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How free trade makes us all better off

David Ricardo solved the riddle of free trade

I seem to have spent half the week explaining free trade and the concept of comparative advantage to people who are fearful of the rise of China and India.

When you see a country doing far better than it was two decades ago in industries your own country once dominated, it’s easy to be spooked.

Yet the lesson of the past couple of hundred years is that those who have traded have prospered, while those with closed borders have languished. (Free free to send me a postcard from North Korea with evidence to the contrary).

Even the rise of China can be put down to it joining the WTO.

It’s true that both it and India – and many emerging countries – seem to do best when they protect certain domestic industries rather than relaxing all their trade restrictions, but that’s a long way from saying free trade is bad.

But what about the US? Hasn’t it run up a huge deficit partly by buying cheap Chinese goods instead of American made products?

Well, no. Leaving aside whether the US is half as indebted as its critics suggest (they tend to ignore assets) the fact is that American consumers have enjoyed a decade of cheaper trainers, jeans, computers, and iPhones on the back of free trade. Their bucks went further.

You might argue those things weren’t worth exchanging some of the future wealth of US citizens for, but it’s wrong to deny they have no economic value.

International free trade makes us all richer

The empirical evidence in favour of free trade is very strong, but there’s also a solid theory behind it.

What’s more, the theory supporting free trade is 200 years old!

It was the British economist David Ricardo who first realised that free trade between two countries would make the citizens of both better off – even when one country is much better at doing everything than the other!

Ricardo used the example of England and its oldest ally Portugal to illustrate.

Assume England and Portugal make and trade just two products – cloth and wine. Imagine that England is worse at making cloth than Portugal. Yet thanks to the bad British weather, it’s even worse at making wine!

In other words, Portugal is more productive than England in both wine and cloth.

In these circumstances, you might think Portugal would be better off making everything it needs for itself, since it can make both wine and cloth more efficiently than England.

But in fact, it’s best for everyone if Portugal trades its wine for cloth made in England. This is because the total output of the two countries will rise.

Seems wrong, doesn’t it? Let’s look at some example figures (inspired by David Smith’s Free Lunch economics primer).

First for wine:

  • Sunny Portugal finds it easy to make wine. 25 workers can produce a barrel of wine a day.
  • In rainy England, it’s hard. 200 workers are needed to make a barrel a day.

Now for cloth:

  • In Portugal, 25 workers are also needed to make a roll of cloth.
  • Back in England, 50 workers are needed to make a roll of cloth.

Clearly Portugal is best off making wine. But Portugal also has an absolute advantage in making cloth.

Is there anything England can do?

Ricardo explained that in this circumstance, it’s best for Portugal to switch production from cloth to wine, and for England to switch the other way.

Let’s say both countries have a population of 1,000 workers. These workers happen to be divvied up between the two industries such that:

  • Efficient Portugal produces 1,000 units of wine and 1,000 of cloth a day.
  • Less efficient England turns out just 125 units of wine and 500 units of cloth.

Remember from the numbers above that England needs four times as many workers to produce wine (200) than cloth (50).

  • If England switches all its inefficient wine production to making cloth, it will now make 1,000 units of cloth a day.

That’s a big boost in output – but now the English have no wine?

In these circumstances, free trade will see Portugal switch some workers from cloth production to its equally efficient wine production, in order to satisfy the English demand for wine.

Because Portugal is equally efficient at producing both products, it still produces 2,000 units of goods a day.

But English productivity has soared!

It’s 1,000 workers now produce 1,000 units of goods a day, instead of the 625 units they were producing before they switched to cloth and instead imported wine from Portugal.

  • Total output (GDP) has therefore risen from 2,625 to 3,000 units a day.

This example shows it is comparative advantage that matters in trade, not absolute advantage.

What’s in free trade for Portugal?

You might wonder why Portugal should bother doing the switch. Why buy less efficiently produced English cloth?

As Smith explains in his take on Ricardo’s example:

“The answer is that the price of English cloth will be determined by ‘world’ levels. English cloth workers, because they are half as efficient, will tend to be paid half as much as Portuguese workers. The Portuguese will thus be able to afford to buy a significant proportion of the increase in world output.

“There is still a gain for England and its workers, though, from moving from appallingly inefficient wine production to cloth. It’s a win-win.”

Think about trade with China to see this happening right now. Our own factories are far more efficient than Chinese labour-dependent ones. But we readily buy stuff made in China, because the cost of most goods produced there is so much lower.

If you’re interested in the minutia of free trade and Ricardo’s law of comparative advantage, there’s plenty to be debated. What about transportation costs? What about the cost of switching production?

The main point though is that it’s good for everyone for countries to do what they’re best at. We will all be better off from free trade, albeit at the cost of allowing poorer countries to close the gap with richer ones.

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{ 11 comments… add one }
  • 1 Neil Wilson August 13, 2010, 3:38 pm

    Obviously I agree with all this. It is a self-evident truth at macro level.

