Why Trade Is Critical to the Production of Wealth Evolution of Economic Theory: Traditional idea: Mercantilism (protectionism) believed best policy; still very popular Adam Smith (1776) explained the value of 1) the division of labor and 2) specialization of labor

Adam Smith and the Pin Factory

Evolution of Economic Knowledge Smith’s Pin Factory: One man can make one bad pin a day 10 men could make 48,000 pins a day 18 steps in production that exploits economies of scale What prevents the world from being covered in pins? The extent of the market. This helps explain some features of wealth creation, but there is more.

A Completely Original Concept David Ricardo (1817): Comparative Advantage The great economist, Paul Samuelson, was asked by a great mathematician at MIT to name a concept in social science that was both true and nontrivial. The answer: Comparative Advantage “Thousands of intelligent men … have never been able to grasp the doctrine … or to believe it after it was explained to them.”

Most People Cannot Comprehend It Poll of American Democrat voters: By margin: they agree that “free trade agreements have been a bad deal for the U.S.” Poll of American Republican voters: By margin: they agree that “free trade is a bad idea.” Poll of all American voters: 60% nationwide agreed with the statement that “foreign trade has been bad for the U.S. economy.”

To Understand a Complex Subject, Break It Down to the Simplest Level Consider the most basic economy: One man with two goods— he can only trade with himself. Then make it more complicated— two men trading two goods. The real world is very difficult to comprehend; models help us to understand the workings of complex trade.

The first modern novel in English based on a true story (like this lecture):

A Side Note: What was he doing there?

The Island Today

No Man Is an Island Crusoe stranded alone on an island for years. Presume Crusoe spends his time making breadfruit bread (BB) loaves and cups of coconut milk (CM). He has ability to produce these as seen on the production possibility curve. Maybe he eats a balanced diet of 25 CM and 5 BB a week. Crusoe’s weekly Production Possibility BB CM

Crusoe Meets Competent Friday Friday, living on other side of island, same resources, also makes BB and CM, but is more productive. Why? Both work hard every day. Friday also produces BB and CM. He eats a balanced diet of 45 CM and 15 BB loaves. Then the two meet. Friday’s weekly Production Possibility CM BB

Friday Is Better at Making Both Crusoe and Friday notice differences in how much of both goods they can produce each week. Friday is better at making both – an absolute advantage. BBCMRatio Note: these ratios are Crusoe1050 1/5 personal opportunity Friday3090 1/3 costs. But: Who is the low cost producer of which good, compared to the other? Who has comparative advantage?

Poor Crusoe Trades with Rich Friday Noticing differences in costs of producing CM and BB, let us presume they agree to trade 5 BB for 20 CM at the end of the week. So Friday must make 5 more BB; Crusoe must make 20 more CM. Assume this term of trade: 1 BB for 4 CM (5 BB for 20 CM) Who is the winner from this trade? Who is the loser?

Trade Creates Wealth Exchange occurs: Crusoe has 6 BB and 25 CM Friday has 15 BB and 50 CM Crusoe Friday CM BB CM

Trade Exploits Comparative Advantage The process of voluntary trade makes both parties richer. No more effort was required – just specialization in the thing one is relatively better at doing compared to the trading partner. The less productive person, Crusoe, has something to offer the more productive Friday. Adding thousands of goods and millions of people complicates the math but not the outcome. Trade creates wealth. There are no exceptions to this. Trade also requires social cooperation.

Trade Among Nations Assume companies in Japan and in Mexico make shirts and cars for their consumers. Current production abilities are up to 5 million shirts per week in Mexico and up to 50,000 cars per week — given current resources in labor and capital. Current production abilities are up to 4 million shirts per week in Japan and up to 100,000 cars per week — given current resources in labor and capital.

Creating New Wealth To have more cars, resources must be taken from shirt production — opportunity cost. Resources are scarce. We cannot have everything. One person or one nation cannot be best at making everything. We trade goods for goods based at what we are best at doing. Specialization and division of labor follow.

Mexican Shirts = Japanese Cars

Production Possibility: Mexico Car and shirt production without trade cars shirts o 5m 50k 25k 2.5m Current production — based on internal costs in Mexico and demands of consumers — results in 25,000 cars per week and 2.5 million shirts being produced and bought by consumers in Mexico each week. Domestic prices are not relevant for trade with foreigners, what matters are relative costs — 100 shirts for 1 car is the internal rate of trade.

Production Possibility: Japan Cars and shirt production without trade cars shirts 100k 4m2m 50k Current production — based on internal prices and demand in Japan — results in 50,000 cars and 2 million shirts per week being produced and bought in Japan. The internal rate of trade is 40 shirts for one car within Japan. What do Japan and Mexico have to offer each other?

Gains from Trade: Comparative Advantage Internal rate of exchange in Mexico is 100/1 shirts for cars. Internal rate of exchange in Japan is 40/1 shirts for cars. Comparing these two producers: Who is the lower cost producer of cars? Who is the lower cost producer of shirts? Trade will occur somewhere between 100/1 and 40/1. Bargaining. Let us assume 60/1.

Trade: Both Become Wealthier MexicoJapan cars 0 shirts 50k 5m2m cars shirts 0 4m3m 100k 50k Mexico specializes in shirts — makes 5 million, sells 3 million to Japan. Japan specializes in cars — makes 100,000, sells 50,000 to Mexico for 3 million shirts. Both end up beyond their own production possibilities — trade allows people in both nations to have more of what they want. New point of production New point of production

Is There a Problem? Japan and Mexico both are wealthier due to trade. Citizens in both nations get more of what they want at lower cost. Note: Trade is done by Yen and Peso, but that is just for convenience — people want cars and shirts — not money. Expand this to 100 nations and 10,000 goods. The math is more complicated, but same wealth creation results. So why is there opposition to free trade? What about new technology?

Name This Piece of Land

Tale of Two Nations South Korea North Korea $30,000 per capita$1,800 per capita Market oriented Juche Stalinist

Milton Friedman explained it best: “The most important single central fact about a free market is that no exchange takes place unless both parties benefit.”