Trade

The foundations of economics

Why do we trade in the first place? 

What’s the point of exchanging goods and services in an economy? Why don’t we just hoard as much as possible since we’ll then become richer...right? These views, known as mercantilism, dominated 17th-18th century European trade policy. The idea was that countries would do well if the value of their exports (what they sell to other countries) is greater than the value of their imports (what they buy from other countries). 

This was achieved primarily by restricting trade via things like tariffs or embargoes. According to mercantilism, the more gold you collect, the wealthier you become. Seems straightforward enough right? This line of thinking, however, has a glaring flaw. If every country is trying to maximize their exports and minimize their imports, someone is going to have to lose. In order to remain “in the lead” (exporting the most and importing the least), countries had to pass the aforementioned policies which often created a win-lose situation. 

It’s also a funny coincidence that European imperialism was at its height under mercantilism (it’s actually not a coincidence at all because countries had this hoarding mindset where they sought to take over as much as possible to keep for themselves). 

Anyways, these now rejected ideas were brought to an end with the father of economics, Adam Smith and his book The Wealth of Nations. Smith’s ideas of trade had 2 key components to it: division of labor and comparative advantage. 

How do we divide labor? 

Imagine an assembly line of workers who are putting together pencils, with each of them performing a specific task such as shaping the wood or installing the graphite stick. This is the division of labor in action - each worker is more productive since they can each focus on what they do best. This concept applies far beyond the assembly line. To get the wood, there were lumberjacks who specialized in chopping down trees, the graphite came from people who specialized in mining, and the factory itself was built by construction workers who specialized in building factories. 

To quote Adam Smith from his book:

In every improved society, the farmer is generally nothing but a farmer; the manufacturer, nothing but a manufacturer. The labor...necessary to produce any one complete manufacture, is almost always divided among a great number of hands.

Imagine what it would be like to make a pencil completely from scratch. While it may initially sound simple, you’ll quickly realize that it’s not. You’d have to harvest the wood, mine the graphite, shape the metal, make the paint, create the rubber, etc. Without the specialization displayed on the assembly line, nothing much would get made efficiently. This is why for most of human history, when there was very little division of labor (at least compared to today), the average quality of life wasn’t so great. 

Ok. What does this have to do with trade? 

While division of labor makes people productive, it’s trade that makes people better off. To show why both of these ideas coincide with one another, let’s say we have a guy named John who has a choice of either making a cake or drawing a portrait. John has been drawing portraits all his life and he therefore excels at it. With this in mind, John ought to specialize in drawing portraits because that’s what he’s good at.

John, however, really wants a cake, which he doesn’t know how to make. But fear not, for he can just go to his friend Jane, who’s a master baker, and ask her to make a cake. Jane, on the other hand, wants a portrait of her drawn up. This, ladies and gentlemen, is a classic win-win scenario: John wants the cake, and Jane wants the portrait. If John agrees to draw the portrait in exchange for a cake, both sides are now better off. 

To see how this plays out in the real world, take a look at this graph, known as the production possibilities frontier: 

What exactly am I looking at? 

If the United States dedicates all their resources to making planes, they can make 50 per day, whereas if they dedicate all their resources to making clothes, they can make 100 tons per day. In the case of China, they can only make 10 planes and 80 tons of clothes per day if they dedicate all their resources to either of the given products. 

For both planes and clothes, the US has what’s known as an absolute advantage, where you can produce more of something than someone else. It may seem that the US has no reason to trade in this scenario and should instead just produce on their own. But remember: specialization of labor makes both countries better off. 

To produce 1 plane, the US has to give up 2 tons of clothes (50/100 = 1:2). For China to produce 1 plane, they lose 8 tons of clothes (10/80 = 1:8). On the other hand, for the US to produce 1 ton of clothes, they lose 1/2 a plane (½ = 1 : 0.5). For China to produce 1 ton of clothes they only lose ⅛  of a plane (10/80 = 1/0.125). 

Who has the advantage now? 

The answer is both countries - the US has an advantage in planes, since they can make them at a lower opportunity cost (the loss of potential gain from alternative uses of resources), and China has an advantage in clothes, since they can make them at a lower opportunity cost. Both countries have what’s called comparative advantage, which exists if you can produce a good at a lower opportunity cost than someone else. 

So if we want to become better off, trading is the answer then? 

Exactly. One of the few ideas that unites most economists from whichever school of thought they identify with is that specialization and trade generally makes the world a better place. Modern economics is in fact built upon this theory of mutually beneficial exchanges being just that: beneficial to both parties involved. As economist Friedrich Bastiat once said: “by virtue of exchange, one man’s prosperity is beneficial to all others.”