Almost all Western economists currently advocate for the benefits of free trade, a principle supported by global bodies like the World Bank, the International Monetary Fund, and the World Trade Organization (WTO). This perspective gained traction post-World War II, leading to the establishment of the General Agreement on Tariffs and Trade (GATT) in 1947 by Western leaders.
However, economic theory has significantly progressed since the days of Adam Smith, especially after the inception of GATT. To fully grasp the nuances of international trade agreements and chart a course for future trade policies, it’s crucial to examine the evolution of economic theory and its current standing.
In the 17th and 18th centuries, mercantilism was the dominant economic philosophy. It posited that a nation’s prosperity was tied to exporting more than it imported, accumulating wealth primarily in gold and silver. This accumulation was seen as vital for funding a larger military and expanding colonial holdings.
Thomas Mun, a director of the British East India Company, was a prominent mercantilist. In a letter from the 1630s to his son, Mun articulated the core tenet of mercantilism: “The ordinary means therefore to increase our wealth and treasure is by Foreign Trade, wherein wee must ever observe this rule; to sell more to strangers yearly than wee consume of theirs in value…By this order duly kept in our trading,…that part of our stock which is not returned to us in wares must necessarily be brought home in treasure.”
Mercantilist ideology favored government intervention to boost exports and control economic activities. They advocated for import restrictions to maintain a trade surplus, believing that national success came at the expense of others. The ideal scenario under mercantilism was exporting finished goods and importing raw materials to maximize domestic employment.
Adam Smith challenged mercantilism in his seminal work, The Wealth of Nations, published in 1776. Smith proposed that trade could be mutually beneficial even if one nation was more efficient in producing one product while another excelled in a different product. Specialization based on absolute advantage would lead to increased overall production compared to a no-trade scenario. This view advocated for less government intervention and fewer trade barriers.
The Theory of Comparative Advantage
David Ricardo refined trade theory further in 1817 with his On the Principles of Political Economy and Taxation. Ricardo introduced the concept of comparative advantage, arguing that trade could be advantageous even when one nation held an absolute advantage in producing all traded goods.
Ricardo demonstrated that comparative advantage, not absolute advantage, drives international trade. This theory suggests that nations can benefit from trade even if one can produce everything more cheaply. The key is relative efficiency.
An analogy often used is that of a lawyer who is better at both law and typing than their secretary. It’s still more efficient for the lawyer to focus on higher-paying legal work and delegate typing to the secretary. Similarly, countries should specialize in producing goods where they are comparatively more efficient, leading to greater total production and wider consumer choice.
Smith and Ricardo focused on labor as the sole factor of production. In the early 20th century, Bertil Heckscher and Eli Ohlin, Swedish economists, expanded the theory to include multiple factors of production. The Heckscher-Ohlin theory suggests that a country will export goods produced using its relatively abundant factors and import goods requiring factors in which it is relatively scarce. A classic textbook example involves England and Portugal, trading textiles and wine. England, with abundant capital, would export capital-intensive textiles, while Portugal, with abundant labor, would export labor-intensive wine. Free trade under these conditions maximizes efficiency, increasing overall production and lowering prices. Economists widely accept this model as applicable to numerous products and countries through empirical studies and mathematical models.
Dominick Salvatore, in his textbook International Economics, emphasizes the law of comparative advantage as a cornerstone of international trade theory, “one of the most important and still unchallenged laws of economics…the cornerstone of the pure theory of international trade.”
Comparative advantage applies to various factors of production beyond just labor and capital. Natural resources like land, technology, and different types of labor (skilled vs. unskilled) also play a role. Factor endowments can evolve over time, for example, through depletion of resources or improvements in education leading to a more skilled workforce.
Product life cycles also influence comparative advantage. Initially, computers were capital and skilled-labor intensive, giving the United States a comparative advantage. As production scaled up and became more standardized, the comparative advantage shifted to countries with cheaper labor. Even within a product category, production methods can vary across countries, like cotton production being mechanized in the U.S. but labor-intensive in Africa. These shifts in factors of production don’t invalidate comparative advantage but rather change the product mix a nation can produce most efficiently relative to its trading partners.
