by Ian Fletcher
A quota is also the worst kind of protectionism from the taxpayer’s point of view. Any barrier to imports—quotas, tariffs, voluntary restraints, closed distribution networks—raises the price of the imported product and its domestic substitutes. But a tariff puts much of the price increase into the taxpayer’s pocket. On the other hand, a quota puts it into the hands of the foreign producer. So in effect, the VRA was legalized price-fixing for the Japanese auto industry! This price-fixing then raised that industry’s profitability, enabling it to plow even more money into R&D aimed at surpassing American producers. (This effect was intensified by the fact that the VRA raised the price of Japanese cars, which were de facto rationed, more than the price of American cars, which were not.)330
The VRA also did nothing to ensure wise use of the increased revenues it handed to the U.S. auto industry by increasing its market share and enabling it to raise prices (by an average of $659 in 1984).331 All possible uses of revenue are not equal in their value to an industry’s long-term health. It can go to increased profits, increased capital investment, increased wages, or some combination of these. As it happened, most went to immediate profits and wages, not investment, the key to the industry’s long-term future.332 Twenty-five years later, the industry is paying the price, with Chrysler and General Motors having passed through bankruptcy and Ford having avoided it only by using the threat thereof to extract concessions from its unions and suppliers. In 2008, Toyota broke GM’s 77-year reign as the world’s largest automaker.
The intent (and effect) of the VRA was to relocate automobile production, be it by the Big Three or foreign producers, to the United States. Unfortunately, so-called transplants, the U.S. factories of German, Japanese, and Korean companies, are a problematic solution. (There are now 17 in the U.S.)333 While they do move production jobs to the U.S., they leave most design jobs at home. Transplant-made cars also have a much heavier dependence on imported parts: the average domestic content of the Big Three is 79 percent, but transplants average only 63 percent.334 Transplants also undermine the ability of any future tariff to revive an autonomous American auto industry, as foreign producers are now entrenched inside any future tariff wall.
POSITIVE STRATEGY VS. BAND-AIDS
It is important to avoid calling for protectionism merely to save dying industries. In recent decades, protectionists have reliably fretted about these industries, rarely about the harm free trade does to still healthy ones, and almost never about industries that free trade prevented America from developing in the first place. But trying to keep a primitive labor-intensive industry in the U.S. by protecting it (and perhaps stuffing it with subsidized investment) will just squander money that would have been better spent defending an industry in which America has a fighting chance. Or breaking into an entirely new “sunrise” industry. All over America, there are people stocking shelves at Walmart for $8 per hour who could have been HDTV manufacturing technicians at perhaps double that.335 (This industry doesn’t exist in the U.S., so we don’t know what their wages would be, but we can guess by looking at other industries that require comparable skill sets.)336 These people don’t know who they are, so they don’t complain about it, but they are just as big a part of our trade problem as the outright unemployed.
Most of the benefits of protectionism center on winning tomorrow’s industries and keeping today’s from falling into trouble, not on rescuing industries already dying. Centering protectionism on dying industries is like lecturing a heart attack victim lying in an ambulance on diet and exercise. Better than nothing, but still suboptimal. Industries in trouble are often (not always, as free traders claim) industries in which high-wage nations like the U.S. are becoming intrinsically uncompetitive, and which we quite rightly should be shedding.
Protectionism cannot protect every job in America, even if this is the natural promise that tends to get made in the political arena. Even if we could, this would not be a rational objective, as keeping every existing job would mean that the workers in them could not be upgraded to better jobs over time—which is what we should want. And even if everyone can’t upgrade to a better job, the natural progression of industry life cycles means that no job will last forever. There is no future for VCR factories, even if this was a sunrise industry in 1978. As a result, an effective defense of the U.S. industrial base will be a rolling defense, not a static one.
PART II
THE REAL
ECONOMICS
OF TRADE
Chapter 5
Ye Olde Theory of Comparative Advantage
The theory explained in this chapter is false. It is the 192-year-old theory of comparative advantage, invented by David Ricardo in 1817. Ricardo was a London stockbroker, self-made millionaire, and Member of Parliament who turned economist after reading Adam Smith’s famous The Wealth of Nations on holiday. It dates from a time when most of America was wilderness, railroads were an experimental technology, doctors still used leeches, and veterans of the American Revolution walked the streets of Philadelphia. The quickest route between the United States and China was by clipper ship, which took well over two months. Trade with Japan, however, was impossible, as the country had been sealed off from the outside world by the Shogun in 1635 and would wait another 37 years for Commodore Perry to open it up. Great Britain was the world’s largest manufacturer and trading nation. World economic output was about one half of one percent of what it is today.337 International trade was approximately three percent of that output,338 in comparison with today’s 26 percent.339
It is, however, absolutely necessary that we understand this quaint and unreliable theory because to this day it remains the core of the case for free trade. All the myriad things we are told about why free trade is good for us are boiled down to hard economics and weighed against the costs by this single theory and its modern ramifications. The rest is details and politics. If this theory is true, then no matter how high the costs of free trade, we can rely upon the fact that somewhere else in our economy, we are reaping benefits that exceed them. If it is false, we cannot. Free traders admit this, for although other theories of trade exist, their normative content is Ricardian.340 The battle over Ricardo is therefore decisive.
