The Invisible Hand: How Markets Work
2. Why are markets important?

Economists have spent a great deal of time studying market transactions. It's their business, for which they are employed in . . . their own labor market. Markets matter. Someone who invested her savings in the stock market during the 1990s saw her wealth grow at a remarkable rate. If she invested in the early 2000s she saw her wealth - her retirement fund, say - shrink at an equally remarkable rate. It matters. Markets push your life. Your parents met on the job, that is, as a result of a transaction in the labor market. Your house as a kid was a result of a housing and a mortgage market. You ate Spaghetti-Os by the grace of the market in canned goods. The market in higher education helped determine your choice of where to go to college.

Markets, as old Adam Smith pointed out, make us richer. Specialization within markets means that individuals are free to pursue jobs that make the most of their talents and interests. This was Smith's vision of a modern economy. He wrote of an extensive "division of labor," his phrase for specializing in putting doors on cars in an assembly line or specializing in the surgery of feet. Each person specializes in a certain type of work and then uses her higher, skilled income to buy goods and services from others. It opens up endless possibilities for mutually beneficial exchange. Maria and the owner of the gasoline station have different specializations: one in getting through college, the other in selling gasoline. The specializations give them reason to enter into an exchange. The difference in their occupations makes them trading partners. Aristotle had a similar idea. "For it is not two doctors that associate for exchange, but a doctor and a farmer, or in general people who are different and unequal." Or as Jonathan Sacks, the chief rabbi of Britain and the British Commonwealth, put it recently, "it is the market-the least overtly spiritual of contexts-that delivers a profoundly spiritual message." What message? "It is through exchange that difference becomes a blessing, not a curse."

We live and work in a highly interdependent society where jobs are specialized and a typical household buys goods and services from thousands of sources around the globe. Since you are reading this book you likely live in a country that has embraced specialization and trade, and the rewards lie in a vastly higher standard of living than our grandparents or great-grandparents could imagine.

Bayla: So it's the "different" and "unequal" part that makes specialization so beneficial, right?

Klamer: That---plus exchange. It's crucial to combine exchange with specialization. Otherwise we end up with a surplus of self-produced insurance policies or gasoline or economics textbooks, but nobody to trade with. . . .

McCloskey: . . . and a shortage of everything, except for the few things that we alone produce!

Killing markets by war or corruption or taxation or prohibition makes us poorer. Markets can be killed off, and in human history have been, repeatedly. The Congo starves because its markets have been killed off. Economic self-sufficiency and its communist cousin-the absence of division of labor in a communal organization, turning away from the market-sounds like a noble alternative. In The German Ideology Karl Marx idealized the life of non-market non-specialization:

In communist society. . . nobody has one exclusive sphere of activity but each can become accomplished in any branch he wishes. . . . Society regulates the general production and thus makes it possible for me to do one thing today and another tomorrow, to hunt in the morning, fish in the afternoon, rear cattle in the evening, criticize after dinner, just as I have a mind, without ever becoming hunter, fisherman, shepherd, or critic.

But in fact such a life condemns people to meager living standards, as utopian communities, religious or hippie, periodically discover.

Caption: Intrigued by 1960s ideas of communal living and lack of division of labor, hippie communes flourished in the U.S. But "flourish" may be the wrong word for many of them. Courtesy:

Think of the American pioneers, living on remote homesteads with no choice but to produce almost everything on their own. They embodied the virtue of self-reliance. But they worked from sunup to sundown, seven days a week, for bare bread without coffee. They were largely self-sufficient but poor, backs broken.

More and more people in the modern world can live as Marx dreamed---but through capitalist specialization, exchange, and ingenuity, not through sharing unspecialized poverty in socialism. Even the great prophet of self-sufficiency, Henry David Thoreau (1817-1862), who claimed to have "earned my living," as he put it in Walden, "by the labor of my hands only" in a little hut on a hill overlooking Walden Pond in Concord, Massachusetts, only did it for two years and two months. And even then he cheated: he consumed some things he didn't make with his own hands, such as nails and books.

Caption: Henry David Thoreau (1817-1862) experimented at Walden Pond with economic self-sufficiency. He failed.

The key to getting richer, as Adam Smith said, is not to work harder or strictly alone or self-sufficiently but smarter: to specialize based on what economists call comparative advantage and then trade with others who are doing the same. When a Nobel-prize winning physicist challenged a Nobel-prize winning economist to name an idea in economics that was both surprising and true the economist thought for a moment and replied, "comparative advantage."

Here's the idea. Think of a Saturday afternoon at home. Maria and her 8-year old brother Alessandro (she calls him "Alex") are asked to rake as much as they can of the lawn and clean up as much as they can of the garage, from 1:00 to 5:00. Maria has an "absolute" advantage in both tasks: she is better---that is, faster per hour---at cleaning and raking than her little brother. Does that mean she should do everything, and let Alex sit and watch? Obviously not. Alex should do something, right? Otherwise his labor, absolutely feeble though it is, is being thrown away, not used at all. Clearly to get the most accomplished in the afternoon both Alex and Maria need to have worked all afternoon.

