Dr. P.V. Viswanath

pviswanath@pace.edu

Why trade is good for you

Oct 1st 1998, The Economist

A short tour of economic theory

ECONOMISTS are usually accused of three sins: an inability to agree among themselves; stating the obvious; and giving bad advice. In the field of international trade, they would be right to plead not guilty to all three. If there is one proposition with which virtually all economists agree, it is that free trade is almost always better than protection. Yet the underlying theory is not readily understood by non-economists. And the advice that follows from it—protection does not pay—is seldom wrong.

The argument for free trade is based on the theory of comparative advantage. This is one of the oldest theories in economics, usually ascribed to David Ricardo, an Englishman who wrote in the early 19th century. To see how it works, imagine two countries, East and West, which both produce two kinds of goods, bicycles and wheat. In a year, an Eastern worker can make two bikes or grow four bushels of wheat. A Westerner, however, can manage only one bushel or one bike. Each country has 100 workers, and initially both of their workforces are split evenly between the two industries. So East produces 200 bushels of wheat and 100 bicycles, whereas West produces 50 bushels and 50 bikes (see table 3). Since East can produce both wheat and bicycles more cheaply than West, it has an absolute advantage in both industries. Even so, Easterners will benefit from trading with Westerners. This is because East is relatively more efficient at growing wheat, where it is four times as productive as West, than it is at making bikes, where it is only twice as productive. In other words, it has a comparative advantage in wheat. At the same time, West has a comparative advantage in making bikes, even though it has no absolute advantage in anything.

According to Ricardo’s theory, both countries will be better off if each specialises in the industry where it has a comparative advantage, and if the two trade with one another. Specialisation increases world output. Suppose that East specialises in wheat growing, shifting ten workers from its bicycle factories to its fields, and producing 240 bushels and 80 bikes. West moves 25 workers from wheat farming into bike making, where its comparative advantage lies, and produces 75 bikes and 25 bushels. Global production rises (see second panel).

The point of economic activity, however, is not to produce but to consume. Both countries can enjoy more bikes and more wheat if they trade on terms at which both will gain. If East is going to import bikes, it will pay no more than two bushels in return (faced with a higher price, it would be better off moving workers back to the bike factory). Similarly, West will pay no more than one bike per bushel. Suppose that the “terms of trade”, as economists call the ratio of export to import prices, are set at one-and-a-half bushels per bicycle, and that 33 bushels are traded for 22 bikes. The result (third panel) is that both countries are better off.

In essence, the theory of comparative advantage says that it pays countries to trade because they are different. West’s relative deficiency in bike manufacture is less than in wheat farming. It is impossible for a country to have no comparative advantage in anything. It may be the least efficient at everything, but it will still have a comparative advantage in the industry in which it is relatively least bad. And even if a country were the most efficient in every industry, giving it an absolute advantage in everything, it could not have a comparative advantage in everything. In some industries, its margin would be more impressive than in others.

Economists’ next argument for free trade is that opening up markets to foreign suppliers increases competition. Without free trade, domestic companies may have enjoyed monopolies or oligopolies that enabled them to keep prices well above marginal costs. Trade liberalisation will undermine that market power. Competition should also spur domestic companies to greater efficiency because they will not be able to pass on the costs of slackness in higher prices.

In addition, free trade means that firms are no longer limited by the size of their home country, but can sell into bigger markets. In industries where average production costs fall as output increases, producing economies of scale, this means lower costs and prices. In such industries, trade also increases the variety of products on offer. If a car manufacturer, say, were limited to its home market, it would have a choice between producing small quantities of a number of models and large quantities of just a few, which could be produced more cheaply thanks to economies of scale. But given free trade, it would be able to produce more models because they could all be produced in large enough numbers.

All these arguments revolve around re-allocating resources to produce one-off improvements—what economists call the “static” gains from trade. But they think there are also “dynamic” gains to be had: freer trade can mean faster economic growth.

In recent years, theories of economic growth have become much more sophisticated. Although economists have long realised that productivity growth is a prime determinant of general economic growth, models of growth in the past made no attempt to explain productivity growth, but assumed that it was “exogenous” (caused by outside factors). Modern “endogenous” growth theories, however, do try to explain productivity growth.

Freer trade can play a part in this in a number of ways. For one, by making markets bigger it creates more scope for “learning by doing”—ie, for firms to become more efficient with repetition. Larger markets also offer bigger incentives for firms to invest in research and development. Moreover, trade disseminates knowledge and technology. Simply by participating in international markets, countries are exposed to other countries’ techniques, and have an incentive to copy and improve on them.

All this can make the relationship between trade, technology and growth quite complicated. For example, freer trade does not necessarily mean faster growth all the time. If a country’s comparative advantage lies in slow-growing, traditional industries, it may cut back its production in other, faster-growing industries, so its growth rate may fall. But later on it will benefit from the technical advances of countries with a comparative advantage in faster-growing industries, which will give it better computers, more advanced drugs and so forth than if every country had tried to make everything for itself. Slower growth in the short run might therefore be balanced by faster growth in the long term.

Pinning down the link between freer trade and growth is not easy. One problem is how to measure the openness of a country’s trade policy: trade barriers can take many different forms. Even so, there is good reason to believe that freer trade and faster growth generally go together.

Exceptions that prove the rule
So is free trade always the best policy? Not quite. One well-known exception is the “optimal tariff” imposed by countries that are big enough to exert an influence on the world prices of the goods they trade. By raising tariffs, they can significantly reduce world demand, cutting the world price of the good and tilting the terms of trade in their favour.

A second example, which came to prominence in the 1980s, is “strategic trade policy”. In an industry with economies of scale, the imposition of a tariff, by reserving the home market for a domestic firm, allows the firm to cut its costs and, with luck, to undercut foreign rivals in overseas markets. Economists and politicians reckon that this might work in civil aircraft, semiconductors and cars.

However, it is rare for governments to be powerful enough to set optimal tariffs—and even rarer for them to have enough information to do so with pinpoint accuracy. They would need to be able to recognise a likely business proposition, and get their maths absolutely right. Even then, rival countries could follow suit, leaving them all worse off.

Questions:

1. What are the advantages of free trade, according to economists?
2. How does the possibility of factor mobility affect the theory of comparative advantage?
3. How does the advent of the multinational corporation impact the theory of comparative advantage? Is it possible to reconcile the theory with multinational corporations?