Free Trade is for the Rich

Comparative Advantage Athletes involved in team sports embody the theory of comparative advantage. Even players who are better in all positions than everyone else will enable the team to win more games being a team player.

Numerical Example International trade is a team activity. Countries at war, hot or cold, lose income themselves and inflict economic losses on their rivals through embargoes. Countries at peace, even if unstable, can help themselves and their rivals by trading.

Numerical Example Let us think about the bilateral trade between two countries called JPN & USA. Both countries have agricultural and manufacturing sectors. Let’s call them Rice & Autos for short. I have left out services to keep the analysis as simple as possible.

Numerical Example: Continued Both countries also have resources, labor, land and capital in differing quantities. We call these resources “Labor” for short. USA’s labor resources total , while JPN’s total Adding three zeros to the end of these numbers would be more realistic, but would take up valuable space. Don’t worry about differing labor/capital/ land intensities. We’ll include that later.

Numerical Example: Continued Now, how much do they produce of each output, rice & autos? That depends on productivity of the resources, of labor. Highly productive labor produces a large quantity of output. But this also means that the production of any unit of output requires a small amount of labor.

Numerical Example: Continued To put the matter differently, If (Output/Labor) is a large number, labor is highly productive. If it is a small number, labor is not very productive. The reciprocal, Labor/Output, measures how much labor it takes to produce one unit of output. The same unit might be produced by small numbers of highly productive labor or by large numbers of less productive labor.

Numerical Example: Continued Now we must decide on a measurement for output. We can start in manufacturing with one standard automobile. Rice, however, comes in many quantities. Assume that the unit is large, one container load, so that its market value is the same as that of one automobile.

Numerical Example: Continued This assumption is very convenient and, due to the quantities going into trade, not unrealistic. If, for example, JPN’s output is autos & units of rice, total output is worth in the market. That is JPN’s GDP. Furthermore, if JPN exports autos they get back (import) units of rice.

Numerical Example: Continued Now we need to get down to business. Labor input requirements (costs of production) for one unit of each good are given in the following table. Resource Costs per Unit USAJPN AUTOS95 RICE86

Numerical Example: Continued To clarify, in a one year time period, the efforts of 9 workers in the USA will be able to produce one automobile. In JPN, it takes only 5 workers. Also, 8 workers in USA & 6 workers in JPN can produce one unit of rice.

Numerical Example: Continued JPN, clearly, has a very significant cost advantage. This is called an “absolute advantage” and would lead most observers to conclude that JPN has nothing to gain in trade with USA. In fact, it appears that low cost JPNese imports would flood into USA and cause widespread unemployment. Sounds awful! Let’s pass some laws!

Numerical Example: Continued The next step is to go from productivity to output possibilities. Remember the assumed labor endowments of 108k & 72k. The next table shows Maximum Possible Outputs. USAJPN AUTOS RICE Note: = /9; = 72000/5; etc. Each number assumes total specialization in the one industry.

Numerical Example: Continued What good are these numbers? First, they give us endpoints of a spectrum of possible output combinations. Second, because they are in the same ball- park, they tell us that USA & JPN have about the same GDP, USA’s earned with greater labor power & JPN’s earned with greater productivity. We will return to this point later.

Numerical Example: Continued Now, let’s assume that JPN & USA are completely self-sufficient; no trade at all. Demand & consumer taste conditions cause labor to be divided evenly between the two industries. In USA, 54k workers are allocated each to autos and to rice. In JPN, 36k workers end up in each industry. The following table summarizes the results.

Numerical Example: Continued Production & Consumption: No Trade WORLD USAJPNTOTALS AUTOS RICE GDP Note that each of the four numbers in the center cells is exactly half what they were in the preceding table. GDP is equal to the sum of the outputs as explained before.

Numerical Example: Free Trade Under free trade, each country will end up producing only one good. This is because this example does not take into account economies of scale, diminishing returns or other problems that would arise. However, there are many assumptions as to partial specialization that could be made. The results will be much the same.

Numerical Example: Free Trade The following table contains figures only for consumption in the two countries. The figures for output were given in the second table above. Both countries specialize in one of the goods, export about half of their output and import an equivalent amount of the other good.

Numerical Example: Free Trade Consumption: Free Trade & Specialization WORLD USAJPNTOTALS AUTOS RICE GDP Note: USA produces units of rice and exports 6500 in return for 6500 autos. JPN produces automobiles and exports 6500 in return for rice from USA. USA keeps 7000 units of rice for home consumption; JPN keeps 7900 automobiles.

Numerical Example: Conclusion In the next table, the four earlier tables are all put together. Notice that the final results with free trade enable both countries to consume more of both goods and to have larger GDPs than would exist under self- sufficiency.

USA & JPN: TRADE

Geometric Diagram of Trade Some students like geometry, some don’t. All can ignore it.

Autos Rice JPN: USA: JPN: USA: MAXIMUM PRODUCTION & CONSUMPTION WITH TRADE & COMPLETE SPECIALIZATION (12750, 13200) (13500, 14400) PRODUCTION & CONSUMPTION WITH NO TRADE. EQUAL DISTRIBUTION

Between the Lines We assumed quantities of autos & rice such that the world exchange ratio was 1:1. Under self-sufficiency, the ratios would be 8/9 in USA and 6/5 in JPN. That is, 8 autos would have a market price (due to labor costs) such that 8 autos would exchange for 9 units of rice, the higher value of autos due to the fact that they require more labor & are therefore more costly than rice.

Between the Lines Hence, the world exchange ratio is between the two national ratios: (8/9) < (1/1) < 6/5. Why 1/1? I assumed it for two reasons: it falls between the two ratios and it is easy. But lots of ratios fall between 8/9 & 6/5. An economist/philosopher named John Stuart Mill published a paper in 1844 in which he solved the problem using linear programming. But LP was not invented until Ahead of the curve.

Free and Fair Trade Low productivity means low wages. By and large, poor people are not very pro- ductive, at least not in economic markets. Increased productivity means more output per person and, of course, more income. Trade, when free, raises incomes above non-free levels, but increased productivity (compare JPN & USA incomes per capita) can do lots more.

Free Trade & Fair Trade Raising productivity is the key to raising incomes, but the process is not easy. Fair trade will increase the incomes of less productive people by taking income from the more productive. There will invariably be less to go around in total and probably slower growth rates. Free trade is definitely fairer that fair trade.

Reality Calling This model can be generalized and most of the ideas remain intact. This is an example of the complaint that economics is trivial in two dimensions and impossibly difficult in three or more. But it is not a good example: was this exercise trivial?