    Unfortunately at micro level you get problems, because wine workers are not easily retrained to cloth workers. They don’t like the change, or the pay is less, or its in a different part of the country. Or simply that the people involved aren’t good enough to be cloth workers.

    It’s the human aspect of Ricardo that’s the problem. That’s why we car plants are subsidised and we have employment rights that lock an employer into employing particular people.

    Nobody has really solved that problem,.
    .-= Neil Wilson on: Why not simply a Universal Pension =-.

  • 2 Damien August 13, 2010, 4:28 pm

    I want free trade for customers too. You speak only about corporations, but the fact is that only them make profits from free trade.

    I take a simple example, I want to buy a mac which is by far less expensive in USA than in Europe. I just can’t because corporate re-create border and Apple will tell you that you HAVE to buy it in your own country. It’s even the truth in Europe between countries despite I should be able to buy my stuff from anywhere.

    This is crap, free trade should allow me to buy where the price in the lower. Corporate (and some governments) are preventing customers to get profit from it and only them have benefits from this better price / productivity.

    I can take even more extreme example: Adobe Creative Suite
    US price: 1400€ without VAT
    France price: 2300 € without VAT

    If I try to buy it from Adobe / Amazon and try a delivery in France, they will tell me “no it’s not possible, buy it in France”. Even if I chose the download release which doesn’t care about geographics!!! Is this free trade ? I don’t think so.

    Sad.

  • 3 ermine August 13, 2010, 6:00 pm

    There are external issues too. Resource limitations, energy and raw materials depletion, pollution. They all limit the scaleability of free trade, limiting the real-world application of this.

    If China and India derive their energy in the same way as we do, and produce at the same rate per capita as we did, I think there may be global problems in the energy and pollution department…

    A decade of falling real average wages in the US is also indicating that this is not so much a catch-up to developing world living standards as a fall in Western living standards and a rise in others. That may be fairer overall, but it still hurts over here…
    .-= ermine on: The Pinch – David Willetts says it’s the Baby Boomers Who are Wrecking the Economy =-.

  • 4 Early Retirement Extreme August 13, 2010, 6:02 pm

    So suppose I, as a US person, am one of those unproductive ones. Now, I can’t go to China and get a job there more suited to my productivity because I’d need a passport for that. And I can’t stay and work a low pay job in the US suitable to my skills, because the greater efficiency of my neighbors drives up housing costs. In other words, the lack of freedom in immigration/emigration, sticks the lower skilled people in the high skilled country. Hence all the complaining …
    .-= Early Retirement Extreme on: A plan to financial independence at 35 =-.

  • 5 Moneyedup August 14, 2010, 3:59 am

    I am in favor of free trade, as long as it goes both ways. So many jobs in America’s manufacturing industry have been lost and are now overseas. There needs to be a balance of production and trading in order for a country to be successful. Buying everything overseas at a lower cost can result in a cheaper product (as in a less durable or reliable product).
    .-= Moneyedup on: What if I gave you 500 =-.

  • 6 The Investor August 14, 2010, 12:19 pm

    Interesting comments guys. I was hoping readers Lemondy or Niklas might come along to bang the drum for free trade, so for now I’ll just make a couple more observations.

    Firstly, I don’t think Ricardo’s theory implies free trade is necessarily good for workers. The division of corporate/national profits is a political decision at the state level. I suspect in the US corporates, shareholders and the rich have been capturing a lot of the benefit of free trade in the past couple of decades, at the expense of labour. Write to your Senator, not to an economist.

    On the same point, ten years is probably too short a period to look at the impact of trade on a country. There’s a lot of noise related to animal spirits, credit contraction and expansion, and again politics. A few decades would be more like it.

    I don’t really understand this fear of China and India, as I’ve said before. Does anyone reading this blog use a single brand named product from either country? I don’t. Overwhelmingly we’re still capturing the high-end value from global trade.

    That will change – Indian and Chinese brands will emerge – but that will be a good thing. As a Brit, I don’t feel I’ve lost out because of the emergence of Boeing or Apple in the past 100 years in the US. Why should it be different now?

    Also, as I keep saying the US is still a very rich country for most of its citizens. Think about a spoiled debutante complaining when you hear about its travails. It’s the biggest economy in the world, and its currency is so well respected that even the financial crisis didn’t derail bond yields (the opposite in fact). Every country would love to have such problems.

    In the short-run US consumers swapped future earnings for debt that they pumped into inflated house prices that have now blown up, with both destruction of value and an increasing burden on future generations via tax. Free trade played a part in this (by driving down the cost of money and yields) but it was the US cult of consumption that did the real damage.

    Its citizens could have traded some of their great wealth for more overseas assets (as its corporates have done, in fact) but they choose to consume instead. It’s a choice.

