Gains from specialization and division of labor
Businesses can achieve higher output levels and greater productivity from their workers through specialization and division of labor. More than 200 years ago, Adam Smith noted the importance of this factor. Observing the operation of a pin manufacturer, Smith noted that when each worker specialized in a separate function needed to make pins, 10 workers together were able to produce 48,000 pins per day, or 4,800 pins per worker. Smith doubted an individual worker could produce even 20 pins per day working alone from start to finish on each pin.
The division of labor separates production tasks into a series of related operations. Each worker performs one or a few of perhaps hundreds of tasks necessary to produce something. This process makes it possible to assign different tasks to those individuals who are able to accomplish them most efficiently (that is, at the lowest cost). Furthermore, a worker who specializes in just one narrow area becomes more experienced and more skilled in that task over time.
Trading partners can also benefit from specialization and the division of labor. The law of comparative advantage developed in the early 1800s by the great English economist David Ricardo, explains why this is true. The law of comparative advantage states that the total output of a group of individuals, an entire economy, or a group of nations will be greatest when the output of each good is produced by the person (or firm) with the lowest opportunity cost.
Comparative advantage applies to trade among individuals, business firms, regions, and even nations. When trading partners are able to use more of their time and resources to produce the things each is best at, they will be able to produce more together than would otherwise have been possible. In turn, the mutual gains they get from trading will result in higher levels of income for each. It’s a win-win situation for both.
If a good or service can be obtained more economically through trade, it makes sense to get it that way rather than producing it for yourself. For example, even though most doctors might be good at record keeping and arranging appointments, it’s generally better for them to hire someone to perform these services for them. That’s because the time doctors spend keeping records is time they could have spent seeing patients. The revenue forgone as a result of seeing fewer patients would be greater than the cost of hiring the worker. The issue is not whether doctors are better record keepers than the assistants they could hire, but rather how they should use their time most efficiently.
If you think about it, the law of comparative advantage is common sense. If someone else is willing to supply you with a good at a lower cost than you can produce it yourself, doesn’t it make sense to trade for it and use your time and resources to produce more of the things you can produce most efficiently? Consider the situation of Andrea, an attorney who earns $100 per hour providing legal services. She has several documents that need to be typed, and she is thinking about hiring a typist earning $15 per hour to do it. Andrea is an excellent typist, much faster than the prospective employee. She could do the job in 20 hours, whereas the typist would take 40 hours.
Because of her greater typing speed, some might think Andrea should handle the job herself. This is not the case. If she types the documents, the job will cost her $2,000-the opportunity cost of 20 hours of practicing law at $100 per hour. Alternatively, the cost of having the documents typed by the typist is only $600 (40 hours at $15 per hour). Andrea’s comparative advantage lies in practicing law. By hiring the typist, she will increase her own productivity and make more money.
The implications of the law of comparative advantage are universal. Any group will be able to produce more output from its available resources when each good or service is produced by the person with the lowest opportunity cost. This insight is particularly important in understanding the way a market economy works. Purposeful decision making indicates that buyers will try to get the most for their money. They will not knowingly choose a high-cost option when a lower-cost alternative is available. This places low-cost suppliers at a competitive advantage. Thus, they will generally survive and prosper in a market economy. As a result, the production of goods and resources will naturally tend to be allocated according to comparative advantage.
Most people recognize that Americans benefit from trade among the nation’s 50 states. For example, the residents of Nebraska and Florida are able to produce a larger joint output and achieve higher income levels when Nebraskans specialize in producing wheat and other grain products, and Floridians specialize in producing oranges and other citrus products. The same is true for trade among nations. Like Nebraskans and Floridians, people in different nations will be better off if they specialize in the goods and services they can produce at a low cost and trade them for goods they produce at a high cost.
Strategic Options (Real Options)
Thinking of project option features in capital budgeting is essential. For example, firms have A real option depends not on an underlying financial asset (such as a stock), but on an underlying real asset.
the ability to shut down production if the market price of their output product were to fall. That is, a project that allows management to curtail production when it is unprofitable is the equivalent of a call option with a strike price that depends on the price of the output good. Such options are called real options, because their exercise depends on the value of “real” assets, rather than on the value of financial assets. The house with a mortgage was a real option.
If the base asset is a stock price in the future, we know the underlying stock price today and that the rate of return until expiration is roughly normally distributed. If the underlying base asset value (e.g., the house or the firm’s output product or the firm’s input product [e.g., gold or oil]) is similarly roughly normally distributed, we can even use the Black-Scholes formula to value the derivative asset. Doing so replaces the need to estimate the appropriate cost of capital, E ( r ), on the project with the need to estimate the variance, σ ( r ). (Usually, estimating volatility is easier and more reliable.)
However, the most important aspect of real options is to recognize their presence, not the method of valuation. Whether the B-S Formula is used to avoid estimating the appropriate cost of capital, or a CAPM type formula with an expected cash flow estimate is used to obtain the appropriate cost of capital, is of relatively less importance. The big mistakes that managers often commit is that they fail to value the real option at all.