Building on the concept of opportunity cost, Baetjer explains how specialization and trade make us richer.

Howard Baetjer is a Lecturer in the Department of Economics at Towson University in Towson, Maryland, where he teaches courses in microeconomics, comparative economic systems, and money and banking.

Building on the concept of opportunity cost, Baetjer explains how specialization and trade make us richer.


Howard Baetjer: All right. This is the fourth and final lecture on basic economic concepts and what we’re going to cover here is the all important subject of specialization, division of labor, and trade. The elements of the lecture are first of all why do specialization, division of labor, and trade increase output for humanity? [00:00:30] Then the second topic we’ll get to is that wonderful concept of comparative advantage, the law of comparative advantage which explains why it’s always better to specialize in trade no matter how much of a dunce you may be or how much superior to everyone else you might be.

First of all, there’s consensus among economists that specialization, division of [00:01:00] labor, and trade make humanity’s standard of living higher. As specialization, division of labor, and trade have spread around the world, humanity’s standard of living has increased. What we’re going to so now is look at why that is. By the way, it’s worth emphasizing there’s a lot of disagreement among economists about a lot of things. There’s not much disagreements about this. Specialization, division of labor, and trade makes [00:01:30] everybody better off. Okay. Let’s start with this quotation I’ve given you from Matt Ridley. This comes from his book, The Rational Optimist. Would you like to read it?

Student: Sure. As I write this, it is 9:00 in the morning. In the two hours since I got out of bed, I have showered in water heated by North Sea Gas, shaved using an American razor running on electricity made from British coal, eaten a slice of bread made from French wheat spread with New Zealand butter and Spanish marmalade, then brewed a cup of tea using leaves grown in Sri Lanka, [00:02:00] dressed myself in clothes of Indian cotton and Australian wool, with shoes of Chinese leather and Malaysian rubber and read a newspaper made from Finnish wood pulp and Chinese ink.

Howard Baetjer: That’s terrific. I can’t recommend that book highly enough. It’s just a wonderful book. Matt Ridley’s The Rational Optimist. He captures in that passage the tremendous depth of global trade now and global exchange and the extent to which we specialize in different things. [00:02:30] Let’s look at the world as a system of cooperation. I had a friend once, I won’t take time to give you the context and I was talking about the market economy in my usual enthusiastic terms. He said, “But Howie, the market economy’s about competition.” It brought me up short because I realized that’s not the way I’ve been thinking about it for a long time. Market economy is about cooperation. [00:03:00] Certainly there’s competition in there but as some great economists have said, we compete to see who can cooperate better. Competitors are the competing cell phone makers. They’re all falling over themselves to see who can cooperate with you better by giving you what you want better and cooperate better with their suppliers so as to provide you with a less expensive phone.

Certainly there’s competition in world economy but it really makes sense to look at [00:03:30] the world economy as what Hyatt called the extended order of human cooperation. This vast pattern of human beings all working hard to the contribute to the well being of other people. In the confident expectation that others are going to be doing the same for them. Keep that up, cooperation in mind. We’ll talk about Leonard Reed’s I pencil in a couple of lectures, that’s another good thing to have in mind [00:04:00] by way of illustrating how wonderful human cooperation is and how remarkably extensive it is.

To emphasize a point, each of us in an advanced economy, is constantly producing for others rather than for ourselves. I’m not giving this lecture to educate myself, I’m giving it to educate those who will listen and the car makers aren’t producing cars [00:04:30] because they want thousands and thousands of cars, they’re producing them for other people. We’re all specializing in one small part of the evolving pattern of production, trying to get as good as we can at doing that little part of it so the output will be as abundant as possible and they’ll be as much to go around as possible. That’s a really good way of thinking about the world economy. We each are producing for others and then we trade out of our [00:05:00] income from that for what we want.

Now, why do specialization, division of labor, and trade increase output? I’ll put that question to you all. What are some of the main reasons why specialization, division of labor, and trade mean there’s more for everyone?

Student: I think there are two main reasons. The first one is specialization, you get better at doing what you are doing.

Howard Baetjer: Okay, good.

Student: As I work [00:05:30] on an assembly line I get better and better at my own task and everyone else gets better and better at their own tasks and at the end we produce more cars.

