Neoliberalism explained 3 - Free trade and comparative advantage

[SimpleDon]

Neoliberalism explained 3 - Free trade and comparative advantage

Free trade and open borders are cornerstones of neoliberalism, the 20th century re-branding of the 19th century's classical liberalism.

The idea that free trade benefits everyone who participates in it is based on the economic theory of comparative advantage. This is the idea that in international trade different nations each do something different well and free trade allows each nation to concentrate on what they do best, that is what they do more efficiently, while importing products that other nations do better.

Like many things in economics what is true for individuals isn't true on a larger scale, in this case, for nations.

The application of comparative advantage to international trade relies on four assumptions, all of which are questionable.

The theory assumes that the trade is between nations. International trade is between companies just like the domestic trade. The companies compete against each other for the international trade just like they do for the domestic trade. Individual companies don't care about comparative advantage, they are seeking an absolute advantage over their competitors. If my company manufacturers furniture I could care less that another company produces shoes at a low cost. I need to produce furniture at a lower cost than other furniture producers. According to the theory, comparative advantage between nations will only work if each nation has an advantage in different products. However, most often the advantage that one nation has is in all of its industries, and that is low wages. Then all of of the advantage is owned by the low wage nation and all of the exports flow to the high wage nation and all of the money flows to low wage nation. The obvious result in the high wage nation is a perpetually high trade deficit, unemployment, high public or private debt to replace the money leaving the economy and de-industrialization in the high wage nation.

It assumes full employment and full capacity utilization in both nations. That before the international trade starts both nations are producing a product at low cost compared to other nation's cost and both nations are producing another product at a higher cost compared to the other nations costs. It further assumes that both nations are utilizing all of the available factory capacity and employing all of the available workers to produce both the lower cost product and to produce the higher cost product. Then when the trade begins in order for a nation to increase the production of the lower cost product to they will have to take workers from the higher cost product's production, to have to close the higher cost products factories and to build new production factories for the additional production of the low cost product to export. But full employment and full capacity utilization are very much not the norm in developed or in underdeveloped nations. And available, unused resources means that more of everything can be produced without the reallocation of resources required to benefit from comparative advantage.

It assumes the existence of an automatic mechanism to equalize the trade balances. Free Trade Enthusiasts usually offer one of two candidates for this automatic mechanism, floating exchange rates or competition forcing lower prices and wages in the importing nation eventually making them competitive again. It will not surprise you that neither are valid, and neither work as an effective automatic mechanism to lower the trade deficit. One fails as an automatic mechanism and why it does is not understood by mainstream economists because of their economics aversion to understanding how money is created and ultimately how money is destroyed. The failure of the other hinges on mistaking finished consumer products with commodities and how prices are set for them. Both ignore the effects of income distribution, treating the money flows as having the same impact on a nation's economy no matter who receives it. The idea behind a floating exchange equalizing the trade balance is that over time a large trade deficit will force the value of a nation's currency lower raising the price of the imported goods higher and reducing the demand for them while increasing the demand for the native product. The problem with this is something called 'Kaldor's reflux,' that the trade deficit reduces the money supply in the importing country, reducing economic activity and increasing the amount of debt in the economy. Both defeat most of the automatic leveling. This reflux is seen in nations with a fixed exchange rate too, differing only in the details of how it comes about. In the case of the fixed exchange rate the central bank is required to defend the currency's value by reducing the money supply. With the floating exchange rate the blind optimism of the free market enthusiasts tells us that the central bank has a choice whether or not to try to support the currency's value, but practically there is no choice. The idea that falling prices and wages will operates as an automatic trade leveler fails for an obvious reason, prices and wages don't fall. Wages and prices are sticky, basic human nature dictates that they can only increase and that they can never decrease. Finally both candidates for an automatic trade leveler end up pretty much at the same place, dependent on prices and wages to fall in value to limit the imports and to increase exports, one by reducing the value of the currency and the other by reducing amount of money, the number of dollars, to pay for the product or the labor. This means that both are dependent on supply and demand setting a lower price for the product or the labor. That prices are set by price competition. But the prices of goods and for wages aren't set by supply and demand and prices for products largely isn't set by price competition. Show Prices for goods other than commodities are largely administered prices set by the producer based on his average per unit cost of production added to a target profit per unit. This means when he lowers his wage bill by shifting his manufacturing to a low wage nation, there is nothing to force him to reduce the price of the product to reflect the entire cost savings. He can take a part of it as increased profits. In fact they take the majority of the cost savings as increased profits, because prices are sticky. Producers don't want to compete based on price. Competing based on price is a no win game that results in little or no profit. So producers compete on anything and everything but price. They largely compete based on two things, quality and innovation. Their product is new and improved and it is better than the competition's products. Supply and demand are valid and important concepts in economics, it is just that they don't set prices. Yes, consumers are price conscious, they buy the least expensive item that meets their idea of quality. Therefore the producers dedicate their advertising to raise consumers expectation of quality and function and to promote the idea that consumers need to own the latest and the greatest product even if it replaces a working product that meets the consumer needs. All of this means that the main result of off shoring manufacturing is not lower prices for products but the conversion of wages into profits. This is where the myopic vision of most of our economists fails to go. That the income distribution matters significantly in how the economy behaves. This short sightedness is doubly hard to understand. First, it is based on the well established fact the people who have high incomes save more of their income than they spend on consumption. And conversely the people who have low incomes spend more of their incomes on consumption and save less of their incomes. This is normally expressed as the rich have a greater propensity to save, the non-rich have a greater propensity to consume. As far as I know this proposition is accepted by all economists as fact. The second reason it is strange that the majority of the economists in this country do not see that income distribution matters significantly is that their most closely held theory of economics, the theory that guides our current political economic policies, the so-called supply side economics, depends entirely on the proposition above. They tell us that we should increase income inequality because the rich are more likely to invest their money. That everyone else will just spend their money on consumption. Then they will turn around and declare that income inequality doesn't matter to the economy. While both theoretically do impact the trade deficit or surplus by a minor amount they do it so slowly that it is immeasurable.

