Oct 1st 1998
From The Economist print edition
A short tour of economic theory
ECONOMISTS are usually accused of three sins: an inability to agree among themselves; stating the obvious; and giving bad advice. In the field of international trade, they would be right to plead not guilty to all three. If there is one proposition with which virtually all economistsagree, it is that free trade is almost always better than protection. Yet the underlying theory is not readily understood by non-economists. And the advice that follows from it—protection does not pay—is seldom wrong.
The argument for free trade is based on the theory of comparative advantage. This is one of the oldest theories in economics, usually ascribed to David Ricardo, an Englishman who wrote in the early 19th century. To see how it works, imagine two countries, East and West, which both produce two kinds of goods, bicycles and wheat. In a year, an Eastern worker canmake two bikes or grow four bushels of wheat. A Westerner, however, can manage only one bushel or one bike. Each country has 100 workers, and initially both of their workforces are split evenly between the two industries. So East produces 200 bushels of wheat and 100 bicycles, whereas West produces 50 bushels and 50 bikes (see table 3).
Since East can produce both wheat and bicycles more cheaplythan West, it has an absolute advantage in both industries. Even so, Easterners will benefit from trading with Westerners. This is because East is relatively more efficient at growing wheat, where it is four times as productive as West, than it is at making bikes, where it is only twice as productive. In other words, it has a comparative advantage in wheat. At the same time, West has a comparativeadvantage in making bikes, even though it has no absolute advantage in anything.
According to Ricardo’s theory, both countries will be better off if each specialises in the industry where it has a comparative advantage, and if the two trade with one another. Specialisation increases world output. Suppose that East specialises in wheat growing, shifting ten workers from its bicycle factories to itsfields, and producing 240 bushels and 80 bikes. West moves 25 workers from wheat farming into bike making, where its comparative advantage lies, and produces 75 bikes and 25 bushels. Global production rises (see second panel).
The point of economic activity, however, is not to produce but to consume. Both countries can enjoy more bikes and more wheat if they trade on terms at which both willgain. If East is going to import bikes, it will pay no more than two bushels in return (faced with a higher price, it would be better off moving workers back to the bike factory). Similarly, West will pay no more than one bike per bushel. Suppose that the “terms of trade”, as economists call the ratio of export to import prices, are set at one-and-a-half bushels per bicycle, and that 33 bushels aretraded for 22 bikes. The result (third panel) is that both countries are better off.
In essence, the theory of comparative advantage says that it pays countries to trade because they are different. West’s relative deficiency in bike manufacture is less than in wheat farming. It is impossible for a country to have no comparative advantage in anything. It may be the least efficient at everything,but it will still have a comparative advantage in the industry in which it is relatively least bad. And even if a country were the most efficient in every industry, giving it an absolute advantage in everything, it could not have a comparative advantage in everything. In some industries, its margin would be more impressive than in others.
Economists’ next argument for free trade is that opening...