Howard Baetjer: Okay, you’ve taken me out of my planned order but that’s great. Let’s go with that. You get better and better. People develop better skills at doing whatever they’re doing. Think of a skilled welder or a pianist or an architect by practice. This is your point. By practice, we get better at what we’re doing.

Student: Yeah.

Howard Baetjer: That’s one main reason. Somebody give me another. [00:06:00] I’ll prompt you then a little bit since it’s quiet. These people who are specializing and production, not only do they practice and produce more because of their skill at what they’re doing, but they’re also thinking all the time about what they’re doing and often when they think about what they’re doing they come up with …

Student: Innovations.

Howard Baetjer: Innovations, better ways of doing things and better tools for doing it. If you focus all on one job, often you’re going to think, “There’s a [00:06:30] better way to do this. If I just had a whatchamacallit, I could do it better and you invent the whatchamacallit. Another reason why specialization, division of labor, and trade mean more output is that we develop better tools and processes. We figure out ways to apply devices to what we’re doing.

I love the applications of the laser, which when it was invented people thought, “What is it good for? It’s a neat toy but what’s it good for?” People have used it [00:07:00] to emit a plane of laser light over a field so as to get the field exactly level but the plane of laser light directs the scraper on a big earth mover thing that scrapes it off. If the laser shows that the field is riding up a little bit, that tells the blade to engage and cut the field down a little bit. If it dips down, the laser sensor says [00:07:30] we’ve dipped down a little bit and so the hydraulics of the machine push out some soil. We drive these machines merrily back over these 40 acre fields and get them like a billiard table because people have figured out ways.

Farmers know we need to irrigate. In order to irrigate effectively the field needs to be smooth. We don’t want these dips and valleys. It needs to be flat. A laser plane of light is flat, how do we apply this? The specialists figure [00:08:00] out ways to develop tools and processes and devices which make them more productive. Other reasons why specialization, division of labor, and exchange make us more productive. I got two more on my list.

Student: It allows for a division of knowledge too.

Howard Baetjer: Very nice.

Student: If I had to go to work everyday and be a pharmacist and bicyclist and a doctor and a [00:08:30] pilot on a plane I couldn’t have all of that knowledge in my brain to do any of those jobs well.

Howard Baetjer: Very nice. Well done. Let’s add that, that was not on my list. I think of it as implied and the division of labor and knowledge but increasingly and even from the first really for human beings the most important labor we do is the mental labor, is the knowledge, the thinking. Yes, that’s one. Two more still to go. Why specialization, division of labor, and trade make us better off. [00:09:00] I’ll give you a hint. Ready? Economies of …

Student: Scale.

Howard Baetjer: Scale. Economies of scale. Specialists can do things on a massive scale using really cool equipment that can produce large numbers of things. When they do that, the unit costs are lower. Let’s take what might be an obvious example. In order to build a jet air liner, [00:09:30] you need a big building, right with some really good equipment in it. If you tried to pay for the building and all that equipment out of one airliner, that would be a very expensive airliner. But if you produce hundreds of airliners using that building and that equipment, you can spread the cost of the building and equipment over hundreds of airliners and each one costs less. Things are cheaper by the dozen. Doing things on a larger scale allows us [00:10:00] to do them more effectively. That goes right along with the division of knowledge and the specialized processes and tools that we use also.

In this regard. Let’s enjoy the famous passage about the division of labor from the very first couple of pages of The Wealth of Nations. Would you read it for us?

Student: But in the way in which this business is now carried on, not only the whole work is a peculiar trade but it is divided into an number of branches [00:10:30] of which the greater part are likewise peculiar trades. One man draws out the wire, another straightens it. A third cuts it, a fourth points it and the fifth grids it at the top for receiving the head. To make the head requires two or three distinct operations. To put it on is a peculiar business, to whiten the pins is another. It is even a trade by itself to put them into the paper and the important business of making a pin in this manner divided into about 18 distinct operations which [00:11:00] in some manufactories are all performed by distinct hands. Though in others the same man will sometimes perform two or three of them.

