Tuesday, February 10, 2004

Fisking on Free Trade and Comparative Advantage

For the ECO 499 Seminar on Globalization, I thought I would fisk one of the readings. From the CPE their article on trade and comparative advantage can be found here.

They get the basic outline of comparative advantage correct, but they go awry when critiquing it. Let's look at their first critique.

First, consider what happens if the Poors open their borders to free trade - all the bean producers go out of business because of import competition (remember, the Poors are now producing only rice because of their comparative advantage). Instead of resources simply being switched to rice production, workers get laid off and the land goes idle. All of the gains from trade could be outweighed by the costs of unemployment and less domestic production. In order to get around this problem, the theory of comparative advantage assumes full employment -that NO UNEMPLOYMENT EXISTS, hardly a realistic assumption for most economies.

Ricardo's model was one of the first general equilibrium models, used to predict the sectoral distribution of resources when at full employment. He showed that consumption could be increased beyond what is possible from only domestic production. The model does not deal with nor was it intended to deal with the dynamics of the shift, rather it was only meant to analyze the starting and ending equilibrium points. Arnold Kling says it better here.

Second, in the process of specialization, comparative advantage assumes that everything used in one type of production can be automatically re-deployed to another type of production. In other words, the skills of workers are instantly transferable from one type of production to the other, the same machinery and equipment are used, and the same inputs. The theory ignores the fact that, often, when switching from one type of production to another, workers need to be re-trained and new investment in different types of equipment needs to be made. All of this costs resources -costs that can reduce the gains from trade. The theory of comparative advantage assumes that RESOURCES ARE PERFECT SUBSTITUTES.

While the math works out easier if one assumes constant opportunity costs (inputs are perfect substitutes), it is not required to achieve the results of comparative advantage. The fundamental insight of comparative advantage is that shifting production to something you are RELATIVELY better at, and trading away the extra production at a different rate then you previously did domestically, will allow you to consume more of both goods than would be possible without trade. Note that specialization need not be complete, in fact if opportunity costs are increasing then specialization will likely not be complete, but there will still be gains from trade. It is true that there are switching costs, but it is hard to believe that one time switching costs can possibly outweigh the present discounted value of all future gains that would be experienced by all future generations. See Delong here.

Finally, the theory of comparative advantage assumes that producers don't move between countries. Therefore, the beans producers in the country of Richies can't move all their production to the Poors, Meagers, or Brokens. While this might seem reasonable if we're talking only about rice and beans (due to climate variations, etc), it doesn't make as much sense when we are discussing shoes and automobiles. Therefore, the theory assumes FREE MOVEMENT OF GOODS AND SERVICES, but at the same time it assumes NO FREE MOVEMENT OF PRODUCTION. This unrealistic assumption greatly compromises the theory.

Really...How? Notice they just leave that dangling, because in fact they are wrong. This argument has recently been used by people from very different political perspectives. Democratic Senator Chuck Schumer and Conservative pundit Craig Richards have been hammered here and it has been more thoroughly debunked here. Remember that Ricardo's was the Labor theory of Value, the traded goods merely represent the labor units that produced them. Trading the goods is the same as trading the labor which produced them. So we would trade labor until the relative price (terms of trade) in each country were exactly the same, eliminating the need for them to trade the goods that were then produced. That is a bit tedious (moving labor), but fundamentally the same as trading the goods.

All of these factors aren't unique to the United States. Other countries could develop such potential as well. The advantage the United States has in trade might be more accurately described as a constructed advantage -instead of some sort of natural superiority. The export-led development of countries like Taiwan, South Korea, and Singapore have been based on a type of constructed advantage, where government intervention built up and protected industries until they could compete on a world scale. The idea of constructed advantage can be an important part of what's been called 'fair trade,' an alternative to free trade that preserves the advantages of trade while protecting other features and capabilities important to communities, such as labor and the environment.

Suddenly I think they don't understand comparative advantage at all. There is no constructing it. It is simply a mathematical fact. Let me give you a classic example without the math: Lets say that I'm both a better pitcher and a better short stop than you are. However, I'm a LOT better pitcher then you are relative to how much better of a short stop I am than you. So I have a comparative advantage in pitching, which immediate means by definition (think invert the ratio), you are a RELATIVELY better short stop. The only time this is not the case is when there is a tie, that is when I am exactly as much a better pitcher than you as I am a better short stop than you. In which case its a coin toss on which job I do, but whichever job I do it does not make the team better off than if we split time in the different positions. The same goes for trade, only when two countries have the same domestic terms of trade will they not benefit from trade with each other (actually there is an economic argument for gains from trade in this case, it utilizes the notion of economies of scale).

The theory of comparative advantage says nothing about who gets the 'gains from trade.' Even if you accept the assumptions of the principle of comparative advantage and believe that free trade raises total income of a country, there is nothing about the theory that indicates that everyone is automatically better off. These benefits could, instead, accrue only to business owners in the form of increased profits. Although there may be gains to be had, how they get distributed is a part of the political process, and there is the possibility that workers and communities could become worse off as a result.

Well, actually the theory does provide you with a way to think about the distribution of the gains, albeit with a very uninteresting conclusion. Since there is only one factor of production, labor, all the gains go to labor, and since the productivity of labor is the same for all units employed the gains are thus shared equally. If you want a richer model that incorporates more factors of productions and therefore provides a more interesting view of how the gains from trade are shared, I suggest you look at the Heckscher-Ohlin theory.

Why is this important? The inefficiencies that occur when restricting trade are small, so why do we care? For a look at one neoliberal's view of the benefits of trade in goods and financial capital read this. I'll give you a hint...small though the gains may be, compounded over time they have dramatic impacts on future generation's standard of living.

If all of this seems like gobblty gook, just ask yourself: Do I benefit from trade? If the answer is no, I suggest you go home and perform your own oil change, but remember that will involve drilling for the oil, by yourself in your backyard. The fact is that we have understood the beauty of specialization since the dawn of time (or trade as the case is here), why do lines on a map affect that most basic insight? And why would we want to let the *potential* for there to be some temporary losers, permanently impoversh us all?

Keywords: Trade, Comparative Advantage, ECO499


H.U. said...

I think the US situation (deteriorating economy) shows that the most "open free trade" economy in the world may not have accrued all the benefits as espoused by economists the world over. I am not biased towards or against either side but I have a balanced view and I know that in the real world "free trade" is not as perfect or as rosy as it is painted out to be.

As technology is enhanced exponentially and the cost of labour is cheap in countries like China and India even "knowledge" based industries like computer programming, accountancy will and are offshored to India since the cost of $2/hr sounds more appetising to a company than paying $30 or more /hr to a worker in the US. So it all comes down to cost. Now with the official collapse of Wall St, investment bankers with prestigious degrees and experience are lining up for jobs that are lower ranked than the ones they used to hold.

So transition costs i.e. of workers shifting industries have high costs attached to them e.g. mental and psychological and financial distress that cannot just simply written off as an "adjustment cost". We are dealing with people here for goodness sake!

This is a really well written article about a computer programmer's take on globalisation and free trade: http://www.gonewiththeworld.com/


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