basketball, we will suppose that Jordan can earn $10,000 per hour. Meanwhile, Joe, his painter, who can hardly sink a free throw, couldn't make more than $1 an hour playing basketball. (Perhaps some people will find his play amusing!) Jordan has a 2-to-1 advantage as a house painter, but a 10,000-to-1 advantage as a hoop star.

"Perhaps Jordan plans on working twenty hours in a particular week. If he divides his time equally between painting his own house and playing basketball, his total output for the week can be valued at:

10 hours painting x $40 per hour = $400

10 hours basketball x $10,000 per hour = $100,000

Total output: $100,400

"If Joe divides his time the same way we could value his production as follows:

10 hours painting x $20 per hour = $200

10 hours basketball x $1 per hour = $10

Total output: $210

"Between them, Michael and Joe have produced $100,610 worth of output. Now let's examine the situation if, as we expect, Jordan hires Joe. Jordan's production can now be valued at:

20 hours basketball x $10,000 per hour = $200,000

Total output: $200,000

"And Joe's at:

20 hours painting x $20 per hour = $400

Total output: $400

"Their total output has risen to $200,400. But, more importantly for an understanding of the law of association, both of them are better off, at least in dollar terms. The painter, who was worse at both jobs, was still able to nearly double the value of his output by concentrating on painting, in which he had a comparative advantage, then by exchanging with Jordan. The law of association demonstrates that, even putting aside moral considerations, it is to everyone's material advantage to cooperate through the division of labor and voluntary exchange. It is the basis of the extended social order.

"The application of this law to international trade is a straightforward extension of our analysis above. Even if a country is worse at producing everything than is some other country, it can still net a material gain by specializing in the areas where it has a comparative advantage and trading for other goods. It is only in the obviously unrealistic scenario where everyone is exactly the "same amount" better or worse than everyone else at every job that the law of association would find no application.

"This law only shows that a material gain is available through specialization. It doesn't take into account any personal preferences other than material gain. It could well be the case that Jordan simply loves house painting, and would not for the world consider hiring someone else to paint for him, harking back to our discussion [earlier] of the person who decides to do his own roofing. If people believe they are saving money doing their own home repairs, they are often mistaken. However, if they love doing the work, perhaps finding it a nice break from their regular job, they may be getting a psychic profit that outweighs their monetary loss."