by Ian Fletcher
Note that the opportunity cost of producing a product can vary from one nation to another even if the two nations’ direct costs for producing the product are the same. This is because they can face different alternative uses for the factors of production involved. So having a low opportunity cost for producing a product can just as easily be a matter of having poor alternative uses for factors of production as having great efficiency at producing the product itself.
This is where underdeveloped nations come in: their opportunity costs are low because they don’t have a lot of other things they can do with their workers. The visible form this takes is cheap labor, because their economies offer workers few alternatives to dollar-an-hour factory work. As Jorge Castañeda, Mexico’s former Secretary of Foreign Affairs and a NAFTA critic, explains it:
The case of the auto industry, especially the Ford-Mazda plant in Hermosillo, Mexico, illustrates a well-known paradox. The plant manufactures vehicles at a productivity rate and quality comparable or higher than the Ford plants in Dearborn or Rouge, and slightly below those of Mazda in Hiroshima. Nevertheless, the wage of the Mexican worker with equal productivity is between 20 and 25 times less than that of the U.S. worker.349
The plants in the U.S. and Japan are surrounded by advanced economies containing many other industries able to pay high wages. So these plants must match these wages or find no takers. The plant in Mexico, on the other hand, is surrounded by a primitive developing economy, so it only needs to compete with low-paid jobs, many of them in peasant agriculture. As a result, the productivity of any one job does not determine its wage. Economy-wide productivity does. This is why it is good to work in a developed country even if the job you yourself do, such as sweeping floors, is no more productive than the jobs people do in developing countries.
If wages, which are paid in domestic currency, don’t accurately reflect differences in opportunity costs between nations, then exchange rates will (in theory) adjust until they do. So if a nation has high productivity in most of its internationally traded industries, this will push up the value of its currency, pricing it out of its lowest-productivity industries. But this is a good thing, because it can then export goods from higher-productivity industries instead. This will mean less work for the same amount of exports, which is why advanced nations rarely compete in primitive industries, or want to. In 1960, when Taiwan had a per capita income of $154, 67 percent of its exports were raw or processed agricultural goods. By 1993, when Taiwan had a per capita income of $11,000, 96 percent of its exports were manufactured goods.350 Taiwan today is hopelessly uncompetitive in products it used to export such as tea, sugar and rice. Foreign competition drove it out of these industries and destroyed hundreds of thousands of jobs. Taiwan doesn’t mind one bit.
WHAT THE THEORY DOES NOT SAY
The theory of comparative advantage is sometimes misunderstood as implying that a nation’s best move is to have as much comparative advantage as it can get—ideally, comparative advantage in every industry. This is actually impossible by definition. If America had superior productivity, therefore lower direct costs, and therefore absolute advantage, in every industry, we would still have a greater margin of superiority in some industries and a lesser margin in others. So we would have comparative advantage where our margin was greatest and comparative disadvantage where it was smallest. This pattern of comparative advantage and disadvantage would determine our imports and exports, and we would still be losing jobs to foreign nations in our relatively worse industries and gaining them in our relatively better ones, despite having absolute advantage in them all.
So what’s the significance of absolute advantage, if it doesn’t determine who makes what? It does determine relative wages. If the U.S. were exactly 10 percent more productive than Canada in all industries, then Americans would have real wages exactly 10 percent higher. But because there would be no relative differences in productivity between industries, there would be no differences in opportunity costs, neither country would have comparative advantage or disadvantage in anything, and there would be no reason for trade between them. There would be no corn-for-wheat swaps that were winning moves. All potential swaps would cost exactly as much as they were worth, so there would be no point. (And under free trade, none would take place, as the free market isn’t stupid and won’t push goods back and forth across national borders without reason.)
Conversely, the theory of comparative advantage says that whenever nations do have different relative productivities, mutual gains from trade must occur. This is why free traders believe that their theory proves free trade is always good for every nation, no matter how poor or how rich. Rich nations won’t be bled dry by the cheap labor of poor nations, and poor nations won’t be crushed by the industrial sophistication of rich ones. These things simply can’t happen, because the fundamental logic of comparative advantage guarantees that only mutually beneficial exchanges will ever take place.351 Everyone will always be better off.
It follows (supposedly) that trade conflicts between nations are always misguided and due solely to their failure to understand why free trade is always good for them. In the words of libertarian scholar James Bovard:
Our great-grandchildren may look back at the trade wars of the twentieth century with the same contempt that many people today look at the religious wars of the seventeenth century—as a senseless conflict over issues that grown men should not fight about.352
Comparative advantage is thus a wonderfully optimistic construct, and one can certainly see why it would be so appealing. Not only does it appear to explain the complex web of international trade at a single stroke, but it also tells us what to do and guarantees that the result will be the best outcome we could possibly have obtained. It enables a lone economist with a blackboard to prove that free trade is best, always and everywhere, without ever getting her shoes dirty inspecting any actual factories, dockyards, or shops. She does not even need to consult any statistics on prices, production, or wages. The magnificent abstract logic alone is enough.
