The Benefits of Specialization and Trade: A Case Study in Pin Making

1. Basic Economic Concepts for Understanding the Value of Trade Specialization  Division of Labor  Productivity  Standard of Living Comparative Advantage = Specialization Among Nations

2. The Case of the Pin Maker Town of about 100 people, only a few of whom buy pins. Hi, I am the only pin maker in town. I cut the wire, I sharpen the end, I grind the top, and I sell the finished pin. I can make about 100 pins per day.

3. Production / Pins 700 Inputs: 1 Worker Outputs: 100 Pins Labor Productivity: 100 pins per worker 600 500 400 300 200 100 Labor 1 2 3 4 5

4. The Case of the Pin Maker Town grows to 200 people. Now I need an assistant. We both cut the wire, sharpen the end, and grind the top of the finished pin. We can make about 200 pins per day.

5. Production / Pins Inputs: 2 Workers Outputs: 200 Pins Labor Productivity: 100 pins per worker Constant Returns to Scale 700 600 500 400 300 200 100 Labor 1 2 3 4 5

6. The Case of the Pin Maker Town grows to 300 people. I hire another assistant. We all cut the wire, sharpen the end, and grind the top of the finished pin. We can make about 300 pins per day.

7. Production / Pins Inputs: 3 Workers Outputs: 300 Pins Labor Productivity: 100 pins per worker Constant Returns to Scale 700 600 500 400 300 200 100 Labor 1 2 3 4 5

8. Town grows to 400 people. The Case of the Pin Maker I hire another assistant. One cuts the wire, two sharpen the ends, I grind the tops of the finished pins. We can make about 600 pins per day.

9. Production / Pins 700 600 500 Inputs: 4 Workers Outputs: 600 Pins Labor Productivity: 150 pins per worker = Increasing Returns to Scale 400 300 200 100 Labor 1 2 3 4 5

10. What Does This Story Tell Us? Dividing the labor process into steps allows workers to specialize and thus produce more. The same number of workers can produce more per worker than when each worker does not specialize. Specialization thus makes each worker more productive, which means that more goods can be produced with the same number of inputs. Each worker can be paid more because they produce more. But the division of labor is limited by the size of the market: there is no need to specialize and produce more if there are not more consumers to buy the additional output.

11. The Case of the Bicycle Maker Frame Makers Wheel Makers Final Assembly Chain Makers Each Figure = 10 Workers

12. Who is most productive? Frame Makers Wheel Makers Final Assembly Chain Makers Each Figure = 10 Workers

13. Buy the wheels rather than make them Rueda Wheel Company Frame Makers Final Assembly Chain Makers Specialization and thus productivity are increased by outsourcing production of one component to a company in town. Each Figure = 10 Workers

14. Buy all the parts rather than make them Rueda Wheel Company Cuadro Frame Company Final Assembly Cadena Chain Company Specialization and thus productivity are increased by outsourcing production of all components to other companies. Each Figure = 10 Workers

15. One company is from another city Rueda Wheel Company Cuadro Frame Company Final Assembly Cadena Chain Company Welcome to Miami! Each Figure = 10 Workers

16. Or from another state Rueda Wheel Company Cuadro Frame Company Final Assembly Cadena Chain Company Welcome to Michigan! Each Figure = 10 Workers

17. Or from another country Rueda Wheel Company Cuadro Frame Company Final Assembly Cadena Chain Company Welcome to Mexico! Each Figure = 10 Workers

18. What Does This Story Tell Us? International trade is really just another form of specialization of labor. Outsourcing of production is done wherever there are gains in productivity, whether that means shifting production to another factory in the same city, a factory in another city, or a factory in another country. The mere presence of an international border makes no difference to the underlying argument.

19. Comparative Advantage English economist David Ricardo, 1817. The most important and most misunderstood idea in the theory of trade. Essential arguments: (1) Two countries can gain from trade with each other even if one of them is better (more productive) at producing everything than the other: absolute advantage is less important than comparative advantage. (2) Both countries can gain from trade even if wages in those countries are very different. (3) Trade allows specialization and economies of scale.

20. Should England and Portugal Engage in Trade? England has an absolute advantage in both Wine and Cloth. That is, 1 unit of labor in England can produce 2 units of Wine or 4 units of Cloth. In Portugal, 1 unit of labor can produce only 1 unit of Wine or 1 unit of Cloth. English workers are more productive than Portuguese workers and probably get paid more because they produce more. England is probably a richer country because it is more productive.

21. Comparative versus Absolute Advantage: Opportunity Cost Ricardo argued that opportunity cost was the key to gains from trade. The opportunity cost of an item is what we have to give up to get that item. So, the opportunity cost of 1 unit of Wine in Portugal is 1 unit of Cloth. The opportunity cost of 1 unit of Wine in England is 2 units of Cloth. The opportunity cost of 1 unit of Cloth in England is ½ unit of Wine. The opportunity cost of 1 unit of Cloth in Portugal is 1 unit of Wine.

22. Comparative versus Absolute Advantage: Opportunity Cost • Comparative advantage says that countries will export those goods for which they have a lower opportunity cost: • 1 unit of Wine in Portugal is 1 unit of Cloth. • 1 unit of Wine in England is 2 units of Cloth. • 1 unit of Cloth in England is ½ unit of Wine. • 1 unit of Cloth in Portugal is 1 unit of Wine.

