Something significant has happened over the last two hundred years, giving rise to an incomprehensibly complex web of international economic activity. What changed? Economic Historians point to two important developments: division of labor and trade.
Division of Labor
Throughout history, households generally produced what they consumed. There were artisans. They produced goods, taking them from raw materials to finished product. The work was piecemeal and usually from home. In the era leading up to the industrial revolution, this began to change in Europe. Some piecemeal workers, especially in Britain, were being gathered into production sites. With greater oversight, quality and productivity improved. But the real innovation came as stages of production were broken down in to discreet tasks.
Instead of taking a product from raw materials to finished product, individuals specialized in only one part of the process. Specialization meant two things. The worker became highly proficient at doing one task very well, thus becoming more productive at that task, and less skilled workers could be trained to do specific tasks eliminating the need for multi-skilled craftsmen … great productivity with less input cost.
The advent of internal combustion engines and the mechanization of the factories accelerated this specialization process. Productivity expanded by magnitudes previously unimaginable. Over time, the cost of goods fell faster than wages, actually improving standards of living. Goods became cheaper to buy in relative terms. The road to this happy outcome was horrific for many of the workers who lived through the changes of the Nineteenth Century but that story is for another day.
Division of labor, supplemented by mechanization, radically increased productivity. But productivity is pointless if there is no one to buy your products. Remember that throughout the past most people lived in isolated communities. With mass production you would quickly saturate the community with your product. There would be no more customers. Enter trade.
Trade has two critically important qualities that need to be highlighted. They are not immediately obvious to many: value creation and coordination through information and incentives.
First, trade creates wealth. There is a simple game used in schools that illustrates this reality.* A teacher randomly distributes items of roughly equal value to each student in a class. Each student writes down how much they value their item on a scale of one to ten. All the values are combined for a class value. The teacher then divides the class into groups of five. The groups of five are invited to trade. In one group, a boy gets Barbie clothes and a girl gets baseball cards. They decide to swap. They each have something of greater value to them. After trading, the teacher has the students record how much they value their current possession. The group total is calculated again. The new score is higher. Then the teacher permits the students to trade with anyone in the class. The students rate their possessions once and the class value is totaled again. The collective value has gone still higher. Wealth has been created through simple exchange ... without anything being produced.
This reality underscores a discovery that took centuries to uncover. No item has intrinsic economic value. Nor is the value of a product equal to the labor employed to create it … as both the early Nineteenth century classical economists and Marxist economists believed. An items economic value is determined by what someone is willing to give for it. How much is a bottle of water worth as it is being sold to you by someone at your front door? How much is that same bottle of water worth after you have been lost in the desert for 24 hours without water and come across a hermit who will sell it to you? We buy things based on how much usefulness (utility) we perceive the item will have for us. Multiple people bidding into a market is what sets the price for products.
When we move from the trading game example into national or world economies it doesn’t work quite as eloquently … the details of why this is so goes beyond our scope here. Nevertheless, the general principle is true: trade creates a great deal of value through mutually beneficial exchange. The bigger the trade network, the greater the opportunity for everyone to benefit.
Division of labor and trade built on each other. Division of labor, and then mechanization, led to greater productivity. People were drawn into close proximity (urbanization) to participate in the new production facilities, thereby creating larger communities. There was increased demand for transportation infrastructure that would move raw materials in and finished goods out, as well demand for better local transportation. Large concentrated communities facilitated trade as did infrastructure that connected communities together. With greater trade came greater demand for products motivating producers to become even more productive through specialization and mechanization. And so the cycle was created.
(* Illustration is from Jay Richards.)