Why free trade can be good for an economy, and a brief explanation of its potential undesirable unintended consequences
To raise funds for concert tickets, 2 friends offer car-washing and lawn mowing services. Dave happens to be a very efficient worker. He can wash twice as many cars and mow 1.5 times as many lawns as Richard, as below.
To maximize productivity, how should the boys split their work? Richard slept through macroeconomics, so he suggests Dave do all the work since he’s faster at both anyway – typical Richard.
But Dave remembers what David Ricardo, the British economist, said about comparative advantage. Dave argues that, although he has an absolute advantage on both tasks – he’s faster at both – he’s constrained by time. Every minute washing cars is a minute not mowing lawns, and vice versa. Dave draws up a table showing the opportunity cost, which is how much he loses by not spending his time efficiently.
To wash a car, Dave gives up mowing 0.38 lawns (1.5 lawns for every 4 cars) versus Richard’s 0.5. Dave has comparative advantage, so he should wash cars. Meanwhile, Richard has comparative advantage over Dave at mowing lawns. He should do it because it only costs him 2 car washes when it costs Dave 2.67.
My wood for your sheep
The concept of comparative advantage explains why free trade is a good thing. Producing stuff costs. Besides the raw material and labor involved with manufacturing goods, there’s opportunity cost too – every time an economy decides to produce something, it gives up the opportunity to produce something else. Countries should specialize in goods and services where their opportunity cost is lower compared to other nations.
Let’s look at strawberries and crude oil. South Korea exports the former, and Saudi Arabia the latter. If Saudi Arabia wants strawberries, it should just import from South Korea instead of struggling – and failing – to cultivate the fruit. Otherwise, it may end up diverting resources that will be more productive at extracting crude oil into an impossible task. By engaging in trade, both South Korea and Saudi Arabia benefit. They satisfy their wants and needs at minimal cost.
The benefits of trade apply to goods and services that aren’t impossible for an economy to produce. The Philippines is heavily agricultural, but it also imports rice from countries with a comparative advantage in rice production. This provides the Philippine market with additional variety as well as cheaper options.
Use it to your (comparative) advantage
Where and how do economies gain comparative advantage in producing goods and services? When it comes to producing something like fruit or oil, some countries are naturally good, given their geography and climate. Russia can’t specialize in tropical fruits, but it’s a top producer of vodka, thanks in part to its harsh, cold weather.
Another reason why some countries can specialize in certain goods and services is the makeup of their resources. China’s large population makes it conducive to manufacturing, especially in labor-intensive industries. Meanwhile, India, with an equally large population, has a labor force fluent in English and trained in IT, hence why so many companies outsource remote customer service there. Western nations can rely on India’s fairly educated English-speaking population to provide support services like customer care and business processing. China doesn’t have as many English speakers, so it doesn’t attract call centers.
In addition, countries can gain comparative advantage by virtue of their institutions. For example, Singapore is a global financial hub because it has good banking structures and a stable political and financial ecosystem.
Does free trade kill jobs?
In 2016, then-presidential candidate Donald Trump said, “My plan includes a pledge to restore manufacturing in the United States.” In countries like the US, where manufacturing used to account for 32% of jobs, it’s all too easy to grieve for the past and blame free trade for the nation’s ills. That imported goods cost jobs is a common remark we hear. But is it true?
Cheap imports can take away jobs, but the issue is complex. With the money you save from buying imported goods, you might eat at a neighborhood café or get a haircut at the salon. Whatever you save benefits your local economy. When you get to have your cheap imported goods and a nice meal at the café, don’t you get to enjoy more without spending more?
Free trade can threaten domestic jobs, but, on an aggregate level, the economy is better off. When local industry is under threat by foreign competition, businesses need to find a way to stay competitive. Otherwise, their workers suffer.
Economies of scale
Why do countries with comparable economic profiles trade with each other? Intra-industry trade, the trade of goods within the same industry, allows countries to achieve economies of scale. Producing at higher volumes lowers per-unit cost by spreading fixed costs like tools, equipment, and research across a larger production quantity. This concept is known as ‘economies of scale.’
To produce a chair, for example, you’d need a saw, some glue, and wood. Glue is sold by the pail, so making 1 chair leaves you half a pail of glue extra. What if you decided to produce 10 chairs? You’d have to buy 10 times as much wood and 5 times as many pails of glue, but the saw you have is enough to complete the job. This brings costs down somewhat. You waste half a pail of glue less, and you distribute the cost of 1 saw across 10 chairs.
