Notes_on_Trade.doc

THE BENEFITS OF COOPERATION Each person tries to make the choices that give him or her the greatest net benefit, but the economy is made up of many people, and they do not make their choices in isolation from each other. Instead, we all depend upon thousands of other people every day in order to obtain the goods and services we want to consume. The first thing I do in the morning is make a pot of coffee. Someone, probably in Africa, Asia or Central America, grows and harvests the beans. Other people buy the beans, transport them, and roast them. The employees at the coffee shop put the beans on the shelf and sell them. I grind the beans in my coffee grinder (made in Mexico), place them in a filter, and pour in the water that I boiled in a copper kettle (made in China). I am only fifteen minutes into my day and already I have depended on the cooperation of dozens, if not hundreds, of people on four continents. Most of them do not know each other and none of them has any idea who I am, and yet they have all cooperated to provide me with a cup of coffee. Most of us take this cooperation for granted, but about 250 years ago the Scottish philosopher Adam Smith recognized it as one of the greatest achievements of civilization. In 1776, Smith published his Inquiry into the Nature and Causes of the Wealth of Nations, and as a result he has come to be widely regarded as the founder of modern economics. Smith observed that, unlike people in the past, most people in modern economies produce very few of the goods they consume. We do not build our own shelter, raise our own food, or make our own clothes. Instead of being self sufficient, spending our time doing many different things, we spend our time doing what we are good at. By practicing one thing, we get even better at it. Sometimes, because our attention is focused on one thing we see better ways of doing it. Specialization enables us, as an economy, to produce far more goods and services than if each person tried to be self sufficient. The problem is that to specialize in one thing, we have to get other people to make all the other things we want and then give them to us. How do we get all these people to cooperate with us? If they are our friends or family we might ask them to do it as a favor, but we do not know most of the people who make the goods we want to consume. We obtain their cooperation by appealing not to their good nature, but to their self interest. We offer them something they want in exchange for something we want. This is what we do every time we go to a store. When we buy a candy bar we are saying we would rather have it than the money; the owner of the store is saying she would rather have the money than the candy bar. So we trade. Each voluntary trade makes both sides, buyer and seller, better off than before. It is intuitive to most people that specialization and trade can make people better off. What is not intuitive is that specialization and trade can make people better off even when one of them is not epecially good at anything. Everyone Has A Comparative Advantage People can always benefit from trade. To see why, consider a hypothetical example. Warren Buffet made a fortune of more than $40 billion by managing the investment firm Berkshire Hathaway. Now, imagine that Mr. Buffet is also the world?s fastest typist. Should he do his own typing or hire someone who is slower than himself? He should hire a typist. The typist actually has an advantage over Warren Buffet when it comes to typing, even though he is slower. The typist?s advantage is that spending an hour typing does not cost him nearly as much as it costs Mr. Buffet. The typist is not giving up millions of dollars that he could be earning by studying new investment opportunities. A person who can do something at a lower cost than someone else has a comparative advantage at that thing. Everyone has a comparative advantage at something. The typist?s comparative advantage does not come from being better at typing, it comes from the fact that Warren Buffet is so good at investment analysis. The better we are at something, the more costly it is for us not to do it, and the better off we will be if we can specialize and trade with others. In other words, the real benefit of trade is that it enables us to use our time and resources doing what we are relatively good at. The same benefits exist for trade between countries. Specialization and trade are organized in different ways in different societies. Sometimes people specialize based on customs. In the past, a person was a farmer, or a weaver, or a blacksmith because his father was a farmer, or a weaver, or a blacksmith. Sometimes a government tells people what to produce and what trades they can and can not make. In the Soviet Union there was a great deal of specialization and division of labor; the state told people what to specialize in and who they could sell it to. In the United States we, as individuals, make most of the decisions about what we specialize in and with whom we trade. Almost 80 percent of all goods and services are produced by private businesses, and over 80 percent of the goods produced are purchased by households and businesses for consumption or investment. Several different names have been used to describe economies like the United States: a capitalist economy, a market economy, and a free enterprise system. All of