It is actually rather a pity the theory isn’t true.
THE SEVEN DUBIOUS ASSUMPTIONS
The theory of comparative advantage tends to provoke blanket dismissal by opponents of free trade. This is unfortunate, as its flaws are easy enough to identify and it can be picked apart on its own terms quite readily. These flaws consist of a number of dubious assumptions the theory makes. To wit:353
Dubious Assumption #1: Trade is sustainable.
We looked at this problem at considerable length before, in Chapter Two, when we analyzed why trade, if paid for by assuming debt and selling assets, is not advantageous to the importing nation in the long run. But there is a flip side to this problem that affects exporting nations as well. What if a nation’s exports are unsustainable? What if an exporting nation, like the “decadent” importing nation we previously examined,354 is running down an accumulated inheritance?
This usually means a nation that is exporting nonrenewable natural resources. The same long vs. short term dynamics we looked at before will apply, only in reverse. A nation that exports too much will maximize its short term living standard at the expense of its long-term prosperity. But free market economics—which means free trade—will perversely report that this is efficient.
The classic example of this problem, almost a caricature, is the tiny Pacific Island nation of Nauru, located roughly halfway between Hawaii and Australia. Thanks to millions of years of accumulated seabird droppings, the island 100 years ago was covered by a thick layer of guano, a phosphate-rich substance used for manufacturing fertilizer. From 1908 to 2002, about 100 million tons of this material was mined and exported, turning four-fifths of Nauru’s land into an uninhabitable moonscape in the process. But for a few years in the late 1960s and early 1970s, Nauru had the world’s highest per capita income (and tellingly acquired one of the world’s worst obesity problems). But after the deposits ran out, the economy collapsed, the nation was reduced to r
eliance upon foreign aid, and unemployment neared 90 percent.
Nauru is obviously an extreme case, but it is hardly the only nation making its way in international trade by exporting nonrenewable resources. The oil-rich nations of the Persian Gulf are the most obvious example, and it is no accident that OPEC was the single most formidable disruptor of free trade in the entire post-WWII era. But other nations with large land masses relative to population, such as Canada, Australia, Russia, and Brazil, also depend upon natural resource exports to a degree that is unhealthy in the long run. Even the United States, whose Midwestern agricultural exports rely upon the giant Ogallala Aquifer, a depleting accumulation of water from glacial times, is not exempt from this problem.
The implied solution is to tax or otherwise restrict nonrenewable exports. And that is not free trade.
Dubious Assumption #2: There are no externalities.
An externality is a missing price tag. More precisely, it is the economists’ term for when the price of a product does not reflect its true economic value. The classic negative externality is environmental damage, which reduces the economic value of natural resources without raising the price of the product that harmed them. The classic positive externality is technological spillover, where one company’s inventing a product enables others to copy or build upon it, generating wealth that the original company doesn’t capture. The theory of comparative advantage, like all theories of free market economics, is driven by prices, so if prices are wrong due to positive or negative externalities, it will recommend bad policies.
For example, goods from a nation with lax pollution standards will be too cheap. As a result, its trading partners will import too much of them. And the exporting nation will export too much of them, overconcentrating its economy in industries that are not really as profitable as they seem, due to ignoring pollution damage. For example, according to The New York Times:
Pollution has made cancer China’s leading cause of death…Ambient air pollution alone is blamed for hundreds of thousands of deaths each year. Nearly 500 million people lack access to safe drinking water…Only 1% of the country’s 560 million city dwellers breathe air considered safe by the European Union.355
It has even been argued, by economists such as Sir Partha Dasgupta of Cambridge, that China’s economy may not be growing at all if one takes into account the massive destruction of its soil and air.356 Free trade not only permits problems such as these, but positively encourages them, as skimping on pollution control is an easy way to grab a cost advantage.357
Positive externalities are also a problem. For example, if an industry generates technological spillovers for the rest of the economy, then free trade can let that industry be wiped out by foreign competition because the economy ignored its hidden value. Some industries spawn new technologies, fertilize improvements in other industries, and drive economy-wide technological advance; losing these industries means losing all the industries that will flow from them in the future (more on this in Chapter Nine).
These problems are the tip of an even larger iceberg known as GDP-GPI divergence. Negative externalities and related problems mean that increases in GDP can easily coincide with decreases in the so-called Genuine Progress Indicator or GPI.358 GPI includes things like resource depletion, environmental pollution, unpaid labor like housework, and unpaid goods like leisure time, thus providing a better metric of material well-being than raw GDP.359 This implies that even if free trade were optimal from a GDP point of view (which it isn’t), it could still be a bad idea economically.
The problem of positive and negative externalities is quite well known, even to honest free traders, because externalities are, by definition, a loophole in all free-market economic policies. Free traders just deny that these externalities are big enough to matter. Or they propose various schemes to internalize them and make prices accurate.