It assumes away returns to scale. It is important to understand that the theory of comparative advantage relates to what economists call opportunity costs, not to absolute costs. The opportunity cost of two mutually exclusive alternatives is the benefit that would have been gained from the alternative that is not chosen. Investopedia has examples of this. Returns to scale is the driver of the industrial revolution. The natural and desirable course is for the most efficient, lowest cost producers to grow larger, providing them profits to become even more efficient, squeezing out less efficient competitors. We are referring to absolute, not opportunity costs here. Comparative advantage with its focus on opportunity costs actually stops industrialization's path to efficiency and maximizing returns to scale. For example, in the most obvious example of selecting the most advantageous opportunity cost instead of pursuing the lowest absolute cost, moving manufacturing to a low wage country stops the pursuit of more efficient manufacturing through say automation. It provides profits without forcing the capital gained from the profits having to "work" hard. It leaves the additional profits with nothing to do. This is very dangerous, as we saw when some of this "lazy," excess capital found its way into the home mortgage market through unregulated financial derivatives. They triggered a financial market collapse that nearly destroyed the world's economy in 2008. The financial markets are inherently unstable. The more money that is put into them, the faster money is put into them and the more they are deregulated or not regulated, the more unstable they are. We learned this in 1876 and again in 1890 and again in 1921 and again in 1929 and yet again in 2008 and many more times than I can remember off of the top of my head.

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There are many examples of Free Trade Enthusiasts, FTEs, on this board quoting comparative advantage as the support in economics theory for free trade.

I would be willing to bet that the vast majority of the FTEs here didn't understand these assumptions that comparative advantage theory relies on, much less how easily those assumptions are shown to be unrealistic. Unfortunately this they share with the majority of economists in the US.

=======================​

These observations are those made and shared by post-Keynesian economics. It is my contention that while economics is very complex, that the complexity is in trying to model the economy so that we can understand the magnitude and speed of the economy's reaction to a particular stimuli, but the principles of economics and the direction that the actions push the economy are fairly easy to understand and to put into language that people can grasp.

In short, the questions in economics of how much and how fast are hard to answer but the questions of why are relatively easy.

I relied on a number of sources for the above discussion, but mainly on Post Keynesian Economics, New Foundations, by Marc Lavoie, 2014, Edward Edgar Publishing, Inc., Northampton, Mass. US, section 7.5.2, p. 523-526.

This is a graduate level textbook and therefore it is quite expensive, $180, although it was available as an eBook for ~$40, which what I own, but I couldn't find it today. I haven't directly posted quotes from the book because, one, I foolishly bought it in Google player and they don't let me copy from the book and, two, it is written in the rather thick technical language that economists use and three, it pre-supposes knowledge of economics and especially of post-Keynesian economics that many here may lack, no offense meant.