ABSOLUTE VS. COMPARATIVE ADVANTAGE
To understand comparative advantage, it is best to start with its simpler cousin absolute advantage. The concept of absolute advantage simply says that if some foreign nation is a more efficient producer of some product than we are, then free trade will cause us to import that product from them, and that this is good for both nations. It is good for us because we get the product for less money than it would have cost us to make it ourselves. It is good for the foreign nation because it gets a market for its goods. And it is good for the world economy as a whole because it causes production to come from the most efficient producer, maximizing world output.
Absolute advantage is thus a set of fairly obvious ideas. It is, in fact, the theory of international trade most people instinctively hold, without recourse to formal economics, and thus it explains a large part of public opinion on the subject. It sounds like a reassuringly direct application of basic capitalist principles. It is the theory of trade Adam Smith himself believed in.341
It is also false. Under free trade, America observably imports products of which we are the most efficient producer—which makes absolutely no sense by the standard of absolute advantage. This causes complaints like conservative commentator Patrick Buchanan’s below:
Ricardo’s theory...demands that more efficient producers in advanced countries give up industries to less efficient producers in less advanced nations...Are Chinese factories more efficient than U.S. factories? Of course not.342
Buchanan is correct: this is precisely what Ricardo’s theory demands. It not only predicts that less efficient producers will sometimes win (observably true) but argues that this is good for us (the controversy). This is why we must analyze trade in terms of not absolute but comparative advantage. If we don’t
, we will never obtain a theory that accurately describes what does happen in international trade, which is a prerequisite for our arguing about what should happen—or how to make it happen.
The theory of comparative advantage has an unfortunate reputation for being hard to understand,343 but at bottom it simply says this:
Nations trade for the same reasons people do.
And the whole theory can be cracked open with one simple question:
Why don’t pro football players mow their own lawns?
Why should this even be a question? Because the average footballer can almost certainly mow his lawn more efficiently than the average professional lawn mower. The average footballer is, after all, presumably stronger and more agile than the mediocre workforce attracted to a badly paid job like mowing lawns. If we wanted to quantify his efficiency, we could measure it in acres per hour. Efficiency (also known as productivity) is always a matter of how much output we get from a given quantity of inputs, be these inputs hours of labor, pounds of flour, kilowatts of electricity, or whatever.
Because the footballer is more efficient, in economic language he has absolute advantage at mowing lawns. Yet nobody finds it strange that he would “import” lawn-mowing services from a less efficient “producer.” Why? Obviously, because he has better things to do with his time. This is the key to the whole thing. The theory of comparative advantage says that it is advantageous for America to import some goods simply in order to free up our workforce to produce more-valuable goods instead. We, as a nation, have better things to do with our time than produce these less valuable goods. And, just as with the football player and the lawn mower, it doesn’t matter whether we are more efficient at producing them, or the country we import them from is. As a result, it is sometimes advantageous for us to import goods from less efficient nations.
This logic doesn’t only apply to our time, that is our man-hours of labor. It also applies to our land, capital, technology, and every other finite resource used to produce goods. So the theory of comparative advantage says that if we could produce something more valuable with the resources we currently use to produce some product, then we should import that product, free up those resources, and produce that more valuable thing instead.
Economists call the resources we use to produce products “factors of production.” They call whatever we give up producing, in order to produce something else, our “opportunity cost.” The opposite of opportunity cost is direct cost, so while the direct cost of mowing a lawn is the hours of labor it takes, plus the gasoline, wear-and-tear on the machine, et cetera, the opportunity cost is the value of whatever else these things could have been doing instead.
Direct cost is a simple matter of efficiency, and is the same regardless of whatever else is going on in the world. Opportunity cost is a lot more complicated, because it depends on what other opportunities exist for using factors of production. Other things being equal, direct cost and opportunity cost go up and down together, because if the time required to mow a lawn doubles, then twice as much time cannot then be spent doing something else. As a result, high efficiency tends to generate both low direct cost and low opportunity cost. If someone is such a skilled mower that they can mow the whole lawn in 15 minutes, then their opportunity cost of doing so will be low because there’s not much else they can do in 15 minutes.
But other things are very often not equal, because alternative opportunities vary. The opportunity cost of producing something is always the next most valuable thing we could have produced instead. If either bread or rolls can be made from dough, and we choose to make bread, then rolls are our opportunity cost. If we choose to make rolls, then bread is. And if rolls are worth more than bread, then we will incur a larger opportunity cost by making bread. It follows that the smaller the opportunity cost we incur, the less opportunity we are wasting, so the better we are exploiting the opportunities we have. Therefore our best move is always to minimize our opportunity cost.
