Econ 101
This post comes under the sub-section Econ 101. Under Econ 101 I try to cover some basic economics concepts that will come handy in public policy discussions. We won't cover economic theory exhaustively, there are many textbooks that can do this better. We will be focussed on developing an economic way of looking at the world.
Everyone Benefits
Lebron James is one of the best basketball players of all time. He started playing in the NBA at the age of 18 in 2003. After 20 years he is still one of the best players in the world. Talk about longevity and consistency! Lebron is also popular for being a family man. He has three kids and is always seen to be spending a lot of time with them.
For a moment, let us assume that Lebron is also a very good cook. Being the loving father and husband he is, let's say he decides to cook for his family once every day. Now, cooking is a time-consuming activity. Lebron might have to take significant time away from training every day to cook for his family. In Basketball, there is a lot of work that goes behind the scenes in the gym, physio, and recovery. For Lebron, an hour of cooking comes at a price of an hour spent training basketball. This will affect his game and his revenue.
One way in which he can approach this is by having a cook in his house, who will cook for the entire family. Even if Lebron thinks that he is better at cooking than anyone else, the cook will allow Lebron to focus more on basketball in which he is definitely better than the cook. Here, a trade has occurred. Lebron has traded his skills in basketball (or the money he made from it) for the services of a cook. Through this transaction, both Lebron and the cook are benefited. Lebron gets to focus on what he does best. The cook does his job and gets paid for it.
That is the beauty of trade: everyone benefits from it, even those who are not particularly productive. That is because productive people can't do everything, and they need others to trade with. Lebron James may be able to cook a meal better than many, but he still hires people to do his cooking because for him an hour of cooking comes at the price of an hour spent in training. Given the choice of spending an hour cooking or training, Lebron James is better off training. In other words, Lebron James' opportunity cost of cooking is very high.
Specialisation & Economies of Scale
However, the advantages of trade go beyond those of exchange. The ability to enhance production through specialisation is the true strength of trade.
All of us makes trades in our daily lives. Every time you make a purchase at a grocery store, you are trading your products or services (or the money you made from it) for someone else's. Few of us would survive if we had to grow our own vegetables, stitch our clothes, build our houses, or manufacture our cell phones. We rely on a farmer - a specialist in farming - to give us vegetables. With specialisation, the farmer learns more about vegetables and the tailor learns more about clothes than either could if each one of them needed to work on the farm and stitch clothes. Specialisation leads to division of knowledge. Through the division of knowledge, the sum total of knowledge increases and so does productivity. We survive and prosper only because of such specialisation and the productivity that it brings about.
Trade also allows us to leverage economies of scale. Economies of scale refers to the reduction in costs when goods are mass-produced. For example, using a combine harvester increases the ease of harvesting wheat and hence reduces the price of wheat. But a farmer will not be able to afford a combine harvester if he was growing wheat only for himself. When a farmer grows wheat for thousands, a combine harvester reduces the cost of bread for all. This is economies of scale, and it exists because of the possibility of trade.
Here, it is important to understand that specialisation is not necessarily about getting better at something. In other words, the increased productivity due to specialisation will happen even if someone doesn't get better at something after specialisation. The source of the increased productivity is simply a better assignment of people to the various tasks. But how do we know who gets assigned which activity?
Comparative Advantage
Assignment of activities needs to happen based on what economists call comparative advantage. Comparative advantage is an idea that was proposed by the great 18th century economist David Ricardo. A person has a comparative advantage at something if he can produce it at a lower cost than others. (Remember, when we talk about costs, we consider opportunity costs too).
Let's go back to our previous example of Lebron James and his cook. Lebron clearly has a comparative advantage at playing basketball than his cook. The opportunity cost of Lebron not spending enough time in training is the millions of dollars he makes by being at the top of his game. Lebron's cook on the other hand has a comparative advantage at cooking. Now, we should note that Lebron may be better at cooking than his cook. That is, Lebron may have an absolute advantage at cooking over his cook. But the opportunity cost of Lebron doing the cooking is very high compared to that of his cook's opportunity cost. Hence his cook has a comparative advantage over Lebron when it comes to cooking. That is, the cook can engage in cooking at a lower cost than Lebron.
The theory of comparative advantage says that when people specialise on activities in which they have a comparative advantage, they can trade to each other's mutual advantage. So, when Lebron and his cook trade, both are benefitted. What this implies is that even people who are not very productive can also benefit from trade. Notice that even if Lebron's cook never gets better at cooking than Lebron, the transaction is mutually beneficial for both. Specialisation is not about someone getting better at something or being better at something. It is about someone having a comparative advantage in one activity over another person with whom he makes a trade. The good news is, everyone always has a comparative advantage at something.
Government & Trade
Apart from individuals, the idea of comparative advantage applies to nations as well. A country might have comparative advantage in producing one kind of good or service over another.
For example, a country like US has a very educated population that is skilled in making a variety of goods and services. But the educational qualifications and higher order skill sets of such a populace is better leveraged by engaging them more in creative endeavours like technology innovation than in manufacturing textile or steel. Although US may be very good at manufacturing textile or steel, the opportunity cost of engaging in these activities is high. So US is better off trading for steel and textiles with other countries, while engaging in activities in which they have a comparative advantage.
But in many countries, especially in India, there are calls for self-sufficiency. Pre-1990s it used to be called 'import substitution', these days they call it 'Atmanirbhar'. The idea remains the same - not being dependant on any other nation, produce what we consume. These ideas are fuelled more by emotions than economic logic. As aspiring policymakers, you need to remember that self-sufficiency is a road to poverty. Innovation and trade, based on comparative advantage and specialisation, is the road to prosperity.
Homework:
Here is a story that I found at Econlib which explains the concepts of comparative advantage and trade.
Read this article which talks about India’s comparative advantage.
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