From: thompson@atlas.socsci.umn.edu (T. Scott Thompson)
Subject: Re: Free Trade or Comparative Advantage
Reply-To: thompson@atlas.socsci.umn.edu
Organization: University of Minnesota
Date: Fri, 14 Aug 1992 18:05:18 GMT

rob@KAMAN.COM (Rob Vienneau) writes:

>In this forum, a Stanford economist recently began a discussion by
>stating, in the usual authoritarian and obscurantist manner typical of
>the higher learning, that the theory of comparative advantage shows
>that the employment impact of the new free trade agreement is nothing
>to worry about.  Although the theories of international trade and
>development are not my specialty, insofar as an amateur can be said to
>have a speciality, I'll offer some comments here.  Apparently these
>theories aren't known at Stanford either.  I'll ignore all
>methodological questions, other than to point out one ought to wonder
>how an "ought" can be derived from a theory that normally is presented
>as an "is." Instead, I'll examine the theory of comparative advantage
>on its own grounds.

> [fairly accurate explanation of Ricardian comparative advantage
   deleted.]

>This argument can be generalized to many countries, many goods, many
>factors, and more flexible production conditions.  What cannot be
>removed, as far as I know, are the assumptions that factors (e.g. 
>finance capital and labor) are immobile between countries, that the
>level of employment is given, and that changes in technology are
>exogeneous. 

This is not quite true.  Plenty of research has been done extending
Ricardian theory and its successors to situations in which some or all
factors of production are mobile between countries.  These
considerations suggest that factor mobility is something of a
substitute for free trade, and that factor mobility in no way upsets
the basic case against protectionism.

In particular, lack of free trade with Mexico and other low wage
countries can be seen as one explanation for _why_ wages are lower
there, and _why_ capital in the U.S. is interested in moving elsewhere.
The consensus of most economists is that free trade is likely to lower
international disparities in wage rates and rates of return on
capital.  Trade restrictions on the other hand encourage the migration
of illegal immigrants into the U.S.  and capital flight by U.S.
corporations.

It is true that the theories assume that the level of employment is
given.  Unfortunately, economic science (we are in sci.econ, aren't
we?)  has been rather unsuccessful explaining the phenonmena of
unemployment.  Neoclassical economics essentially rules out the
possiblility of any involuntary unemployment.  Some economists (not
me, however) do not even think that involuntary unemployment is a real
phenomena.

Theories that do explain involuntary unemployment typically rest on
assumptions about price stickiness or assume away certain kinds of
labor contracts without giving any evidence that these assumptions
conform to reality.  (In fairness, this kind of thing happens often in
academics, which does not make it any more excusable.)

But let me turn this criticism around.  I have yet to hear any sound
arguments that show that free trade increases the aggregate level of
involuntary unemployment.  (You must take into account the likelihood
that free trade increases employment in export oriented sectors in any
such argument.)  So I see the unemployment issue as not coming down
convincingly in either direction.

Now for the point about changes in technology being exogenous.  You
_may_ have a point here.  Economists do not understand the process of
technological change very well, nor do they understand the process of
how technological innovation is spread internationally.  This is area
of very active current research.  It is closely related to a branch of
recent research that has been dubbed the "New International Economics"
or NIE.  NIE tends to focus on the one aspect of the Ricardian theory
that really _is_ essential, namely that markets are competitive.
(Technological innovation can lead to imperfect competition.  This is
one reason why the two issues are related.)  The NIE has shown that
trade restrictions can be beneficial in the presence of imperfect
competition.

You did not mention another common criticism of the Ricardian theory
-- namely that its welfare conclusions can break down in the presence
of market externalities (such as pollution) that have real effects on
social welfare.

I can assure you that academic economists (including those at
Stanford) are and have been well aware of the kinds of things that can
go wrong in the arguments for free trade, and are actively working on
these kinds of problems.

Perhaps surprisingly, most academic economists still think that
protectionism is a bad thing.  There are several reasons.

