Saturday, October 08, 2005

What do countries trade? Why do countries trade?

If you read fairly typical antiglobalist propaganda (see here), you would think that foreign trade is somehow detrimental to an economy. An economy trades mainly because the foreigner wants to monopolize the domstic market. While the economy is ruined by imports, we also ruin ourselves by misallocating our scarce local resource to produce exports only to serve the foreigner.

Phobias have zero rational basis; xenophobia is no different. Fortunately many countries have, by joining the World Trade Organization, signalled their intention to liberate themselves from this obsolete way of thinking.

Consider the the first question in the title; of course I am not after opening some trade statistics book to find out what products are imported and exported. What I mean is, what is the reason those products are imported or exported? The answer was already given by Ricardo (quoted here). Without using the phrase, Ricardo was already elucidating an answer based on opportunity cost. Opportunity cost is a central concept in economics. When you produce cloth, the cost of doing it is not, I repeat not, determined by the amount of inputs (land, labor, machinery, materials) used up in the process. The cost is the vaue of the goods that are given up because resources have been shifted to produce the cloth. After all, these resources are means to an end, right? So the actual cost can be found only by examining the trade-offs between competing ends.

Once you get over that hump, the rest is (comparatively) easy. Suppose (as in Ricardo's example) 1 of cloth costs England 100 men, while 1 of wine costs 120 men. Portugal meanwhile can produce the same cloth with only 90 men, and the same wine with only 80 men. Laypersons (and most anti-globalists, I think) would say that it England will have to import both wine and cloth from Portugal, because it costs more (in terms of labor) in England. Wrong! Again, the labor does not matter; what matters is what you get out of the labor. So, with this in mind, consider: in Portugal 1 of wine costs 8/9 of cloth (= 80/90). Meanwhile in England, 1 of wine costs 1.2 of cloth (= 120/100). So wine has a lower opportunity cost in Portugal, than in England. However the reverse must be true: cloth must have a lower opportunity cost in England! By giving up one of wine, you can only get 8/9 of cloth in Portugal; however, in England, by giving up 1 of wine, you can get 1.2 of cloth. So:

What does England trade?
It exports cloth and imports wine.

What does Portugal trade?
It exports wine and imports cloth.

Why does England trade?
Because it is more beneficial for it to do so.

Why does Portugal trade?
Because it is more beneficial for it to do so.

Suppose say 1 of wine trades for 1 of cloth. Then by importing 1 of wine, it need only export 1 of cloth; to get the same wine without trade, the amount of cloth that needs to be given up is 1.2. Meanwhile Portugal gives up 1 of wine and gets 1 whole cloth; without trade, it will have to make do with only 8/9 of cloth.

Folks, you have just heard the simplest and most powerful argument for free trade. Everything else is gravy.

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