Traditional trade theories, like those of Ricardo and Heckscher-Ohlin, rely on assumptions like perfect competition and no government-imposed barriers. Another assumption is diminishing or constant returns to scale, meaning production costs per unit either increase or stay the same as production volume increases. For instance, a farmer might face higher costs for each additional unit of wheat due to less fertile land or increased labor costs.
A key assumption is that basic factors of production—land, labor, and capital—are not traded internationally. While Ohlin believed factor mobility was limited, he argued that trade would equalize factor returns across countries. Paul Samuelson further developed this into the factor price equalization theorem, suggesting that free trade would eventually equalize factor prices across nations. For example, wages for unskilled workers in high-wage countries might fall relative to capital returns and reach parity with wages in low-wage countries, while the opposite would happen in low-wage countries. The implications of this are significant, particularly concerning wage disparities and labor market adjustments in different economies.
In static terms, comparative advantage theory suggests that free trade benefits all nations through increased output and consumer welfare due to more efficient production. James Jackson of the Congressional Research Service describes trade liberalization as strengthening competitive and productive industries and reallocating resources from less productive to more productive sectors.
Many economists argue that the dynamic benefits of free trade might outweigh the static gains. These dynamic benefits include increased competitive pressure on firms, technology and knowledge transfer, introduction of new products, and improved adoption of commercial law, affecting both what is produced (static effects) and how it’s produced (dynamic effects).
Terms of Trade
Terms of trade, another critical concept in international trade theory, refer to the ratio of export prices to import prices. A country’s terms of trade improve when it can obtain more imports for a given quantity of exports.
Consider the U.S. exporting aircraft to Japan and importing televisions. If one aircraft initially buys 1,000 televisions and later buys 2,000, the U.S. terms of trade have improved. Conversely, if an aircraft buys only 500 televisions, the terms of trade have worsened.
Various factors can influence terms of trade, including changes in demand, supply, or government policies. Increased Japanese demand for U.S. aircraft improves U.S. terms of trade. However, if Japan starts producing its own aircraft, the increased supply shifts terms of trade in Japan’s favor.
Paradoxically, productivity improvements in a country can worsen its terms of trade. For example, if Japanese television manufacturers become more efficient and lower prices, Japan’s terms of trade decline as they need to export more televisions to buy the same quantity of aircraft.
Countries may attempt to manipulate terms of trade in their favor through measures like optimum tariffs or currency manipulation, adopting a “beggar-thy-neighbor” approach. Dominick Salvatore defines an optimum tariff as maximizing net benefits from improved terms of trade against the trade volume reduction. While the tariff-imposing nation might benefit, its trade partner’s welfare declines due to worsened terms of trade and reduced trade volume, potentially leading to retaliation. Even without retaliation, the global welfare under an optimum tariff scenario is less than under free trade. Free trade, therefore, maximizes overall global welfare.
The Economic Effects of Trade Liberalization
The primary goal of reducing trade barriers is to increase trade volume, which is expected to enhance economic well-being. Economists often use GDP per capita as a measure of economic well-being, although it has limitations. Joseph Stiglitz points out that GDP fails to capture factors like security, leisure, income distribution, and environmental quality, which are crucial to people’s lives and sustainable growth. GDP also doesn’t distinguish between beneficial and detrimental economic activities; for instance, pollution and subsequent cleanup both contribute to GDP.
Multilateral trade negotiations under GATT/WTO typically result in tariff reductions over time rather than complete elimination. However, bilateral or regional free trade agreements (FTAs) often aim for near-complete tariff elimination between member countries, usually over a transition period.
While reducing trade barriers generally promotes free trade, tariff reductions can sometimes paradoxically increase protection for domestic industries. Jacob Viner illustrates this with an example of tariffs on wool and woolen cloth. Removing tariffs on wool while keeping tariffs on woolen cloth increases protection for the domestic cloth industry, assuming no domestic wool production.
This can occur in multilateral trade negotiations where tariffs on non-sensitive products are reduced more than on sensitive ones. In FTAs, this effect is temporary during the transition period before tariffs are fully eliminated. Generally, reducing trade barriers increases trade volume, which is the intended outcome of trade agreements.
Increased exports due to improved market access through trade agreements clearly benefit an economy. When a trade partner reduces barriers, U.S. exports typically increase, boosting U.S. production and GDP. This also creates a multiplier effect as suppliers to exporting firms also see increased sales, further enhancing GDP.
