Economic Principles: How the Market Works

Chapter 3: The Dynamics of Interactions

• Comparative advantages
• The sources of uncertainty: subjectivity, time, change
• The entrepreneurial dimension of decision making: subjective rationality
• Division of labour and division of knowledge
• The use of knowledge
• The role of institutions

To be remembered:

•  Comparative advantage

•  Entrepreneur

•  Uncertainty

•  probability

•  contract

•  property

Bibliography:

Adam Smith: Wealth of Nations: the pin factory

David Ricardo: Principles of economics

Kirzner: Competition and Entrepreneurship

Knight: Risk, Uncertainty and Profit

Hayek: The Use of Knowledge in Society

What we have shown so far and what comes next

This chapter aims, like the two previous one, at setting the stage for a sound economic analysis of reality. We will here discuss some fundamental characteristics of economic activities and more generally of social life. Those characteristics ultimately explain the evolution of our societies. The content of this chapter will therefore, at least to some, appear a bit too abstract. But I offer no apologize for that: When you wish to get a clear picture of what is going on, keeping your nose on reality will lead you nowhere. On the contrary, you need to step back a little bit. Stepping back: This is what we are doing now. Later on we will zoom on reality.

Before going further, however, it might be helpful to recall what we have assessed so far. In the first chapter we have said that the general goal of economics�or political economics�is to understand why some groups or societies get wealthier than others; the ultimate goal being to find a path to a better life. In the second chapter we asked ourselves some methodological questions: how do we do to understand the evolution of societies? We choose�or, to be more exact, I suggested that we rely on methodological individualism. So the plan is to explain social phenomena as the outcome of individual choices, of human action. Individuals struggle to improve their well being; and progress eventually results from those efforts.

We end up the last chapter with two remarks: we said that in their struggle for a better life, individuals are limited by their knowledge. The economic problem is therefore, to a large extent, a knowledge problem . The second remark was that exchange is particularly useful to deal with that problem. This chapter is devoted to those two features of human life, knowledge and exchange, which are so essential if one wish to understand the dynamics of the world.

To trade is a positive sum game

If there is a well spread belief in public opinions all around the world. It is that every transaction has its winner and its looser. What one party gains from trade has to be lost by someone else. Mathematicians have a word for that type of situation: they call it a zero sum game , because if you add up the effects of trade on all the participants you end up with zero. When someone has gained 10 through trade, someone else must have lost 10.

For some reasons that we don't have time to analyze here, this belief is particularly strong when the discussion bears on international trade : if one country benefits from trade, it is surely at the expense of another one. How could for instance a poor country benefits in trading with a well developed country? This is impossible, they say, and consequently some form of protectionism must be implemented. Hence, barriers to trade are built everywhere. Individuals are no longer free to trade.

That this belief is unfounded should be clear to any objective mind. Indeed, it is enough to look at our daily life to see how ridiculous the claim is. We trade from morning until evening, with the baker, the bus driver, the stationary where we buy our favourite newspaper, the owner of the coffee shop, the telephone company, and so on, and it is obvious that life would be miserable if we had to cook our own bread, get direct information about what is going on in the world, or bring our messages ourselves without using the services of a telephone company. Meanwhile, the baker and the owner of the grocery store are more than happy to trade with us. From this we must conclude that, contrarily to what the widespread belief referred above claims, both sides benefit from trade . Trade is therefore a positive sum game.

Some would immediately reply that, if it is true that both sides benefit from trade, a huge problem nonetheless remains: in many cases one side benefits much more than the other, so that trade remains unfair. This is an important point, but I ask you for now to be patient and wait for later discussions (in particular until chapters 8, 10 and 13). It is enough for now that we agree that both sides benefit as long as trade is voluntary.

Let us note in passing that our claim�trade is a positive sum game�is a logical implication of the postulate of rationality. Indeed, according to that postulate, individuals chose what best serves their goals. Therefore, if I choose to trade it is because I am better off trading than refraining from trading!

Comparative advantage and the division of labour

The lesson drawn in the previous section is one of the most important, may be the most important, in economic theory. As a matter of fact it is with that lesson that �modern� economic thinking started to develop, and two names are closely associated to it: Adam Smith and David Ricardo . Smith pointed out to the division of labour as the main engine of progress, while Ricardo showed that every nation has an interest in specializing in those productions for which it has a comparative advantage. But clearly the division of labour and the specialization that goes with it are possible only if you can trade your production against other things you need. The expansion of trade opportunities and the division of labour are two sides of the same coin.

At that point, the alert student might disagree. Can't we have division of labour without trade, will he ask? After all, employees of the same company or the same administration don't trade with each other, and nonetheless there is a division of labour within the company or the administration. Right. But this solution is very limited because the division of labour have there to be organized �from the top�, by the boss of the company or by the boss of the administration. And the boss will quickly run into the knowledge problem. So, once again, I ask you to be patient. We will deal with the knowledge problem in the second part of this chapter and you will then see why division of labour and trade form, in a sense, the winning combination.