I’ve seen a small manufactory of this kind where 10 men only were employed and where some of them consequently performed two or three distinct operations. Though they were very poor but in differently accommodated with the necessary machinery they could, when they exerted themselves make among them about 12 pounds of pins a day. [00:11:30] There are in a pound upwards of 4,000 pins of a middling size. Those 10 persons therefore could make among them upwards of 48,000 pins in a day, each person therefore making a tenth part of 48,000 pins might be considered as making 4,800 pins in one day. But, if they had all brought separately an independently and without any of them having been educated to this peculiar business, they certainly could not each of them made 20, [00:12:00] perhaps not one pin in a day.

Howard Baetjer: Okay, now notice the advantages of specialization, division of labor, and trade that you’ve identified for me are all advantages of specialization as such and that’s good. I think they’re the most important ones. Specialists, just because they specialize develop deeper skills, they develop better tools and processes and they can use economies of scale.

Most of the time my students come up with other advantages. [00:12:30] What have you missed here? Advantages of specialization and trade? They think about inter‐​regional trade and they think of the natural advantages of place. They think for example that one of my favorite examples is, “Where should we produce blue crabs? In Maryland or Iowa?”

Student: Maryland.

Howard Baetjer: Maryland because Maryland has the Chesapeake Bay. [00:13:00] A natural resource that’s just great for producing crabs whereas Iowa has these long, flat fields. Is it possible to produce blue crabs in Iowa?

Student: I guess.

Howard Baetjer: Sure. You could get giant aquariums and truck in sea water at great expense. You could do it but it would be very expensive. It makes much more sense to take advantage of the natural advantage of the Chesapeake Bay. For growing vast quantities of grain, take advantage of the fields of Iowa. Makes more sense to produce skiing in the Colorado Rockies and [00:13:30] in Switzerland than in the desert somewhere, although they have skiing in the desert. Some of the wealthy Arabic oil countries have built ski hills but it’s much more expensive to do it that way.

Columbia and Brazil should produce our coffee. Taking advantage of these natural advantages which provides the ability to produce [00:14:00] whatever the goods are at lower cost, at lower resource cost. Take the ski hill in the desert. You have to use a tremendous amount of energy to cool the building that has the ski hill to cool the water and blow the snow onto it. It’s very, very expensive to do it that way. When we take advantage of natural resources of climate and soil we can do things less expensively. There are your two main categories of the advantages [00:14:30] of specialization, and trade. One category used the natural advantages of geography and climate, the others take advantage of these efficiencies from specialization as such that we started off talking about.

Next, does it make sense for someone or for a region that’s better at producing several things [00:15:00] to trade with another region that’s not as good with producing any of those things? The answer to that, and this is one of the really cool counterintuitive insights of economics is the answer to that is yes. Even if you’re better at everything, or your country is better at everything, it still should specialize and trade with other countries that aren’t as good at doing these things. This was explained to humanity by the great economist David Ricardo in what he called [00:15:30] the law of comparative cost but it’s come down for reasons I can’t explain in our text books as the law of comparative advantage.

To understand comparative advantage, we need to distinguish it from absolute advantage. The Chesapeake Bay has an absolute advantage over the plains of Iowa for producing blue crabs. The plains of Iowa have an absolute advantage over the Chesapeake Bay for producing corn. Brazil and Columbia have an absolute advantage over Maine and [00:16:00] Idaho for producing coffee. Absolute advantage means the ability to produce something at lower resource costs. You just need fewer resources to get the results.

But what if one region has an absolute advantage or disadvantage in everything? Let’s look at David Ricardo’s law of comparative cost. It’s not intuitively obvious and it’s a terrific insight. Okay, we’ll do this with a simple arithmetic example. [00:16:30] This is taken from my textbook, Gwartney Stroup Sobel and Macpherson. Excellent textbook. The example they set up assumes we have two countries, Japan and the United States. Japan has 50 million workers in our imaginary example. The United States has 200 million workers.

Then, look at the output per worker day that we imagine. We imagine that a worker in Japan could produce three units of food or nine units of clothing [00:17:00] in a day. A worker in the United States could produce two units of food or one unit of clothing in a day. So, sing out for me, guys. Which country has the absolute advantage in producing food?

Student: Japan.

Howard Baetjer: Which country has the absolute advantage of producing clothing?

Student: Also, Japan.