these names mean essentially the same thing: households and private businesses own the resources and make the decisions about how to allocate them. The decisions about what to produce, how to produce it, and who receives it are made by people voluntarily trading with each other in markets. THE BENEFITS OF TRADE Even the most vigorous opponents of free trade accept that America should import some goods. For instance, it is acceptable to import agricultural products that are grown in the tropical regions of the world, such as bananas, cocoa, and coffee. Of course, most tropical produce can be grown in some parts of the United States, but it is very costly. Labor and other resources have to be diverted from more productive areas. The argument that allows for importing tropical produce is precisely the argument for free trade generally. We should buy from other countries the goods that they can produce more cheaply than we can. With trade, we get the imported goods more cheaply than if they are produced domestically. Moreover, we are more productive when we do not have to devote our resources to producing things that we are not good at. Ever since the English economist David Ricardo published Principles of Political Economy and Taxation in 1814, economists have used simple examples with two countries and two goods to illustrate the benefits of free trade. The hypothetical story is a long way from reality, but it makes it easier to see the benefits of trade than trying to consider all countries and all goods at the same time. Imagine that the United States and Canada each have 100 million workers, and that each country produces only two goods: wheat and cars. If an American works in manufacturing, he can produce three cars per year. If he is in agriculture, he can produce five tons of wheat. If a Canadian works in manufacturing, she can produce one car per year. If she is in agriculture, she can produce five tons of wheat. The countries can allocate workers however they want. They can decide to employ a few in agriculture and many in manufacturing, or the other way around. In the absence of trade, each country has to employ some of its workers in manufacturing and some of its workers in agriculture in order to have both cars and wheat. Let us say that, in the absence of trade, each country allocates half of its workers to manufacturing and half to agriculture. The result of dividing workers equally between the activities is shown in the first row of Table 8.1. Each country produces 250 million tons of grain. The United States produces 150 million cars, and Canada produces 50 million cars. When a worker in the United States produces his five tons of grain, we give up production of the three cars he could have produced. When Canada uses a worker to produce five tons of grain, it gives up just one car. Even though Americans and Canadians are equally productive in agriculture, wheat is more costly to produce in the U.S. because we sacrifice more car production. In other words, the opportunity cost of producing wheat in the U.S. is higher than the opportunity cost of producing wheat in Canada. This implies that the U.S. is relatively better at producing cars. Suppose the United States specializes in the production of cars, and Canada specializes in the production of wheat. The results of specialization are shown in the second row of Table 8.1. It is important to note that total production increases with specialization. Total wheat production remains at 500 million tons, but total car production increases from 200 million to 300 million. Because of the increase in total production, it is possible for Canada and the U.S. to trade so that each country has at least as much of each good as it did before it specialized and more of one of the goods. One possible trade would be for the United States to trade 125 million cars for 250 million tons of grain. Both Canada and the United States end up with more cars and as much wheat as they had before. Each country is better off with trade than without trade. Each country is able to benefit from trade because they are able to increase the total amount of trade by using resources more efficiently. Table 8.1 The Benefits of Trade Wheat for United States Wheat for Canada Cars for United States Cars for Canada No Specialization 250 million 250 million 150 million 50 million Specialization 0 500 million 300 million 0 This is really just another version of the story about the benefits of trade presented in Chapter One. We are all better off from trading with each other than trying to be self-sufficient. We can specialize in doing what we are good at and then trade with others. We do not have to waste our time trying to do things that we are not good at. The same logic applies to trade between countries. It is possible to grow coffee in the United States, but our resources are much better-suited to growing other crops. If we try to grow a little coffee, we have to give up a lot of the crop that the land and labor could have produced. Specialization and free trade enable us all to use our resources where they are most productive, and to enjoy the fruits of productive efforts elsewhere in the world. THE COST OF PROTECTION TO CONSUMERS If we tried to grow coffee in the U.S., we would end up paying more for a pound of coffee, and more for the crops given up to produce it. We all pay for protectionism by paying