So let us come back briefly to Smith. Its famous book, �The Wealth of Nations�, starts with the story of the visit of a pin factory. I advise you to read those pages. The reason why Smith tells that story and places it at the very beginning of his book is to send us a clear message: According to him, the division of labour is an essential route to progress. In the absence of it, much less pins would be produced every day. What a waste?

But, as said earlier, individuals can divide work between them, and specialize only if they can then trade their productions. Once you have produced those thousands of pins, you need to exchange them with things that will satisfy your needs: foods, clothes, housing, instruction for your kids, and the like. And indeed, Smith stresses later in his book the role of the expansion of the market .

Let us note that Smith perceives also clearly the connection between division of labour and expansion of knowledge . Indeed, as we split the making of a pin in many parts, each employee being entrusted with one step of the production process becomes better at it (we say, increases his or her productivity). He becomes so to speak an expert, which means that he will develop a specific knowledge that he would not have had the opportunity of developing if he had been entrusted with the whole production process. To take another example, if I attempt to build my house alone I am taking great risks as far as the quality of the house is concerned because I am not an expert in plumbing, electricity, painting, etc. I don't have that knowledge and if I wish to acquire all that knowledge, it will probably take me many years to build a house that professionals could have built in a few months. And still the quality might be poor. So let us keep in mind that link between division of labour and expansion of knowledge.

David Ricardo wrote his �Principles of Political Economy and Taxation� in 1818 and almost two centuries later, his most celebrated theory of comparative advantage is still taught in our universities. This theory is helpful to make a point which is somehow counter intuitive. Assume that we have two countries, England and Portugal, which can produce one of two products, wool or wine, or both. Each country has the necessary technology to produce each item, but England is not as efficient as Portugal. As indicated in the table below, in an hour of time England produces 2 kilos of wool, while Portugal can produce 3 kilograms. And the same holds for Wine: while England can produce 2 litters of wine an hour, Portugal can produce three times more.

Production per hour of labour

If labour is the only thing it takes to produce wool and wine, 1 then why should Portugal trade with England? After all, whatever they would buy from England would be cheaply produced in Portugal. England has nothing interesting to sell to Portugal, it has no advantage. This is what our intuition tells us. But this is plainly wrong! As we will show (or rather as Ricardo showed), a �technologically backwarded� country gains from trading with a most advanced one, and the reverse is equally true.

If you are not convinced, it might be useful to use some graphs. On the graph we draw what economists call the production frontier for each country assuming each country is endowed with 100 hours of labour. With those 100 hours, England can produce everything on the blue line or below. Portugal, on the other hand, can produce everything which lies on the red line, or below. What they will decide to produce depends upon their preferences. Let us assume that England choose to produce 100 litres of wine and 100 kilograms of wool. This is the brown point E on the graph. Meanwhile, Portugal may choose to produce 180 litres of wine and 210 kg of wool. This is the brown point P. So far, no trade is taking place. Each country lives in autarky.

If England specializes in the production of wool and trade, what will happen? England can produce E'(0 l , 200 kg ). England will then be better off if Portugal accepts to trade 100 kg of English wool against, let us say 110 l of wine. Indeed, if Portugal accepts such a deal, England ends up with a basket E*(110 l , 100 kg ) which is better than E. Actually, E* lies beyond England's production frontier. So that would be amazing! But will Portugal accepts?

Well, Portugal, in order to maintain its level of consumption (corresponding to its initial position P), will have to produce 110 kg of wool (since it will receive 100 kg from England) and 290 l of wine (the 110 l it gives to England, and the 180 l necessary to maintain its own level of consumption). So can Portugal produce a basket made of (290 l , 110 kg ) ? Some basic calculus shows that this is feasible. Actually you can easily check that Portugal can produce 300 l of wine and 150 kg of wool with its allocation of 100hours of labour, which is point P' on the graph.

So let us summarize: If England and Portugal accept to trade, England produce E', Portugal produce P', then England gives 100 kg of wool to Portugal against 110 l of wine. So that England ends up in E* and Portugal in P*, both being well above their production frontier.