Dubious Assumption #3: Factors of production move easily between industries.
As noted earlier, the theory of comparative advantage is about switching factors of production from less-valuable to more-valuable uses. But this assumes that the factors of production used to produce one product can switch to producing another. Because if they can’t, then imports won’t push a nation’s economy into industries better suited to its comparative advantage. Imports will just kill off its existing industries and leave nothing in their place.
Although this problem actually applies to all factors of production, we usually hear of it with regard to labor and real estate because people and buildings are the least mobile factors of production. (This is why the unemployment line and the shuttered factory are the classic visual images of trade problems.) When workers can’t move between industries—usually because they don’t have the right skills or don’t live in the right place—shifts in an economy’s comparative advantage won’t move them into an industry with lower opportunity costs, but into unemployment. This is why we hear of older workers being victims of free trade: they are too old to easily acquire the skills needed to move into new industries. And it explains why the big enthusiasts for free trade tend to be bright-eyed yuppies well equipped for career mobility.
Sometimes the difficulty of reallocating workers shows up as outright unemployment. This happens in nations with rigid employment laws and high de facto minimum wages due to employer-paid taxes, as in Western Europe. But in the United States, because of our relatively low minimum wage and hire-and-fire labor laws, this problem tends to take the form of underemployment. This is a decline in the quality rather than quantity of jobs. So $28 an hour ex-autoworkers go work at the video rental store for eight dollars an hour.360 Or they are forced into part-time employment: it is no accident that, as of September 2009, the average private-sector U.S. work week had fallen to 33 hours, the lowest since records began in 1964.361
In the Third World, decline in the quality of jobs often takes the form of workers pushed out of the formal sector of the economy entirely and into casual labor of one kind or another, where they have few rights, pensions, or other benefits. Mexico, for example, has over 40 percent of its workers in the informal sector.362
This all implies that low unemployment, on its own, doesn’t prove free trade has been a success. This is recognized even by the more intellectually rigorous free traders, such as former Federal Reserve Chairman Alan Greenspan, who has admitted that, “We often try to promote free trade on the mistaken ground, in my judgment, that it will create jobs.”363 Greenspan is correct: even if free trade worked completely as promised, it would not increase the number of jobs, only their quality.364 And when we speak of job gains and losses from trade, these are gross, not net, numbers, as people who lose their jobs due to trade will usually end up working somewhere, however dismal.365
A recent study by the North Carolina Employment Security Commission explored the problem of workers displaced by trade. In 2005, North Carolina experienced the largest mass layoff in its history, at the bedding firm Pillowtex, costing 4,820 jobs. By the end of 2006, the workers’ average wage in their new jobs was $24,488—a drop of over 10 percent from before.366 A large number had been sidelined into temporary employment, often as health care aides. Nationally, two-thirds of workers are working again two years after a layoff, but only 40 percent earn as much as they did previously.367 The human cost is obvious, but what is less obvious is the purely economic cost of writing off investments in human capital when skills that cost money to acquire are never used again. This kind of cost is most visible in places such as Moscow in the 1990s, when one saw physics PhDs driving taxis and the like, but America is not exempt.
There is also a risk for the economy as a whole when free trade puts factors of production out of action. As Nobel Laureate James Tobin of Yale puts it, “It takes a heap of Harberger triangles to fill an Okun gap.”368 Harberger triangles represent the benefits of free trade on the standard graphs used to quantify them.369 The Okun gap is the difference between the GDP our economy would have, if it were running at
full output, and the GDP it does have, due to some of its factors of production lying idle.370 Tobin’s point is simply that the benefits of free trade are quantitatively small, compared to the cost of not running our economy at full capacity due to imports.
Dubious Assumption #4: Trade does not raise income inequality.
When the theory of comparative advantage promises gains from free trade, these gains are only promised to the economy as a whole, not to any particular individuals or groups thereof. So it is entirely possible that even if the economy as a whole gets bigger thanks to freer trade, many (or even most) of the people in it may lose income.
We looked at this problem a bit before, at the end of Chapter One. Let’s take a slightly different analytical tack and look again. Suppose that opening up a nation to freer trade means that it starts exporting more airplanes and importing more clothes than before. (This is roughly the situation the U.S. has been in.) Because the nation gets to expand an industry better suited to its comparative advantage and contract one less suited, it becomes more productive and its GDP goes up, just like Ricardo says. So far, so good.
Here’s the rub: suppose that a million dollars’ worth of clothes production requires one white-collar worker and nine blue-collar workers, while a million dollars of airplane production requires three white-collar workers and seven blue-collar workers. (Industries often differ in this way.) This means that for every million dollars’ change in what gets produced, there is a demand for two more white-collar workers and two fewer blue-collar workers. Because demand for white-collar workers goes up and demand for blue-collar workers goes down, the wages of white-collar workers will go up and those of blue-collar workers will go down. But most workers are blue-collar workers—so free trade has lowered wages for most workers in the economy!
