Unit 2 Technology and incentives

2.3 Comparative advantage, specialization, and markets

In 1600, the great manufacturing centres in the world—for textiles and other goods not produced on farms—were in Asia. The Industrial Revolution in Britain, and later in the rest of Europe and the US, changed this. By 1900, Europe, and the places that Europeans populated, produced most of the manufactured goods. Europe and its offshoots had come to specialize in manufacturing, benefiting from rapid changes in technology that raised their output per worker. The rest of the world specialized in farming, where technology improved slowly and populations were caught in a Malthusian trap.

To understand how these events came about, we need three concepts: comparative advantage, specialization, and the division of labour.

Before specialization on a global scale

Think of the objects in your workspace. Do you know the person who made them? What about your clothing? Or anything else near where you are sitting?

Now imagine that it is 1776, the year when Adam Smith wrote The Wealth of Nations. The same questions, asked anywhere in the world, would have had differents answers.

At that time, many families produced a wide array of goods for their own use, including crops, meat, clothing, and even tools. Many of the things you might have owned in Adam Smith’s day would have been made by a member of the family, or of the village. You would have made some objects yourself; others would have been made locally and purchased from the village market.

A change that was underway during Adam Smith’s life, but has greatly accelerated since, is specialization in the production of goods and services. As Smith explained, we become better at producing things when we each focus on a limited range of activities. This can happen for three reasons:

increasing returns to scale, economies of scale, increasing returns
When production exhibits increasing returns to scale, increasing all of the inputs to a production process by the same proportion increases the output by a higher proportion. The shape of a firm’s long-run average cost curve depends both on returns to scale in production and the effect of scale on the prices it pays for its inputs. See also: decreasing returns to scale, constant returns to scale.
  • Learning by doing: We acquire skills as we produce things.
  • Difference in ability: Because of skill, or the characteristics of the natural surroundings (such as soil quality, for example), some people are better at producing certain things than others.
  • Economies of scale: Producing a large number of units of a good is often more cost-effective than producing a smaller number. We investigate this concept in more detail in Unit 7.

People do not typically produce the full range of goods and services that they use or consume in their daily lives. Instead we specialize: some producing one good, others producing other goods; some working as welders, others as teachers or architects. Likewise, firms specialize in particular goods, or sometimes in just one part of the production process for a good. And countries specialize too: Cambodia’s largest exports are gold and knitwear; Singapore specializes in integrated circuits; is the world’s biggest exporter of shirts.

Comparative advantage: Gains from specialization

A simple example illustrates how, when people (or firms, or countries) differ in their ability to produce different goods, they can benefit from specializing and trading. Specialization means each person does just one or a few of the large number of tasks necessary to complete some project or reach some goal. It shows something surprising: all producers can benefit, even when this means that one producer specializes in a good that another could produce at lower cost.

Imagine a world of just two individuals (Greta and Carlos) who each need both of two goods, apples and wheat, to survive. They have different productivities in apple and wheat growing, shown in Figure 2.2a. If Greta spent all her working time producing apples, she would produce 1,250 in a year. If she only produced wheat, she would produce 50 tons per year. Carlos has less fertile land than Greta for producing both crops: if he devoted his time (the same amount as Greta) to apple growing, he would produce 1,000 per year, and if he produced only wheat he would produce 20 tons.

Production if 100% of time is spent on one good
Greta 1,250 apples or 50 tons of wheat
Carlos 1,000 apples or 20 tons of wheat

Figure 2.2a Productivity in apples and wheat.

absolute advantage
A person or a country has an absolute advantage in the production of a particular good if, given a set of available inputs, they can produce more of it than another person or country.
comparative advantage
A person or a country has a comparative advantage in the production of a particular good if the cost to them of producing it, relative to the cost of another good, is lower than for another person or a country. See also: absolute advantage.

Greta is more productive than Carlos in both apples and wheat: she has an absolute advantage in both crops. Carlos has an absolute disadvantage.

But Carlos’s disadvantage is less in apples than in wheat. Greta can produce 2.5 times as much wheat as Carlos, but only 1.25 times as many apples. We say that Greta has a comparative advantage in wheat. And despite his absolute disadvantage, Carlos has a comparative advantage in apples.