First, many of the arguments against free trade are essentially
beggar-thy-neighbor arguments.  The arguments about low wage Mexican
labor are a good example.  Because the U.S. is big (and therefore has
some monopoly power with respect to world markets), clever use of
protectionism can force U.S. income up and Mexican income down.
However, it can be easily demonstrated (in the mainstream theories,
that is) that the income of the world as a whole is lowered in the
process.  Furthermore, it seems unlikely that the U.S. government is
able to fine tune the tariff structure well enough to ensure that
protectionism actually raises U.S. income, since not even the experts
have any idea what kind of tariff structure is needed to achieve this
result.

Second, many of the arguments against free trade are really arguments
against the redistribution of income that free trade _may_ generate.
Many "amateurs" (by the way, Ricardo was an "amateur") miss this
point.  The extension of Ricardo's model to multiple factors of
production that you mentioned drastically changes the model in one key
respect.  It shows that free trade can hurt some individuals.  It also
shows, however, that the net gains in national income are positive, so
that it is possible, in principle, for everyone to be made better off
with trade, _provided_some_mechanism_is_provided_for_compensating_
_those_hurt_by_the_move_to_free_trade!

As far as I know, academic economists universally recognize that some
individuals have legitimate concerns about the personal consequences
of free trade.  But trade is no different from other economic
activities that affect relative incomes.  Instead of arguing against
free trade, perhaps we should be arguing for a more equitable
distribution of income, but this is really a separate issue.

Third, many of the arguments against free trade rest on imperfections
in the economy (e.g. pollution, imperfect competition, unemployment)
that have little to do with trade per se.  In these cases, although
protectionism can improve national welfare, it is almost never the
best way of doing so.  In the case of pollution, for example, the best
way to avoid new pollution in Mexico, for example, is to regulate it
directly (perhaps with a pollution tax there) rather than indirectly
by discouraging trade.  It is easy to make this argument rigorously.
In these cases protectionism is what economists call a "second best"
policy.

Finally, suppose that taking all of the above into account you
determine that some protectionist policy _may_ raise national welfare.
Are you convinced that the current pattern of protectionism actually
does this.  The bottom line of 200 years of economic research is that
only under very special conditions can certain kinds of protectionism
help.  Most economists do not think that the status quo reflects the
conditions needed.

>An argument that takes the level of employment as given cannot be said
>to show that free trade has no effect on the level of employment. 
>Suppose this assumption is relaxed to state that long run tendencies
>towards full employment exist.  This still does not mean that a sudden
>removal or decrease in tariff barriers will not cause problems.  An
>adjustment process must occur in which a country's whole structure of
>production is transformed for specialization in the production of a
>different set of goods.  Economists set themselves too easy a task if
>they confine themselves to demonstrating that the sea is calm after the
>storm has passed.  These transitional problems remain.  Capital goods
>are not ectoplasm that can be instantly and costlessly transformed from
>being appropriate to producing one set of goods to being appropriate for
>another.  Nor can one casually assume the ultimate direction in which
>the economy is headed is independent of the route it travels to get
>there. 

Economists are well aware that adjustment costs exist and that
adjustment processes have significant effects on the welfare
implications of a move to free trade.  Again, there is an extensive
academic literature.  Unfortunately, it is again the consensus of this
literature that (1) free trade is beneficial in the long run even when
adjustment costs are taken into account, and (2) adjustment processes
hurt some people in the "short" run (which admittedly could be rather
long).  Again, you simply do not accurately represent the current
state of affairs in academic research.

>Another problem with this model is the theory of exchange rates lying
>behind it.  With continuous production functions, the theory derives an
>equilibrium set of exchange rates between different currencies.  But, as
>far as I know, the volume of transactions on currency markets is much
>larger than that needed to clear accounts between those engaged in
>international trade.  The dominant influence is speculation -
>individuals trying to guess what the future will bring.  In a market in
>which prices move in response to the participants' beliefs about what
>others will believe tomorrow about future movements, it's hard to accept
>the Neoclassical argument that prices tend towards realizing some
>physical constraint.  See Chapter 12 of Keynes' _General_Theory_ and
>almost any commentary on it by G. K. S. Shackle. 

