FEATURED ARTICLE | DECEMBER 4, 2006
Treasure Island: The Power of Trade. Part II. How Trade Transforms Our Standard of Living
To begin to answer that question in the first part of this essay, I told the story of the Fishers and the Palmers, two newly-wed families shipwrecked on a tropical island, desperately seeking food and water. The Palmers can barely gather enough fish and fresh water to survive. The Fishers are better at both. But even though the Palmers are inferior in both tasks to the Fishers, they still have something to offer in trade—their time. By collecting water for the Fishers, the Fishers have more time to fish. And by fishing for the Palmers, the Fishers create more time for the Palmers to collect water.
In the example I used, the Fishers have a comparative advantage in fishing. Even though they are better water collectors than the Palmers, collecting water means not fishing. It is better for the Fishers to produce water by what I call the roundabout way—by fishing and swapping the fish for water. Similarly, the Palmers have a comparative advantage in collecting water. While they are able to fish, fishing is costly—it means giving time up from water collecting. Better to get fish by collecting water and swapping it for fish.
The result is a higher standard of living for both families. How does this happen?
The simple answer is specialization. When we think of the benefits of specialization, we think of learning-by-doing, the extra productivity that comes from doing one thing over and over. This effect of specialization can be very powerful. If you only grow cedar trees, you learn a lot about how they grow and how they die. You learn a lot about how to respond to an increase in the price of cedar trees that's temporary and one that's permanent. You become a more effective user of land and human effort and equipment. So it can be productive to have someone specialize in growing cedar trees rather than having the maker of pencils, say, master not just the assembly of pencils, but the growing of the cedar necessary to make the wood of the pencil.
But learning by doing isn't the source of the increased productivity of the Fishers and Palmers. No one has actually become more productive. The source of the increased productivity is simply a better assignment of people to the various tasks. It is tempting to say that people have been assigned to what they do best, but that statement has no meaning. After all, the Fishers are the best water collectors and they have given up water collecting.
People have been assigned to the tasks that lead to the greatest output where "greatest" takes into account the importance of extra protein relative to diminished water. Trade has allowed the two families to use the one truly scarce resource on the island—the time of the families—as productively as possible.
In the first installment of this story, I portrayed the Fishers as cold, cruel and unfriendly. They traded with the Palmers out of the narrowest self-interest. What is remarkable about the post-trade assignment of tasks is that it is the assignment of tasks that the Fishers and Palmers would agree to if they were all members of one loving family. Yet the invisible hand of self-interest has induced the two families to create the same level of output they would create in a situation where they all cared about each other.
Trade, fundamentally, is about cooperation. Your skills allow me to leverage mine by specializing, making both of us better off. Notice that there is nothing constant about comparative advantage. If the Fishers manage to escape from the island and a new family arrives that is again better than the Palmers at each activity but in a different ratio, the Palmers could have a comparative advantage at fishing even though nothing about their skills has changed. The lesson is that the best use of your time in a world of trade depends on the skills of others. Our differences create the potential for specialization and the creation of wealth.
Adam Smith's story of specialization is found in his story of the pin factory. David Ricardo talks about the differences between Portugal and England. The implicit differences between Smith's and Ricardo's views of specialization can be found in James Buchanan's and Yong Yoon's discussion in "Globalization as Framed by the Two Logics of Trade,"The Independent Review, v. VI, n.3, Winter 2002, pp. 399-405.)
Trade based on our differences is one source of specialization. The other comes from Adam Smith's insight that the division of labor is limited by the extent of the market. Smithian specialization comes from what we might call economies of scale. When there are enough families collecting water or enough families fishing, then someone can make a living fabricating canteens or fishing nets. And when the markets for canteens or fishing nets grows large enough, they can be produced by workers as part of an assembly line or production process rather than by individual craftsmen. Both forms of specialization, from trade based on our differences and from economies of scale based on the expansion of the market, increase our opportunities beyond what they would be under self-sufficiency.
Self-sufficiency is the road to poverty. Trade creates wealth by letting me use your skills along with mine.
This story of how trade expands opportunities has nothing to do specifically with international trade—trade across human-created borders. There is nothing significant about the nationality or the birthplace or the accents or language of the people in the story who do the trading.
What is the lesson of comparative advantage, specialization and the story of the Palmers and the Fishers for our lives?
The lesson of comparative advantage is that while anything we do is worth doing well, not everything we do well is worth doing. Not everything we do well is worth doing. A CEO who is a great cook still orders take-out, even take-out that isn't as good as what the CEO can make. The cost of cooking isn't just the grocery bill—it's the time taken away from managing the company.
Consider Jane Galt, the pseudonym of an accomplished journalist who blogs on economics and policy. Evidently, she loves to cook. She recently blogged on the best kitchen gadgets. Her descriptions made we want to buy all of them—Jane writes very well and her passion for cool stuff is contagious. A visitor to the site commented, perhaps tongue in cheek, that the failure of Jane to be hired as a copywriter for a kitchenware catalog was proof that markets don't work well. But of course, just the opposite is true. Jane remains a journalist precisely because markets do work well—as good as she is at writing catalog copy, she's even better at journalism. For Jane to become a copywriter for a catalog would be very costly even though she's very good at it. I presume the kitchenware makers can't pay her enough to bid her away from her day job as a journalist.
