3. Division of Labor and Economies of Scale

Trading goods and services in the free market can make both buyers and sellers better off. Trade arises when different economic agents specialize in the production of different goods and services. Such specialization is also called division of labor.

Imagine a pre-industrial, agricultural economy, where everyone owns a farm. One way this economy could work is if everyone produced all the food, clothing, farm equipment and everything else that they needed. But that would be inefficient. If each person needs to do lots of different tasks, they will not be equally good at all of them. That is because they will not have the right skills to do everything well, and they may never have the chance to spend enough time on any task to become truly expert at it. Someone who makes a pair of shoes once a year will never be an expert shoemaker.

Instead, efficiency improves if each household specializes in a task they know how to do well – and trades the resulting product with other households. The shoemaker makes shoes, the fisherman catches fish, and the tailor makes clothes. The economy produces better-quality products and everyone benefits.

Industrial societies took the division of labor even further as many goods became too complex to be produced by a single person. In the 18th century, Adam Smith described a factory that subdivided the production of a metal pin into 18 separate tasks. He claimed that if each worker performed all the tasks from start to finish, they would only manage to make one pin a day. But by asking different workers to specialize in different tasks, the factory produced many more pins than they would have otherwise.

Now, once a firm specialized in the production of certain goods and/or services and subdivided the production process into separate tasks, the next crucial determinant for its output is its size. While the manager of a small firm might be able to distribute tasks to workers in the most efficient manner, the firm will often not be able to produce as cheaply as its bigger competitors. This has to do with a concept called economies of scale, which describes the technological or cost advantages of large-scale production, something that can be observed in many industries.

Economies of scale arise when the firm’s production cost per unit falls as the total quantity produced rises. For example, a large industrial oven can bake more loaves of bread, with a lower cost of production per loaf, than a small oven at an artisanal bakery. This can make it more difficult for small firms to penetrate existing markets and forces them to make their products stand out through different methods.