Firms benefiting from increased exports may hire more workers and increase shareholder dividends, circulating money through the economy. This is known as the money multiplier effect: every dollar of income generates further spending and income in the economy.
Exports directly increase a nation’s GDP, as shown in the GDP equation: GDP = C (Consumption) + In (Investment) + G (Government Spending) + (E (Exports) – I (Imports)). Trade’s impact on GDP is thus the net difference between exports and imports. Beyond this static measure, expanded exports also drive dynamic efficiency gains as companies scale up and become more competitive.
Increased imports have a different economic impact. By GDP definition, increased imports reduce GDP. If domestic firms lose market share to imports, they may reduce production and employment, leading to ripple effects throughout their supply chains and reducing overall economic output.
This might seem to support mercantilist views favoring import restrictions. However, most economists today reject this conclusion, arguing that reducing trade barriers benefits a country even unilaterally. Adam Smith and subsequent economists contend that the ultimate goal of production is consumption. Stephen Cohen and colleagues argue that trade liberalization benefits consumers regardless of reciprocal actions from trading partners, suggesting that the emphasis on reciprocity in trade liberalization efforts might be misplaced.
Unilateral trade barrier elimination is particularly beneficial when a country doesn’t produce a certain product, expanding consumer choice. However, as Viner noted, an exception occurs when removing barriers on raw materials or components increases effective protection for finished goods.
Even when domestic production exists, increased import competition often leads to lower prices, benefiting consumers. Consumer savings are then re-spent on other goods and services, partially offsetting domestic production losses in import-competing sectors.
Import competition also drives dynamic benefits by forcing domestic producers to become more efficient. Lower prices can also positively influence monetary policy by reducing inflation risks, allowing central banks to adopt more accommodative monetary policies with lower interest rates, which in turn stimulate investment and other productive sectors.
Economic Models
Economists use sophisticated models to simulate the economic impacts of trade agreements. These models, based on modern trade theories, are useful for quantifying trade barriers, although results are highly sensitive to model assumptions.
The Applied General Equilibrium Model (CGE), or Computable General Equilibrium Model, is widely used to assess economy-wide effects of trade policy changes. James Jackson of the Congressional Research Service notes that these models incorporate assumptions about consumer behavior, market structure, production technology, investment, and capital flows, including foreign direct investment.
CGE models can estimate trade agreement impacts on trade flows, labor, production, welfare, and even the environment. They are ex ante, forecasting changes resulting from trade agreements, and consider effects across all involved countries. These models are based on input-output models, tracing industry interdependencies and use extensive data.
CGE models are powerful in showing economy-wide effects, but their complexity makes the underlying assumptions less transparent. While useful for understanding potential trade agreement outcomes, they are not precise predictions and have limitations.
Model results are highly dependent on assumptions, such as product substitutability and market competition levels. Different assumptions can yield wide-ranging results, even reversing the direction of projected changes.
Economic data quality is also a limitation, even for developed countries like the U.S. Trade and economic data compatibility between and within countries is often poor. The U.S. uses the NAICS system for domestic economic data, based on production processes, while international trade data uses commodity classifications. NAFTA partners also use NAICS, but the EU uses the Nomenclature of Economic Activities. Concordances between these systems are imperfect.
Nontariff barriers (quotas, subsidies, regulations) must be converted to tariff equivalents, which is often unreliable. Assessing barriers in new trade agreement areas like services, investment, and intellectual property is even more challenging.
Even tariff measurement is not straightforward. Weighted tariffs, based on import proportions under each tariff line, can be misleading. High tariffs that block imports entirely might be wrongly given no weight.
Jagdish Bhagwati criticizes trade models as “flights of fancy in contrived flying machines,” questioning the reliability of their estimates. While this view is extreme, trade models should be used cautiously, recognizing their inherent limitations.
The Economic Theory of Trade Blocs
GATT framers favored multilateral trade barrier reduction for maximizing benefits from comparative advantage-based production. Article I of GATT, the most-favored-nation (MFN) treatment, mandates equal trade barrier treatment for all GATT members.
However, GATT also recognized the role of regional integration, allowing trade blocs to eliminate internal barriers while maintaining external tariffs. Article XXIV provides an exception to MFN, permitting customs unions and free trade areas (FTAs) that discriminate against non-members. Customs unions have internal free trade and a common external tariff, while FTAs have internal free trade but individual external tariffs.
