Free trade theory

Few topics in economics create as much consternation and debate as trade theory. While economists tend to view the globalization of exchange as being essentially benign and welfare enhancing, the public often see it as a dangerous threat. From an economic point of view national borders are completely arbitrary. If prosperity stems from the extent of the market and the division of labour, you want it spread over as wide a geographical area as possible. If restrictions on trade (such as tariffs or quotas) make little sense when imposed between different cities, they make no more sense when imposed between different countries.

Adam Smith

When Adam Smith published the Wealth of Nations in 1776, one of his chief accomplishments was to critique the prevailing views about trade policy. The sixteenth century to late eighteenth century were dominated by mercantilism – the belief that national wealth is maximized by increasing exports and accumulating precious metals in return. This coincided with the emergence of nation states, and they competed for resources through trade policy. Trade was deemed to be zero sum, therefore one nation succeeded by harming its rivals. As Laura LaHaye says,

“mercantilism is economic nationalism for the purpose of building a wealthy and powerful state”.

Laura LaHaye

The alternative to economic nationalism, is economic liberalism – free trade.

Smith provided a coherent and penetrating critique of mercantilism by arguing three main things:

  1. Trade is positive sum. When two people exchange goods it is because they both believe they are being made better off, and whether they are in two different countries doesn’t change this.
  2. Specialization leads to growth. A division of labour means that we can concentrate on more efficient production, and allows us to trade for things we can’t make for ourselves.
  3. Laissez-faire policy is truly egalitarian. Mercantile trade policies help merchants by increasing the cost to consumers. An egalitarian trade policy would help consumers (by allowing cheap imports) rather than producers (who want to keep prices high).

Free trade will be the link to bind Each nation to the other;
’Twill harmonize the rights of man With every fellow brother.

Origin unknown

Nations don’t grow wealthy by accumulating gold and silver, they grow wealthy by “improving their industrial and agricultural productivity”. At the time Smith’s insights led to a revolution of thought away from mercantile protectionism and towards nineteenth-century free trade. However, mercantilism struck back. The Great Depression saw the end of economic liberalism, and World War II unleashed a military-industrial complex that once again sought to dictate trade policy based on the special interests of producers.

But what are the arguments in favour of free trade? The main one is the concept of comparative advantage.

Here we use basic demand and supply analysis to look at the welfare effects of trade intervention:

Martin Wolf (2023, p. 64) argues that although the first wave of globalization was largely driven by innovations in transportation (e.g. the railway and steamship), the second wave was “the liberalisation of trade barriers and the fall in the cost of communication and data processing, which has made possible an unprecedented integration of production across the globe”.

Although transport improvements (such as container ships and commercial jet aviation) have contributed, the main technology was pure trading. He also points out that “nearly all emerging and developing countries still have substantially higher barriers to trade than high-income countries, partly because they postponed liberalisation until the late twentieth century”. As the graph shows, reducing trade barriers remains a major opportunity to increase prosperity around the world:

In Dave Chappelle’s Equanimity he does a bit mocking Donald Trump’s approach to jobs. With 19:46 remaining, he points out that if we brought jobs from China to the US then an iPhone would cost $9000. “Leave that job in China where it belongs! None of us want to work that hard. I want to wear Nikes I don’t want to make them”. Chappelle’s point is that it’s better to have cheap imports than low productivity manual labour.

“I want to wear Nikes I don’t want to make them”

A literary example of the recognition of an extended social order in the creation of seemingly trivial household items is David Lodge’s ‘Nice Work’ (1988) – see here.

This guy attempted to make a sandwich from scratch. It cost $1500 and took 3 months. It’s remarkable how cheap and plentiful sandwiches are, due to an extended global supply chain and division of labour.

Economics is positive sum for the following reasons:

  • Heterogeneity of people, and the diversity of preferences.
  • Increasing returns to scale (i.e. the benefits of team work and joint production).
  • Division of labour and specialization (i.e. the principle of comparative advantage).

Donald Boudreaux and Douglas Irwin on free-trade tips from 1846, The Economist, June 25th 2021 – an overview of the Corn Laws