Chapter 63: Free trade (3.1)
International issues are amongst the most controversial and divisive in economics but I dare say that the majority of economists agree that trade and international exchange has been one of the most beneficial economic endeavours in humankind. Most economists view trade – more specifically free and fair trade – as one of the prime determinants of increased living standards in the world. Trade is good. Yet in spite of the benefits of trade having time and again proven to far outweigh costs, a good many interest groups will look upon my statement as highly political and therefore inappropriate to put into a school textbook.
However, my defence of the statement ‘Trade is good’ is not founded in a political standpoint but an economic standpoint whereas a good deal of the anti-trade rhetoric supporting statements such as ‘Trade creates unemployment’ is often erroneous and indeed sometimes nothing else but cheap political point-winning. A good deal of this section and the next will attempt to define ‘good’ in as measurable economic terms as possible. Then I leave it to you, the economist, to deliberate whether the statement is normative or positive – and right or wrong.
The core of international economics is comprised of issues which arise when independent nations interact in order to conduct economic transactions such as trade and foreign investment. The topics looked at here centre on the reasons for and benefits of trade; why protectionism exists; trade patterns and economic integration; the balance of payments; exchange rates; and the terms under which nations trade.
Ek Chuah, God of Trade, Tulum, Mexico. (circa 5th century AD)
- Why we trade
On the shelves around me here in my office/classroom as I write this sentence one finds a bowl of bananas (Mexico), a thermos of coffee (Colombia/Kenya/Nicaragua), cigars (Cuba) and sugar (Denmark) – basically all the major food groups needed by writers. I also have a mobile phone, two computers, a hand-held computer, a USB memory stick and about 150 books on economics. With the exception of the bananas and my manta ray boots[1], very little has actually been produced here at home, yet here I am, happily eating a banana and sipping sweet coffee in anticipation of my evening cigar.[2] At the same time, my editor in Australia, Rory, is using silver from Mexican minesto frame his ‘Economics Textbook of the Year’ award. This must mean that someone in Tegucigalpa, Honduras, is walking to work wearing a pair of kangaroo skin boots – since my bananas didn’t come from Australia but Honduras. In effect, the Mexicans sent silver to the Australians in exchange for boots, and used the Australian boots to trade for Honduran bananas. No, wait: the Aussies used Australian dollars (AUD) to buy Mexican pesos (MXN) with which they then bought silver; the Mexicans used the Australian dollars to buy Honduran Lempira (HNL) and then bananas; and the Hondurans exhanged the Lempira to get Australian dollars and R. M. Williams boots.
Now each country has a pile of foreign currency to be used at will. Mexicans on their way to The Great Barrier Reef in Australia can get some AUD at the airport in Toluca; a Honduran steel business can buy MXN at the bank in order to purchase steel rolling machines from ArcelorMital in Mexico; and when Rory gets fed up with editing silly footnotes in economics textbookshe can buy HNL at the exchange office to import goods from Honduras and start a Things Honduran shop in Cunnamulla. This is an example of, respectively, trade in services, capital and goods. This silly example introduces five key reasons for trade;
- Countries can traderesources which are not available at home.
- Increased competition leads to lower prices, better quality goods and innovation.
- Countries can specialise and achieve lower costs due to economies of scale.
- Trading nations will be able to consume outside their own PPF. (See HL concept of comparative advantage in Chapter 64.)
- Increased trade leads to growth, development and a possible peace dividend.
FACTOR ENDOWMENT – SWEDISH BALL BEARINGS AND HONDURAN BANANAS
The triangle of trade above shows a most basic economic fact that is all too often lost in the debate; the only way Mexicans can visit the Great Barrier Reef is by trading some silver. (Or rather, since most tourists don’t produce silver themselves, they will use a domestic ‘silver certificate’ – MXN – which Australians will accept in order to buy silver and boots from Mexico.) Why do we trade instead of producing everything domestically?
Simple; growing bananas in my home country of Sweden would be only slightly more ludicrous than having herds of kangaroos in Kiruna in northern Sweden.[3] In a similar vein, the cigars on my desk are from Cuba but could just as easily have come from Nicaragua, Mexico, the Dominican Republic or 20 other countries. In fact, increasingly, my cigars are from Mexico and Honduras – but none of them are from Sweden, Norway or Finland.
