Why trade?

David S. Dahl | Regional Economist

Published October 1, 1993  | October 1993 issue

Economists, who are supposed to be a contentious bunch, have generally agreed that the community at large stands to gain in material standard of living from specialization and exchange according to the various nations' comparative advantage. —Paul A. Samuelson

While economists may agree that nations benefit from free trade, they have yet to bring many others around to their point of view. A recent study by the Congressional Budget Office on the North American Free Trade Agreement's (NAFTA) impact "leads to the single resounding conclusion that the net effect on the U.S. economy would be positive and very small." Nevertheless, only 31 percent of respondents to a late-July The Wall Street Journal/NBC News Poll favored NAFTA, 29 percent were opposed and 36 percent were undecided.

Part of the public's reluctance to support NAFTA may stem from not understanding the "principle of comparative advantage." Forty-seven percent of the general public responding to a 1992 Gallup Poll, for example, believe that setting quotas on imports would increase U.S. employment. This response would be incorrect on an economics examination, for in 1817 the English economist David Ricardo demonstrated that quotas and other international trade restrictions reduce countries' well-being.

Countries benefit from specialization

By taking advantage of their differences, Ricardo argued, countries could gain from specialization and trade. Both England and Portugal could produce cloth and wine, he stated, but in England cloth cost less to produce than wine, while in Portugal wine was less expensive. England had the "comparative advantage" producing cloth and Portugal had the "comparative advantage" producing wine. Therefore, each country gained by exporting some of the product that was inexpensive to produce domestically in exchange for importing the product that it found relatively expensive to produce.

"Let us each specialize in the production of what we're good at, and then trade the fruits of our labor," is how The Wall Street Journal describes the principle of comparative advantage in a recent editorial. Minnesota manufacturers, for example, specialize in exporting computers, medical equipment and electronic components. The revenue from these exports provides these firms and their employees with additional funds to purchase goods and services produced in Minnesota or elsewhere. Thus, resources are directed to their most efficient uses and living standards are enhanced.

Economies of scale may also accompany the specialization arising from free trade. Minnesota, for example, specializes in high-technology exports. For these products, research and development costs can be large, and their manufacture may require complex and expensive machinery. Export sales allow these firms to spread costs over additional units, which lowers their unit cost and enhances their competitiveness.

Free trade also forces countries to be more competitive because they compete worldwide instead of just domestically. The additional competition makes raising prices difficult and requires firms to be efficient if they desire to retain or expand their market share. In the United States the prices of commodities which are more sensitive to competition from imports have risen less rapidly than the prices of services which are less sensitive to imports.

Due to the principle of comparative advantage and its associated benefits, gains in total output have accompanied increases in international trade. "Since the postwar recovery began in 1950, average annual growth, globally, has been 3.5 percent, while the value of trade in real terms, has grown 6.5 percent a year. For every $100 billion more in goods that are traded around the world, growth is pushed about $10 to $20 billion higher than it otherwise would be," said Gray C. Hufbauer, economist at the Institute for International Economics, in a recent Business Week article.

Myths about free trade

Nevertheless, "free trade, one of the greatest blessings which a government can confer on a people, is in almost every country unpopular," said the nineteenth century English historian Thomas Macauley. In the United States this unpopularity comes from several widely held myths about free trade.

One myth is that restricting imports protects American workers' jobs. Indeed, imports have cost some workers their jobs; in the 1980s, 410,000 auto workers were permanently displaced, according to Congressional Budget Office figures. Many of these job losses stemmed from sales lost to foreign automakers. Americans, however, have been able to afford those autos and other imports in part because of earnings gathered from exports. In both the Ninth District and the nation job gains have accompanied rising exports.

If imports are restricted, employment in the protected industries may be higher with protection than without it. But foreigners would have less to spend on U.S. exports, and employment in other export industries could fall. "Thus, import restrictions have little or no effect on total employment, although they do distort the distribution of employment among sectors," concluded the Council of Economic Advisors in their 1985 Annual Report.

Another myth is that protectionism is fairer than free trade for lower- and middle-income families. Like a sales tax, import restrictions raise the cost to consumers, and in industrialized countries they are targeted at basic, labor-intensive goods that comprise a relatively large share of lower-income budgets. In 1988, for example, the average tariff on clothing was 18.4 percent, and the share of income spent on clothing by those with the lowest incomes was more than twice the share spent by those with the highest incomes. "The quotas and tariffs that force import prices up to protect U.S. apparel jobs don't matter much in Beverly Hills, but they put a big dent in pocketbooks in Watts," according to a recent Newsweek article.

The next myth is that the United States should restrict imports to protect its economy from subsidies foreign governments pay to their producers that enable them sell to to the United States below cost. This protection, though, is unnecessary. Some governments undoubtedly do subsidize their exporters. But they must tax their citizens to pay for those subsidies, while U.S. consumers pay prices that are lower than they otherwise would be. "Was it noble of the United States to send goods and services as gifts to other countries in the form of Marshall Plan aid or, later, foreign aid, but ignoble for foreign countries to send us gifts in the indirect form of goods and services sold to us below cost?" asks economist Milton Friedman.

A related myth is that because other countries impose trade barriers, the United States must also impose them. The benefits of free trade, however, are relatively independent of other countries' actions. In 1846 Great Britain unilaterally repealed its Corn Laws. Critics contended that imported grains would depress Britain's economy. Instead, it boomed. Other grain-producing countries had the wherewithal to purchase its manufactured goods, and Great Britain became an "engine of growth" for the 19th century world economy.

To the extent other countries enact trade restrictions, those countries and the United States gain less from trade. But retaliating in kind compounds the problem. In 1930 President Hoover imposed unprecedented tariffs in the Smoot-Hawley Act. Other countries in turn boosted their tariffs, and the world economy slid into the Great Depression. "Competition in masochism and sadism is hardly a prescription for sensible international economic policy!" Friedman says.

Free trade a scapegoat for other problems

Besides widely held myths about free trade, rising imports are often the scapegoat for other problems. During the 1970s, for example, American automobile prices rose sharply and U.S. manufacturers lost 10 percent of their market share. Oil price shocks, inflationary fiscal and monetary policies, and mismanagement by the auto companies and their unions caused the price increases that contributed to the loss of market share. "Internationalization drastically raises the penalty for mismanaging an economy," according to a recent Newsweek article.

Nevertheless, our economy is going to continue to be increasingly tied to the world economy, and in the words of Thomas Jefferson: "Our interest will be to throw open the doors of commerce, and to knock off its shackles, giving freedom to all persons for the vent of whatever they may choose to bring into our ports, and asking the same in theirs."