I don't see what exchange rates have to do with the argument
for/against free trade, unless governments indirectly restrict
individuals' rights to trade by making certain kinds of currency
transactions illegal (as was done in the Soviet Union).  Currency
speculation surely introduces some risk into international
transactions that are not there in domestic transactions, but I do not
see how this affects the basic arguments against protection.

>A glance at what is traded also reveals large deficiencies in the
>theory.  Some countries specialize in raw materials.  Some trade in
>semifinished goods.  [And, as required by the theory, consumer goods are
>traded.  The roles of immigration, movements in finance, and
>multinationals are also of interest.  In short, the assumptions that
>factors of production are relatively immobile between countries and that
>consumer goods dominate trade are rarely met in practice.  Also, one is
>hard pressed to believe that a country should be indifferent to whether
>it specializes in bananas, oil, steel, autos, or consumer electronics. 
>Obviously, changes in the technology available to a country are affected
>by what it produces.  Both Adam Smith and Friedrich List knew this, but
>academic economists cannot accept it without rejecting the whole of
>Neoclassical economics. 

The first point in this argument is not factually correct.  The theory
places no restrictions on the kinds of goods that are traded, and
models exist that allow for intermediate goods and untraded goods.
These models do not contradict the Ricardian conclusion in favor of
free trade.  I believe that I have already addressed the other points
made.

>As a final empirical point, the theory of comparative advantage has been
>falsified.  After WW II, Europe lay in ruins.  Presumably, the U.S.  had
>a relative advantage in capital intensive goods.  But the Nobel laureate
>Leontief found that in that period the U.S.  imported capital-intensive
>goods, whatever that means, and exported labor-intensive goods. 
        ^^^^^^^^^^^^^^^^^^^^
>Neoclassicals added a few epicylces to their theory, labelled this the
>Leontief Paradox, and continued on their way in ignorant bliss. 

The so called Leontieff Paradox that you mentioned is no longer
considered a paradox in academic circles.  First, it is questionable
whether or not it is true that the U.S. exported labor-intensive
goods, since Leontieff's study did not take into account human capital
(e.g. technological knowledge) in calculating the factor intensity of
U.S. trade.  Other studies do not support Leontieff's empirical
findings.  Secondly, the Leontieff finding, if correct, is only
paradoxical in a world with only two goods and two factors of
production.  In a world with many factors of production and many
goods, Leontieff's empirical results are fully consistent with the
theory.

>And for a final theoretical point.  A whole alternative theory sprang up
>from Keynesian Macroeconomics.  Suppose consumption increases in a
>country, but much of it is spent on imported goods.  Then the multiplier
>effect, which increases the GNP and employment, is considerably
>lessened.  On the other hand, countries who export the goods now being
>consumed by the first country might increase their demands for imports
>from that country, with consequent improvements in that country's
>employment.  Then, of course, one might want to consider how different
>monetary policies in different countries affect this process. 
>Obviously, there's room for the development of lots of theory here, and
>a lot was developed.

As I have said, I have not seen any theories that convincingly argue
that free trade might lower employment.  This includes Keynesian
theories.  I think that Keynes would agree, since he was instrumental
in setting up the new international organizations that led to major
decreases in international tariffs after World War II.

>I hope this note has made it clear that a competent analysis of free
>trade and employment must consider much more than the theory of
>comparative advantage, either in introductory or advanced forms.  And
>I only considered a selected subset of issues here.

> Robert Vienneau                      I sit in one of the dives
> rob@kaman.com                        On Fifty-Second Street
>                                      Uncertain and afraid
>P.S. Has anyone read                  As the clever hopes expire
>this far?                             Of a low dishonest decade:

Yes!

>                                      Waves of anger and fear
>                                      Circulate over the bright
>                                      And darkened lands of the earth,...
>                                                        W.H. Auden
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T. Scott Thompson           thompson@atlas.socsci.umn.edu
Dept. of Economics
University of Minnesota