From: rob@KAMAN.COM (Rob Vienneau)
Newsgroups: sci.econ
Subject: Free Trade or Comparative Advantage
Date: 14 Aug 92 02:47:25 GMT

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.

David Ricardo originated the theory of comparative advantage to explain
why relative labor values do not regulate the price of goods traded
internationally.  Although the labor theory of value was rejected by
academics after the Neoclassical revolution, Ricardo's theory of
international trade was retained almost unchanged in a completely
different setting. 

Here is a rational reconstruction of Ricardo's example.  Suppose both
England and Portugal consume only two goods, cloth and wine.  Suppose
cloth and wine are both produced with only one factor of production,
labor.  Furthermore, suppose the given technology exhibits constant
returns to scale such that:

In England, 100 men are needed per square yard of cloth produced
            120 men are needed per barrel wine produced

In Portugal, 90 men are needed per square yard of cloth produced
             80 men are needed per barrel of wine produced.

Suppose the level of employment is given in both countries.  Note that
for any level employment, Portugal can produce more of any basket of
goods (x square yards of cloth, y barrels of wine).  That is, Portugal
has an absolute advantage in both goods.  Nevertheless, both countries
gain, assuming they are interested in maximizing consumption for their
given levels of employment, if they engage in trade in consumer goods. 
For a certain range of prices, England should produce only cloth, and
Portugal should specialize in wine.  Note that it does not matter to
this argument how much or how little workers in England are paid
compared to those in Portugal.  (I suppose, then, those who
misunderstand what's been demonstrated think the UAW need not fear cheap
Mexican labor.)

The nonprofessional economists who do not see how both parties benefit
from trade need not worry.  The great Chicago economist thought that
Ricardo was more likely to drive the average person to drink than to
convince him that free trade in wine was a good idea.

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. 

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. 

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. 

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. 

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. 

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.

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:
                                      Waves of anger and fear
                                      Circulate over the bright
                                      And darkened lands of the earth,...
                                                        W.H. Auden