The Benefits of Trade and Optimal Allocation of Employees

After Adam Smith’s paradigm of the invisible hand, the most influential concept ever developed by an economist was probably David Ricardo’s theory of comparative advantage. Comparative advantage explains why countries always benefit from free trade. His theory, however, also has applications for how businesses should allocate their employees.

To understand comparative advantage, consider the following:

Table 9: Absolute Advantage

	Jane	Bill
Time it takes to cook	10 hours	5 hours
Time it takes to clean	5 hours	10 hours

In this example Jane and Bill live in adjoining apartments. It takes 15 hours for both people to do all their cooking and cleaning. Jane, however, is better at cleaning, and Bill is better at cooking. If the two work together, and have Jane do all the cleaning and Bill, all the cooking, then it will take each only 10 hours to do their work. This result may seem unimportant, but it’s really magical!

Think: By trading their services, each person can save 5 hours. No one besides these two people need get involved, and obviously no one gets hurt. Just by trading, these two can be made better off. This result has widespread implications for companies and countries. When you have two people, each of whom is best at one particular task, there are considerable benefits to specializing. Each should do what he is best at. Similarly, when countries trade, each country can specialize in what it does best, and both can be better off.

In the previous example one party was absolutely better at cleaning and the other at cooking. What would happen if, as in the following example, Bill was better at both cooking and cleaning?

Table 10: Comparative Advantage

	Jane	Bill
Time it takes to cook	5 hours	1 hours
Time it takes to clean	3 hours	2 hours

Could the parties still benefit from trading their services? After all, since Bill is now better at both cooking and cleaning, does he have anything to gain by working with Jane? Actually, yes. If the parties work alone, it takes Jane eight hours to complete her chores and Bill three hours to complete his. But, if Bill does all the cooking and Jane does all the cleaning, it takes Jane six hours and Bill only two. Both parties can still benefit by trading services.

What is going on here is that Bill is comparatively better at cleaning than Jane is. True, in an absolute sense Bill can complete both tasks faster than Jane can. It takes Bill twice as long to clean as it does for him to cook. Jane, however, is better at cleaning than cooking. Thus the two parties can still benefit from trade.

This example shows that even when one person is better at everything than another, the two can still benefit from trade if each specializes in what he does best. The strength of this simple argument is why virtually all economists support free trade. Even when a productive country like the United States trades with a third-world nation, both can benefit from trade even if the United States is better at doing everything.

Consider the benefits of trade for a company. Assume that your company produces both widgets and sprockets, and the following holds:

In one day Jane can make either one widget or one sprocket.

In one day Bill can make either two widgets or seven sprockets.

Again, Bill is better at everything. Bill is clearly a more valuable worker than Jane is. Imagine that you are considering firing Jane. You should first determine her exact value to you. Consider this: What can Jane produce over a two-day period? The answer seems simple. It seems that over two days she could produce either two widgets, two sprockets, or one of each. Actually, Jane could do better. Through the magic of trade Jane could also produce seven sprockets over a two-day period.

Seven sprockets: how is this possible? Imagine your company has only Bill, and you develop an urgent need for two widgets. Obviously Bill would need to spend one day making them. This would mean that Bill does not spend that day making sprockets. Thus, the cost to your company of producing two widgets is seven sprockets. Now, assume that you hire Jane. Jane could spend these two days making two widgets. This would free up Bill to make seven sprockets. Two days of Jane’s time allows your company to produce an extra seven sprockets, so this is what she is worth to your company.

The lesson from this example is that when considering what an employee can do, you should look at not only what she can accomplish, but also at what she can help other people accomplish by freeing up their time.