higher prices for goods and services. The average American household pays an additional $21 a year for sugar and products containing sugar because of restrictions on sugar imports. Similarly, the average household pays higher prices to protect the steel, and clothing, and lumber, and tuna industries. The list of protected items goes on and on. The Institute for International Economics estimated the cost of protectionism at $6,000 per household in the late 1990s. For comparison, in 2005, a single person with an income of $29,000 paid about $4,000 in income taxes. Job Loss From Protection Few are aware of how much they pay for protectionism, and even fewer are aware of the jobs that are lost because of protectionism. Protectionism raises the prices of goods that are used as inputs by American firms to produce their own products. For these firms, protection raises the cost of production. A higher cost of production reduces supply and employment by the firms. For example, about 200,000 jobs were lost in steel-using industries due to protection of steel in 2002. Fewer than 200,000 people are employed in steel production in the U.S. The higher cost of production, of course, also raises the price of the product. In some cases, firms that use protected products as inputs find their own exports reduced because of protectionism. TRADE AND JOB LOSS No one who supports free trade should make the mistake of suggesting that it makes everyone better off right away. Preventing imports through tariffs and quotas and other barriers is not called ?protectionism? for nothing. It protects certain people, and when the protection is removed, those people are hurt. It is true that removing protection causes some people to lose their jobs. Consider the simple example above, in which Canada and the United States produce wheat and cars. In the example, we assumed it was easy to switch people from wheat production to car production. In real life it is difficult. Farmers live in rural areas, not in cities where the cars are made. It may be difficult for them to leave their old lives behind and move to a new place. They may experience a long period of unemployment as they move from one job to another. They do not have any experience in automobile manufacture, so although they may have a lot of work experience on the farm, they may have to start in an entry level position. Table 8.2 shows how many jobs are saved by protectionism in a few industries. The table also shows the cost of saving a job in each industry. Recall that the average American household pays $21 to protect sugar producers. Protection saves 2,261 jobs in the sugar industry at a cost of $826,104 per job. If that seems like a lot to pay each year to save a job, then consider the benzenoid chemicals, luggage, and softwood lumber industries. Protection saves a little over 1,000 jobs in these industries at a cost of over a $1,000,000 per job per year. Saving jobs through protection does not come cheap. Table 8.2 Cost of Saving Jobs Industry Jobs Saved Total Cost (millions $s) Cost per Job Benzenoid chemicals 216 $ 297 $ 1,376,435 Luggage 226 290 1,285,078 Softwood lumber 605 632 1,044,271 Sugar 2,261 1,868 826,104 Polyethylene resins 298 242 812,928 Dairy products 2,378 1,630 685,323 Apparel and textiles 168,786 33,629 199,241 Source: G. C. Hufbauer and K. A. Elliott, Measuring the Costs of Protection in the United States, (Washington, D.C.: Institute for International Economics, 1994), pp. 11?13. While the jobs saved by protectionism are significant to the individual workers who do not have to look for new jobs, protectionism has no noticeable impact on overall employment. Despite the fact that the share of trade in the American economy has increased by 16 percentage points since 1960, the unemployment rate in the early 2000s is practically the same as it was in the early 1960s. Job loss due to foreign trade does not affect overall unemployment because it is very small part of overall job loss. In the early 2000s, around 15 million jobs were lost in each year. About 2 percent was lost due to foreign trade. At the same time, about 15 million new jobs were created each year. The turnover of jobs, as some are created and some are destroyed, is called churn. The term churn is also used to describe the turnover of businesses as some fail and others are created. Churn, of course, means to stir things up. It is an essential part of economic growth. As new products and new processes are introduced into the economy, resources must be moved from one place to another to take advantage of the innovations. Every year far more people lose jobs because of technological change than because of changes in trade flows. More often than not, lost jobs are not lost to outsourcing overseas, they are eliminated by innovations that increase productivity. From 1995 to 2002, the U.S. textile industry lost 202,000 jobs. If these jobs were outsourced to take advantage of cheap labor in China, it does not show up in Chinese employment figures. The Chinese textile industry lost 1.8 million jobs during the same period. Manufacturing employment in the United States began declining in the late 1970s. The decline in manufacturing employment is sometimes used to imply that manufacturing has become less important in the American economy. Nothing could be further from the truth. The Federal Reserves index of manufacturing production