I seem to have spent half the week explaining free trade and the concept of comparative advantage to people who are fearful [1] 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 [2].
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 [3] 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 [4] 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 [5]
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 [6]) 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 [7], 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.