Finally, imagine producing 100 chairs. At that volume, you can negotiate with your supplier for bulk pricing to bring your per-unit cost of wood and glue down. And as you continue to make more chairs, you build on your expertise, finding faster, better ways to produce.
By your powers combined
Imagine 2 countries cooperating on the production of an aircraft model. By splitting the whole into portions, workers in each economy can become specialists of their specific part, building deeper knowledge and honing their skills. Instead of having to spread themselves thin building a wide knowledge base on different aspects of production, they can have a laser focus on their respective specialties. By working together, countries enjoy economic gains they won’t otherwise achieve by going it alone.
Trade also allows economies to have a variety of goods. For example, a country produces 500 units of a car model. If it wants to produce 2 models, it can only produce 150 units of each. With the same input level, its output decreases. Alternatively, it can find another country in a similar situation. Each country can produce 500 units each of both models, then swap half with each other. This way, efficiency is maintained, but consumers have more options.
The dark side of free trade
Trade and globalization have opened doors for businesses, though some doors lead to less desirable consequences. Large corporations maximize profit using cheap labor in lower-income countries. These countries often have weaker regulations. Laborers work in unsafe environments handling dangerous chemicals with long hours and little pay.
These outsourcing practices benefit consumers in developed countries, who are sometimes unaware or unconcerned about the plight of factory workers in countries like Bangladesh. Critics may condemn these practices as exploitative and oppressive, but workers tolerate harsh conditions, believing sweatshop work will save them from poverty. Whether these practices lead to more harm than good is a contentious topic and subject to debate.
Perhaps there is less room for discussion with forced labor and child labor. Yet they are still realities in some parts of the world. For now, consumers must decide where they draw the line. Do they really want to know about the origins of their cheap clothes and electronics? To this end, the idea of ‘ethical consumerism’ has gained ground in recent years.
Who benefits from protectionism?
When people focus on the job loss and reshuffling that result from international trade, nationalistic sentiments pave way for protectionist practices. Tariffs are taxes slapped onto imported goods and services, ‘protecting’ local industry by raising prices on imported goods. Although local producers benefit, consumers suffer due to higher prices.
Alternatively, a country may set import quotas, a cap on how much of any specific good can be imported into the country, like only allowing 3 million Chinese car imports annually. Finally, governments may direct their attention inward and, instead, grant subsidies or tax cuts to local producers, thus lowering the cost of domestic goods. Subsidies are common in agriculture, oil, housing, and healthcare since these are crucial to citizens’ welfare.
Protectionism may benefit some players within the economy, but, on the whole, society is worse off for it. Less competition reduces quality and innovation and ultimately slows economic growth. But protectionism has its advantages. Countries don’t want to be reliant on other nations for key goods, as trade can be used as a bargaining chip for political issues. A degree of independence helps insulate a country’s economy from external shocks.
Currency exchanges and their impact on free trade
Exchange rates – the price of one currency expressed in another country’s currency – are crucial in international trade. Most currencies’ values fluctuate constantly, adjusting to demand and supply. In the foreign exchange market, demand for a currency – let’s say the US dollar – comes from foreigners wanting to invest in the US, tourists who want to buy American goods, and American companies seeking to swap their foreign earnings into US dollars.
If US$ 1 was worth €1.11 Euros but is now worth €0.64, who benefits? The US dollar is weaker, so a European who needs US$ 100 gets to pay less of their currency in exchange – €64 now versus €111 before. The buyer benefits when a currency weakens.
Even when you have no plans of buying or selling US dollars, its value affects you. Saudi Arabia, the world’s largest oil producer, pegs its currency to the US dollar. When the US dollar is stronger, so too is the riyal. Thus, Saudi Arabia can sell its oil at a cheaper price, making gas prices more affordable for everyone else.
Interest, inflation, and exchange rates
As a trade partner of the US, does the EU benefit from a weaker dollar? It depends on who imports more from whom. If the EU exports to the US more than it imports from the US, a weaker dollar means that Americans now have to pay more for EU goods. As the US seeks cheaper goods elsewhere, the volume of EU exports to the US may decrease. Countries who are net exporters have an incentive to keep their currency relatively weak in order to maintain their export volume.
Several factors affect exchange rates. Let’s say South Korea’s interest rates go up. The high interest rates will attract foreign investment. As demand for the Korean won increases, so too does the currency’s value.
But investors need to be mindful of inflation too, as it can chip away at investors’ expected interest income. If South Korea’s nominal interest rate is at 1.75% while its inflation rate is currently 2.5%, a foreigner’s investments in Korean won loses value over time at a rate of 0.75%.