What should he do? Well, suppose Alex is bad compared to Maria at raking---by her standards he's little and weak, and so he can't handle the lawn rake very well---but that he is very, very bad at cleaning up the garage. He doesn't really understand, for example, what should be thrown away and what should be kept. He's 8 years old and that busted-up bushel basket looks to him like it would make a neat top for a fort in the bushes.

So the smart move is to assign him to lawn raking, at which he has a "comparative" advantage. Note well: he is not assigned to it because he has an "absolute" advantage. He doesn't. Maria is better at everything. But in the smart assignment of tasks, Alex does the raking all afternoon, producing what little he can with that assignment. Maria starts the garage cleaning, coming to help rake the lawn in after she's finished the garage, at which she is very much the better worker, or at any rate gotten as much of it cleaned as she judges is socially desirable. As a result of being smart, the little "society" of Maria plus Alex accomplishes the most it can in the four hours available. If Maria's time was on the contrary misallocated, and she set herself to lawn raking too early, before she had finished the job of cleaning the garage, less would get accomplished. The garage would not be entirely cleaned, though more of the lawn would be raked. Since Maria has a comparative advantage in cleaning the garage, to get the unit of lawn raking she would be giving up too much garage cleaning. Assigning Alex to lawn raking gives up less garage cleaning, because he's especially bad at it.

In fact you can show---we will in Chapter 17---that if the tasks are allocated by comparative advantage the production possibilities curve of the Maria/Alex society moves out compared with the one in which, say, Maria moves out to the lawn before exhausting the garage job. Specialization by comparative advantage produces potentially more of everything.

Klamer: The same is true of a basketball team. The great Michael Jordan of the Chicago Bulls was, everyone agrees, absolutely better at every job on the court. He could shoot better, defend better, assist better.

Ziliak: Yeah. I'll bet he could give out water and manage the stadium better, too!

Klamer: Probably. If the smart way to allocate jobs was determined by who had the absolute advantage, then the other four players should have sat down, and let Jordan do everything.

Ziliak: Which shows that absolute advantage---Jordan's or Maria's---is not the smart way to allocate jobs. Jordan played guard, which was his comparative advantage, but the rest of the team continued to play. The team got the most points per game as a result!

The most dramatic example of specialization and comparative advantage is in international trade, as we'll see in Chapter 31. The international division of labor enables the U. S. to export soybeans, jet aircraft, and financial services to countries around the world in exchange for bananas, crude oil, and assembled items like shoes. The United States could choose to grow its own bananas. But at what opportunity cost (see chapter 2)? To reproduce the growing conditions that occur naturally in tropical climates, U. S. banana growers would have to make huge capital investments in mammoth glass-domed greenhouses, artificial lighting, and lots of sprinklers. It would make U. S. bananas, of course, very, very expensive. That is, their production would absorb scarce resources that could've been employed in more valuable ways. Like Maria going to the lawn too early, or Scottie Pippin sitting on the bench watching Jordan do everything. Or the Japanese growers of melons, who by governmental protection are encouraged to grow melons in Japan's unsuitable climate, at a price of $20 a melon, instead of the 80 cents in the U. S.

The news from Adam Smith's "simple and obvious system of natural liberty" is not all good. One danger of specialization is that it makes each person economically vulnerable. As we become more specialized, we become more dependent upon others, i.e., self-insufficient. Madagascar in the 1980s, for example, had become too dependent on one buyer of their exports of vanilla beans, namely, the Coca Cola company. When Coke switched to the relatively cheaper corn syrup sweetener, Madagascar suffered a deep loss of jobs and income. But paradoxically, according to Aristotle and Smith, this is precisely why markets are so important and effective. Markets capitalize on our uniquely human ability to cope with our self-insufficiency through prudent bargaining. Madagascar learned a difficult lesson. (Though so did Coke, by the way, a different lesson, since consumers when they knew they were buying it hated the new flavor, and said so with a sharply reduced demand for the so-called "New Coke.")

According to Smith and Aristotle, markets promote healthy interdependence among people by cultivating our human capacity to "live by exchanging." They enable us to turn our individual weaknesses (neediness, dependence upon others) into a collective strength. In a large-scale, labor sharing network, in which each individual can profitably cooperate with multitudes of others whom they don't even know or necessarily care about, we prosper. And as Rabbi Sacks noted, we are led to admire difference instead of attacking it. In this regard markets have made us richer than we otherwise would have been culturally and intellectually and ethically as well as economically.

Aristotle saw the human element clearly. "It is by exchange that [men] hold together." Twenty centuries later, Smith pushed the argument further by noting that market exchange is peculiarly human:

Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog. Nobody ever saw one animal by its gestures and natural cries signify to another, this is mine, that is yours; I am willing to give this for that. Give me this which I want, and you shall have this which you want . . . It is in this manner that we obtain from one another the far greater part of the good offices which we stand in need of.

Paul: So why do I need to know about comparative advantage?

McCloskey: It explains specialization and it explains trade. People and countries will specialize in the production of things at which they do comparative better. And then they will trade to take advantage of specialization. So Americans will buy shoes, toys and laptops from the Chinese, and they get our planes, movies, and cars.