Trade blocs can either enhance or diminish global welfare based on whether they create new trade based on comparative advantage or divert trade from more efficient non-members to bloc members. Jacob Viner defined trade creation (1950) as occurring when a bloc member with a comparative advantage gains market access within the bloc due to removed barriers.
Trade creation benefits exporters in the efficient member and consumers in the importing member due to lower prices. Domestic producers facing new competition lose, but the overall gains outweigh the losses, enhancing global welfare through efficiency gains.
Trade diversion, conversely, occurs when a member gains sales at the expense of a more competitive non-member simply because of preferential tariff treatment within the bloc. Non-member exporters with a comparative advantage under equal conditions lose due to trade diversion.
Importing countries also lose tariff revenue on diverted imports now coming from bloc partners duty-free. While consumers gain from tariff-free imports, this gain is less than the lost revenue, making the nation worse off overall. Trade diversion harms both the importing country and the rest of the world, with losses exceeding the gains for the bloc member benefiting from diversion.
If trade diversion outweighs trade creation, the trade bloc diminishes global welfare. If trade creation is greater, global welfare increases.
Beyond these static effects, trade blocs also aim for dynamic benefits like expanded production from larger markets and improved efficiency from increased competition. Larger market access is particularly vital for smaller economies needing scale for efficient production.
To mitigate adverse effects, GATT Article XXIV requires trade blocs to eliminate barriers on “substantially all” internal trade and allows GATT members to review agreements. If a GATT member faces higher tariffs due to a customs union, Article XXIV mandates compensation. However, Article XXIV has been ineffective in controlling trade bloc proliferation, leading to distorted trade patterns today.
Trade Theory Meets New Realities
From Adam Smith (1776) to GATT (1947), trade theory evolved slowly. Since GATT, significant modifications have updated traditional Western trade theory to reflect modern industry and commerce.
In Smith, Ricardo, and Heckscher-Ohlin’s time, companies were small, and trade was mainly in agriculture, minerals, or small-scale manufacturing. By 1947, large-scale manufacturing and trade in manufactured goods were prevalent.
In 1979, Paul Krugman observed significant trade between developed countries with similar factor endowments. For example, the U.S. and Europe, despite similar factor endowments, trade extensively within the same industries, exporting and importing automobiles and parts.
The Heckscher-Ohlin model couldn’t explain this intra-industry trade. Krugman’s theory emphasizes product differentiation and economies of scale. Products like Jeeps and Volkswagens are differentiated but benefit from economies of scale: larger production volumes reduce per-unit costs within limits. Unlike wheat, where costs rise with volume, automobile production costs decrease with scale. High capital investment and scale make it difficult for new entrants to compete.
Trade based on product differentiation and economies of scale leads to countries specializing in differentiated products within broadly defined industries and trading parts and finished goods. The U.S. might specialize in Jeeps, and Europe in Volkswagens. Many modern developed economies feature industries with increasing returns to scale, where factor returns might not equalize through trade. Labor returns in labor-scarce economies could even increase rather than decrease, contrary to factor price equalization theory.
Western economic theory has also adapted to the rapid growth of world trade relative to overall economic growth since the 1970s. The ratio of U.S. exports to GDP more than doubled from 4.9% in 1973 to 10.2% in 2005. Globally, this ratio rose from 10.5% to 20.5%.
This export growth is due to companies evolving from domestic to multinational and then global. GATT’s first six rounds reduced developed-country tariffs on industrial goods from 40% post-WWII to under half by 1967 (Kennedy Round). Simultaneously, international communication and transportation improved dramatically.
Companies in sectors like electronics and chemicals became multinational corporations, sourcing and producing parts and materials across countries. Each border crossing creates an international trade transaction, as does the export of the final product.
This trend has accelerated in the last 25 years, creating global supply chains across almost all industries. Products often contain parts from numerous countries. For example, a suit might have cotton from West Africa, fabric from Bangladesh, be sewn in China, with buttons from India, and then be exported to the U.S. The Airbus A380 jumbo jet had parts from over 1,500 suppliers in 27 countries. Companies now have global supply chains, sourcing parts worldwide based on cost efficiency, factor endowments, or incentives like tax holidays.
