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At what price? Neither will want to import what it could make more cheaply at home. So West will want at least five bikes per computer; and East will not give up more than 25 bikes per computer. Suppose the terms of trade are fixed at 12 bicycles per computer and that 120 bikes are exchanged for ten computers. Then West ends up with 270 bikes and 60 computers, and East with 130 bicycles and ten computers. Both are better off than they would be if they did not trade.
This is true even though West has an “absolute advantage” in making both computers and bikes. The reason is that each country has a different “comparative advantage”. West’s edge is greater in computers than in bicycles. East, although a costlier producer in both industries, is a relatively less-expensive maker of bikes. So long as each country specialises in products in which it has a comparative advantage, both will gain from trade.
Fair deal
Some critics of trade say that this theory misses the point. They argue that trade with developing countries, where wages tend to be lower and work hours longer than in Europe and North America, is “unfair”, and will wipe out jobs in high-wage countries.
It is generally accepted that trade with poor countries has been one of the factors reducing the wages of unskilled workers, relative to skilled ones, in the United States. That said, the threat to rich-country workers from developing-country competition is often overstated.
For a start, it is important not to confuse absolute and comparative advantage. Even if developing countries were cheaper producers of everything under the sun, they could not have a comparative advantage in everything. There would still be work for people in high-wage countries to do.
Moreover, it is not true that countries with cheap labour always have lower costs. Wage differences generally reflect differences in productivity; companies in low-wage countries often need far more labour to produce a given amount of output, and must deal with less efficient communications and transportation systems. In most cases hourly wages are not decisive in determining where a product is made.
Suppose that the “fair traders” succeed in eradicating international differences in production costs, so that a given product cost precisely the same to make in different countries. In that case, no country would have a comparative advantage, and hence there would be no trade. Rich-country workers, who are also consumers, would lose.
At first blush, real-world trade patterns would seem to challenge the theory of comparative advantage. Most trade occurs between countries which do not have huge cost differences. America’s biggest trading partner, for instance, is Canada. Well over half the exports from France, Germany and Italy go to other European Union countries. Moreover, these countries sell similar things to each other: cars made in France are exported to Germany, while German cars go to France, dependent largely upon consumers’ differing tastes rather than differences in costs.
The importance of geography and the role of similar but different products appealing to diverse tastes expand our understanding of why trade occurs. But they do not overturn the fundamental insight of the theory of comparative advantage. The agricultural exports of Australia, say, or Saudi Arabia’s reliance on oil, clearly stem from their natural resources. Poorer countries tend to have relatively more unskilled labour, so they tend to export simple manufactures, such as clothing. So long as relative production costs differ between countries, there are gains to be had from trade.
Enter the state
What is confusing, perhaps, is that comparative advantage is often the product of history and chance, not of differences in natural resources or workers’ skills. A stark example is America’s civil-aircraft industry. There is no God-given reason why the production costs of jumbo jets, relative to other goods and services, should be lower in America than in Japan. But they are: America’s early embrace of airmail, its large purchases of military aircraft and the great public demand for air travel in a large country all helped American plane makers get big early on, allowing them to achieve per-plane costs lower than those of foreign competitors.
A logical question follows: if comparative advantage can be created, why should governments not help create it? The idea is that through subsidies, such as those given by several European nations to finance the European-made Airbus passenger jets, governments can promote their own national champions and hobble foreign rivals. Since the late 1970s, a stream of theoretical research has shown that governments can use such “strategic trade policy”, in principle, to make their own citizens better off.
The theoretical work, however, has shed little light on how, in practice, governments can select which industries to subsidise—and which to tax in order to finance the subsidy—so that, in the end, the country’s welfare is improved. And then there is the matter of politics: once the government has agreed to support “strategic” industries, every industry will assert its strategic importance in order to share in the pie. Under real-world political pressures, the allure of strategic trade policy fades quickly.
Governments’ intervention in trade is not limited to fine calculations of strategy. There is plenty of aid to politically sensitive industries, such as agriculture. And governments often rush to obstruct “unfair” competition from abroad.
Anti-dumping duties are a case in point. In theory, these are intended to keep foreign producers from “dumping” goods abroad at less than their cost of production, by subjecting the goods to extra import duties. In practice, they are a politically neat method of protecting a particular industry. Once the favoured weapon of rich-world governments, anti-dumping duties have been been taken up eagerly by developing countries (table 4).
Despite such machinations, world trade flows more freely than it used to. This is due mainly to international agreements under which governments agree to forswear trade barriers—most notably, the General Agreement on Tariffs and Trade (GATT). All told, there have been eight rounds of GATT talks since 1947, in which countries have cut their import tariffs. Tariffs on manufactured goods are now down to around 4% in industrial countries.
The most recent GATT round, the Uruguay round, ended in 1993. The Uruguay round did much more than cut tariffs on goods. It heralded a big institutional change, creating the World Trade Organisation (WTO), which now boasts 132 members, as a successor to GATT. It also made three big changes to the rules of world trade. First, it began the process of opening up the most heavily protected industries, agriculture and textiles.
Second, the Uruguay round vastly extended the scope of international trade rules. The rules were extended to cover services, as well as goods. New issues, such as the use of spurious technical barriers to keep out imports and the protection of foreigners’ “intellectual property”, such as patents and copyrights, were addressed for the first time.
Of these new agreements, the one in services is especially interesting. A lot of trade no longer involves putting things into a crate and sending them abroad on ships. Many services, can be traded internationally: a British construction firm can build an airport in Japan, and an American insurance company can sell its products in Germany.
Lots to talk about
The WTO estimates that commercial-service trade was worth $1.2 trillion in 1996, around one-quarter of the value of trade in goods. The services agreement, plus a recent deal on telecommunications trade, should ease the barriers that limit such trade.
The third change wrought by the Uruguay round was the creation of a new system for settling disputes. In the past, countries could (and sometimes did) break GATT rules with impunity. Under the new system, decisions can be blocked only by a consensus of WTO members. Once found guilty of breaking the rules (and after appeal) countries are supposed to mend their ways. This system so far seems to be working better than the old one, and is helping to build up the new institution’s credibility.
Despite these recent advances, there are plenty of difficulties ahead. China, the world’s second-biggest economy, and its 11th-biggest exporter, is not yet a member of the WTO, and talks on its accession have been difficult. Some countries, such as America and France, would like to see the WTO address itself to the relationships between trade, labour standards and the environment. Others, notably India and Malaysia, are opposed. In 1996 the WTO’s members agreed to study the issues, but there is no agreement about whether the WTO should go further.
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