It should go without saying that I am wholly responsible for the statements above and for the translation from the economic language and the ideas of Dr. Lavoie, Lord (Nicholas) Kaldor and others.

This is an entry in my exposure of the weaknesses of neoclassical and neoliberal economics and a further example of my ignorance of basic, elemental economics, first called to my and to the entire board's attention by coloradoatheist and dismal. This is my explanation of why item number FMF-23, here, of the Foundations of Market Fundamentalism is wrong.

 

[laughing dog]

The above analysis provides an excellent criticism of the neoclassical free trade model in point 2-4. However, point 1 is filled with two important misconceptions.

First, comparative advantage is about products or services not overall trade surpluses or deficits. Having a comparative advantage in some products means not having a comparative advantage in other products. There is no reason to expect that an overall trade surplus or trade deficit will arise out of comparative advantage.

Second, when comparative advantage refers to costs, it is the economic cost (expenses plus opportunity costs) that are relevant. A country with absolute advantages in all goods still does not have a comparative advantage in every good in terms of what is given up to expand production under full employment and increasing or constant marginal costs.

 

[lpetrich]

I wish to add a further problem: it is built around the a presumption that an economy will essentially be steady-state. That is a reasonable assumption in some cases, but no in others. Traditional economics does not seem very good at doing dynamics of economies, and it seems to have a more general problem of spherical-cow modeling -- using too many simplifying assumptions that may or may not be valid.

For instance, protectionism, like government subsidies more generally, is good for building industries, even if it is not very good for mature industries.

I would not dismiss free trade outright. It is good for similar economies, not so good for dissimilar ones.

 

[SimpleDon]

The above analysis provides an excellent criticism of the neoclassical free trade model in point 2-4. However, point 1 is filled with two important misconceptions.

First, comparative advantage is about products or services not overall trade surpluses or deficits. Having a comparative advantage in some products means not having a comparative advantage in other products. There is no reason to expect that an overall trade surplus or trade deficit will arise out of comparative advantage.

Second, when comparative advantage refers to costs, it is the economic cost (expenses plus opportunity costs) that are relevant. A country with absolute advantages in all goods still does not have a comparative advantage in every good in terms of what is given up to expand production under full employment and increasing or constant marginal costs.

I agree with what you say. I thought that this is what I said.

I don't understand your statement that comparative advantage is concerned with expenses plus opportunity costs. That really doesn't make any sense to me. Could you explain? I viewed opportunity costs as an alternative to absolute costs, that it is the whole value of the road not taken.

Perhaps the problem is mine. I thought that I could avoid referring to comparative advantage being defined in terms of opportunity costs instead of absolute costs. Then when I hit point 4 I realized that I couldn't avoid it. In my experience it is hard for some to understand opportunity costs.

I am not trying to train economists here, I am just trying to give some idea of how shaky the orthodox economics is, especially the Econ 101/102, that seems to be the basis our current political economics, which I don't believe that many professional and academic economists accept any more.

I don't want to appear to be berating someone who uses his freshman economics, all that most people take. I want to just point them to an explanation of the problems that have been realized over the eighty years since the The General Theory of ... was published.

 

[EricK]

So what happens if you apply your theory to just the United States? Is free trade a good idea between the states? Or will the high wage states lose out to the low wage ones in some way? Will the lower wage states end up with all the money flowing towards them?

 

[Loren Pechtel]

The important factor here is the exchange rates must properly float. When they don't you get a long term imbalance like we have with China.

 

[Canard DuJour]

The above analysis provides an excellent criticism of the neoclassical free trade model in point 2-4. However, point 1 is filled with two important misconceptions.

First, comparative advantage is about products or services not overall trade surpluses or deficits. Having a comparative advantage in some products means not having a comparative advantage in other products. There is no reason to expect that an overall trade surplus or trade deficit will arise out of comparative advantage.

Second, when comparative advantage refers to costs, it is the economic cost (expenses plus opportunity costs) that are relevant. A country with absolute advantages in all goods still does not have a comparative advantage in every good in terms of what is given up to expand production under full employment and increasing or constant marginal costs.

I agree with what you say. I thought that this is what I said.

I don't understand your statement that comparative advantage is concerned with expenses plus opportunity costs. That really doesn't make any sense to me. Could you explain? I viewed opportunity costs as an alternative to absolute costs, that it is the whole value of the road not taken.