More precisely, we say that Carlos has a comparative advantage in apples because his relative cost of producing apples (that is, relative to wheat) is lower than Greta’s.

How do we measure relative cost in this example? Carlos and Greta are using their own labour and land to produce crops for their own survival. Although they have no monetary costs, they face opportunity costs. For Greta, the opportunity cost of 50 tons of wheat is 1,250 apples, so the opportunity cost of every ton of wheat she produces is \(1,250/50 = 25\) apples. Using Figure 2.2a to work out the other opportunity costs we get:

Opportunity cost of 1 ton of wheat Opportunity cost of 1 apple
Greta 25 apples 0.04 tons of wheat
Carlos 50 apples 0.02 tons of wheat

Figure 2.2b Relative costs of apples and wheat.

The first column shows that Greta’s relative cost of wheat is lower than Carlos’s. She has a comparative advantage in wheat. But Carlos has a comparative advantage in apples: his relative cost of producing an apple (the amount of wheat he has to give up) is lower than Greta’s.

If Carlos and Greta cannot trade with each other, they must each be self-sufficient, consuming exactly what they produce. Suppose that Greta chooses to use 40% of her time in apple production, and the rest producing wheat. Column 1 in Figure 2.2c shows that she produces and consumes 500 apples (40% of her maximum apple production, 1,250) and 30 tons of wheat (60% of her maximum wheat production, 50). Similarly Carlos spends 30% of his time producing apples, and 70% producing wheat.

But if they were to specialize, each producing only the crop in which they have a comparative advantage, Greta would produce 50 tons of wheat while Carlos would produce 1,000 apples. Total production of both crops (Column 2) would be higher than under self-sufficiency. Suppose that they reach an agreement that both will specialize, and then Greta will sell 15 tons of wheat to Carlos in return for 600 apples. Column 3 shows their consumption under this agreement.

Self-sufficiency Complete specialization and trade
Production Consumption Trade
(1) (2) (3) (4)
Greta Apples 500 0 600 Buys 600 apples
Wheat 30 50 35 Sells 15t wheat
Carlos Apples 300 1,000 400 Sells 600 apples
Wheat 14 0 15 Buys 15t wheat
Total Apples 800 1,000 1,000
Wheat 44 50 50

Figure 2.2c Comparing self-sufficiency and specialization.

The table shows that it is possible for both Greta and Carlos to be better off by specializing and then trading with each other. Comparing Column 3 with Column 1 shows that both of them would consume more of both goods than they were able to do under self-sufficiency.

This is just one example of a trade that makes both Greta and Carlos better off. In their agreement, the ‘price’ (the rate of exchange) of a ton of wheat is 40 apples. Exercise 2.3 shows that there are other agreements at different prices that would have had similar effects.

The surprising thing mentioned above is that Greta ended up buying 600 apples from Carlos even though she could have produced those apples at a lower cost herself (in terms of labour time). This was a better way to spend their time because while Greta had an absolute advantage in producing both goods, Carlos had a comparative advantage in producing apples, which means they could both benefit from specializing in producing what they were best at.

Specialization and markets

Carlos and Greta, in a world with just two people and two goods, can realize the advantages of specialization through an agreement to trade with each other. But our world is more complex: people want to be able to consume many goods, while specializing in producing just a few themselves. It would be difficult to exploit the potential benefits from comparative advantage through bilateral agreements to specialize and trade.

division of labour
The specialization of producers to carry out different tasks in the production process.

For this reason, the division of labour—which refers to specialization in producing things either within a firm, or across society (or even the entire world) as a whole—poses a problem for society: how are the goods and services to be distributed from the producer to the final user? In the course of history, this has happened in different ways, from direct government requisitioning and distribution as in many economies during the Second World War, to gifts and voluntary sharing as in families today and as practised among even unrelated members of a community by our hunting and gathering ancestors.

Capitalism enhanced our opportunities for specialization by expanding the role of both markets and firms. Markets contribute to increasing productivity by allowing people to benefit, through trade, from producing goods for which they have a comparative advantage.

Chapter 3 in The Wealth of Nations is titled: ‘That the Division of Labour is Limited by the Extent of the Market’, in which Smith explains:

When the market is very small, no person can have any encouragement to dedicate himself entirely to one employment, for want of the power to exchange all that surplus part of the produce of his own labour, which is over and above his own consumption, for such parts of the produce of other men’s labour as he has occasion for.

