The conventional economics
view…
◦ “Every individual seeks the most
advantageous employment for his capital….
◦ “Study of his own advantage necessarily leads
him to prefer that employment most
advantageous to society”
- Adam Smith, 1776

Models from economics generally assume
that if everyone pursues self-interest, things
will work out for good
◦ May assume adherence to some straightforward
ethical principles

Free Trade occurs when a government
does not attempt to influence, through
tariffs, quotas, or other means,
◦ what citizens can buy from other countries or
◦ produce and sell to other countries

The Benefits of Trade allow countries to be
richer by specializing in products they can
produce most efficiently

The history of government involvement in
trade presents mixed evidence
◦ There are lots of problems with trade
 There may be some ways that some
governments can make things better by
intervening (that is, by not practicing free trade)
◦ But government intervening in free trade is
definitely dangerous
 Restrictions on trade have
 kept some countries very poor
 contributed to huge depressions


Till the 16th century, philosophers didn’t
theorize much about trade
Then mercantilists sought what we now call
‘development,’ teaching that a nation’s
wealth depends on accumulated “treasure”
◦ Gold and silver are the currency of trade

Mercantilists argued their countries should
run a trade surplus
◦ Maximize export through subsidies
◦ Minimize imports through tariffs and quotas

Flaw: “zero-sum game”
◦ Mercantilists neglected to see
the benefits of trade

Adam Smith argued (Wealth of Nations,
1776): Capability of one country to produce
more of a product with the same amount of
input can vary
◦ A country should produce only goods where it is most
efficient, and trade for those goods where it is not efficient

Trade between countries can, therefore,
benefit both sides
◦ Example: Portugal/wine vs.
England/wool
◦ Ghana/cocoa vs.
South Korea/rice

As people specialize and seek higher
incomes, they may learn to do their
specialties better
Suppose one country is more efficient
than another in everything?
 There are still global gains to be made
if a country specializes in products it
produces relatively more efficiently
than other products


David Ricardo (Principles of Political
Economy, 1817):
◦ A country should import products for which it is relatively
inefficient even if the country is more efficient in the
product’s production than country from which it is
buying

Trade is a positive-sum game
Theory of
Comparative Advantage

Countries have comparative advantage in
goods for which the opportunity cost of
production is relatively low
◦ That is, those that can be produced by giving up
relatively little in production of other goods

This means your country
has comparative advantage in the
product or service where the ratio
Resources required in your country .
Resources required in the other country
is low
Ghana has absolute advantage in both cocoa and
rice, but its comparative advantage is in cocoa.
Cocoa Korea has comparative advantage in rice .
20 tons
15
tons
5 tons
Ghana
Korea
10 tons
3.75
tons
Let Korea specialize
in rice – Ghana expands
cocoa production to replace
all Korean cocoa production
lost
Then Ghana can replace all Korean
cocoa production and the countries
have more of both goods.
15
tons
Rice
The country less efficient in everything
will be poor …


But it would be even poorer if it did not trade
This argument leaves money out of the
discussion entirely
◦ It’s designed to show there can be benefits from
trade even for poor countries

This is a very simple case, but the basic
conclusions are generally valid and
are used in setting international policy
◦ We’re assuming no transportation costs
◦ We’re simplifying by not talking about
currencies
◦ We’re assuming constant returns to scale
◦ We’re assuming resources can move freely
from production of one good to another
◦ We’re not thinking about effects on
income distribution


In a money economy under free trade, the
country that is less efficient will have
low wages
It will be able to sell the products where it has
comparative advantage without any special
tariff or subsidy protection
◦ But it may need to work on infrastructure,
institutions, and education for trade
 China, India both sell cheap manufactured goods
 China sells more because it has better
transportation infrastructure and government
that supports manufactured exports

Immobile resources:
◦ Resources do not always move easily from one
economic activity to another
 So some rice farms will persist in Ghana no matter what
 (Rice farmers will be losers as cheap rice comes from
Korea)

Diminishing returns:
◦ Diminishing returns to specialization suggests that
after some point, the more units of a good the
country produces, the greater the additional
resources required to produce an additional item