Kei-Mu Yi of the World Bank notes that standard economic models adequately explain trade growth until the mid-1970s but not the subsequent surge. Models accounting for supply chains do explain this growth, with vertical specialization estimated to account for about 30% of current world trade.
Yi highlights that tariff reductions have a much greater impact on global supply chains than on traditional trade. In the suit example, a 1% tariff reduction in China, Bangladesh, and the U.S. reduces the suit’s cost to U.S. consumers by 1.5% if imported fabric and buttons constitute half the suit’s cost. If the suit were entirely made in China, the reduction would only be the U.S. tariff reduction (1%).
The rise of supply chains has significant implications. “Country of origin” becomes less meaningful as products have multiple origins. Traditional trade statistics become less informative. Developing countries need to integrate into global supply chains to increase value-added in their contributions. Companies become “global” rather than “national” in their perspective.
Trade in Factors of Production and Services
Traditional trade theory assumed trade in goods, not factors of production (labor, capital, technology) or services. However, capital, technology, and services now move more freely across borders, and labor migration is also increasing. Recent trade negotiations address investment, intellectual property, services, and labor.
If factors of production were perfectly mobile, their costs would equalize across trading countries, diminishing comparative advantage and potentially reducing international trade.
However, barriers beyond trade restrictions impede factor mobility. Workers are reluctant to leave home, and investors are wary of unfamiliar markets. Even without government barriers, factor costs wouldn’t completely equalize across countries.
Similarly, trade in services was largely unconsidered in early post-WWII economics. Services were often seen as non-tradable. This view persisted among trade negotiators for decades after GATT.
Geza Feketekuty, a lead U.S. negotiator on services in the Uruguay Round, recounts an anecdote where a Swiss delegate dismissed services trade by saying he couldn’t get a haircut from a foreign barber. The committee chair countered by noting German women benefiting from French hairdressing services exports.
Economic theory for services trade is still evolving. Generally, the principle of comparative advantage is considered to apply to services trade as well as goods. Feketekuty argues that comparative advantage theory should apply equally to tradable goods and tradable services like insurance and engineering.
Many services, such as telecommunications, are integral to other economic activities. Liberalizing these services can have broad economic effects. Lower telecommunications costs can enhance manufacturers’ global competitiveness, enable farmers to access new techniques, and boost service sectors like tourism through internet access. Telecommunications liberalization even facilitated “offshoring,” where companies moved operations like call centers to low-cost countries.
Liberalizing other sectors like tourism might primarily impact revenues and employment within that sector, with minimal broader economic effects. Some service liberalizations have multiplier effects across the economy, while others mainly benefit the specific sector.
Creating Comparative Advantage
Classical Western trade theory was based on 18th-century economic conditions. Factors of production were relatively fixed. Land was immobile, labor mobility was restricted, and capital movement was limited by political barriers and market knowledge. Technology was simpler and more uniform across countries. Production often faced diminishing returns.
In this context, Ricardo’s model of trade explained patterns well: England specialized in textiles due to wool and capital, and Portugal in wine due to climate and soil. If Portugal restricted textile imports, it would harm its own economy, and Britain would still benefit from importing Portuguese wine.
However, the 20th-century economy changed. Increasing returns to scale became relevant for some products. Steel, automobiles, and other sophisticated goods saw reduced per-unit costs with increased production through automation.
By the late 20th century, the global economy was significantly different. Land and labor remained relatively fixed, but capital became more mobile again. Technology became highly differentiated, with the U.S. leading in many areas.
Established companies with large capital investments and knowledge gained significant advantages. Large production runs lowered marginal costs. New competitors faced high capital entry barriers.
In this new environment, government policies could create comparative advantage. Countries could invest in education to upskill their workforce, subsidize R&D for new technologies, or implement policies to transfer technology or capital from other countries, even through practices like technology piracy or technology transfer requirements for foreign investors.
Ralph Gomory and William Baumol highlight this shift: “The underlying reason for these significant departures from the original model is that the modern free-trade world is so different from the original historical setting of the free trade models. Today there is no one uniquely determined best economic outcome based on natural national advantages. Today’s global economy does not single out a single best outcome, arrived at by international competition in which each country serves the world’s best interests by producing just those goods that it can naturally turn out most efficiently. Rather, there are many possible outcomes that depend on what countries actually choose to do, what capabilities, natural or human-made, they actually develop.”
