Fundamental Economic Concepts (Part 7 of 12) – Division of Labor and the Benefits of Exchange -
Understanding the concept of comparative advantage is one of the keys to understanding economics. Most people (including those that make economic public policy for our country) do not understand this essential concept. Comparative advantage is the fundamental concept driving all economic transactions and forms the basis for human society. Division of labor and the benefits of exchange are among the primary reasons humans choose to live together and interact in society. Enormous benefits are realized through specialization and division of labor.
  • [The Law of Comparative Advantage] is the most important idea in the history of social analysis....This law -- a law like gravity, not a law like the speed limit -- is a description of why people cooperate and the ubiquity of the conditions that lead to this cooperation.” Jeffrey Tucker, Cooperation: How a Free Market Benefits Everyone
Comparative advantage may be best understood by thinking of the concept in terms of “low cost advantage”. Here's a quick example:
  • Even if Murray is stronger, smarter, and more productive than Paul in every way, it is still mutually beneficial for both people to engage in trade. Let's say Murray has the ability to produce 20 hamburgers and 40 glasses of lemonade in a day. Paul has the ability to produce only 5 hamburgers and 20 glasses of lemonade in a day.

  • The relative cost for Murray to produce a hamburger is 2 glasses of lemonade (40 divided by 20) while the relative cost for Paul to produce a hamburger is 4 glasses of lemonade (20 divided by 5). Remember, costs are measured by the alternatives you have to give up in order to obtain a particular good.

  • If Murray devotes more time to specializing in the production of hamburgers (his low cost advantage) and Paul specializes in production of lemonade (his low cost advantage), the two can then trade to mutual benefit. In fact, using the above scenario, if Murray devotes an extra hour a day to producing hamburgers instead of lemonade, and Paul devotes all of his time to specializing in the production lemonade, they are actually able to produce 10 more glasses of lemonade than if they remained in isolation without specialization and trade.
In our example above, Murray and Paul actually increase their total sum productivity by specializing and trading (note that their productive capabilities and technology was held constant). In economies of free free exchange, because of comparative advantage (low cost advantage), trade is beneficial and advantageous to both parties.

Division of labor and free exchange is the path to increasing wealth in a society because of the law of comparative advantage. In a system of free exchange, neither party is exploited and both parties benefit. This system is especially advantageous to members of society that are less skilled, less capable, and/or “underprivileged” in absolute terms. Because of trade, they are able to obtain and enjoy goods and services that otherwise would have never been possible to them.

It is for this reason that nations that protect property rights and permit individuals to engage in relatively free exchange are infinitely more wealthy than those the do not respect property rights or allow individuals to exchange freely. Property rights and freedom to exchange (freedom from coercive control) are two keys to reducing if not eliminating poverty. Most everywhere that poverty exists in the world, it can be directly linked to forcefully government intervention in these two areas. Poverty is an economic problem caused by brutal, exploitative politics.

Additional Suggested Reading:

I, Pencil by Leonard E. Read...If you don't do anything else today, read this miraculous short story!!!

Cooperation: How a Free Market Benefits Everyone- Jeffrey Tucker provides a great illustrative explanation of comparative advantage in this article.

Economics and Knowledge by F.A. Hayek

If you have the time, here is a great lecture on Division of Labor by Hans-Hermann Hoppe. Hoppe goes on to discuss the theory of money which is a great introduction to the next two parts in the A-equals-A Fundamental Economic Concepts series: Prices and Money.

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