A pencil is disposable. If you drop one on the floor, you may well let it roll away without thinking twice. But what it takes to make a pencil, considered closely, is awe-inspiring. What’s even more awe-inspiring is that almost everything in the economy is the result of this kind of near-miraculous economic coordination.

This division of labor creates substantial economic gains, both at the level of a firm that’s producing a good and at the level of a national economy. How does it do that?

Division of labor allows workers to focus on the things they are best suited to do and allows firms to take best advantage of local resources. If you run an ice-cream business, odds are the person who designs the labels won’t be the same person who tends the dairy cattle. Similarly, you may be able to raise dairy cows in Wisconsin, but you’ll need a warmer climate to grow your sugar. Bringing the right workers and the right resources from many locations means more productivity.

Workers who specialize typically become more productive with practice. In the automobile manufacturing business, assembly line workers are often the best at coming up with new ways to perform their tasks. When receiving a service, we all want an experienced and specialized person for the job, whether we’re looking for a doctor or a hairdresser. Some organizations develop specializations, too. Firms that focus on one or just a few “core competencies,” as they are called, often do better jobs than firms that try to do everything.

Division of labor allows a firm to take advantage of economies of scale. “Economies of scale” is the jargon for saying that, in certain cases, a larger firm can produce at a lower average cost than a smaller firm. A tiny factory that produces only one hundred cars a year will have much larger production costs per car than a factory making ten thousand cars, which can take advantage of specialization and assembly line production. The concept of economies of scale helps make sense of how the world works. Without economies of scale, every little city and town would have tiny little factories for making very small numbers of cars, refrigerators, clothing, and other products. But in a world that takes advantage of economies of scale, regions produce one kind of thing in large numbers and trade with other regions that produce something else. The division of labor doesn’t happen only within a firm; it happens also within economies and even across countries. For example, auto manufacturing is not spread evenly across the United States, but happens mostly in a north–south corridor reaching from Michigan to Alabama.

A high-income economy typically has a greater division of labor than a low-income economy. The average citizen of a wealthy nation doesn’t need to know anything about, say, electronics or weaving or dairy farming. You don’t need the knowledge or the skills to produce everything you need because specialization and trade provide access to smartphones and cheddar cheese. Instead, you can buy goods that embody all that different knowledge, and then you pay for those goods by working at a highly specialized job of your own. The economy is the social mechanism that coordinates this extraordinary division of labor. As the economist Robert Heilbroner (1968 [2009], p. 2) once wrote:

Division of labor increases production in firms, national economies, and the global economy. Nations, like workers or firms, can develop specialized skills and expertise. One recent major trend in world trade is sometimes called “breaking up the value chain”—meaning that the parts of production are becoming more widely separated. People sometimes talk about “American cars” or “Japanese cars,” a distinction that used to make sense, because just about all the parts of those cars were made in America or Japan. Today, the seat cover for a car might be made in one nation, its inner springs in another, and the parts installed in yet a third place. The parts move back and forth across national borders so frequently that there may be no clear answer to the question of where the car was made. If America wants to take advantage of division of labor, we don’t want to focus on undertaking every step of production ourselves. There are, of course, complex issues of both gains and losses involved in international trade, which we’ll look at in depth later. But on the whole, division of labor—in which every nation specializes in certain goods and even certain services—can make all parties better off.

One useful metaphor for understanding an economy with a high division of labor is to imagine that all the goods produced by an entire economy could be collected in one storehouse. When you produce something, you bring it in the front door. When you want to consume something, you go around to the back door to pick it up. The division of labor means we’re all producing different things and bringing them to the storehouse, and so a problem arises: The stuff that goes in the storehouse needs to be the same as what comes out of the storehouse. It would be pointless to produce or store products that no one ever used or that had no particular function, and you’d want to avoid a situation in which lots of people were waiting at the back door of the storehouse for something that wasn’t available.

So how can we coordinate what goes in and what comes out of the storehouse? Unfortunately, the honor system is not a practical solution. Think about what happens in a dormitory refrigerator. If a dorm has a common fridge, you put things in and you hope that everyone will replace what they’ve used and that you’ll always have milk for your morning (or midnight) coffee. But as anyone who has opened a common fridge to find it full of sour milk and stale pizza knows, this never works in a dormitory. It won’t work well in the economy at large, either.

A society needs a system for placing value on what people bring to the storehouse and what they take out, as well as some way to link the two. If somebody brings a product to the storehouse that nobody wants, it won’t have any value. If someone brings something to the storehouse and there’s already a lot of it in there and no one wants much of it, then its value will be small. Conversely, if someone brings something to the storehouse that people are eager to have and there’s hardly any of it available, then that product will have a higher value.

In a market economy, the value of what goes into and comes out of the storehouse is determined by supply and demand. The value of a product in a market economy is its price—and paying a price for goods offers an incentive for people to make careful choices about what they take out of the storehouse and not to take more than they will actually consume. The value of labor in a market economy is shown by the wage or salary that is paid, which in turn provides an incentive to provide goods and services that are valuable to others. The price mechanism and those forces of supply and demand—which will be the focus of the next chapter—are how a market economy coordinates the division of labor and matches up what goes into the great storehouse of the economy and what comes out the other end. Of course, the storehouse metaphor is limited. It doesn’t take into account issues such as fairness, poverty, pollution, taxes, or regulation. We’ll discuss these issues and others later.

In theory, decisions about what is brought in and what’s taken out of the storehouse could be made by the interactions of individuals in markets, or by government, or by some combination of the two. But in any case, every society has to answer those three basic questions of economics: What is made? How is it made? Who is going to consume it?

A decentralized market economy, with its division of labor, works so marvelously well at providing a wide array of goods and services that, for practical purposes, people in high-income countries often take it for granted. One sometimes hears about people who come from places without market-oriented economies, where government rations most goods and where the variety and price of what is available in the stores is dismal. When those people stand in the aisle of a modern supermarket or giant retail store in a high-income country, they gape in wonder. One part of economics is to understand and analyze—and maybe marvel at just a bit—the feats of coordination that a market-oriented economy accomplishes every day.