In the late 20th century, industry dominance could stem from natural comparative advantage, government policy, or historical accidents. U.S. dominance in aircraft likely resulted from a strong education system, a large domestic market (military), and the destruction of competitors’ industries (Japan, Germany, England) in WWII.
Once industry dominance is established, it’s very hard for others to compete due to high capital costs and technology barriers. A web of suppliers also contributes to competitiveness. Conversely, losing dominance makes market re-entry difficult.
Dominant industries benefit a country economically through high wages and stable employment.
Market access is crucial in this model of created comparative advantage. Without free trade, government subsidies to new entrants become prohibitively expensive, needing to overcome both foreign barriers and jump-start domestic production. The WTO and FTAs set rules governing government actions to create comparative advantage, such as subsidy codes limiting permissible subsidies.
Gomory and Baumol note that with created comparative advantage in decreasing-cost industries, trade patterns have many potential outcomes. “These outcomes vary in their consequences for the economic well-being of the countries involved. Some of these outcomes are good for one country, some are good for the other, some are good for both. But it often is true that the outcomes that are the very best for one country tend to be poor outcomes for its trading partner.”
Government policies can create dominant industries, but these might not be as efficient as industries developed elsewhere. Japan’s steel industry, despite lacking domestic energy and having high wages, became dominant, while China, with low labor costs and abundant coal, theoretically should have been the more efficient producer. (Though China has since become a major steel producer).
While governments can create comparative advantage in some areas, inherent comparative advantage remains relevant in others, especially in industries with constant or increasing costs, like agriculture, versus decreasing costs, like automobiles, aircraft, or semiconductors. This is particularly relevant to the car parts manufacturing industry. While some nations might have natural advantages in raw materials or labor costs, government policies and strategic investments can significantly influence which manufacturing company ultimately achieves a comparative advantage in producing specific car parts.
Neomercantilism
While comparative advantage theory dominates Western economic thought and underpins GATT/WTO, mercantilism is generally rejected.
However, some East Asian countries, including Japan, South Korea, and China, have pursued a neomercantilist model focused on export-led growth with carefully managed import liberalization. These nations aim to build strong export industries by initially protecting domestic industries, providing subsidies, and using currency manipulation to stimulate growth.
Neomercantilist success doesn’t invalidate comparative advantage. These countries succeed by targeting industries where they have or can create a comparative advantage. Japan initially focused on steel and autos, then electronics, using import protection and subsidies to make domestic firms globally competitive, especially in the U.S. market.
Neomercantilist strategies require access to foreign markets, facilitated by GATT/WTO trade liberalization. They often involve industrial policy, where governments select and promote key industries. Successful industrial policy requires competent, politically insulated government officials, like Japan’s MITI. While MITI had successes, it also made mistakes, such as initially discouraging Honda’s growth in the auto industry.
Neomercantilist countries also prioritize education and high savings rates to fund export industries. Japan’s savings rate was often over 20% of GDP, and China’s approaches 40% today, compared to the low U.S. savings rate.
Many economists argue that neomercantilism is effective short-term but unsustainable long-term. Governments struggle to “pick winners” and effectively promote industries. Japan’s neomercantilist success waned after the mid-1990s, leading to economic stagnation. Some economists believe Japan needs to shift to stimulating domestic demand. South Korea and China have also pursued neomercantilism, with long-term effectiveness yet to be seen.
Some economists argue that government intervention can boost specific sectors but not the overall economy. Western economists and policymakers generally oppose U.S. industrial policy, fearing political pressures would ensure its failure.
The debate in the West centers on responding to foreign neomercantilist practices. Free trade advocates argue against import barriers, even in response to others’ barriers, based on Adam Smith’s consumer-centric view. They argue against offsetting “de facto subsidies” to consumers from underpriced imports.
Others argue that free trade aims to promote comparative advantage-based competition for global efficiency. Subsidies and currency manipulation distort this, allowing less efficient producers to dominate, reducing overall welfare. Countervailing duties or similar measures could restore a “level playing field” for comparative advantage-based trade.