Howard Baetjer: So Japan has an absolute advantage in both. Do they still get any benefit from [00:17:30] trading with the United States? The answer is yes. Let’s see how that works. To try to make this clear and simply understandable, let’s take two different scenarios.
In the first scenario we’ll imagine no trade in specialization, rather each country splits its workforce in half and let’s see what then they have by way of food and clothing to consume. In the second scenario, we’ll image that they specialize [00:18:00] intelligently and then each country trades half of its output for half of the other output. What we’ll see is both countries would be better off with a result of this specialization.
Okay. To begin with, suppose Japan and the United States each split up their workforce, devoting half the work force to food, half the workforce to clothing. How much food could Japan produce in a day?

Student: 75 million.

Howard Baetjer: [00:18:30] 75 units of … Is it million? Yeah. 75 million units of food in a day. And how much clothing could they produce in a day with the other half of their workforce.

Student: 225.

Howard Baetjer: 225 million units of clothing. All right. Now, for the United States. Again, we’re imagining no trade. They consume what they produce. The United States puts half it’s workforce on food, so how much do they produce?

Student: 200.

Howard Baetjer: 200 million units of food. And how much clothing?

Student: [00:19:00] 100.

Howard Baetjer: 100 million units of clothing. Then, add those up. Okay, let’s get the total produced in this scenario with no trade. It’s gonna be a total of 275 food and 325 clothing. Is my arithmetic right? Okay, good. So you can think of that as the … When there’s no trade, a country can only consume what it produces, so these figures [00:19:30] will put the limit on what each country can consume and the total that can be consumed.
Now, let’s suppose that they concentrate the work force where they have what Ricardo called a comparative advantage and we’ll get into more of that. So they specialize at what they are … Well, let’s do it this way. Compare Japan’s advantages. It has an absolute advantage in food and an absolute advantage in clothing. In which [00:20:00] would you say it has the greater advantage?

Student: In clothing.

Howard Baetjer: Clothing, right? It’s nine to one better at clothing, where it’s only three to two better at food. They’re clearly much better … I was going to save this for later, but I’ll give it to you now. The best way I could remember comparative advantage as a student was to think of it in an intentionally ungrammatical and therefore memorable way. They should do what they are more better at or in the case of the United States, where they’re worse at both, they should [00:20:30] do what they’re less worse at.
Let’s look at the case where Japan focuses on what it’s more better at, that is clothing, right? Think it through with the United States. They’re worse at both, right? Worse at food. They have an absolute disadvantage in food, an absolute disadvantage in clothing. In which is the disadvantage smaller?

Student: Food.

Howard Baetjer: Food, right? [00:21:00] They’re worse at food, but they are less worse at food then they are at clothing. Now let’s assume that Japan focuses where they have a comparative advantage, that is on clothing, puts the entire workforce on clothing and the United States puts its entire workforce where it’s less worse, that is on food. So give me the numbers again. How much food does Japan produce?

Student: None.

Howard Baetjer: None. They put the whole workforce on clothing. And how much clothing do they produce?

Student: 450.

Howard Baetjer: [00:21:30] 450 units of clothing. The United States puts its whole workforce on food. How much food do they produce?

Student: 400.

Howard Baetjer: 400. And how much clothing?

Student: None. Zero.

Howard Baetjer: Zero. All right. Now, add up the total food produced and the total clothing produced. The total food produced is all from the United States, it’s 400 food, as compared to only 275 food when the countries where not specializing. The total clothing produced is 450, [00:22:00] all produced in Japan. That’s the total produced, whereas the total would have been only 325 if each country spit its own workforce. Okay?

We can see clearly there’s more produced and maybe this is the way to remember the lesson. When people, regions, countries, specialize according to comparative advantage, there is more to go around. That’s the great insight to remember from this.

But now, suppose the countries do agree to trade [00:22:30] half of their output to the other country in each case. What that leaves us with than now Japan has instead of only 75 food, it has half of the United State’s 400. So instead of 75 … Did I say that right? Yeah. Japan has 200 food from the United States and half of it’s clothing left of 225. Meanwhile, the United States is left with 200 food, but it has half of Japan’s 450 clothing, which means it has [00:23:00] 225 clothing to consume, instead of only 100.

