Division of Labor, Part 3: The System of Exchange

division of labor wealth of nations impartial spectator central planning comparative advantage

Michael Munger for AdamSmithWorks

August 21, 2019
This essay is the third and final part of a series. Read Part 1 and Part 2.

In two earlier essays, I explained what Adam Smith meant by his notion of “division of labor,” and how the commercial system is situated in Smith’s larger system of self-correcting “propriety.” In this essay I consider the dynamic function of division of labor, and the place of “planning.”

As I wrote for the Concise Encyclopedia of Economics (2015), the theory of division of labor has important dynamic elements. This makes the dynamic processes of commerce a tempting target for efforts at government planning. The traditional “blackboard” justifications for the exchange are either differences in endowments, or differences in preferences. The only way exchange will not emerge in a group of people, in other words, is if they all have both identical endowments and exactly the same preferences.

Since these conditions are unlikely, particularly if the “group” is geographically large enough to encompass different regions or nations, we expect exchange to emerge naturally. But that level of exchange is unlikely to sustain the “machine” of value and opulence that Smith describes in the Wealth of Nations. For that system to function, we need division of labor.

In effect, every household, every city, and every nation, at increasing scale, must decide “make or buy.” Is it cheaper for us to make these products, or to buy them from someone else? The naïve version of this notion is captured in the Ricardian doctrine of “comparative advantage.” It’s hard to grow bananas in Alaska; it’s much cheaper to trade salmon, which Alaska has in abundance, for bananas from Guatemala, even though Alaska and Guatemala are physically distant from each other.

That version of comparative advantage is often trotted out as the justification for international trade. But it is not what Smith had in mind.  To be fair, as Meloqui (2017) notes, it’s not what Ricardo himself had in mind, either, even though we now call this the “Ricardian model of comparative advantage” in our classrooms. Ricardo’s logic and examples are actually quite congenial to Smith’s argument about division of labor, rather than intrinsic comparative advantage arising from different endowments such as climate or soil.

For Smith, division of labor creates, on its own, a basis for exchange. Suppose we started in a world of clones, with a uniform distribution of natural resources and climate around the globe.  We then employ the random assignment of training and apprenticeships, in geographic clusters. There would quickly emerge significant differences in productivity across people based on the development of tools, the acquisition of dexterity through practice and training, and the invention of new kinds of machines.  Smith was at some pains to illustrate this proposition, using his (surprisingly self-deprecating) example of the philosopher and the street porter. The point of the example is that, while the philosopher might like to think of him/herself as being innately superior to the porter in some way, many of the apparent differences are simply the result of extended application of study and practice, made possible by division of labor.
The difference of natural talents in different men, is, in reality, much less than we are aware of; and the very different genius which appears to distinguish men of different professions, when grown up to maturity, is not upon many occasions so much the cause, as the effect of the division of labour. The difference between the most dissimilar characters, between a philosopher and a common street porter, for example, seems to arise not so much from nature, as from habit, custom, and education. When they came in to the world, and for the first six or eight years of their existence, they were, perhaps, very much alike, and neither their parents nor play-fellows could perceive any remarkable difference. About that age, or soon after, they come to be employed in very different occupations. The difference of talents comes then to be taken notice of, and widens by degrees, till at last the vanity of the philosopher is willing to acknowledge scarce any resemblance. But without the disposition to truck, barter, and exchange, every man must have procured to himself every necessary and conveniency of life which he wanted. All must have had the same duties to perform, and the same work to do, and there could have been no such difference of employment as could alone give occasion to any great difference of talents.

…By nature a philosopher is not in genius and disposition half so different from a street porter, as a mastiff is from a grey-hound, or a grey-hound from a spaniel, or this last from a shepherd's dog. Those different tribes of animals, however, though all of the same species are of scarce any use to one another…. The effects of those different geniuses and talents, for want of the power or disposition to barter and exchange, cannot be brought into a common stock, and do not in the least contribute to the better accommodation and conveniency of the species. Each animal is still obliged to support and defend itself, separately and independently, and derives no sort of advantage from that variety of talents with which nature has distinguished its fellows. Among men, on the contrary, the most dissimilar geniuses are of use to one another; the different produces of their respective talents, by the general disposition to truck, barter, and exchange, being brought, as it were, into a common stock, where every man may purchase whatever part of the produce of other men's talents he has occasion for.(Smith, 1991; Book I; emphasis added)

The people who are now the philosopher and street porter were once very similar, and in fact nearly indistinguishable. One developed the talent of “being a philosopher.” That development depended on a system where others did all the other things—making food and clothing, providing housing and security, and so on—that made it possible for the philosopher to study for decades. 

There are few situations where there are fixed endowments that make the “make or buy” decision solely a technical problem. Instead, cost and productivity differences are endogenous, the consequence of human ingenuity and the division of labor.  Today's cost advantage for one country may disappear if another country finds a better, cheaper way to produce the product.  And the way to get better and cheaper is to exploit the division of labor.