    Inflation is literally a mixed bag, literally. Most goods have fallen in real term prices in the US in the past 20 years, especially once you look at how much more you get for your money (from computers to cars). A US citizen’s paycheck will generally have gone further when spent on the things that are traded (clothes, computers etc). Their real problem has more been healthcare and taxes. It’s not dissimilar here in the UK.

    The answer is probably more free trade, not less. For instance, it’s only a matter of time before we start sending people to India for operations on the NHS in my view. We’re already importing its doctors, but I think the Indians will realize they’ll do better to keep more of the profits at home.

    This may show up again in a slowdown in growth of our domestic healthcare industry, and a growth in the India’s equivalent, but are you really going to complain about reduced taxation to fund future healthcare costs / getting a heart operation for $5,000 instead of $50,000? (Figures plucked from the air but make the point).

    Environmental issues – absolutely. Luckily China is pioneering green technology while we continue to fiddle with oil wells. Thank goodness, again, for free trade.

  • 7 Mosschops August 16, 2010, 9:49 am

    Free trade is a wonderful thing in theory, but I think its proving to now be a bit of a mixed bag in practice. People may have access to cheaper goods, but its coming at a price of pressure on wages if not outright job losses to large sectors of the economy. It may well be that they could offset this by investing abroad as you state, but that isn’t really going to happen as having either the time or the knowledge to do this isn’t that widespread. So I think that the title of the article is correct – “How free trade makes us all better off”, but I think the “us” is probably people who have high disposable income and actively invest in overseas markets, or who work for large corporates. But for society as a whole, I’m increasingly not so sure. Are we better off as a whole with Apples for instance costing 10% less, their shareholders being better off, but less tax being taken in as all the manufacturing is done by Foxconn?

  • 8 Barb Friedberg August 17, 2010, 11:08 pm

    Smart post! I’m all for FREE TRADE and competition. I wonder how the world would look with true market forces at work? Econ 101 anyone?
    .-= Barb Friedberg on: When to NOT to Splurge =-.

  • 9 Damien August 20, 2010, 11:52 am

    The problem with your theory is that you are speaking about countries that have not a really big economic differences.

    For everything you can take, you can do the same job in China / India for 10x less money because of ->poverty<-.

    With exaggeration, let's take again your example:

    First for wine:
    Sunny Portugal finds it easy to make wine. 25 workers can produce a barrel of wine a day.
    In rainy England, it’s hard. 200 workers are needed to make a barrel a day.
    In China, 2000 workers are needed to make a barrel.

    Now for cloth:
    In Portugal, 25 workers are also needed to make a roll of cloth.
    Back in England, 50 workers are needed to make a roll of cloth.
    In China, 500 workers are needed to make a roll of cloth.

    In every case, they don't care, as 10x more people in China / India will still cost less than 10x less people in Europa.
    Now China is coming to become too expensive for our 'great' shareholders and they start to put their factory in Thailand and Vietnam where there is more poverty.

    The THEORY of free trade is about productivity, the REAL free trade we see everyday is about making profit from poverty all around the world.

  • 10 The Investor August 20, 2010, 1:17 pm

    I wish it was my theory Damien – I’d be proud of a theory that when put into practice lifts millions out of poverty and enriches life for everyone. Alas, it’s standard economic theory and hundreds of years old.

    Your counterexamples are straw men. Yes, factories are seeking out cheaper locations – but China isn’t getting any poorer, its GDP is growing at over 10%! This is exactly what we’d expect to happen.

    Literally hundreds of millions of Chinese people have been lifted out of near-subsistence level agriculture over the past 20 years. Don’t ask me, as the UN. I am all for it helping Thailand and Vietnam too (though as I always state I fear the environmental consequences of increasing consumption).

    As for the other end of the argument – those up the chain are doomed – that’s not true either I’m afraid.

    To pick one of innumerable examples. America was originally a country with the cheapest labour going – free through slavery. A century or two on it boasts companies like Apple and Microsoft. Yet I bet cotton farmers were moaning as they became uncompetitive saying “what will America do in the future if it can’t make cotton”.

    Cheers for taking the time to comment, even if I strongly disagree. 🙂

  • 11 Khaleef @ KNS Financial September 8, 2010, 10:01 pm

    The idea of retraining our citizens being difficult is only true if the transfer is immediate. It takes time for a country to realize that they are inefficient in producing certain goods, and over time employment and production should naturally shift to the more efficient categories – under free trade, that is!

    This means that the horse & buggy industry will become the automotive industry; those who make parts for typewriters will now work for Microsoft and Intel. We see it happen all the time within a nation, the only difference is that in these examples the reason for change is innovation, not cooperation. However, the same logic applies in the case of free trade.

    There can be no argument that the cost of many of the goods that we (in the US) purchase is lower due to them being produced in countries that have much lower costs of production!
    .-= Khaleef @ KNS Financial on: Devastating Changes Coming for Flexible Spending Arrangements FSA’s =-.

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