They believed that if people were left to
trade on their own, they would naturally
trade the goods in which their countries had
comparative advantage
◦ “Every individual seeks the most
advantageous employment for his capital….
◦ “Study of his own advantage necessarily leads
him to prefer that employment most
advantageous to society”
- Adam Smith, 1776


They didn’t advocate that government ensure
that the right kind of trade take place
They believed that if governments put no
barriers in place, businesspeople would make
the right kind of trades because it would be
in their economic interest.
When Intervention May Help

Infant industry
◦ Oldest argument for protection
- Alexander Hamilton, 1792
◦ Hamilton said that US textile & machinery industries
were ‘infants’
 They needed protection to give them time to learn to be
competitive
 If given time, they would learn to compete
◦ WTO rules allow countries to protect infant industries
Infant industry protection is only good if it
helps the industry become efficient

Japanese automakers – were protected with
‘infant industry’ tariffs for 20+ years, became
world leaders

Brazil automakers – world’s 10th largest auto
industry – wilted when protection eliminated
In industries with high fixed costs:
◦ Specialization increases output,
◦ The ability to achieve economies of scale increases
through exporting
◦ Learning effects are high.
 These cost savings come from “learning by doing”


In many industries, world demand will
support few competitors
Successful firms may emerge because of
“First-mover advantage”
◦ Economies of scale may preclude new entrants
◦ Role of the government becomes significant

Some argue that it generates a need for
government intervention and
strategic trade policy
When Intervention May Help

Strategic trade policy
◦ Government should use subsidies to protect promising
firms in newly emerging industries with substantial
scale economies
◦ Governments may benefit if they support domestic
firms to overcome barriers to entry created by
existing foreign firms
 Airbus in Europe
 Didn’t work for U.S. in flat panel displays
For economists, the key point is
the power of free trade

Free trade is more efficient almost all the
time

Free trade (open economies):
◦ Free trade might increase a country’s stock of
resources (as labor and capital arrives from abroad)
◦ Increase the efficiency of resource utilization inside
each country as well as between them
Paradox: US exported labor-intensive
goods when it had lots of capital


The U.S. seems to be good at inventing new
products
The important factors may be highly
specialized
◦ Software design engineers


Or the U.S. may have a unique constellation
of factors that produces new products
Production of the new products tends to be
labor intensive at first
◦ The U.S. imports older, heavy industrial products
Development of the
World Trading System

Intellectual arguments for free trade
◦ Adam Smith and David Ricardo 1776-1820s

Free trade emerged gradually as
government policy in Britain, the leading
nation in the 19th century
◦ Repeal of the Corn Laws (1846) allowed free trade in
food
◦ Leading European nations maintained free trade
through late 19th Century to WW I
Development of the
World Trading System

Great Depression
◦ US stock market collapse (1929)
 Partial recovery
◦ Congress adopted the Smoot-Hawley tariff (1930)
 Almost every industry had its “made to order tariff”
 Foreign response was to impose own barriers
 Everyone’s exports tumbled
◦ Depression continued almost till World War II
Development of the
World Trading System


No one wanted to repeat the mistakes of
the 1930s
General Agreement on Tariffs and Trade
(GATT) - multilateral agreement established
in 1948 under US leadership
◦ Big conference at Bretton Woods, NH, during WW II
◦ Objective was to liberalize trade by eliminating tariffs,
subsidies, and import quotas
◦ 19 original members grew to 120
Development of the
World Trading System

GATT used ‘rounds of talks’ to gradually
reduce trade barriers
◦ Mutual tariff reductions negotiated
◦ Dispute resolution only if complaints were received

Uruguay Round GATT 1986-93
The World Trade Organization



The WTO was created (1995) during the
Uruguay Round of GATT to police and
enforce GATT rules
Most comprehensive trade agreement in
history
Formation of WTO had an impact on
◦ Agriculture subsidies (stumbling block: US/EU)
◦ Applying GATT rules to services and intellectual
property
◦ Strengthening of monitoring and enforcement