Perhaps the problem is mine. I thought that I could avoid referring to comparative advantage being defined in terms of opportunity costs instead of absolute costs. Then when I hit point 4 I realized that I couldn't avoid it. In my experience it is hard for some to understand opportunity costs.

I am not trying to train economists here, I am just trying to give some idea of how shaky the orthodox economics is, especially the Econ 101/102, that seems to be the basis our current political economics, which I don't believe that many professional and academic economists accept any more.

I don't want to appear to be berating someone who uses his freshman economics, all that most people take. I want to just point them to an explanation of the problems that have been realized over the eighty years since the The General Theory of ... was published.

Maybe the wording here was a bit ambiguous :

According to the theory, comparative advantage between nations will only work if each nation has an advantage in different products. However, most often the advantage that one nation has is in all of its industries, and that is low wages. Then all of of the advantage is owned by the low wage nation and all of the exports flow to the high wage nation and all of the money flows to low wage nation.

As I understand it, even if one nation has absolute advantage in several or all industries, comparative advantage pertains if each nation specialises in whatever it has the biggest absolute advatage in. Because that - somewhat counterintuitively - results in absolutely more production at lower cost than if fewer nations produce everything they have absolute advantage in. The problem, as you say, is that the latter is what happens in the real world, because (among other reasons) the actual trade is between specialist firms, not nations.

International "free trade" is neither necessary nor sufficient condition of a comparative advantage scenario. If anything, it'd need some supranational planning agency to enforce it.

 

[SimpleDon]

I wish to add a further problem: it is built around the a presumption that an economy will essentially be steady-state. That is a reasonable assumption in some cases, but no in others. Traditional economics does not seem very good at doing dynamics of economies, and it seems to have a more general problem of spherical-cow modeling -- using too many simplifying assumptions that may or may not be valid.

For instance, protectionism, like government subsidies more generally, is good for building industries, even if it is not very good for mature industries.

I would not dismiss free trade outright. It is good for similar economies, not so good for dissimilar ones.

Yes, this is true. It is more than a little ironic that all of the developed, mature economies, who are now recommending free trade to under developed countries, became mature developed economies under a protective cover of tariffs and capital controls.

And the current mainstream economics always assumes an economy at equilibrium as a starting point. This is to make the math easier. All economics do this I suspect.

Yes, it is difficult to do dynamics on the models of the economy. The current most popular DSGE model has ~200 variables and ~300 equations constraining them. And before 2008 it didn't contain any provisions for debt, banking, money or income distribution. Is it any wonder that it didn't predict the Great Recession, according to the model financial sector induced crises can't happen.

Another problem with the orthodox economics is that they assume that the economies tend to a general equilibrium, the "GE" in DSGE. This assumes that the economies of the world tend to self-correct to the most beneficial steady state economy, that is the full employment and full capacity utilization one. It was one of Keynes' realizations that while economies do try to reach an equilibrium, human beings finally prefer order over chaos after all, that there are many different equilibrium states that can be reached, all but one being a less than the beneficial* one.

And of course, what is the most beneficial state of the economy is a whole other discussion. For example, is full employment sufficient if 20% of the population is poor even while working 40+ hours a week? If 40% are? 50%? 99%?




* beneficial beneficial beneficial (if I once misspell a word, the misspelling gets stuck in the automatic correction mechanism of my writing program and it is the misspelling that is offered for selection, the only way to get it correct is to write the correct spelling letter by letter over three to four times, and I frequently forget to erase the results of the process)

 

[LordKiran]

So what happens if you apply your theory to just the United States? Is free trade a good idea between the states? Or will the high wage states lose out to the low wage ones in some way? Will the lower wage states end up with all the money flowing towards them?

Most of the jobs effected by rising minimum wages are service jobs that can't just be shipped out. If anything they're more likely to be replaced in the coming decades as computers and machines become better and better with each passing year.

 

[coloradoatheist]

So what happens if you apply your theory to just the United States? Is free trade a good idea between the states? Or will the high wage states lose out to the low wage ones in some way? Will the lower wage states end up with all the money flowing towards them?

It's a good question. Why one imaginary line over another. Why stop at state and put tariffs on counties within a state or even at the subdivision level. Make sure every neighborhood is self sufficient.