Unbalanced Trade
Comparative advantage theory typically assumes balanced trade or temporary, cyclical trade imbalances. Dominic Salvatore notes that persistent trade deficits could lead a nation to import goods where it might have a comparative advantage under balanced trade, but he considers this a minor issue as “most trade imbalances are generally not very large in relation to GNP.”
Economists often consider the “current account” balance, broader than merchandise trade, including goods and services trade, net international income (overseas profits, royalties, interest, dividends), and unilateral transfers (foreign aid, private transfers).
Current account deficits or surpluses can be cyclical, influenced by business cycles. Rapid economic growth increases import demand, while export performance depends on trade partners’ growth. Cyclical imbalances are less concerning. Deficits to finance long-term investment, like 19th-century U.S. borrowing for infrastructure, are also less problematic. However, borrowing for short-term consumption is more concerning as it doesn’t generate future income to repay debt.
A fundamental principle is that a country’s overall balance of payments (current and capital accounts) must balance. A current account deficit must be offset by a capital account surplus.
Balance of Payments = Current Account + Capital Account = Zero
Two key factors influence current account balances: savings and investment relative to consumption, and exchange rates. Higher borrowing from abroad increases trade deficits. Joseph Stiglitz notes that trade deficits and foreign borrowing are “two sides of the same coin.” Increased government borrowing, without offsetting private savings or investment decreases, leads to more foreign borrowing and larger trade deficits.
Exchange rates also play a role. A persistent trade deficit should theoretically cause a currency to depreciate, making imports more expensive and exports cheaper, restoring trade balance.
However, countries can manipulate exchange rates. China, for example, has pegged its currency (renminbi) to the dollar, preventing appreciation despite large trade surpluses with the U.S. China buys U.S. Treasury bills with its dollar surplus, maintaining an undervalued renminbi and overvalued dollar. This is similar to Japan in the early 1980s. An undervalued exchange rate acts as “both an import tax and an export subsidy,” a highly mercantilist policy.
Conclusion
Comparative advantage remains a fundamental principle in economics, although several important caveats are often overlooked.
First, Ricardo’s theory assumes increasing production costs, where comparative advantage arises from natural endowments. However, many modern products have decreasing costs, allowing countries to create comparative advantage through policy and investment.
Second, the factor price equalization theorem suggests free trade equalizes factor returns, potentially lowering wages in high-wage countries for unskilled labor. However, this may not hold in decreasing-cost industries.
Third, early theories focused on goods trade, not factor trade. Increased factor mobility accelerates factor price equalization.
Fourth, balanced trade is often assumed. Persistent imbalances can distort comparative advantage, potentially causing deficit countries to import goods where they could be competitive, especially in decreasing-cost industries, leading to long-term competitive decline.
The global economy has evolved significantly since Smith and Ricardo. Trade is now dominated by global corporations with complex supply chains, enabled by trade liberalization and technology. These supply chains drive rapid trade growth relative to GDP.
While the U.S. benefits from trade partners reducing barriers, and generally benefits from reducing its own, import liberalization has domestic labor and production impacts that need consideration.
Multilateral trade liberalization best promotes comparative advantage-based trade. However, neomercantilist policies and exchange rate manipulation can distort competition and reduce global welfare. Understanding comparative advantage and its complexities is crucial for navigating global trade and ensuring fair competition in industries like car parts manufacturing, where strategic policies and company decisions play a significant role in determining Which Manufacturing Company Has The Comparative Advantage For Car Parts on the global stage.
[1] Thomas Mun, in a letter written to his son in the 1630s, available at http://socserv.mcmaster.ca/econ/ugcm/3ll3/mun/treasure.txt.
[2] William Bernstein notes that Smith was not the first to advocate the advantages of free trade. He says, “By far the most remarkable early free-trader was Henry Martyn, whose Considerations upon the East India Trade preceded by seventy-five years Adam Smith’s Wealth of Nations.” William J. Bernstein, A Splendid Exchange: How Trade Shaped the World (New York: Grove Press, 2008), 258.
[3] David Ricardo, On the Principles of Political Economy and Taxation (London: John Murray, 1821).
[4] Bertil Ohlin actually published this theory in 1933. A brief explanation of the Heckscher-Ohlin theory is available at http://nobelprize.org/educational_games/economics/trade/ohlin.html.