Opportunity costs

By accepting trade, both countries were able to reach some level of well-being they could never reach alone. How can we explain that result? Ricardo said that although England had no absolute advantage in the production of either good (Portugal is more efficient in everything), nonetheless England has a comparative advantage in the production of wool. Indeed when England decides to produce one kilogram of wool it will take it 30 minutes of labour and it therefore has to give up the possibility of producing one litre of wine it could have produced during those 30 minutes. So, in a sense, One kilogram of wool costs England one litre of wine. Do the same computation for Portugal and you will see that one kilogram of wool costs Portugal two litres of wine. In the language of modern economics we will say that opportunity cost of producing one kilogram of wool is higher in Portugal than it is in England. 2 It is for this reason that trade is interesting for both parties. 3

Let me tell you a story that illustrates once more that fundamental result. There is a very successful popular singer in Italy by the name of Paolo Conte. Paolo Conte is also a lawyer. Assume he is an excellent lawyer; the best in town. What should Paolo do? Should he both sing and go to court? Most probably not. He should trade with someone, let us say Chiara, for whom, even though she is not as good a singer, and not as good a lawyer as Paolo, being a lawyer bears a lower opportunity cost: she does not have to give up a brilliant career as a singer.

This notion of opportunity cost is very helpful. It reminds us that to choose is to give up on something. That's what scarcity is all about. It reminds us also that time does not have the same value for everyone, precisely for that reason. It does not either have the same value for the same person at different moment of his life: when I am in my office, time does not have the same value as when I am on vacation, away from everything. The value of time, like the value of every thing, is subjective , in the sense that it depends of the person considering the use of that thing, of when and where he is considering it.

From the division of labour to the dispersion of knowledge

Trade leads to specialization and specialization leads to the dispersion of knowledge which itself makes trade more interesting, and so on. Here is the dynamics we have been going through the last centuries. A dynamic which has made us much wealthier. A dynamic that resulted in a wonderful global expansion of knowledge. But also a dynamic that has made each one of us, taken separately, much more dependent on others' knowledge. From this we can draw immediately two lessons:

Progress comes with the dispersion of knowledge. You can hardly have one without the other.

•  If progress comes with the expansion of knowledge it does not eradicate our ignorance. Each individual choice is surrounded by uncertainty . This uncertainty comes partly from the fact that knowledge is expanding, so that we don't know what will be the state of the art tomorrow.

If I insist on those lessons, it is because, once again, they are somehow counter-intuitive. Our intuition tells us that, as we get more developed, we get to know more and more things, and therefore uncertainty decreases and we can feel more secure, safer. Of course, this is not totally wrong. Indeed I would rather be sick at the beginning of the 21 st century than at the end of the 19 th . In that sense we are undoubtedly safer today . It is also true that as development takes place, we understand better many illnesses, we understand better how the planets work, we know better how to grow fruits, how to build tall buildings, how to send a message across the planet, and so on. But who is �we�? It is no one in particular. It is dispersed knowledge. And for that reason, each one of us is still ignorant of many things

It might useful, in order to illustrate that point, to compare the knowledge of a young person, living in, let's say Triavna, three hundred years ago, and the knowledge of a young person living in the same city of Triavna today. That person three hundred years ago had probably, like other members of his home town, a wide range of knowledge: knowing about farming, hunting and fishing, about the seasons and horses, and so son. That person would have probably been better equipped to survive on a desert island than the person born in Triavna today. Today, he will be more dependent upon his neighbours. True, he knows many things that others don't. But still he would be panicking at the idea of living on his own.

Because progress and some form of uncertainty are inseparable, each human society has had to deal with that dilemma : On one hand we would like to eradicate uncertainty because it is unpleasant and destructive (it might lead to favour short term strategies at the expense of long term, more productive strategies), on the other hand we cannot do it (recall that the status quo, i.e., doing nothing is no solution) and, even if it was possible, we would not choose to do it because that would mean no novelty, no creation, no discovery, in short, no progress. That dilemma is dealt with through the choice of institutions . Institutions have a great impact on our behaviour, because they tell us what we are free to do, what we are liable for, what would be our compensation for accepting to bear more risks than the average individual. Institutions are designed to help us form our expectations in a changing, and therefore uncertain, world.

Because institutions are essential to deal with the knowledge problem, we will constantly throughout that course come back to them. Hence, the market, you will soon understand, is nothing else than a process of interactions that takes place in a specific institutional framework based on private property, freedom to contract, and some liability rules. That institutional framework�which is not totally fixed as we will see�allows for some, necessarily imperfect, solution to the knowledge problem. Other institutional frameworks are of course feasible and political economics consists in the comparison of various institutional frameworks and of the dynamics of interaction each one generates in order to select the one more likely to lead to progress.

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1 Or, if you prefer, we assume that for England and Portugal, labour is the only scarcity constraint in the sense that they have a huge amount of land, sun, water, grass, and everything necessary to make wool and wine.

2 As a friend of mine, Mario Rizzo, pointed out to me, in fact all costs are « opportunity » costs. When I think about what something costs me, I always see what else I could do with time or with that money; what opportunity I have to forgo if I get that thing.

3 A good exercise will be to change the table so that the opportunity costs are the same. For instance, you can use:

Here there is no gain from trade to be expected.