The same lesson applies to a country. Just because America could make fabulous televisions doesn't mean we should have a television industry. The cost of producing televisions means less of something else. It might be better to make that something else and trade with foreigners for televisions. Letting people outside the United States sell us televisions and cars and watches and steel and shoes frees up resources that allow us to make more of other things we value.
Or consider Bill Belichick, the coach of the New England Patriots who was an undergraduate economics major. He would probably make a fine economist. But he is also a fine football coach. It is tempting to say he's a better football coach than he is an economist. But that's not a meaningful statement. What can "better" possibly mean in the everyday sense of the word? Had Belichick lived in the 1930s, he might have chosen economics as his profession. But the productivity of coaching football in 2006 is much higher than it was in 1930. So he coaches. The most productive use of one's time depends on the skills that others can provide. But it also depends on the value of those skills. When football is more popular as it is today compared to the 1930s, being an economist is too expensive a route for Mr. Belichick.
These real world examples help us understand the significance of trade in the real world where there are millions of people, millions of products and millions of ways to spend our time working in the marketplace. In what activities do I have a comparative advantage? How can I possibly make the calculations of the ratio of my productivity to yours and everyone else's? What is my comparative advantage?
The existence of prices and wages makes it possible to answer these impossible questions. Prices and wages emerge as we trade with one another. They are a by-product of trade. But the prices and wages are in turn what make trade so powerful in an economy with millions of people doing millions of tasks. Prices and wages help us decide what to produce via trade—the roundabout way—and what to produce on our own—the direct way. Suppose fish is $5 a pound and I can catch three pounds of fish in a day. Look at my lecturing wage. If I can earn more than $15 dollars a day lecturing, I lecture and visit the fish market at the end of the day. And so it is with most of the things we enjoy. We produce them the roundabout way by buying them with the money we earn working at the most productive activity the marketplace find for our time.
Money is not all that matters. I might still teach even if I earned less than $15 a day simply because I love teaching compared to fishing. And I might fish even if it is "inefficient" because I love to fish. Prices and wages allow us to choose how we spend our time in the most productive way possible, where "most productive" includes the non-monetary satisfactions we receive on the job alongside the money. Without prices and wages we would have no way of possibly figuring out the best ways to use our time, what we should specialize in and what we should let others make for us via trade.
Without prices and wages, how could Bill Belichick possibly know that football makes a good hobby in 1930 but a passionate 80-hour a week job in 2006?
The simple story of the Palmers and the Fishers captures many of the essential lessons of trade:
What's the most important element missing from the simple story of the Fishers and the Palmers? In this simple story, everybody gains from trade all the time. In the real world, the distributional aspects of trade are the source of much of the concern some have about globalization and the expansion of trade. But even here, I think the simple story of the Fishers and the Palmers has something to teach us.
Let's go back to Treasure Island with the Fishers and the Palmers. Suppose the two families settle into their new life of trade where the Palmers spend their days specializing in water collecting and the Fishers spend their days fishing. They are surviving and decide to stay on the island and raise their families there. One day, something happens that benefits one family and harms the other. Which of the following scenarios would you tolerate and which would you try and stop if you were the ruler of the island:
If you were in charge of this island, would you interfere with any of these changes that harm the Fishers? Would you ban imports of fish? Would you keep out immigrants who fish? Would you fence off the cove? Destroy the net? You might want to know if the fall in the Fisher's well-being is temporary or permanent. But would there be any logic to treating the first two scenarios involving trade, differently from the last two scenarios involving increases in productivity from the cove or the net?
Our political system treats them very differently. Congress won't bail out Chrysler if Ford finds a way to make cheaper and better cars. But Congress might bail out Chrysler if Honda makes cheaper and better cars. Is there any fundamental difference between these two examples? Cheaper cars, whether they are from Ford or Honda, ultimately make America a richer country though not every American will benefit right away.
Even the Fishers can benefit from economic change. That change creates the opportunity for the Fishers to move away from fishing and do something else productive. There is more to life than fish and water. And the Fishers have other skills outside of fishing. They chose fishing because at the time, that was the most productive activity for them. But they can do other things. Now that cheap fish are available, something else is the best use of the Fisher's time. And if the Fishers struggle to adapt to the changes on Treasure Island, their children will surely inherit a richer range of choices.
Without an increase in productivity or the opportunity to trade beyond these two families, the Palmers and the Fishers will always live near subsistence. But if the families on the island can now acquire fish more easily, then the Fishers and their children can devote their time to doing other things that enrich their lives and the lives of those around them. The Palmers will have the ability to pay for those things now that fish are cheaper.
This is the story of American economic life in the 20th century. Innovation and expanded trade reduce the number of Americans necessary to produce what we want. Yet the number of jobs doesn't fall. The number of jobs grows steadily with population and the desire to work. As innovation and trade reduce the number of people working in agriculture or manufacturing, that frees up capital and human skills to make other things, things we couldn't have if we lived in a static world, the antibiotics and iPods and cell phones and heart valves and MRI machines and flat screen TVs. Banal things and glorious things. Things that entertain and things that extend our lifespan. Our skills and the skills of the next generation can turn to creating and making those things.
Not everything we do well is worth doing. And even the things worth doing now are not necessarily worth doing tomorrow. Self-sufficiency is the road to poverty. Innovation and trade are the road to prosperity.