The free trade externality

Neoclassical economists will tell you that, invariably, free trade is a good thing. If there’s a barrier to trade between any two parties anywhere in the world, everyone would be better off with its removal. That’s not necessarily so. Often it is, but I present here a case for where and when protection is necessary for trade to lead to a universally good outcome.

Following a somewhat paradoxical Enlightenment result known as comparative advantage economists will point out that even if one party is better at everything than another, so long as they have different natural efficiencies they benefit from specializing. For example if Italy can produce both wheat and wine better than England, but Italy is better at wine than wheat and England the opposite, it will be to their mutual benefit if they specialize so Italy produces only wine, England only wheat, and they trade. At a basic level, the model holds.

Common criticisms of comparative advantage are the following:

Fairness: The model shows that there are mutually agreeable prices where both parties are better off after specialization. However the model doesn’t show that these prices will be agreed. Because of market power the efficiency benefits may accrue unequally to one party, or in extremis only one party may end up better off. Of course all participants will enter trades willingly in any one round, but market power accumulates over several rounds and after competing participants enter so it’s possible for a rational and uncoerced party to end up worse off.

Fragility: Although specialization is more efficient, it makes the parties more susceptible to market shocks. In this example either Italy or England may be severely affected if consumer demand for wine or wheat falls abruptly or if some calamity makes it hard to produce either of these goods. In a more realistic example, a small third-world community that forgoes (diversified) subsistence farming to produce a single cash crop is very vulnerable to both market and weather risks.

Scaling: The simple model of comparative advantage makes rather classical assumptions about how much production scales. If both Italy and England have natural limits to production then they both must be employed; fully in the naive model. Modern production scales very different, effectively without limit other than demand. So if we’re talking about information goods, technology, and such things the producer who is absolutely better scales to produce all of the good and the less efficient party is absolutely unemployed. This is a very real issue and is behind the demand shock that the world is facing, but it’s not the topic of the present critique. It’s worth a discussion by itself.

My main critique of free trade, or rather my defense of limited protection, is this externality:

The free trade externality
Suppose there are agents, like people, around the world embedded in different local economies ordered by wealth like so.

A : Western investor
B : Western manager
C : Western doctor
X : African doctor
Y : African farmer
Z : African laborer

The ABCs trade happily a high volume of goods and services in a high price environment. More medicine gets transacted in New York than in rural Kenya, and each procedure is more expensive. The XYZs trade a much lower volume of real goods at much lower prices, but everyone has security.

Then along comes free trade and suddenly the ABCs hire all of Y’s capacity to produce coffee for export. Y earns enough to buy food in the open market (at mid price) but Z starves.

What happens to Z is an externality. They’re not directly involved in the trade but they face a scarcity because their demand can no longer compete effectively with the rich consumers’ demand and they lose the use of resources. Note that there’s no reason other than charity to expect Y’s wealth to “trickle down” to Z. If anything, Y has now less need for Z’s services (Y has more options) so they’re going to pass even less income to Z than before.

This “free trade externality” is I think the chief reason why free trade isn’t always good and some arrangements warrant protection. My heuristic is that free trade is effective when both parties are roughly equal, meaning they are similarly compelled to trade and they’re embedded in economies with similar price levels. If they’re not:

  • The weaker party, meaning the one most compelled to trade by circumstances or the one operating in the lower price environment, gets an unfair deal. They settle at a lower than fair price.
  • Worse, the immediate neighborhood of the lesser trading party suffers a scarcity as output is diverted and compensation is not returned.

The effect is a bit like electronics where bad things happen if you connect two distant parts of a circuit that operate at different voltages. In trade the intense flow of value though a price differential might enrich the traders (rather than blow up wires) but it still affects the functioning of the local network at each end.

So trade is good, but I’d advocate protection against the case where mismatched markets are directly connected by long-distance links. The proper use of protection should be, mainly, to compensate the consumers in the poor economy who face a scarcity and much less so the rich producers who face competition. We need export, not import tariffs, and the money thus collected has to compensate poor people of the exporting region for the loss of their resources.

The key is to spread the gain from trade beyond the immediate trading partner. While economies were isolated people in each locality were compelled by circumstances to trade with each other, yielding real security. With international free trade as naively practiced a few participants are selectively detached from the trading network of the poor economy and loosely reattached in the world market. Some form of mitigation is needed to re-connect or share the benefits of trade to the wider network of the poor economy.

Note that “Fair Trade” schemes may be beneficial or harmful depending on how they approach this issue. Neutral or harmful if they look after just the producer, beneficial if they spread the benefit to their community.

Ideally in my opinion trade would be more beneficial if goods didn’t cross extreme price differentials but instead the majority of trade happened between relatively matched economies: If the third world traded with the BRICs, and in turn the BRICs with the West, that’s more effective than Africa selling out primary production direct to the West. Opportunism chases the opposite, direct trade over the greatest possible price differential, which is why I would advocate protection.

A similar argument can be made with immigration, which is analogous to trade except when it comes to the wishes and aspirations of the people concerned. Economically at least I think it would work better and create less stress if people migrated from their ancestral economies to somewhat richer ones, where their qualifications may match and they may integrate more easily, than if the poorest people in the world went to the richest countries to become a kind of underclass. At the very least selective immigration (rich countries accepting the most qualified applicants) should be recognized as harmful and countries that practice it should compensate the donor societies for brain drain. Note this is only an economic, not a social or political view.

So in summary, free trade isn’t always good. It’s good for the trading partners and especially the richer one, which is why it happens. But it imposes a huge externality on the poorer economy by taking the output of its most productive members (by market value) effectively making long-distance trade links at the expense of organic local ones. Protection is warranted, either to share the gains more equitably with the local economy or to encourage trade to form along shallower rather than extreme price differentials.

One thought on “The free trade externality

  1. Great writing. Thanks. I came across your post on a John Nash interview (with Yanis V); found your comments on money instructive. But I don’t understand why “worrying about the stock of money is absurd”. If money is “a shared claim on whatever value the economy yields in the here and now”, isn’t printing new money analogous to diluting existing shareholders by issuing new stock?

    Thanks again for your writing. The points you make above are extraordinary. First time I’ve heard of this free trade externality. I find it self-evidently true. I trust I’ll live to see the day when it’s widely acknowledged.

    The scaling issue is a bit chilling. Zuckerberg a billionaire! That creepy guy who owns the Mavericks…! The winner take all dominance of one global winner will require some significant redistribution of wealth, nicht? Are humans up to it? Is the Bill Gates model of assembling enormous wealth then making targeted investments in the most critical quality of life issues an adequate model for this redistribution? Tax the wealthy…?


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