Now, all the text books use simple examples like this, which make the point clear. If you can do the arithmetic or the math, you can do it with 10’s of countries, 100’s of products and it works out the same way, but this simple two by two example shows you the principle.
It’s good not to get lost in the arithmetic and remember [00:23:30] the main lesson that comes out of it. When people specialize According to comparative advantage and trade, they have more. Okay?

Let me add just one thing for completeness sake. There are three ways I recommend to find a country’s or region’s comparative advantage. One is to compare the absolute advantages if the country or region has an absolute advantage in both and look which is [00:24:00] the comparatively larger advantage. That’s it comparative advantage. To do that for the country with an absolute disadvantage in both, we’ll look at the disadvantages and find the one that is comparatively smaller. We say that as it’s comparative advantage. My preferred way as I said, is to look at what you’re more better at or less worse at. That’s your comparative advantage.

The textbook way of doing it is to look at what the region can produce not at the lower [00:24:30] resource cost, but at the lower opportunity cost. There’s an opportunity cost to putting a Japanese worker into the field producing food, every unit of food that he produces means nine units of clothing he didn’t produce, so the opportunity cost of producing food in Japan is nine units of clothing. That opportunity cost of food is much higher than in the United States, if you compare those you’ll see that Japan [00:25:00] has the lower opportunity cost of producing clothing, and the United States has the lower opportunity cost of producing food. That’s how we find comparative advantage: to sum up the main lessons, we benefit from specialization, the division of labor, and trade and when we specialize according to comparative advantage and trade, there’s more for everybody. Questions?

Student: [00:25:30] Does the principle of comparative advantage only apply to countries or does it apply to individuals as well?

Howard Baetjer: It applies to individuals as well. In fact, in my courses I try to avoid talking about international trade and talk about inter‐​regional trade to make it more general because obviously some wheat is grown profitably in Maryland because some regions of Maryland have really good fields for wheat. They would have a [00:26:00] comparative advantage with them. I like to use a somewhat silly example to illustrate the general applicability of comparative advantage in this way. Suppose that Towson, where I teach was having a benefit basketball game where Michael Jordan was coming to play with a group of faculty. To tell you a little bit about my basketball skills, I was a terrible shooter, and a terrible dribbler but as a former football player I was a good rebounder [00:26:30] and I’m proud to say in my younger days I was a white man who could jump. I was a good rebounder.

Suppose you’re the coach and you have to determine where will we position on the offensive end of the court, where will I position Michael Jordan? You’re the coach. You tell Michael Jordan where to play. Where do you position Baetjer, where do you position the other three guys? Who would you put out at the point shooting the three pointers, making the lightening drives to the basket, Baetjer or Jordan? [00:27:00]

Student: Jordan.

Howard Baetjer: Jordan because he’s better. I should ask it differently. Who’s better at shooting long shots, Jordan or Baetjer?

Students: Jordan.

Howard Baetjer: Who’s better at driving to the basket, Jordan or Baetjer?

Students: Jordan.

Howard Baetjer: Who’s better at rebounding?

Student: Baetjer.

Howard Baetjer: Who’s better at rebounding?

Student: Oh, Jordan.

Howard Baetjer: You compliment me. There’s no way I’m as a good a rebounder. Jordan’s better at everything, right? He’s got an absolute advantage in every aspect of the game by [00:27:30] miles. You’ve got to decide where to put us. Where would you put Jordan? Under the basket to get rebounds or out at the point to shoot?

Student: At the point.

Howard Baetjer: Out at the point to shoot, right? Where would you put Baetjer?

Student: Rebounding.

Howard Baetjer: Under the basket rebounding. I thank you for that because by that you have acknowledged that I have a comparative advantage over Michael Jordan in rebounding. I’m worse at all aspects of the game, but I’m less worse at rebounding. That’s [00:28:00] why you would put me under the … You want to position us according to comparative advantage. The opportunity cost of putting Michael Jordan under the basket to get rebounds would be absurdly high. He’s a good shot! Okay, same thing applies. As you look at the different kinds of human activities you’ll find this applies very generally. My wife and I for example, you’ll see this example in the textbook, in the kitchen I have a comparative advantage in cleaning up [00:28:30], she has a comparative advantage in cooking and so we divide the labor that way. It’s very generally applicable to regions, to individuals and to nations.