Economies of Scale and Comparative Advantage

Dan Russell,

Release Date
June 15, 2017


Basic Economics

Economies of scale and comparative advantage let us make bigger and better oranges, grapes, and everything else. For more Dan Russell, watch

    1. What Caused The Economic Boom of Wealth? – Learn Liberty (video): Professor Deirdre McCloskey explains the explosion of wealth in the world since 1800, and how all that wealth was created. 
    2. “Trade Is Made of Win,” Part 1: Wealth Creation (video): Professor Art Carden explains how exchange and trade create wealth for everyone involved. 
    3. When Jobs Kill Wealth (blog): Professor Gary Galles makes the case that instead of being so focused on “creating jobs,” we should be focused on creating wealth.

Dan Russell: Economies of scale and comparative advantage. Let’s suppose a fellow named Frederick lives on a few acres, and that he likes to grow oranges and grapes in his garden. Suppose the north end of Frederick’s garden stays a bit cooler, and the south end gets more heat, so where’s he going to plant his oranges? Oranges like the heat, so he’ll plant them in the southern end of his garden. Grapes grow better without so much heat, so he’ll plant them in the northern end. That’s the best he can do, but his whole garden is still in a northern place, so his garden will never produce oranges as well as it produces grapes. Now suppose that Frederick takes a journey down south to visit his old friend Jorge, and his friend Jorge lives on a few acres in the south, and he too likes to grow oranges and grapes. One day Jorge is showing Frederick around his garden, and Frederick is really impressed by how well the oranges grow there, and he says to Jorge, “You know, my grapes do just fine up north, and my oranges do okay if I keep them in the southern end of my garden, but the southern end just isn’t far enough south to grow oranges really well.”
Jorge says, “I’ve got the opposite problem. Oranges grow really well here, but the northern end of my garden just isn’t far enough north, so my garden never grows grapes quite as well as it grows oranges. If they could just pick up land and move it, they could each split their gardens in half, so that both of them would get the benefit of northern sunlight on their grapes and southern sunlight on their oranges, but there is a way that they can get exactly the same effect. If Jorge grew oranges for both of them, and Frederick grew grapes for both of them and then they traded, that would be just like Frederick growing his oranges a lot farther safe, and Jorge growing his grapes a lot farther north. It would be as if there was one perfect garden between them, with Frederick looking after the northern end and Jorge looking after the southern end. Notice three things about this story. First, trade gives people the chance to specialize where their efforts have the lowest opportunity costs. In other words, where they have a comparative advantage.
Every resource that Frederick devotes to growing oranges could be used more productively to grow grapes instead. Compared with himself, Frederick has an advantage in growing grapes rather than oranges. Trade makes it possible for people to use their comparative advantage to create wealth by putting their resources to their more productive uses. Trade lets people discover how they can be of as much use to other people as they can, and how they can make their local resources as useful to other people as they can. Second, people can’t create wealth if they ignore comparative advantage. Suppose that Frederick turned down Jorge’s offer to trade grapes and oranges, and instead went on growing his own oranges. He’d still keep really busy in his garden, and it might even look like he was creating wealth, but that wouldn’t be true, because that would ignore the opportunity costs of the work he’s doing to have oranges. Even though Frederick would be working hard, he’d actually be destroying wealth.
Wherever wealth is being created, comparative advantage is part of it. Third, what I didn’t tell you about Frederick and Jorge, but you may have guessed it from their names, is that if you looked on a map, you’d see a political border between them. When they trade, they’re actually trading across a border. Without trading across borders, people’s efforts would be duplicated all across the planet, and as a species, humans would waste massive inputs to get pretty meager outputs. By trading, we can leverage our different strengths to produce much more with much less. Because of comparative advantage, trade is able to bring the best of the planet to all of the planet.