You get the picture. Part of the answer lies in each country’s factor endowment (= ‘gift’) in land – i.e. soil and climate – labour and capital. Honduras is perfect for banana cultivation and has abundant labour; Sweden has a 500 year history of producing industrial steel and invented the ball bearing; and Australia has kangaroos. The argument just put forward is easy to understand; each country has an abundance of certain factors of production which the others do not. This is the simple argument. A slightly more advanced argument is that the trading which takes place in different goods arises from a difference in the relativefactor endowment of land in each country. Sweden could (and indeed did) grow tobacco and manufacture cigars, but would give up a great deal of resources in doing so, thus forgoing a great many SKF ball bearings which could be used to pay for an even higher quantity of Honduran cigars.
Countries are differently endowed with the factors labour and capital and will therefore have different cost ratios in the use of these factors; the higher the relative abundance of labour compared to capital, the lower the labour costs. Honduras has far more labour relative to capital while Sweden has the reverse situation. This is reflected in the domestic cost ratios for capital; Sweden is a most technologically advanced nation with very high labour costs while Honduras is a developing nation with low labour costs. The cost of using labour – relative to capital – will be much higher in Sweden than in Honduras. Honduras will therefore be far more likely to utilise labour in its production than capital and vice versa in Sweden.
VARIETY AND QUALITY OF GOODS – CARS AND KNIVES
Why is it then that so much trade takes place between countries with similar factor endowments?! The ball bearings in the previous example could just as soon be produced in any of the three which would mean that Swedish, Honduran and Australian ball bearingscould be exported and co-exist on each of the countries’ shelves. Germany and France share a common border and make thousands of similar products; France makes Sabatiér kitchen knives and Renault cars while Germany makes Zwilling Henkel kitchen knives and VW cars, for example. Why would France produce cars for export and then use the money to import cars from Germany? Resource endowment can hardly explain it and labour costs are higher in France than in Germany!
Consumer preference theory and non-price theories of trade (similar to non-price theories done by HL in Chapters 32 and 33) suggest that consumers desire choice and diversity of products, and the theory of non-price competition adds that consumers are willing to pay a premium for this benefit. Branded goods such as Adidas shoes (Germany), Toyota automobiles (Japan) and Nokia phones will be sold in countries which might well have domestic producers of the same goods, i.e. close substitutes. But a pair of Adidas is not the same as a pair of Brookes; a Toyota is not the same as an Audi; and a Nokia phone is not the same as a Sony-Ericsson. Firms continuously attempt to enhance their products’ non-homogeneity via marketing, so such goods are all competing for our ‘allegiance’ to a brand and the intangible benefits for the consumer that go with that consumption. Whatever the underlying reasons, it is quite clear that most of the growth in trade deals with intra-industry trade (= trade in same-industry goods), which now comprises between 60% and 70% of all trade in North America and in the EU.[4]
GAINS FROM SPECIALISATION - ECONOMIES OF SCALE
Trade is a transaction where two parties exchange goods and both feel better off – or as John Mill put it as early as in 1821; ‘The benefit which is derived from exchanging one commodity for another, arises, in all cases, from the commodity received, not the commodity given.’[5] Two main features of trade that I try to put across to my people at an early stage are;
1) Trade has nothing to do with country borders
2) If a voluntary exchange takes place, then both parties have benefited – i.e. a ‘win-win’ situation rather than ‘win-lose’.[6]
Trade is an economic activity that takes place between villagers in the village; between the villages in the countryside; and between the city and the countryside. I don’t produce cigars or boots but I am an enthusiastic consumer of both. The way I am able to do this is by specialising in something I do reasonably well; warp young fragile minds with economics. The value placed on this earns me ‘cigar/boot’ certificates – which other producers (‘specialists’) accept as payment. Whether these producers are domestic or foreign is really beside the point.[7] Just view the economy as a firm or village, where tasks are allocated according to what each person does best and division of labour is utilised. Now expand this to include a neighbouring country. Adam Smith said it brilliantly in Wealth of Nations; ‘The division of labour is limited only by the extent of the market’.[8] Drawing a line in the sand and sticking different flags on either side does not diminish the validity of Smith’s statement. Trade gives producers a larger arena and the possibility of being manufactured within scale economies while consumers enjoy a far greater range of goods.
Caption: “Impossible!”
CONSUMPTION GAINS – EVERYBODY IS OUTSIDE THEIR OWN PPF!
