A First Principles Framework to Economics and Finance (2)

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This is Part 2 of my seven-part series of “A First Principles Framework to Economics and Finance”. For Part 1 — Assets, Labor, and Technology, read here.

Part 2. Division of Labor and Trade

Now that we have discussed the basics of how the Economic Production Process works (by using Technology to apply Labor to Assets to create useful Outputs), the next building block we will discuss is the Division of Labor and Trade. Why would it be logical to think that Division of Labor and Trade will happen? The reason is that everyone born into this world is unique and everyone’s circumstances are different. We each have our own strengths and weaknesses, interests, and skill sets. Some people may be stronger or more skillful at hunting, while others may be faster at building homes.

These differences manifest into the Economic Production Process by impacting the three key variables we laid out previously — (i) Labor, (ii) Assets, and (iii) Technology. For example, a seasoned logger may have (i) more physical strength (Labor), (ii) a sharper ax (Asset) and (iii) the knowhow that the best way to cut down a tree is by first cutting a notch in the felling direction of the tree followed by cuts toward the notch from the other side of the tree (Technology) that they will likely be able to cut down the tree much quicker than you can. Any differences in these three variables will result in different levels of Outputs.

It is conceivable then, because of the differences in people’s Production Functions, as a society, if people focused their work on producing the Outputs they are relatively better at (i.e. where they have a Comparative Advantage*), the aggregate amount of Outputs of that society will be higher than if each individual produced all of the Outputs necessary for their own existence by themselves. With Trade, whereby people trade their Outputs for other people’s Outputs, everyone in the society (and the society as a whole) will be better off as people can consume a higher amount of aggregate Outputs than what they are able to produce themselves**.

This advantageous outcome, where all parties benefit and are better off, is what creates a Division of Labor among people and allows Trade to develop.

Next time, we will introduce the concept of Money (Part 3) and see how Money is able to massively facilitate Trade.

*For the purpose of this essay, as the aim is to provide an introductory framework, and in order to cover all the topics I noted, I’ve kept the discussions and the concepts quite simple. In order to have a deeper appreciation for the benefits of the Division of Labor and Trade, it would be important to discuss in detail the concepts of Opportunity Costs, Absolute Advantage vs. Comparable Advantage, as well as Production Possibility Frontier. (Should people have interest, I would be happy to write a separate piece diving into these topics.)

For now, I will simply define Comparable Advantage as the relative advantage that a person has in a production process whereby they have the lowest opportunity cost. One hypothetical thought experiment to illustrate this is if both Roger Federer and I are tasked with (i) playing tennis in the U.S. Open and (ii) mowing the lawn. Roger Federer is better at playing tennis than me (duh!) and is able to mow the lawn faster than me. Despite Roger being better at both tasks than me, it would still be beneficial for Roger and I to divide the labor and trade because I have a comparative advantage at mowing the lawn. Yes, I do have an “advantage” over Roger Federer (however counterintuitive this may be). The reason is that the opportunity cost of my not playing tennis is much lower than the opportunity cost of Roger not playing tennis, hence I have a relative advantage in mowing the lawn vs. playing tennis (i.e. my time is better spent mowing the lawn).

**In classical economics, David Ricardo is commonly credited as the first economist to detail the benefits of trade in his 1817 work On the Principles of Political Economy and Taxation. In it, he showed that because of the existence of Comparative Advantage, each party that participates in Trade will be better off than if they did not trade.

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