Gains from Trade

by Russ Roberts on November 16, 2006

in Trade

This essay over at the Library of Economics and Liberty is part one of a two part series I’m writing on comparative advantage. I find it remarkable how poorly professors of economics (including this one) teach and understand a concept that many would label the single most important insight of the discipline.

We force our students to learn various versions of it using graphs and charts, yet its main use in the classroom is to generate tricky exam questions. Few textbooks or classes go beyond the example of two individuals or countries trading two goods. The main punchline in the typical discussion is that trade can be beneficial to both parties even when one party to the transaction is better at both things than the other. We also add that trade creates wealth. And that specialization is good.

But what is the significance beyond two people marooned on a tropical island? What does it have to do with outsourcing? What does it have to do with trade in the real world between two nations when the "nation" is not an autonomous agent making decisions but a bunch of individuals trading with another bunch of individuals across a border? How would you describe the central principle of comparative advantage using everyday English? How would that description carry over to a world with many products and many people to trade with? How do prices change the conclusions if at all, when prices are used in trade instead of barter? Does everyone have a comparative advantage in something in a multi-good multi-person world? What does that mean exactly? What if there are lots of people just like me? Do we each have a comparative advantage? Can my comparative advantage change from one good to another as the skills of others change?

In this two-part series I’ll try and get at the answers using a narrative version of the island story and avoiding the charts and graphs and equations. It turns out that even this absurdly simplified version of the absurdly simplified standard story has some real educational payoff. At least for me. I think I finally understand something about comparative advantage though I’m sure I have more to learn. It is surprisingly deep. I am grateful to my co-host here at the Cafe, Don Boudreaux, for many helpful conversations on the topic including a version of the island story that I’ve adapted as the narrative for the essay.

The second part will be posted over at the Library of Economics and Liberty on the first Monday of December.

Be Sociable, Share!

Comments

comments

24 comments    Share Share    Print    Email

{ 12 comments }

Slocum November 16, 2006 at 9:38 am

I have two comments about your essay. First, what is to prevent the Fishers from driving a much harder bargain? Why should they trade 4 fish for two containers of water? The Palmers start out with 2 fish and 2 water. After they start trading they end up with 4 fish and 2 water — a very good deal. By why would the Fishers not demand an exchange of 3 fish for 2 water or even 2 1/2 fish for 2 water? After all, the Palmers would still be better off taking one of these inferior offers than going back to fishing and carrying water alone. (What would the Fishers do with even more fish if they drove a harder bargain? Well, they could quite fishing earlier every day and relax more).

So it seems true that even though the Fishers are better at everything than the Palmers, comparative advantage makes trading worthwhile for both. BUT, it seems that the absolute advantage of the Fishers puts them in a much stronger bargaining position — a point which doesn't seem to be captured in the story. So you do what you do best, but if you aren't very good at what you do best, trade may make you only marginally better off than before.

The other comment is — what is the effect of taxes/tarrifs? What happens to trade if it's the case that when you catch your own fish and carry your own water, you can keep it all, but when you trade fish for water, the 'king of the island' takes 1/3 of both?

Randy November 16, 2006 at 9:54 am

Slocum,

Re; "…they could quite fishing earlier every day and relax more."

True, and a key point I like to focus in on – that free time is a form of wealth created in nearly every free trade. As you suggest, it can be spent in relaxation, but it can also be invested – perhaps in learning how to make a better cooking pot for the fish. Multiply the small amounts of free time created in every trade by the hundreds of billions of transactions over thousands of years and we begin to see how the human race progresses – and why the progress is likely to continue.

Now lets talk about parasites…

Adam Malone November 16, 2006 at 10:03 am

Slocum- While your point about the king of the island is well taken, I think it makes the point of comparitive advantage even stronger. If instead of taxing the people of the island, the king actually made something like fishing nets, sweaters, huts, larger canteens, salt to preserve fish, and so on…it is possible, even likely that everyone on the island would be better off than when fewer consumers lived on the island.

Dr Roberts' essay also briefly mentions one point that I think he will illuminate in the following essay. The Fishers decided to allow the garden to die. They chose to have more fish to eat rather that to have tastier fish to eat. Although it is not always true, sometimes people will choose to have more of a specific good instead of having more variations of that good.

This is part of the creative destruction that builds strong economies. Over time more efficient means of fishing, water gathering, cooking, etc. will be adopted or invented in order to make everyone better off.

Example: What happens is Mr. Fisher decided to teach Mr. Palmer to fish. (You see while Mr Fisher is bigger than Mr Palmer and Mrs Fisher is bigger than Mrs Palmer, it is likely that Mr Palmer is bigger than Mrs Fisher, therefore he COULD be a better or equal fisherman with the proper training). The result could be that the economy has the same amount of fish, but 5 waters instead of only four. Which could allow the growth of herbs or other types of farming.

Don November 16, 2006 at 10:34 am

Great stuff. What are the chances of cluing the Library of Economics and Liberty's webmasters into the concpet of the printer-friendly version?

coyote November 16, 2006 at 10:44 am

Russell, the debate I always get into is highlighted by this quote from our business columnist in the Arizona Republic (the Phoenix newspaper). He said in a recent column "Americans were assured that new trade accords and China's membership in the World Trade Organization would mean better living standards for American workers. That's because China and other countries supposedly would buy American exports."

