The Big Ideas of Trade

In this section of the course, we're going to tackle trade, one of my favorite topics in economics and one of the most fundamental parts of economics. First, we'll cover the big ideas of trade. Why do we trade? What are the advantages of trade? And what is comparative advantage? Later in this section, we'll dive into the micro-economics of trade. How do we analyze trade using supply and demand, our usual tools? Right now, we're going to look at some of the big reasons for trade.

Let's focus on three benefits of trade. First, trade makes people better off when their preferences differ. Second, trade increases productivity through specialization and the division of knowledge. Third, trade increases productivity through specialization according to comparative advantage. We'll cover the first two of these in this talk and comparative advantage in subsequent videos. The first point, that trade can make people better off when preferences differ, is simple and intuitive, but still deep and fundamental.

Take a look at a company like eBay. eBay is remarkable in that it took low-valued goods and transformed them into higher valued goods, simply by a better matching of buyers and sellers. Almost out of nothing, eBay created value. So, by taking goods which a seller may regard as junk, and have sitting around the attic, and then by finding a buyer who wants those goods and transferring those goods to that same buyer, well that makes both the buyer and the seller better off. Again, we're transferring goods from people who value them a low amount, to people who value them highly, thereby, creating a net gain. Both the buyer and the seller are made better off. The first point says that trade allows us to get the most value out of the goods that we already have.

But the second point is even more important because it says that with trade, we can create entirely new goods, goods that without trade would simply be impossible. The idea here is that specialization leads to improvements and increases in knowledge, and that boosts productivity. Think, for example, about physicians. Physicians specialize. There's a specialist in the ear, nose, and throat, a specialist in heart-disease, a specialist in breast cancer, and so on. If each one of these physicians had to learn everything that the other physicians know, their total combined knowledge would be much less. By specializing, each physician learns more, and the total combination of knowledge is much higher. We get much better health care by having these specialists.

In the same way, if I were to try to grow my own food and tailor my own clothes and have to make my own shoes, I'd be starving, ill clothed, and I wouldn't have very good shoes. I'd certainly wouldn't know much about economics. It simply is not possible for one person to know everything. It's not even possible for one person to know everything about a single topic.

Specialization, however, enables the combined knowledge of a whole group of people, to be much larger than the knowledge in any one brain. Without trade, specialization is impossible. I couldn't specialize in being an economist if I didn't know that I could sell the services of being an economist, being a teacher of economics, and in return for my salary, buy food, clothing and shoes. Again, it's trade which allows this specialization to proceed. Consider this picture of farmers in Vietnam, where 60% of the labor force still works in agriculture. These farmers, actually, they know a lot about farming. The problem is that the knowledge in each one of the heads of these farmers is very often about the same as the knowledge in the heads of the other farmers.

Now, one of the reasons that developing economies are poor, is that they are less specialized. So, they are mobilizing a smaller amount of total combined knowledge. That means, brain power in those economies is not being used to its fullest extent. Compare that to a more developed economy where specialization is much higher. That means, the total amount of combined knowledge in the more developed economy, is again higher. So by specializing, people become more productive and they can learn more and grow and produce more yet.

There's an episode of the classic TV show "Star Trek", where the space aliens kidnap Mr. Spock, to transplant his brain and use it in the computer to run their economy. Now, that's terrible economics. Even Vulcan brains are limited and there's simply so much to know about an economy. It makes much more sense to divide knowledge across many brains and then to have trade. This division of tasks, specialization, where each person knows something different, the combined brain power of society is huge, and it's much more than could be fit into a single brain, even into Mr. Spock's brain.

So again, it's much, much better to use all of the brains in the society, to divide knowledge up, to specialize and then to trade. The only reason that people will specialize in this way, is that they know they can trade the results of their knowledge for other goods. I'm able to specialize in teaching economics and in learning about economics and have to teach it. Because I know, I can trade my lessons for a salary in turn to obtain food, obtain shoes, and obtain clothes. That specialization is made possible by trade. This is one reason why globalization has benefits.

Globalization means that the world as a whole can become more specialized and therefore, our world knowledge increases. We get more scientists and engineers, for example, and those scientists and engineers know more. Adam Smith, the father of economics, even made a fascinating argument connecting trade, geography, civilization, and growth. Smith looked around the world, and he noticed how often civilization begins near sea coasts or along big rivers. Why is this? Smith said it's because waterways help make trade possible, and that increases the division of labor and specialization and thus it boosts economic growth.

Smith said, quote, "As by means of water carriage," by there he means ship and boat, "a more extensive market is opened to every sort of industry than what land-carriage alone can afford it, so it is upon the sea-coast, and along the banks of navigable rivers, that industry of every kind naturally begins to subdivide and improve," end quote. People who live along navigable rivers and sea-coasts, their markets are larger. They have more people to trade with, they can trade more easily, they can specialize more easily. As they specialize, they begin to learn. Industry of every kind naturally begins to subdivide and improve. Specialization increases knowledge. This increases growth, and it's the very foundation of human civilization.

Next, we'll be looking at comparative advantage, one of the best known theories of economics. We'll start with a fun video by my colleague, Don Boudreaux, and then Alex will take you deeper into comparative advantage and give you some homework problems to test yourself with.