This is where trade comes in. Trade enables us to “import” bread (buy it in a store) so we can stop baking our own and bake rolls instead. In fact, trade enables us to do this for all the things we would otherwise have to make for ourselves. So if we have complete freedom to trade, we can systematically shrug off all our least valuable tasks and reallocate our time to our most valuable ones. Similarly, nations can systematically shrink their least valuable industries and expand their most valuable ones. This benefits these nations and under global free trade, with every nation doing this, it benefits the entire world. The world economy and every nation in it become as productive as they can possibly be.
Here’s a real-world example: if America devoted millions of workers to making cheap plastic toys (we don’t; China does) then these workers could not produce anything else. In America, we (hopefully) have more-productive jobs for them to do, even if American industry could hypothetically grind out more plastic toys per man-hour of labor and ton of plastic than the Chinese. So we’re better off leaving this work to China and having our own workers do more-productive work instead.
This all implies that under free trade, production of every product will automatically migrate to the nation that can produce it at the lowest opportunity cost—the nation that wastes the least opportunity by being in that line of business. The theory of comparative advantage thus sees international trade as a vast interlocking system of tradeoffs, in which nations use the ability to import and export to shed opportunity costs and reshuffle their factors of production to their most valuable uses. And (supposedly) this all happens automatically, because if the owners of some factor of production find a more valuable use for it, they will find it profitable to move it to that use. The natural drive for profit will steer all factors of production to their most valuable uses, and opportunities will never be wasted.
It follows that any policy other than free trade (supposedly) just traps economies producing less-valuable output than they could have produced. It saddles them with higher opportunity costs—more opportunities thrown away—than they would otherwise incur. In fact, when imports drive a nation out of an industry, this must actually be good for that nation, as it means the nation must be allocating its factors of production to producing something more valuable instead. (If it weren’t doing this, the logic of profit would never have driven its factors out of their former uses.) In the language of the theory, the nation’s “revealed comparative advantage” must lie elsewhere, and it will now be better off producing according to this newly revealed comparative advantage.
QUANTIFYING COMPARATIVE ADVANTAGE
Let’s quantify comparative advantage with an imaginary example. Suppose an acre of land in Canada can produce either 1 unit of wheat or 2 units of corn.344 And suppose an acre in the U.S. can produce either 3 units of wheat or 4 units of corn. The U.S. then has absolute advantage in both wheat (3 units vs. 1) and corn (4 units vs. 2). But we are twice as productive in corn and thrice as productive in wheat, so we have comparative advantage in wheat.345
Importing Canadian corn would obviously enable us to switch some of our corn-producing land to wheat production and grow more wheat, while importing Canadian wheat would enable us to switch some of our wheat-producing land to corn production and grow more corn. Would either of these be winning moves? Let’s do some arithmetic.
Every 3 units of wheat we import will free up 1 acre of our land because we will no longer need to grow those 3 units ourselves. We can then grow 4 units of corn on that acre. But selling us that wheat will force Canada to take 3 acres out of corn production to grow it, so it will cost Canada 3 × 2 = 6 units of corn. Canadians obviously won’t want to do this unless we pay them at least 6 units of corn. But this means we’d have to pay 6 units to get 4. So no deal.
What about importing Canadian corn? Every 4 units of corn we import will free up 1 acre of our land, on which we can then grow 3 units of wheat. Selling us those 4 units will force Canada to take 4 ÷ 2 = 2 acres out of wheat production, costing Canada
2 × 1 = 2 units of wheat. So we can pay the Canadians what it costs them to give us the corn (2 units of wheat) and still come out ahead, by 3–2 = 1 unit of wheat. So importing Canadian corn makes economic sense. And not only do we come out ahead, but because the world now contains one more unit of wheat, it’s a good move for the world economy as a whole, too.
The fundamental question here is whether America is better off producing corn, or wheat we can exchange for corn. Every nation faces this choice for every product, just as every individual must decide whether to bake his own bread or earn money at a job so he can buy bread in a store (and whether to mow his own lawn or earn money playing football so he can hire someone else to mow it). The entire theory of comparative advantage is just endless ramifications of this basic logic.346
The above scenario all works in reverse on the Canadian side, so it benefits Canada, too. Free traders generalize this into the proposition that free trade benefits every trading partner and applies to every product and factor of production.347 As the late Paul Samuelson of MIT explains it, using China as the trading partner:
Yes, good jobs may be lost here in the short run. But still total U.S. net national product must, by the economic laws of comparative advantage, be raised in the long run (and in China, too). The gains of the winners from free trade, properly measured, work out to exceed the losses of the losers.348 (Emphasis in original.)
LOW OPPORTUNITY COSTS EQUALS POOR NATION