My answer was that this was wrong for a few reasons. First, even if they don't buy our exports, and somehow just sit on all of the dollars they earn from their own exports, we are STILL better off because we are buying certain inputs cheaper, and we can redeploy labor to other things (though this may be absolute advantage rather than comparative advantage).

Second, I answered that most of the dollars will recirculate, so they must be buying something from us, but his measure of our "exports" is too narrow. They may be buying American products and consuming them in the US. Or, most likely, they may be buying American financial instruments. Wealth protection and preservation could be considered an "export", and is in fact one the US probably has a comparative advantage in.

I would love to see sometime how you answer this question

coyote November 16, 2006 at 11:58 am

By the way, here is my shot at answering the question "But what if the trade is not reciprocal?" is here: http://www.coyoteblog.com/coyote_blog/2006/11/an_export_by_an.html

Brad November 16, 2006 at 3:09 pm

It would be interesting in part II if the Fishers "trade" their extra fish production for time to either work on a pipeline or a desalination plant to try to cut the Palmers out. Meanwhile, the Palmers might create a fish farm to cut the Fishers out.

But seriously… thanks for this. Have you considered making a children's book out of the story?

Russ Roberts November 16, 2006 at 9:50 pm

Coyote,

That view of trade (it's all about the exports) totally misunderstands what trade is about. Exports are costly. Exports means taking scarce things (people, raw materials, capital and vision) and using them up. There's nothing good about exports. The best of all possible worlds would be for foreigners to take the money they get from us and use it as wallpaper. Then we could have goods in exchange for pieces of paper. It's cheap to make pieces of paper. It's costly to make Boeing 747s.

Foreigners actually don't want the pieces of paper. They want the goods and services and assets that those pieces of paper entitle them to. That's why THEY are willing to incur the costs of exports. But if somehow they just gave us free stuff or nearly free they would be much better than making us pay for stuff using our scarce resources. It's like saying we shouldn't let people cure disease because it will hurt the health care industry.

I'll try and write more on this some time in a formal essay. I'll have a brief discussion of it in the next email section of EconTalk and I discuss it in my book, The Choice which I'll post on soon.

Look forward to checking out your essay.

Russ Roberts November 16, 2006 at 9:54 pm

Brad,

I have considered turning it into a children's story. I've thought of two versions–an illustrated one for youngish kids 6-10, maybe, and a more dramatic narrative version for older kids. We sure could use more entertaining ways to get the educational lessons across to our kids.

Brad Hutchings November 16, 2006 at 11:14 pm

Russ… Make your "children's story" like this:
http://send.realebooks.com/?bH=41a&c=5b69bebc&p=31

I make the software that does this. I'm making it so authors of these things can put them on any web page or blog posting.

Anyway, I'd be happy to hook you up with the software. It would be fun to turn your story into something that would be chain e-mailed among the masses. Scandalous even ;-) .

lowcountryjoe November 17, 2006 at 6:36 am

A kid's book? Good idea; as children often get simple concepts like cooperation and "we both can gain if we do this". In fact kid understand this things much better than adults — and the politicians who "lead" them — can.

John Konop November 19, 2006 at 5:42 pm

How Bad Trade Deals are Destroying the Middle Class

This is from “Skeptical Economist”.

So far, our global economic failures show up mainly as discontented workers in areas hard hit by import competition. However, the real problems (and the worker problems are quite real) are considerably worse

The United States as a nation is far from self-sufficient or anything close. Back in Kennedy era, imports and exports were in the range of 4 to 5% of GDP. The US economy was closes to autarkic. These days comparable numbers are imports are 16.22% of GDP and exports are 10.46% of GDP. Per se, there is nothing wrong with trade growing as a percent of GDP. However, the brutal reality is that our nation can no longer pay its bills. Imports of goods are almost double exports of goods. We enjoy a small (and shrinking) surplus on services and are now in deficit for payments (profits received from overseas US investments versus profit earned by foreign investment in the US).

If you could only pay half of your bills, would you think you were doing well? Would that be OK? Might some question of economic failure arise? Wouldn’t virtually every American see it that way? Yet, when it comes to our country, it is somehow OK. Of course, it is not.

If you could only pay half of your bills, your debts would be soaring. Guess what? So are the debts of the United States. Of course, the national debt is growing and more than 50% owned by foreigners. However, the debts of ordinary Americans are rising as well and a growing percentage are owned by foreigners as well.

The trade debate is usually depicted in terms of “cramped, narrow minded, locally oriented protectionists” versus “visionary, open minded, free trading globalists”. This caricature is largely correct. However, that doesn’t mean the protectionists are wrong. With America going broke, they are at least on the right side of the issue..

Thomas Friedman demonstrated again the cluelessness of our elites on trade today. His piece “China: Scapegoat or Sputnik” repeated the usual mantra about education solving our problems. His actual words were “health care, portability of pensions, entitlements, and lifelong learning”. Nice ideas, but will they really help middle aged workers without jobs? No, of course not, but the deeper problem is they won’t fix our trade problems either. We will simply go broke faster. What words were missing? How about “overvalued currency”, “RMB versus the dollar”, “China’s lack of currency flexibility”, etc. All notably missing.

Previous post:

Next post: