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A Primer on Trade

November 4, 2002

Tags Big GovernmentCorporate WelfareU.S. EconomyInterventionism

Hardly a day goes by when I don't read something crazy on the subject of international trade, from pundits who blame it for America's economic and social woes, to those who think trade can only thrive in the context of treaties and war. In truth, international trade is nothing more than an extension of the idea of exchange itself: that all people are better off cooperating through contract than fighting with force and coercion.

For that reason, the case for free trade is an important part of the general case for liberty. The argument that people should be free to trade across political borders can be applied to exchange at any level, not only to exchange between citizens of different countries but also to trade within a country. But this point is so little understood, it occurred to me that what is needed is a brief introduction to the entire subject.

Terminology

Since this is an introductory essay, it's appropriate to begin with a discussion of the basic terminology of trade. In the broad sense, international trade is any commerce that takes place across political borders. Any trade between people in different countries is international trade.

The balance of payments is the government's attempt to measure all international trade activity. The major accounts in the balance of payments are exports, imports, capital inflows, and capital outflows. Exports and imports are goods and services sold to and purchased from foreign interests, respectively. It's important to remember that generally these goods and services are exchanged for currency. When exported and imported goods cross a political border in one direction, currency crosses the border in another direction. 

In addition to exports and imports, much of the trade in the world involves situations where no assets leave or enter a country. These exchanges are called capital flows. Capital inflows occur when foreign interests acquire assets in this country. Examples include the purchase of stocks, bonds, real estate, and businesses. Most capital inflows can be thought of as investments, individuals from one country are investing in another country. Conversely, capital outflows occur when domestic interests acquire assets in another country. Just as one country's imports are another country's exports, a capital inflow for one country is another country's capital outflow.

When the dollar value of a country's imports exceeds the dollar value of its exports, the country has a trade deficit. If the country is exporting more than it imports, it has a trade surplus. A trade deficit implies that due to the trade of goods and services, more currency is flowing out of the country than into the country. This net currency outflow is generally associated with a net capital inflow. Similarly, a trade surplus is associated with a net capital outflow. This topic will be addressed later in this essay.

If a government allows its citizens to engage in these commercial transactions without any restriction of any kind, this is free trade. However, most international commerce involves government intervention. Protection is any policy that restricts trade in order to protect a domestic industry from foreign competition. Protectionist policies include tariffs (taxes on imports), quotas (limits on the quantity of imports), and non-tariff trade barriers such as mandates on the quality or the content of imported goods. Protection increases the price of imported goods, reducing the amount of imports, thus protecting some domestic industry from foreign competition. A tariff or quota on imported trinkets, for example, raises the price of imported trinkets making it easier for the domestic trinket industry to gain market share.

It's important to note that consumers are the main beneficiaries of trade and the main victims of protection. Trade drives down prices allowing consumers to buy more goods and protection increases prices.  

Pro and Contra Trade

Let's now consider the cases for and against trade. The classic argument that provides us with the primary economic justification for free trade is called the law of comparative advantage. According to this argument, a country will profit by specializing in the production of goods in which it has a comparative advantage and trading for goods in which it does not have a comparative advantage. Free trade will result in a better use of a country's resources.

Under free trade, a country will use its resources more efficiently in the sense that it will increase the amount of goods available for consumption and production. It will tend to specialize by producing goods that it can produce using fewer resources than its trading partners. This specialization generates the benefits of trade.

A key to understanding this law is realizing that there are two ways for a country to acquire a good. The country can produce the good, cars for example, directly by using its own resources, or it can produce a different good, say wheat, export the wheat, and in return receive imported cars. Foreign trade is simply a way of producing cars by using domestic resources to produce wheat and then trade converts the wheat into cars.[1] 

In order to understand this argument, consider a country, Ruritania, with $100 of resources available. Assume that if Ruritania does not trade with the rest of the world, Ruritanians annually produce 5 cars using $10 of resources per car. This requires $50 of resources, leaving enough resources to produce 50 bushels of wheat using $1 of resources per bushel. Increasing the production of cars to 6 cars would mean that Ruritania would need to decrease the production of wheat by 10 bushels. The economic cost of producing a car is 10 bushels of wheat.

Now, assume that Ruritanian citizens are allowed to trade freely with the rest of the world and that Ruritania can reap the gains of trade by specializing in the production wheat and trading for cars. For the sake of simplification, assume that Ruritanians can purchase foreign cars for $6 of resources per car. In other words, for every car that is imported, Ruritanians must, since wheat costs $1 of resources per bushel, produce 6 fewer bushels of wheat. The economic cost of imported cars, 6 bushels of wheat, is less than the economic cost of producing domestic cars, 10 bushels of wheat. It is in this sense that Ruritania has a comparative advantage in wheat production and is at a comparative disadvantage in the production of cars.  

Now assume that Ruritania imports 7 cars at $6 per car and uses its remaining resources to produce 58 bushels of wheat, again at $1 per bushel. Because of the trade, Ruritania prospers. Ruritania now has more cars and more wheat than it had when it wasn't trading with the rest of the world. The point is that trade allows the country to use its resources more efficiently. This is the essence of the law of comparative advantage.

Generally, however, governments allow some trade, but not free trade, between their citizens and foreign citizens. Governments protect domestic industries, manage this trade with lengthy trade agreements, or limit the trade with trade sanctions of some sort. Trade restrictions increase import prices. In the case of Ruritania, protectionist policies increase the price of foreign cars to $8 per car and at this higher price only 6 cars are imported into Ruritania. This gives Ruritania enough remaining resources to produce 52 bushels of wheat.

Let's recap. When Ruritanian citizens were not allowed to trade with the rest of the world, they used their resources to produce and consume 5 cars and 50 bushels of wheat annually. With free trade, Ruritanians had 7 cars and 58 bushels of wheat to consume every year. When trade was limited due to government intervention, only 6 cars and 52 bushels of wheat were available. This is the fundamental case for trade. Free trade leads to greater wealth and prosperity. Trade restrictions force a society to waste its resources.

What's not to Understand?

Given the airtight case for free trade, the question arises: why do governments intervene in international trade? Why do governments restrict international commerce? If free trade is in the public interest and protection is detrimental to the economy, why is there so much protection?

One obvious answer is that government officials often do not act in the public's interest. They tend  to enact policies that have concentrated benefits for special interests and disperse the costs of the policies around to a large part of the population. Policies that are harmful to the country overall often generate votes and monetary contributions to political candidates. So while this doesn't makes sense from the point of view of the country overall, government officials have an incentive to enact destructive policies.[2] In the case of protection, the costs are dispersed to consumers in general in the form of higher prices, but generate political support from the protected industry.

Infant Industries Argument

While it's true that protection is driven by the self-interest of politicians, let's consider the arguments that conclude that limiting trade is good for a country, beginning with the well-known infant industries argument. According to this argument, it's in a country's interest for the government to protect a developing industry in its infancy. The industry has a period of infancy during which it is not yet prepared to compete on world markets but once the industry grows up and becomes a mature industry it won't need protection any longer. It will be competitive and provide economic benefits for the country. Protection will allow industries that otherwise would fail to grow and prosper, thereby benefiting the country in the long run.

Consider first the infancy period of an industry. There are only two possibilities here: either the present value, the current value of the future stream of profits and losses, of a firm in this infant industry is positive, in which case private investment will fund the industry during its infancy, or the present value of an investment in this industry is negative, in which case the industry may fail without government protection.

If this present value were positive, there would be no need for protection. Private investment would fund the industry. Therefore, the infant industries argument applies to an industry that has a negative present value of its infancy period. Such an industry necessarily takes losses before it becomes competitive.

Let's say that the present value of these losses is $10. Now compare these losses with the present value of the stream of profits of this same industry when it's a mature competitive industry no longer in need of protection. There are only two possibilities here, either these profits are less than or greater than $10, the present value of the losses of the infant industry. In the first case, the present value of these profits is, say, $8. The industry loses $10 during its infancy and generates profits of $8 as a mature industry. The present value of the overall future stream of profits during the life of this industry is a negative $2. Investing in this industry generates overall losses. Private industry would not make this investment and protecting this industry simply wastes resources. This infant industry should be allowed to die. It should not have government protection.

The other possibility is that this industry loses $10 in its infancy, but generates profits greater than $10, say $12, as a mature industry. The total present value of this industry is $2. Maybe this is the type of industry that deserves protection, since the losses incurred during the infancy period are less than the industry's profits during its mature stage.