Few, if any, of the present high income countries in the world would be where they are today without trade. It would be impossible for any single country to produce all the goods desired using domestic resources alone. Perhaps you are holding a ballpoint pen in your hand as you read this. Imagine the countless chemicals and materials that went into making such a simple (?) instrument; oil to produce plastic and dye, the many compounds in the ink, the chromium and steel for the nib (= point)….etc. Furthermore, consider all the machines involved in producing the raw materials….and the machines to make the machines that produce raw materials…. I venture to claim that few economies could produce a simple ball point pen based entirely on domestic resources. A single person would not live long enough to be able to produce the pen all alone. The solution is specialisation and trade.
PRODUCTIVITY GAINS AND GROWTH – MORE FOR ALL
An addendum to the static gains (of trade) in the above trade examples is the long run issue of the effects of specialisation and economies of scale. It is fairly safe to assume that an economy focused on a relatively narrow range of goods would over a period of time ‘move up the learning curve’, i.e. enjoy the benefits of increasedproductivity due to experience and innovations in production.
Even a country which has little in the way of domestic resources will benefit from specialisation due to ultimately hitting economies of scale, i.e. where the costs per unit (average costs) fall considerably as output increases. Just think of Japan and its specialisation in, amongst other areas, automobiles for the past 40 years. The production cost of each car has fallen in inflation adjusted terms throughout the time period. The Japanese have quite clearly shown that specialisation indeed increases productivity and lowers average costs over time.
Open markets, increased trade, increasing specialisation and benefits of scale all help to explain the astounding increase in the proportion of goods manufactured solely for export purposes. Figure 63.1 following illustrates how more and more of what is produced is subsequently sold on foreign markets; in the past 50 years world (real) GDP has increased by 500% while exports have increased by over 1,600% – over three times as much. During this period, the ratio of exports to GDP in the world rose from 7% to 15%.[9]
Figure 63.1 Trends in World merchandise exports and GDP, 1970 – 2003
(Source: Dept of Finance Canada at could we make the words Merchandise Exports and its graph line blue, world GDP in red?)
The graphs in figure 63.1 have a remarkably powerful message attached, once you start to think about it. Any export must mean corresponding imports. As the increase in exports/imports far outstrips the increase in real GDP, then an ever-increasing proportion of world consumption expenditure – and therefore corresponding income – comes from trade. The powerful message is that the largest increase in world trade which the world has ever known coincides with the highest rate of increase in living standards in human history; the past 30 years. This makes it very difficult indeed to claim anything other than that trade adds to income and resulting prosperity and welfare. If a country does well it will not ‘harm’ other countries it trades with – it will instead benefit them with more/cheaper/better goods. International trade is not a zero-sum game.[10]
POLITICAL GAINS - AND A PEACE DIVIDEND
"A day will come when we will see these two huge groups, the United States of America and the United States of Europe, standing face to face, clasping hands across the seas, exchanging their products, their business, their industry". Victor Hugo.
Just as Adam Smith claimed, integration and larger markets have meant economic growth. Not only via benefits of scale, but by the transfer of technology, new ideas and production methods. Trade and the many associated activities are ultimately conducted by people; foreign workers, companies and ownership will all add to trading nations’ fixed and labour capital as people exchange ideas and interact to become more efficient. In this process, there will naturally be clashes of cultures, norms and traditions, but also learning, understanding, acceptance and interdependence. People who are dependent on each other are highly unlikely to wage war against each other.[11] This is not a novel insight but something that nations have been aware of for centuries. Perhaps Guy Tozzoli, a famous trade and peace advocate who founded the World Trade Centers Association with members in over 100 countries, put it best: ''When you're promoting business, you're promoting peace. Because when I understand your aims and your culture, I don't have any reason to declare war on you, and instead we work together. If we're doing business together, we're not going to fight each other because if I owe you money, you're not going to shoot me.''[12]
DEVELOPMENT – AND LACK HEREOF
An additional area where trade has proven highly beneficial to economies is within development. There is increasing evidence that open economies and increased trade has the highest rate of return of all development strategies. In 2003, Horst Köhler and James Wolfensohn (then Managing Director of the IMF and president of the World Bank, respectively) put it most explicitly; ‘Expanding trade by collectively reducing barriers [to trade] is the most powerful tool that countries, working together, can deploy to reduce poverty and raise living standards.’[13]A paper from the IMF in 2010 puts in even starker terms: Lack of integration into the global economy is a major factor in the continued underdevelopmentof the poorest countries.[14]
- The World Trade Organisation
"As the average age in the agricultural sector is so high (above 60) we are just waiting for them to die off." Chief Economist of the WTO, Patrick Low, when asked by one of my former students, Eric Blomquist, what the WTO was planning to do about the problem of agricultural subsidies and the CAP.