increased from 57 in 1980 to 112 in 2003. That is, the production of manufactured goods almost doubled while the number of people employed in manufacturing declined. American manufacturing has not moved overseas. It has gotten more productive. We no longer need so many people to produce our manufactured goods; their labor has been freed up to do other things. In the past, people opposed technological change because it cost people their jobs. During the Industrial Revolution, Luddites (followers of the fictional Ned Ludd) smashed textile machines. Such opposition to technology is not widely accepted today because people see the obvious benefits of technological improvement. People accept that some workers are displaced as a result of technological progress. In the end, technological change and foreign trade have the same three-fold impact. They allow us to use our resources more productively; they lower the cost of goods; they cause people to have to switch jobs. EXPLOITING THE POOR People sometimes support protection but say they are for ?fair trade? or a ?level playing field.? They argue that free trade is not fair because other countries have lower costs of labor or less regulation than in the United States. They claim that globalization exploits the poor. Some go so far as to argue that free trade makes poor countries poorer, and that multinational corporations that use labor in developing countries should be boycotted. The argument that free trade exploits the poor suffers from several flaws. The fundamental flaw with the argument that free trade is being used to exploit workers in less developed countries is that it fails to explain why people voluntarily take low paying jobs in factories in the first place. People choose the factory jobs because they are better than the alternatives. For many factory workers in less developed countries, the only alternative is an even lower paying job and harder work in agriculture. Close examination of the international sector reveals other flaws. If businesses care mainly about cheap labor when they decide where to build factories, then investment flows into the poorest of the poor countries would be large and exports from the poorest of the poor countries would be large as well. The poorest countries and the lowest wages in the world are in Africa. Few businesses move into Africa to take advantage of the low wages. Table 8.3 shows flows of foreign direct investment from the U.S. into other countries. Businesses headquartered in the United States sent more investment dollars to the country of Denmark in 2003 than they did to the entire continent of Africa. Table 8.3 Foreign Direct Investment Position, 2003 Country U.S. Investment In (millions $s) Country Investment In United States (millions $s) United Kingdom 272,140 United Kingdom 218,175 Canada 192,409 Japan 159,160 Netherlands 178,933 Netherlands 153,679 Switzerland 86,435 France 141,400 Africa 18,960 Africa 2,298 Source: United States, Census Bureau, Statistical Abstract of the United States, 2004-2005. Table No. 1283. Foreign Direct Investment Position in the United States on a Historical-Cost Basis by Industry and Selected Country: 1990 to 2003; and Table No. 1288. U.S. Direct Investment Position Abroad on a Historical-Cost Basis by Selected Country: 1990 to 2003. In fact, most international investment flows back and forth between the most developed countries in the world. Of the $1,167,337 million in foreign direct investment in the world in 2001, more than 86 percent went to high income countries, countries that account for less than one-sixth of world population but produce five-sixths of world income. A little more than one half of 1 percent of foreign direct investment went to the low income countries, countries that account for one-third of world population and had an average per capita GDP of $430 that year. The low income countries only accounted for 3.5 percent of world exports. The ?globalized? world is the world of the high income countries, not the world of the low income countries. If low wages and desire to avoid regulation are the driving forces in the international sector, then Madagascar and Zimbabwe should be among leading exporters to the U.S. They are not. Table 8.4 shows the major trading partners of the United States. The most obvious fact about international trade, in fact, is that most trade occurs between the same few rich countries. The only difference between the top ten countries we export to and the top ten countries we import from is that Ireland is on the import list but not the export list, and Netherlands is on the export list but not the import list. Table 8.4. America?s Top Trading Partners Export Purchasers Import Suppliers Canada Canada Mexico China Japan Mexico United Kingdom Japan Germany Germany China United Kingdom S. Korea S. Korea Netherlands Taiwan Taiwan France France Ireland Source: United States, Census Bureau, Statistical Abstract of the United States, 2004-2005. Figure 28.2 Top Purchasers of U.S. Exports and Suppliers of U.S. General Imports: 2003. If American firms were unable to compete internationally, then the trade deficit would be the result of a lack of demand for U.S. products, implying a decline in U.S. exports, but exports have risen to record levels in the past decades. American firms compete especially well in the services sector, where we consistently run trade surpluses.