[5] Dominick Salvatore, International Economics, 8th ed. (Hoboken, N.J.: John Wiley & Sons, 2004), 15.
[6] The concept of product life cycle was introduced by Raymond Vernon in 1966.
[7] A good explanation of this theorem, which shows a hypothetical trading relationship between two countries, is available at http://faculty.washington.edu/danby/bls324/trade/hos.html.
[8] James K. Jackson, Trade Agreements: Impact on the U.S. Economy (Washington, D.C.: Congressional Research Service, 2006), 9.
[9] Salvatore, International Economics, 255.
[10] Stiglitz, Progress, What Progress, 27.
[11] Jacob Viner, The Customs Union Issue (New York: Carnegie Endowment for International Peace, 1950), 48.
[12] Stephen D. Cohen, Robert A. Blecker, and Peter D. Whitney, Fundamentals of U.S. Foreign Trade Policy: Economics, Politics, Laws, and Issues (Boulder, Colo.: Westview Press, 2003), 57.
[13] A commonly used and publicly available CGE model and comprehensive database is available from the Global Trade Analysis Project, which is housed in the Department of Agricultural Economics at Purdue University. The GTAP model and database are available at https://www.gtap.agecon.purdue.edu/default.asp.
[14] Jackson, Trade Agreements, 12.
[15] A second type of model commonly used is a gravity model, which assumes that larger economies have a greater pull on trade flows than smaller economies, and that proximity is an important factor affecting trade flows. And still another common type is a partial equilibrium model, which estimates the impact of a trade policy action on a specific sector, not the general economy. Partial equilibrium models do not capture linkages with other sectors and accordingly are useful when spillover effects are expected to be negligible. However, partial equilibrium models are more transparent than CGE models and it is easier to see the impact of changed assumptions.
[16] A good source for trade data and an explanation of the data systems used is the Foreign Trade Statistics Web site at the Census Bureau, http://www.census.gov/eos/www/naics/.
[17] Jagdish Bhagwati, In Defense of Globalization, Council on Foreign Relations Report (New York:, Oxford University Press, 2004), 230.
[18] The drafters of the GATT probably were focused on the potential benefits of a European customs union that would promote integration. Some historians argue that the U.S. negotiators also envisioned a possible U.S.-Canadian free trade agreement that would eliminate barriers to trade in North America.
[19] Another major exception to the MFN rule pertains to preferences for developing countries. This exception is considered further in chapter 6.
[20] Viner notes a qualification to the rule that global welfare is diminished if trade diversion is greater than trade creation and that is when unit costs decrease in an industry as output expands. In such a case, a small country may not have been able to develop an industry because its market size was too small but is able to develop the industry within a customs union or free trade arrangement.
[21] Kei-Mu Yi, Can Vertical Specialization Explain the Growth of World Trade? (New York: Federal Reserve Bank of New York, 1999).
[22] WTO deputy director-general Alejandro Jara gave an interesting speech May 26, 2010, in which he outlined some of the implications of supply chains for how we think about international trade. His speech is available at www.wto.org/english/news_e/news10_e/devel_26may10_e.htm.
[23] Geza Feketekuty, International Trade in Services: An Overview and Blueprint for Negotiations (Cambridge, Mass.: American Enterprise Institute /Ballinger, 1988), 2–3.
[24] Ibid., 100.
[25] Ralph Gomory and William Baumol, Global Trade and Confl icting National Interests (Cambridge, Mass.: MIT Press, 2000), 5.
[26] Ibid., 5
[27] Ibid., 21.
[28] Cohen, Blecker, and Whitney. Fundamentals of U.S. Foreign Trade Policy, 8–9.
[29] See, e.g., ibid., 54: “The theory of comparative advantage assumes that trade is balanced (i.e., exports equal imports in value) and that labor is fully employed…If trade is not balanced, the surplus country must be exporting some goods in which it does not have a ‘true’ comparative advantage.”
[30] Salvatore, International Economics, 167.
[31] Joseph E. Stiglitz, Making Globalization Work (New York: W. W. Norton, 2006), 252–53.
[32] Aaditya Mattoo and Arvind Subramanian. Currency Undervaluation and Sovereign Wealth Funds: A New Role for the World Trade Organization (Washington, D.C.: World Bank, 2008), 3.