Consider an example: socks. There is nothing about the weather, or geography, of the  city of Datang, Guangdong Province, in China that makes it the logical location for the home of the largest concentration of hosiery knitting factories in the world. About 1/3 of the world’s socks are made in “Sock City,” an area of about 20 square miles.  The reason that all those sock-makers are there is simply the consequence of division of labor.  As more resources were devoted to developing machines, techniques, and specialized training of workers, the manufacturers of Datang were able to offer lower and lower prices.  The Zhuji group of companies, alone, sell enough socks to put one pair of socks on all the 310 million people of the U.S. every year.
But nothing is promised, nothing is owed, in the dynamic system of division of labor. Before 1990, the largest concentration of hosiery mills was not in China. It was not even in Asia. It was in Alabama. Datang pursued division of labor more aggressively, in part with subsidies from the Chinese government. And everything changed. Consider this description of Fort Payne, Alabama, in 2005:
This Appalachian town declared itself the Sock Capital of the World for good reason.  It began making stockings in 1907 and once boasted of producing 1 of every 8 pairs worn on the planet.…The Robin-Lynn Mills Inc. factory, for instance, owns some of the finest equipment in the business, electronic knitting machines from Italy that set the company back more than $25,000 apiece and can spin out a sock in 75 seconds, with the toe seam automatically sewn.

But Robin-Lynn, whose employees typically earn about $10 an hour, didn't turn a profit last year. On the other hand, Three Star Socks in Datang, China, made about $500,000 using knitting machines worth $1,000 each and paying its workers an average of 60 cents to 70 cents an hour plus room and board.  But this familiar story of an enormous difference in costs is only part of the tale of two sock makers and their two towns.

China's advantages in the global marketplace are moving well beyond cheap equipment, material and labor. The country also exploits something called clustering in a way that the United States just can't match. Industrial clusters are like one-stop production centers, achieving economies of scale and driving innovation by geographically bunching suppliers, manufacturers and contractors.

The clusters are one reason China's shipments of socks to the U.S. have soared from 6 million pairs in 2000 to 670 million pairs last year. Meanwhile, American producers, pummeled by imports from China and elsewhere, saw their share of the U.S. hosiery market fall from 69% in 2000 to 44% in 2003, according to the latest industry data.  (Don Lee, “The New Foreign Aid,” Los Angeles Times, April 10, 2005)
It's tempting to think that’s the end of the story. But things are not all tube socks and cherries in Datang. There is a new, and powerful, competitor on the horizon:  Turkey. The companies of Datang have lost more than 5 percent of their world market share, and Turkey has passed Italy as the number 2 maker of hosiery. In 2018, Turkey exported more than 10% of the world’s socks, riding a combination of automation and computerized management of inputs and inventory.  Datang may soon look like the aptly-named Ft. Payne, Alabama, a ghost city of empty factories. 

Perhaps the most remarkable thing about Smith’s insights on division of labor and the seductive power of “managing” industrial policy is that he was able to foresee one of the foremost debates of the 20th century, the “calculation debate.” Smith would not have had the tools to understand fully what we now call the “knowledge problem,” after Hayek’s famous 1945 article. Smith recognized that the notion of planning and directing the dynamic process of division of labor would prove seductive to the “magistrate,” or political leaders.  He showed why we still look to his writing for insight, demonstrating both that there is a role for the state in creating a context for division of labor to flourish, while at the same time warning against trying to do too much.
The civil magistrate is entrusted with the power not only of preserving the public peace by restraining injustice, but of promoting the prosperity of the commonwealth, by establishing good discipline, and by discouraging every sort of vice and impropriety; he may prescribe rules, therefore, which not only prohibit mutual injuries among fellow-citizens, but command mutual good offices to a certain degree. …Of all the duties of a law-giver, however, this, perhaps, is that which it requires the greatest delicacy and reserve to execute with propriety and judgment. To neglect it altogether exposes the commonwealth to many gross disorders and shocking enormities, and to push it too far is destructive of all liberty, security, and justice.  (TMS, Section II, Chapter 1)

Of course, Smith is referring here to the role of the magistrate in guiding the entire system of division of labor embedded in the perceptions of the impartial spectator and our culturally shared sense of propriety. Doing nothing, the state produces “gross disorders and shocking enormities;” doing too much or doing the wrong thing, including restricting the development of division of labor in commercial society, is “destructive of all liberty, security, and justice.” Nobody said it would be easy.

Further Reading
Klein, Dan, and Michael Clark. 2011. "The Music of Social Intercourse: Synchrony in Adam Smith."  Independent Review. pendent Review, 15(3): 413–420.
Klein, Dan, and Russ Roberts. “Theory of Moral Sentiments.” April 6, 2009. Episode 1 of 5 on “Book Club.” Econtalk. http://www.econtalk.org/klein-on-the-theory-of-moral-sentiments-episode-1-an-overview/
Meoqui, Jorge Morales. 2017. “Ricardo’s Numerical Example Versus Ricardian Trade Model: a Comparison of Two Distinct Notions of Comparative Advantage.”  Economic Thought 6.1: 35-55, 2017.
Munger, Michael. 2015. “Division of Labor.” Concise Encyclopedia of Economics. Liberty Fund. http://www.econlib.org/library/Enc/DivisionofLabor.html
Munger, Michael. 2015. “Comparative Advantage: An Idea Whose Time has Passed.” Foundation for Economic Education. https://fee.org/articles/comparative-advantage-an-idea-whose-time-has-passed
Smith, Adam. 1982.  The Theory of Moral Sentiments. Indianapolis: Liberty Fund.
Smith, Adam. 1991. An Inquiry into the Nature and Causes of the Wealth of Nations. Indianpolis: Liberty Fund.