Further consideration, however, reveals that even this industry should not be protected. First of all, government officials have neither the incentive to act in the public's interest nor the ability to make the calculations described above. It's in the public's interest for this industry to develop, but there is no reason to expect the government to recognize this and to be able to protect the appropriate industries. But more importantly, there is no need to protect this industry. This is a worthwhile venture. Private entities would be expected to recognize this investment opportunity and fund this industry. In short, protecting infant industries either wastes resources or is unnecessary.

Another side of the infant industry argument is the position that some infant industries that lose money in the long run need to be protected because this will generate capital formation and economic growth. According to this argument, the industry loses $10 during its infancy and generates $8 of profits when it is mature, but the overall losses of $2 are offset by the fact that the increase in capital formation generates economic growth that is beneficial to society overall.

The problem with this argument is that protection does not increase the amount of capital available, it simply reallocates capital from unprotected industries, comparative advantage industries, to protected industries, which tend to be industries that do not have a comparative advantage. Capital formation is due to savings. An increase in savings leads to an increase in investment in capital formation. Protecting an industry that is not profitable would be more likely to be harmful to savings and capital formation. Again, protecting infant industries wastes society's resources.

National Defense

A second popular argument for protection is the national defense argument. According to this position, during times of peace the government needs to protect vital industries, such as the steel industry, because during wartime steel imports may be restricted and the government will need steel for the war effort. There are three problems with this argument. First of all, protection itself leads to conflict between countries. Countries that trade with each other are less likely to go to war.

Look at it this way. My family trades with Wal-Mart. We have a very large trade deficit with Wal-Mart, importing lots of goods and services from them and exporting nothing to them in return. Suppose that Wal-Mart's management team hated my family because we are a freedom loving people and Christian to boot. Even though they hate our virtuous lifestyle, the fact that we trade with them makes it less likely that they will attack us since this would impose costs on them. They would lose the profits they receive from my trade. Similarly, countries that trade freely with each other are less likely to go to war because they would have to give up the benefits of trade.

Suppose that in spite of the trade between two countries, their governments still choose to go to war. Engaging in free trade during times of peace makes a country prosperous, allowing it to build up its industry, therefore providing more resources during times of war. Protection impoverishes a country reducing its ability to effectively fight a war. Free trade during peacetime enriches a country so that it can produce more steel and other goods vital for a war effort.

A third point against the national defense argument is the previously mentioned calculation argument.[3] Assume that free trade during peacetime did not make a country prosperous, did not provide more resources during times of war. Even in this case, the national defense argument breaks down. Government agents cannot make the calculations necessary to judge which industries to protect, when to protect them, and how much protection to provide. Government officials will tend to provide this protection based on political judgments. Private industry can undertake the monetary calculation needed to make investment decisions and will do a better job of allocating resources to a war effort. An upcoming war will tend to increase the prices of certain goods. Private industry will recognize this and shift resources into the industries needed for war. If the government is going to need steel to fight a war, private investment will expand the steel industry in anticipation of this demand. Free trade strengthens and protection harms national defense.

Cheap Labor?

A third argument for protection is the cheap foreign labor argument. Here, the case is made that trade with countries with cheap labor will decrease domestic wages and jobs will be lost to these countries. Protection will increase the price of imports, preventing this loss of jobs and propping up domestic wages.

The problem with this argument is that it ignores which industries suffer from trade. Yes, under a free trade regime, jobs will be lost in certain industries, industries where the country is at a competitive disadvantage. However, jobs will be gained in industries where the country has a comparative advantage.

In the earlier example, Ruritania had a comparative advantage in the production of wheat. When it traded for cars, it increased its wheat production. Workers and resources moved out of the car industry into the wheat industry. Ruritanian workers get paid more in the wheat industry than the car industry, because they have a comparative advantage in wheat production.

Under free trade, workers tend to be in jobs where they have a comparative advantage. Marginal productivity increases. Wages increase. Therefore, workers, as a whole, have higher wages under free trade than they do with protectionist policies.

Also, the real value of workers' wage rates is determined by the prices of the goods the workers want to consume. Protection increases consumer prices, reducing real wages. Free trade keeps prices low, increasing real wage rates. Workers, as consumers, are the beneficiaries of free trade.

