Trade winds Nov 8th 1997 The fourth in our series of briefs on globalisation looks at international trade. Why does it make sense for countries to trade goods and services? How much trade do they do? And why are there obstacles to freer trade? TIME was when trade flows were of interest mainly to economic experts and executives of big corporations. But over the past few years, the movement of goods and services across national boundaries has become the subject of intense public attention all over the world. To the public at large, trade is the most obvious manifestation of a globalising world economy. Measured by the volume of imports and exports, the world economy has become increasingly integrated in the years since the second world war. A fall in barriers to trade has helped stimulate this growth. The volume of world merchandise trade is now about 16 times what it was in 1950, while the world’s total output is only five-and-a-half times as big (see chart 1). The ratio of world exports to GDP has climbed from 7% to 15% (chart 2). Virtually all economists, and most politicians, would agree that freer trade has been a blessing. However, the economists and politicians would probably give quite different reasons for thinking so. Politicians, by and large, praise greater trade because it means more exports. This, in turn, purportedly means more jobs—and, if the exports involve sophisticated products such as cars or jet engines, more “good” jobs. The American government, zealous to promote exports, has even produced estimates that try to show how many new jobs are created by each $1 billion of American sales abroad. This is misleading. A big export order may well cause an individual company to add workers, but it will have no effect on a country’s totalemployment, which is determined mainly by how fast the economy can expand without risking inflation and by microeconomic obstacles, such as taxes that deter employers from hiring or workers from seeking jobs. America, where exports are a relatively small fraction of GDP, has fuller employment than Germany, where exports loom larger. Gains from trade To economists, the real benefits of trade lie in importing rather than in exporting. Politicians frequently urge consumers to favour domestically made goods, and portray a widening trade deficit as a Bad Thing. But economists know that the only reason for exporting is to earn the wherewithal to import. As James Mill, one of the first trade theorists, explained in 1821: The benefit which is derived from exchanging one commodity for another, arises, in all cases, from the commodity received, not the commodity given. This benefit arises even if one country can make everything more cheaply than all others. The basic theory that explains this, the principle of comparative advantage, has existed since Mill’s day. His contemporary, David Ricardo, usually gets the credit for expounding it. To see how this theory works, think about why two countries— call them East and West—might gain from trading with one another. Suppose, for simplicity, that each has 1,000 workers, and each makes two goods: computers and bicycles. West’s economy is far more productive than East’s. To make a bicycle, West needs the labour of two workers; East needs four. To make a computer, West uses ten workers while East uses 100. Suppose that there is no trade, and that in each country half the workers are in each industry. West produces 250 bicycles and 50 computers. East makes 125 bikes and five computers. Now suppose that the two countries specialise. Although West makes both bikes and computers more efficiently than East, it has a bigger edge in computer-making. It now devotes most of its resources to that industry, employing 700 workers to make computers and only 300 to make bikes. This raises computer output to 70 and cuts bike production to 150 (see table 3). East switches entirely to bicycles, turning out 250. World output of both goods has risen. Both countries can consume more of both if they trade.At what price? Neither will want to import what it could make more cheaply at home. So West will want at least five bikes per computer; and East will not give up more than 25 bikes per computer. Suppose the terms of trade are fixed at 12 bicycles per computer and that 120 bikes are exchanged for ten computers. Then West ends up with 270 bikes and 60 computers, and East with 130 bicycles and ten computers. Both are better off than they would be if they did not trade. This is true even though West has an “absolute advantage” in making both computers and bikes. The reason is that each country has a different “comparative advantage”. West’s edge is greater in computers than in bicycles. East, although a costlier producer in both industries, is a relatively less-expensive maker of bikes. So long as each country specialises in products in which it has a comparative advantage, both will gain from trade. Fair deal Some critics of trade say that this theory misses the point. They argue that trade with developing countries, where wages tend to be lower and work hours longer than in Europe and North America, is “unfair”, and will wipe out jobs in high-wage countries. It is generally accepted that trade with poor countries has been one of the factors reducing the wages of unskilled workers, relative to skilled ones, in the United States. That said, the threat to rich-country workers from developing-country competition is often overstated. For a start, it is important not to confuse absolute and comparative advantage. Even if developing countries were cheaper producers of everything under the sun, they could not have a comparative advantage in everything. There would still be work for people in high-wage countries to do. Moreover, it is not true that countries with cheap labour always have lower costs. Wage differences generally reflect differences in productivity; companies in low-wage countries often need far more labour to produce a given amount of output, and must deal with less efficient communications and transportation systems. In most cases hourly wages are not decisive in determining where a product is made. Suppose that the “fair traders” succeed in eradicating international differences in production costs, so that a given product cost precisely the same to make in different countries. In that case, no country would have a comparative advantage, and hence there would be no trade.