Russ Roberts Podcast on Trade and Economies of Scale
February 12th 2010 00:24
In the early 1800s, David Ricardo is credited with developing the theory of Comparative Advantage, which is perhaps the most important finding in the field of economics. It describes how when two people each specialize in a task and trade, they are able to consume more than if they had tried to do both tasks by themselves. This is the foundation upon which International Trade Theory resides and why economists almost unanimously support extremely low (or no) tariffs.
In theory, one could object and ask the question, "What if people are all the exact same?" If this were the case, then trading does not make any sense. There would be no differences to exploit a comparative advantage. Explaining why this is incorrect was the subject of economist Russ Roberts recent podcast.
Before we get into what Roberts had to say, it is important for you to read this quote from Robert Frank:
For example, as a Peace Corps volunteer in Nepal long ago, I hired a
cook who had no formal education but was spectacularly intelligent and
resourceful. Beyond preparing excellent meals, he could butcher a goat,
thatch a roof, plaster walls, resole shoes and fix broken alarm clocks.
He was also an able tinsmith and a skilled carpenter. Yet his total
lifetime earnings were less than even a very lazy, untalented American
might earn in a single year...
Why does a spectacularly intelligent and resourceful person in Nepal earn spectacularly less than a lazy untalented American?
Russ Roberts' answer to the question:
My one sentence answer (echoed by a number of folks in different form in the comments to the earlier post) comes from my book, The Choice:
Self-sufficiency is the road to poverty.
Now on to a summary of the podcast. Roberts mentions three common "Methods of Self-Improvement" that have been used throughout history:
1. Steal from neighbor (the historically popular choice)
2. Develop better technique/technology =>improved productivity
3. Trade (make excess of one good and trade it for someone else's excess of a different good)
With this background in place, we return to the original question: If EVERYONE has IDENTICAL productivity, can mutually beneficial trade still occur? The answer, according to Russ Roberts, is "Yes!" Why? Because, if the group is large enough, then economies to scale in technology make it possible. For example, if technology makes the cost of 100 items cheaper per item than making 1 product, the opportunity cost shrinks low enough that the seller is willing to accept a lower price. Now, someone mass-producing a good can offer this good at a price lower than it would take an identical individual to make himself one of these goods. What happens if that one person just got the same efficient technology for himself to make his one needed good? Well, it would be more expensive to purchase this new technology and then make one single item, because its cost-effectiveness depends on having a large number of items to produce.
(Application: This is why it is not profitable for small, poor farmers to use modern technology; they need a larger market to make modern technology profitable!)
Who does what if we are not all the same? Two possible answers:
1. Person who is the best at what they do. (This may seem obviously wise, but this is not what Ricardo's comparative advantage advises.)
2. Person who is relatively the best at what they do (even if they may not be the best overall at this job). In other words, their Comparative Advantage.
This leads to the question, who assigns these people to the correct task? Nobody! The ever-changing wages in the economy signal to people where they are most needed. Where people make the most money is where they are creating the most value for the world, but not what they are necessarily best at. The role that wages play are a role that the very best bureaucrat would miserably fail attempting. (caveat: The non-monetary value that you receive from doing your job also plays a role. This is why people do not always take the highest-paying job available.).
(So that is how people are "assigned" or "guided" to tasks efficiently if we are not all the same, but who does what job if we ARE all the same? Again, there are two potential answers:
1. It doesn't matter (Again, this seems correct, but it is not completely.)
2. The first person to think of it!)
Now, in the real world, people are not all the same. This means that specialization is very important. Americans have adapted to a culture of specialization, which makes us fortunate! It is not that we are inherently less-skilled than the protectionist Nepalese, but rather that we do not have an incentive to learn all these skills. The people of Nepal, however, do not have a large market of people to exchange with, which means they have no incentive to adapt modern, productive technology. If the citizens of Nepal were allowed to enter into the global economy, it would make sense for them to invest in expensive modern technology to increase their productivity, and ultimately their standard of living.
Now, Roberts does address the fact that not every worker benefits from increased productivity in a sector. To use one of his examples, farmers used to account for a large percentage of employment in America. As farming techniques became more productive, this displaced thousands of farmers from their jobs. Presumably, some, or maybe many, of them did not find employment right away. Thus, this improvement in productivity harmed several farmers; however, if it were not for the freed labor from improved agricultural productivity, the following generations would not have been nearly as wealthy. There are temporary negatives to specialization and improvement, but the permanent positives far outweigh these negatives in both magnitude and duration.
(Important Point: Adding National Borders to the discussion does not change the conclusions of specialization at all!)
Conclusion: When politicians attempt to sell you on protectionism, remember that they are trying to limit the number of people with whom you can trade. At this point it is important to note that the original list of three "Methods of Self-Improvement" turns into two Methods:
1.) steal from your neighbor
2.) improve productivity, via traditional technology and/or specialization from trade
So, opening your country to trade has the same effect as discovering a new productive technology. On the other hand, placing trade barriers has the same effect as if these politicians were to walk into our offices and take a sledgehammer to all of the desktop computers. They would be destroying productive technology by limited our capacity to specialize and trade. Do not forget that each step toward self-sufficiency and away from free exchange is one more step down the "road to poverty."