The Trade Deficit

A fourth pro-protectionist argument is the anti-trade deficit argument. A trade deficit means that a country is importing, in dollar terms, more goods than it is exporting. According to this line of reasoning, eliminating a trade deficit would imply either increasing exports or decreasing imports. This would either benefit exporting industries or it would benefit the domestic competitors of foreign imports. In both cases, wages would tend to increase in these particular domestic industries. So, trade deficits are economically harmful and protection that is used to eliminate a trade deficit benefits the country overall.

In order to see the fallacy in this argument, it's important to follow the money. A trade deficit implies that more currency is flowing out of the country to pay for imports than is entering the country as payment for exports. This implies one of two situations. Either this currency stays out of the country or it flows back into the country in terms of capital inflows. In the former case, dollars are flowing out of the country and are being held by foreign interests. Foreign agents are trading goods and services that required valuable resources to produce in return for dollars that cost little, in terms of resources, to produce. Not only are such exchanges profitable, the currency outflow reduces the amount of currency within the domestic country, benefiting consumers by reducing prices within the country.

In the latter case, the trade deficit is associated with a net capital inflow. The currency outflow due to the trade deficit is offset by a currency inflow as foreign interests acquire assets within the country. These capital inflows tend to be investments. Foreign interests increase capital formation, they buy bonds and stocks, they build businesses, they create jobs and drive up wages, and they put their money in banks, reducing interest rates.

A country that attracts foreign investment, in other words a country with a healthy economy, will tend to have a net capital inflow and this will be associated with a trade deficit. There is every reason to see the benefits of such a situation. Both the acquisition of imports and the foreign investment are good for the country. Trade deficits do not justify protectionist policies.

The Question of Sanctions

The case against free trade also includes the argument that the government should restrict trade in order to punish foreign governments. Sometimes trade restrictions are imposed not to protect a domestic industry, but to harm a foreign country. Embargoes and trade sanctions are policies that limit or eliminate trade with a particular foreign country. Such policies are meant to harm the targeted country in order to get that country's government to change its policies.

Much of the case for sanctions is based on political philosophy. Economic analysis, however, provides a framework for considering this policy question. Sanctions restrict trade between countries and have the same effects as protectionist policies. If country A imposes sanctions on country B, both countries suffer. Resources are not allocated efficiently, consumer prices rise, and real wages fall.

Oftentimes, a large country imposes sanctions on a small country. If country A were much larger than country B, then the sanctions would harm country B relatively more than country A. A billion dollars of damage is proportionally more harmful to a small economy than to a large economy. The damage to the large country is sometimes overlooked because it is relatively minor. Nonetheless, it's important to recognize that a government if harming its own citizens when it imposes sanctions on other countries.

Also, sanctions are often imposed in response to alleged human rights violations. The goal of the sanctions is to give the foreign government an incentive to stop its oppressive policies. Consider what is happening here. The citizens of two countries, A and B, are mutually benefiting from trade. However, country B's government is oppressing its citizens. Country A's government imposes sanctions on country B, eliminating trade between the citizens of the two countries. In this situation, citizens in country B are being oppressed by their own government, and due to the sanctions, are also being harmed by the foreign government. The sanctions harm the people that they supposedly meant to help. If the goal is to aid the victims of human rights violations, free trade is the correct policy.

In short, the case for free trade is unassailable and the arguments for trade restrictions are flawed. Trade restrictions harm consumers and efficient firms at the expense of less competent firms. Trade generates economic efficiencies, driving down prices, benefiting consumers, and increasing real wages.[4] 


Mark Brandly teaches economics at Ferris State University. Send him  MAIL. See his Mises.org Daily Article Archive.


[1]For a great explanation of this point, see Steven Landsburg’s “Iowa Car Crop” in his The Armchair Economist: Economics and Everyday Life, 1993.

[2]For an explanation of this argument see, for example, Tullock, Gordon, Government: Whose Obedient Servant, 2000, pp. 1–85.

[3]For a more complete discussion of the calculation argument, see Mises, Ludwig von, Economic Calculation in the Socialist Commonwealth, 1920.

[4]For further discussion on issues in international trade theory, I recommend Haberler, Gottfried, Theory of International Trade, 1935.


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