23. Comparative versus Absolute Advantage: Opportunity Cost Because the opportunity cost of producing Wine in Portugal is less than in England (loss of 1 unit of cloth versus 2 units of Cloth), Portugal should specialize in producing Wine which it will then export to England. And because the opportunity cost of producing Cloth in England is less than in Portugal (½ unit of Wine versus 1 unit of Wine), England should specialize in producing Cloth which it will then export to Portugal.

24. Comparative versus Absolute Advantage: Opportunity Cost In a pre-trade world, both countries will attempt to produce both goods, which means that they have to divide their labor force (10 units of labor) between industries: 5 units of labor for Wine and 5 units of labor for Cloth. In Portugal, 5 units of labor can produce 5 units of Wine and 5 units of Cloth. In England, the more productive country, 5 units of labor can produce 10 units of Wine and 20 units of Cloth. Total global output is 15 units of Wine and 25 units of Cloth.

25. Comparative versus Absolute Advantage: Opportunity Cost In a world with trade, both countries specialize in the product in which they have a comparative advantage. This means that Portugal shifts its labor force to producing Wine: 10 units of labor now produce 10 units of Wine. England shifts part of its labor force to making Cloth: 7.5 units of labor now produce 35 units of Cloth. The other 2.5 units of English labor produce 5 units of Wine. Total global output is 15 units of Wine, just as before trade, and 35 units of Cloth, 10 more than before trade. Total global output has increased from 40 units to 50 units.

26. Comparative versus Absolute Advantage: Opportunity Cost 5 units traded In a world with trade, Portugal can now trade 5 units of Wine to England, so that both countries get to consume the same amount of Wine as before trade (5 units in Portugal; 10 units in England). England, which now produces even more Cloth than before, can consume even more than before trade (when it consumed 20 units) and export 5 units (or more) to Portugal, which can now consume at least as much as before trade (when it consumed 5 units). Specialization thus increases aggregate welfare.

27. Free trade is beneficial even if a country suffers from an absolute disadvantage in the production of everything. The relative cost of producing a good is more important for trade than the absolute cost. Higher productivity is no guarantee that an industry can compete, since the opportunity cost of producing that good may be higher than in another country. Comparative Advantage: Implications

28. 2. Lower wages in another country do not mean that it will take all the jobs away from a higher-wage country (pauper labor argument). It would not make sense to shift all production of both Wine and Cloth to Portugal even if Portugal has lower wages than England. Instead, both countries gain by shifting workers to industries in which they have a relative unit labor cost advantage. Comparative Advantage: Implications

29. 3. Low-wage workers in low-wage countries can benefit from trade by specializing in low-wage work that is then exported to higher-wage countries. This may look like exploitation, but it beats the alternative of producing less. Comparative Advantage: Implications

30. The strongest outcomes from comparative advantage occur when there is perfect occupational mobility: that is, workers from one industry can move effortlessly into all other industries. Obviously, this is not true in the real world: workers who sew clothing cannot effortlessly become computer programmers. Comparative Advantage: Caveats (things that might not work out in the real world)

31. Comparative Advantage: Caveats (things that might not work out in the real world) 2. If workers cannot move effortlessly between industries, then workers in import-competing sectors will lose under trade while workers in export industries will gain. Trade may raise overall welfare, but it will produce winners and losers.

32. Comparative Advantage: Caveats (things that might not work out in the real world) 3. Theoretically, the winners might be taxed and their gains from trade could be redistributed to the losers, which means that everyone could still gain from trade. However, in the real world, such transfers may be politically impractical.

33. Comparative Advantage: Caveats (things that might not work out in the real world) 4. This model assumes that business owners will not resist the structural changes that follow from trade. Wine growers in England may not want to lose out to imports from Portugal and may seek protection (tariffs, quotas) to keep Portuguese wine from destroying their English businesses.

34. Comparative Advantage: Caveats (things that might not work out in the real world) 5. If consumption of cloth does not increase, then there may be no need for additional workers in the English cloth industry. This means that trade could lead to unemployment, unless the government of England does something (macroeconomic policy) to encourage more consumption and thus boost the need for labor.

35. Comparative versus Absolute Advantage: Opportunity Cost 5 units traded In a world with trade, Portugal can now trade 5 units of Wine to England, so that both countries get to consume the same amount of Wine as before trade (5 units in Portugal; 10 units in England). England, which now produces even more Cloth than before, can consume even more than before trade (when it consumed 20 units) and export 5 units (or more) to Portugal, which can now consume at least as much as before trade (when it consumed 5 units). Specialization thus increases aggregate welfare.

36. Pre-Trade Production and Consumption Pre-trade, England consumes 20 units of Cloth produced by 5 units of labor.

37. Post-Trade Production and Consumption Post-trade, let’s assume that more Cloth is consumed in England (30 units). Workers produce more through specialization and trade, so more can be consumed.

38. Post-Trade Production and Consumption Post-trade, let’s assume that no more Cloth is consumed in England (back to 20 units consumed, just as in the pre-trade era). That means that we do not need 7.5 units of labor to produce 30 units of Cloth. Instead, we only need 5 units of labor to produce 20 units of Cloth. That means that we will have 2.5 units of unemployed labor.

39. Post-Trade Production and Consumption In the parlance of economists, we have “freed up those workers to pursue other productive activities.” This can be interpreted as either wishful thinking, willful blindness, or a call for macroeconomic intervention to boost consumption and thus the need for labor.