Follow me on Twitter: @AGoldenDoor
In theory, one could object and ask the question, "What if people are all the exact same?" If this were the case, then trading does not make any sense. There would be no differences to exploit a comparative advantage. Explaining why this is incorrect was the subject of economist Russ Roberts recent podcast.
Before we get into what Roberts had to say, it is important for you to read this quote from Robert Frank:
For example, as a Peace Corps volunteer in Nepal long ago, I hired a
cook who had no formal education but was spectacularly intelligent and
resourceful. Beyond preparing excellent meals, he could butcher a goat,
thatch a roof, plaster walls, resole shoes and fix broken alarm clocks.
He was also an able tinsmith and a skilled carpenter. Yet his total
lifetime earnings were less than even a very lazy, untalented American
might earn in a single year...
Why does a spectacularly intelligent and resourceful person in Nepal earn spectacularly less than a lazy untalented American?
Russ Roberts' answer to the question:
My one sentence answer (echoed by a number of folks in different form in the comments to the earlier post) comes from my book, The Choice:
Now on to a summary of the podcast. Roberts mentions three common "Methods of Self-Improvement" that have been used throughout history:
1. Steal from neighbor (the historically popular choice)
2. Develop better technique/technology =>improved productivity
3. Trade (make excess of one good and trade it for someone else's excess of a different good)
With this background in place, we return to the original question: If EVERYONE has IDENTICAL productivity, can mutually beneficial trade still occur? The answer, according to Russ Roberts, is "Yes!" Why? Because, if the group is large enough, then economies to scale in technology make it possible. For example, if technology makes the cost of 100 items cheaper per item than making 1 product, the opportunity cost shrinks low enough that the seller is willing to accept a lower price. Now, someone mass-producing a good can offer this good at a price lower than it would take an identical individual to make himself one of these goods. What happens if that one person just got the same efficient technology for himself to make his one needed good? Well, it would be more expensive to purchase this new technology and then make one single item, because its cost-effectiveness depends on having a large number of items to produce.
(Application: This is why it is not profitable for small, poor farmers to use modern technology; they need a larger market to make modern technology profitable!)
Who does what if we are not all the same? Two possible answers:
1. Person who is the best at what they do. (This may seem obviously wise, but this is not what Ricardo's comparative advantage advises.)
2. Person who is relatively the best at what they do (even if they may not be the best overall at this job). In other words, their Comparative Advantage.
This leads to the question, who assigns these people to the correct task? Nobody! The ever-changing wages in the economy signal to people where they are most needed. Where people make the most money is where they are creating the most value for the world, but not what they are necessarily best at. The role that wages play are a role that the very best bureaucrat would miserably fail attempting. (caveat: The non-monetary value that you receive from doing your job also plays a role. This is why people do not always take the highest-paying job available.).
(So that is how people are "assigned" or "guided" to tasks efficiently if we are not all the same, but who does what job if we ARE all the same? Again, there are two potential answers:
1. It doesn't matter (Again, this seems correct, but it is not completely.)
2. The first person to think of it!)
Now, in the real world, people are not all the same. This means that specialization is very important. Americans have adapted to a culture of specialization, which makes us fortunate! It is not that we are inherently less-skilled than the protectionist Nepalese, but rather that we do not have an incentive to learn all these skills. The people of Nepal, however, do not have a large market of people to exchange with, which means they have no incentive to adapt modern, productive technology. If the citizens of Nepal were allowed to enter into the global economy, it would make sense for them to invest in expensive modern technology to increase their productivity, and ultimately their standard of living.
Now, Roberts does address the fact that not every worker benefits from increased productivity in a sector. To use one of his examples, farmers used to account for a large percentage of employment in America. As farming techniques became more productive, this displaced thousands of farmers from their jobs. Presumably, some, or maybe many, of them did not find employment right away. Thus, this improvement in productivity harmed several farmers; however, if it were not for the freed labor from improved agricultural productivity, the following generations would not have been nearly as wealthy. There are temporary negatives to specialization and improvement, but the permanent positives far outweigh these negatives in both magnitude and duration.
(Important Point: Adding National Borders to the discussion does not change the conclusions of specialization at all!)
Conclusion: When politicians attempt to sell you on protectionism, remember that they are trying to limit the number of people with whom you can trade. At this point it is important to note that the original list of three "Methods of Self-Improvement" turns into two Methods:
1.) steal from your neighbor
2.) improve productivity, via traditional technology and/or specialization from trade
So, opening your country to trade has the same effect as discovering a new productive technology. On the other hand, placing trade barriers has the same effect as if these politicians were to walk into our offices and take a sledgehammer to all of the desktop computers. They would be destroying productive technology by limited our capacity to specialize and trade. Do not forget that each step toward self-sufficiency and away from free exchange is one more step down the "road to poverty."
Follow me on Twitter: @AGoldenDoor
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