Economics for the Curious

Why Do We Trade?

From scarcity to specialization, exchange, and markets

9 min read

Start Here: Nobody Knows How to Make a Pencil

In 1958 the writer Leonard Read told the life story of an ordinary wooden pencil, in the pencil’s own voice. The cedar comes from Northern California and Oregon. The graphite was mined in what is now Sri Lanka. The ferrule is brass, and the eraser and lacquer come from still other places. Then the pencil makes its boldest claim: “Simple? Yet, not a single person on the face of this earth knows how to make me.”

WATCH I, Pencil: The Movie (Competitive Enterprise Institute)

WATCH The Big Ideas of Trade (Marginal Revolution University)

From Scarcity to Markets

Because time and resources are scarce, people look for ways to get more from what they have. One of the most powerful is to divide up the work. That sets off a chain of ideas, each one leading to the next.

1 Specialization: Why divide the work?

Adam Smith opened The Wealth of Nations (1776) with a pin factory. A worker on his own, Smith wrote, “could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty.” But when pin-making was “divided into about eighteen distinct operations,” a shop of ten workers could make “upwards of forty-eight thousand pins in a day.” The OpenStax textbook gives three reasons specialization raises output. People focus on what they do best, they get better with practice, and larger operations can use economies of scale.

2 The extent of the market: How far can it go?

Smith’s third chapter carries the title “That the Division of Labour Is Limited by the Extent of the Market.” A specialist has to sell what she makes to enough buyers to make the effort pay. “When the market is very small,” Smith wrote, “no person can have any encouragement to dedicate himself entirely to one employment.” His example was a porter, who “can find employment and subsistence in no other place” than a great town. A village can’t support a pediatric heart surgeon or a shop that sells only guitar strings. A large, connected market can. Roads, ships, and the internet all widen the market, and finer specialization follows.

3 Trade: Why must specialists exchange?

A pin-maker can’t eat pins. As OpenStax puts it, “specialization requires trade.” People sell their own specialized work and use the pay to buy everything else. Smith traced this to a “propensity to truck, barter, and exchange one thing for another,” and noted that exchange runs on self-interest: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” Each side gives up something it values less for something it values more. That is why both can come out ahead.

4 Comparative advantage: Who should do what?

Specialize in what, exactly? In 1817 David Ricardo gave a surprising answer. What matters isn’t who is best at a task. It is who gives up the least to do it. This is comparative advantage, and it comes straight from opportunity cost. In Ricardo’s example, Portugal could make both wine and cloth with less labor than England. Trade still paid for both countries. Portugal gained by making wine and buying English cloth, even though, as Ricardo noted, Portugal could have made that cloth “with less labour than in England.”

5 Markets: Who coordinates it all?

No one person can know who should make what for millions of others. In 1945 Friedrich Hayek argued that markets solve this problem through prices. Suppose tin becomes scarcer, because a mine closes or a new use appears. Its price rises, and users cut back without knowing why. Hayek called it a “marvel” that “without an order being issued,” thousands of people “are made to use the material or its products more sparingly.” He urged readers to “look at the price system as such a mechanism for communicating information.” Writer Richard Fulmer adds that much of this knowledge isn’t just scattered. It “doesn’t exist until it’s created by the market,” through “countless transactions,” and it must be used quickly “before it becomes outdated.” That is the same idea behind the Price Check sheets.

WATCH Another Look at Comparative Advantage (Marginal Revolution University)

WATCH Markets Link the World and Hayek on the Use of Knowledge in Society (Marginal Revolution University)

Why Trade Isn’t a Contest

Philosopher James Otteson names a common mistake the “Wealth Is Zero-Sum” fallacy. It is the belief that one person’s gain must be another’s loss. Wealth taken by force or fraud really is zero-sum or worse, he writes. But “in a market-based commercial society, wealth is positive-sum, meaning that both (or all) parties to mutually voluntary transactions benefit.” Smith applied the same logic to nations: “It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker.” In this view, a country that buys goods from abroad gains just as a household does when it buys shoes.

Fair Challenges

  • Specialization can narrow the worker (Adam Smith). The strongest early warning came from Smith himself. A worker who spends his life “performing a few simple operations,” he wrote, “generally becomes as stupid and ignorant as it is possible for a human creature to become,” unless “government takes some pains to prevent it.” His remedy was a small school in every parish, paid for “partly, but not wholly,” by the public. The question remains how to keep the gains of specialization without narrowing people’s lives.
  • Gains are spread widely, but losses are concentrated (the China shock). Economists David Autor, David Dorn, and Gordon Hanson studied U.S. towns hit by imports from China. Alongside “the heralded consumer benefits of expanded trade,” they found “substantial adjustment costs.” In the hardest-hit places, wages and work stayed depressed “for at least a full decade.” Later work has found smaller job losses, and economists now debate how large the effects on wages and incomes were. Defenders of open trade agree the costs are real. They argue for helping workers and places adjust rather than for blocking trade. Critics ask whether that help has ever been large enough.
  • Young industries may need a start (Alexander Hamilton and Friedrich List). In his 1791 Report on Manufactures, Hamilton argued that a new industry competing “upon equal terms” with “long matured” foreign rivals is “in most cases impracticable” without government aid. In 1841 the German economist List made a similar case: a nation behind in industry “must first of all strengthen her own individual powers” before it competes freely. Skeptics reply that governments find it hard to pick winners, that protection is hard to remove once granted, and that consumers pay higher prices in the meantime.
  • Some things matter more than cost (security and resilience). Smith also made an exception for defense. He backed England’s shipping laws because “defence, however, is of much more importance than opulence.” Hamilton wanted the country to produce “the means of Subsistence habitation clothing and defence” at home. The hard questions are which goods truly count, how much safety a given cost buys, and who decides. The Manufacturing sheet takes up these questions in detail.

Notice what can and can’t be settled by evidence. How much trade lowers prices, how many jobs it shifts, and how long towns take to recover are empirical questions that studies can test. How to weigh cheaper goods for millions against lost jobs for thousands, or how much efficiency to give up for security, are questions of values.

What Economics Adds

The Normative Question

Economics can show that trade creates gains and also that it shifts who wins and who loses. It can’t tell you how to weigh them. If open trade lowers prices for most people but costs some towns their main employer, what, if anything, do the winners owe the losers? Should help go to the workers, the places, or the industries? When should a country accept higher costs to make something at home? And should the answer depend on whether the trading partner is a friendly nation or a rival?

Key Terms in Plain Words

Division of labor
Splitting the making of a good into separate tasks done by different workers.
Specialization
Focusing on a narrow set of tasks or products instead of doing everything.
Extent of the market
How many buyers a producer can reach; it limits how far specialization can go.
Gains from trade
The extra value both sides get from a voluntary exchange.
Absolute advantage
Being able to produce more of a good with the same resources.
Comparative advantage
Being able to produce a good at a lower opportunity cost than others.
Positive-sum
An exchange or activity in which all sides can gain together.
Wealth Is Zero-Sum fallacy
Otteson’s name for the belief that one person’s gain must be another’s loss.
Price signal
A price change that tells people to use less or supply more of something.
Dispersed knowledge
Hayek’s point that the facts needed to plan an economy are spread among millions of people.
Infant industry argument
The case for temporary protection while a new domestic industry grows.
China shock
The rapid rise of imports from China in the 1990s and 2000s and its effect on U.S. local job markets.

Sources