indessed roscivs

Author’s note: this is an introduction to some of the ideas that I’ve been mulling about recently and am going to be posting about in the next few days. It may not make much sense on its own, but to try and fit everything in one post would have made it waaay too long. Hopefully it will work out better this way.

“Comparative advantage,” first described by economist David Ricardo, elucidates how specialization and trade can make everyone better off.

To take a common example, Farmer Joe and Rancher Bob both have 10 acres of land. They can use each acre to grow potatoes or herd cattle, but due to differing resources and skills, Joe and Bob are not able to produce them equally. Farmer Joe can raise 5 cows per acre, but 15 bushels of potatoes. Rancher Bob, on the other hand, can raise 20 cows per acre, but only 10 bushels of potatoes.

Assuming both of them prefer to consume steak and potatoes approximately equally, Joe would probably allocate 7 acres for cows and 3 for potatoes, resulting in a total output of 35 cows and 45 bushels. Bob, on the other hand, would allocate 3 acres for cows and 7 for potatoes, yielding 60 cows and 70 bushels. Their total production would, taken together, be 95 cows and 115 bushels.

However, if each of them specialized in what they were comparatively better at, and then traded for what they weren’t as efficient at creating, it would make both of them better off. For example, if Farmer Joe just grew potatoes (150 bushels) and Rancher Bob just raised cattle (200 cows), the total production would be 105 cows and 35 bushels of potatoes more than what they could produce separately. If they can trade freely with each other, they both get to enjoy their steak and potatoes, but much more of it than they would be able to otherwise.

But what’s the best way to divide these “gains from trade”? Economics, so far as I’ve been able to tell, doesn’t give us a good way of figuring that out. If Rancher Bob proposes the above scheme and tells Joe that he’ll give him 40 cows in exchange for 100 bushels of potatoes? If Joe farms alone, he’ll only have 35 cows and 45 bushels. If he agrees to Bob’s plan, he’ll have the 40 cows from Joe, and 50 bushels left over (after giving 100 of his 150 to Joe). He’s better off in every way, so it’s rational for him to agree, right?

But hold on—if Bob farms alone, he’ll have 60 cows and 70 bushels … but with his plan in place, he’ll end up with 160 cows (since he gave 40 of them to Bob) and 100 bushels! Joe is better off because of the trade, but Bob is much better off!

This is what I call “the problem of economic profit”.

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