When you hear the word ‘market’ which word do you think of? ‘Competition’ probably is what came to mind. And you would be right to associate the two words.

But you might also answer: ‘cooperation’. Why? Because markets allow each of us pursuing our private objectives to work together, to produce and distribute goods and services in a way that, while far from perfect, is in many cases better than the alternatives.

Markets accomplish an extraordinary result: unintended cooperation on a global scale. The people in the firm that produced your phone did not know or care about you; they were incentivized by the profits they could make—now or in the future. The firm is better at producing phones than you are, and you ended up with it because you paid them, allowing them to buy goods that they need, also produced by total strangers to them.

We explore how markets work in Units 7, 8, and 10.

The division of labour in firms

Markets allow people and firms to specialize in the production of different goods. Specialization also occurs within governments, and in families, where who does which household chore is often associated with age and gender. And it happens within firms, through the way the production process is organized.

Adam Smith begins The Wealth of Nations with the following sentence:

The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgement with which it is anywhere directed, or applied, seem to have been the effects of the division of labour.

He went on to describe a pin factory in which the specialization of tasks among the working men allowed a level of productivity—pins produced per day—that seemed to him extraordinary. Firms may employ thousands or even hundreds of thousands of individuals, most of them working at specialized tasks under the direction of the owners or manager of the firm. Section 2.1 reported how the Chinese firm, Kutesmart, used new technology to enable it to introduce the division of labour to the production of made-to-measure garments. Using the new technology, the work of a skilled tailor was split up into more than 300 operations, each of which was done by workers without tailoring skills, using sophisticated capital goods.

You can think of the firm as a means for large numbers of people, each with distinct skills and capacities, to contribute to a common outcome: the product. The firm facilitates a kind of cooperation among specialized producers that increases productivity.

We examine the question of who does what within the firm and why in Unit 6.

Question 2.4 Choose the correct answer(s)

Alex and Jose live alone on separate islands that can produce oranges and melons. The table below shows how many oranges and melons Alex and Jose can produce. Based on this information, read the following statements and choose the correct option(s).

  Production if 100% of time is spent on one good
Alex 10,000 melons or 15,000 oranges
Jose 15,000 melons or 30,000 oranges
  • Jose has an absolute advantage in the production of both melons and oranges.
  • Jose has a comparative advantage in the production of melons.
  • With trade and complete specialization, Jose will specialize in the production of oranges while Alex will specialize in the production of melons.
  • With trade and complete specialization, if the market price is expressed in terms of the number of melons that can be traded for one orange, higher market prices are better for Alex compared to lower market prices.
  • If both people dedicated 100% of their time to producing melons (or oranges), Jose can produce more than Alex, so Jose has absolute advantage in both goods.
  • Jose can produce twice as many oranges as melons. On the other hand, Alex can produce 1.5 times as many oranges as melons. Therefore Jose has the comparative advantage in the production of oranges, as his cost of producing oranges relative to melons is lower than Alex’s.
  • With complete specialization, each person will only produce the good they have a comparative advantage in. Jose has a comparative advantage in oranges (so will specialize in orange production) and Alex in melons.
  • Jose only produces oranges and Alex only produces melons. Higher market prices means that Alex has to trade a larger quantity of melons for one orange, so he will be worse off compared to when market prices are lower.

Exercise 2.3 Apples and wheat

In the case of Carlos and Greta described in Figure 2.2a, Figure 2.2b, and Figure 2.2c, suppose that market prices were such that 35 apples could be bought for 1 ton of wheat.

  1. If Greta sold 16 tons of wheat, would both she and Carlos still be better off?
  2. What would happen if only 20 apples could be bought for the price of a ton of wheat?

Exercise 2.4 Specialization and trade

Go to the OEC website, which contains data on countries and the goods they trade. Choose two to three countries and read their country profile (under the ‘Profiles’ heading, select ‘Countries’ to access the full list of country profiles).

For each of your chosen countries, read the list of their top exports and top imports. Suggest some explanations for the patterns of specialization that you observe. (It may be helpful to do some Internet research on the background of these countries).