South-Western College Publishing - Economics  

The Wealth of Nations, Part II
Subject Economic Development
Topic(s) Economic Fundamentals
Key Words Specialization, Division of Labor, Diminishing Returns
News Story

Why some nations are rich and others poor has been of on-going interest for economists. In 1776 Adam Smith published An Inquiry Into the Nature and Causes of the Wealth of Nations. Smith, writing at the height of the Industrial Revolution, focused on free markets and the division of labor. Other economists, writing after Smith, have argued that a regionís natural endowments were of primary importance. Still others have focused on institutional and human factors including business, social and political leadership. Two recent studies, one by Jeffrey Sachs and John Luke Gallup, and the other by Paul Krugman, have set forth new theories.

Sachs and Gallup believe that weather and access to a navigable waterway accounts for 50% of the income gap between rich and poor countries. Countries grow wealthy by specializing in the production of a few goods and then trading the surplus product for goods produced in other countries. Trade, at least historically, has meant location near a port or river. Firms attracted to port locations will induce concentrations of workers, providing still further reasons for firms to concentrate in certain locations, thus creating additional wealth. According to Sachs and Gallup, a favorable climate increases productivity and provides protection against the chances of severe disease. The combination of good weather and favorable location translates into higher income.

Another economist, Paul Krugman, noted widening gaps not only between but also within countries. Krugman focused on economic processes like economies of scale to explain the concentration of economic activity in certain areas of a country. However, Krugmanís models show that the process may be self-correcting. Beyond a point, diminishing returns--in the form of congestion and high real estate prices--set in, causing more rural areas to have a competitive advantage.

What are the implications of these findings for economic policy? Sachs and Gallupís findings suggest that policies such as deregulation and free trade advocated by the World Bank cannot be completely effective. Krugmanís arguments suggest that there is a role for economic planning as a means of boosting a countryís economy.

Questions
  1. Explain the terms division of labor and economic specialization.
  2. How does a country gain from specialization and trade? What are these gains?
  3. Using a production-possibility curve illustrate the impact of an improvement in technology. Illustrate the possible advantage that a country might gain from trade.
Source Steven Pearlstein, "Tropical and Landlocked Make a Poor Combination" The Washington Post, April 23, 1998.

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