 

[dismal]

So what happens if you apply your theory to just the United States? Is free trade a good idea between the states? Or will the high wage states lose out to the low wage ones in some way? Will the lower wage states end up with all the money flowing towards them?

It's a good question. Why one imaginary line over another. Why stop at state and put tariffs on counties within a state or even at the subdivision level. Make sure every neighborhood is self sufficient.

Why not individuals? Think how many hours of work you lose out on by not building your own car and growing your own food!

 

[coloradoatheist]

It's a good question. Why one imaginary line over another. Why stop at state and put tariffs on counties within a state or even at the subdivision level. Make sure every neighborhood is self sufficient.

Why not individuals? Think how many hours of work you lose out on by not building your own car and growing your own food!

We need people to be prepared for the zombie or nuclear apocalypse, if they are on their own and have to recover the world, we need to make sure they are ready.

 

[RVonse]

So what happens if you apply your theory to just the United States? Is free trade a good idea between the states? Or will the high wage states lose out to the low wage ones in some way? Will the lower wage states end up with all the money flowing towards them?

Such an occurrence has actually taken place with auto manufacturing which used to be primarily based in Detroit, Michigan but now based in Tennessee and Alabama. I would say most of the movement of manufacturing had to do with strong unions in Detroit but no unions in the southern states.

And I would also venture to say (but can not prove empirically) that the damage to Detroit, Michigan was far greater than the advantage of greater wealth going to the southern states. And I would also argue (but once again have no evidence) economy of scale is far worse in the southern states than it was in Detroit. It takes a lot of skilled people to engineer factory automation and those people now must travel from Detroit to many of these remote locations.

Some may argue that the quality of cars is now better than it used to be. But I would argue that the price of cars is much more now too.

I agree with the OP.

 

[untermensche]

One can always call things "free" trade but isn't free trade really where nations can completely control what capital is doing in their nation?

That is the freedom of nations.

 

[coloradoatheist]

So what happens if you apply your theory to just the United States? Is free trade a good idea between the states? Or will the high wage states lose out to the low wage ones in some way? Will the lower wage states end up with all the money flowing towards them?

Such an occurrence has actually taken place with auto manufacturing which used to be primarily based in Detroit, Michigan but now based in Tennessee and Alabama. I would say most of the movement of manufacturing had to do with strong unions in Detroit but no unions in the southern states.

And I would also venture to say (but can not prove empirically) that the damage to Detroit, Michigan was far greater than the advantage of greater wealth going to the southern states. And I would also argue (but once again have no evidence) economy of scale is far worse in the southern states than it was in Detroit. It takes a lot of skilled people to engineer factory automation and those people now must travel from Detroit to many of these remote locations.

Some may argue that the quality of cars is now better than it used to be. But I would argue that the price of cars is much more now too.

I agree with the OP.

So should have Michigan tried to put in tariffs so that the South couldn't get those jobs? Do the short term gains outweigh the long term gains?

 

[coloradoatheist]

One can always call things "free" trade but isn't free trade really where nations can completely control what capital is doing in their nation?

That is the freedom of nations.

Huh? Can any trade then be considered free because we use money to do it instead of straight barter?

 

[untermensche]

One can always call things "free" trade but isn't free trade really where nations can completely control what capital is doing in their nation?

That is the freedom of nations.

Huh? Can any trade then be considered free because we use money to do it instead of straight barter?

Nations should be able to control barter, trade, whatever you call it.

Should some supranational power be able to determine that slavery is legal and force nations to participate?

 

[dismal]

Such an occurrence has actually taken place with auto manufacturing which used to be primarily based in Detroit, Michigan but now based in Tennessee and Alabama. I would say most of the movement of manufacturing had to do with strong unions in Detroit but no unions in the southern states.

And I would also venture to say (but can not prove empirically) that the damage to Detroit, Michigan was far greater than the advantage of greater wealth going to the southern states. And I would also argue (but once again have no evidence) economy of scale is far worse in the southern states than it was in Detroit. It takes a lot of skilled people to engineer factory automation and those people now must travel from Detroit to many of these remote locations.

Some may argue that the quality of cars is now better than it used to be. But I would argue that the price of cars is much more now too.

I agree with the OP.

So should have Michigan tried to put in tariffs so that the South couldn't get those jobs? Do the short term gains outweigh the long term gains?

Obviously we want to freeze all output/prices at high enough levels so that producers can pay high wages to everyone. Sure, consumers will pay more for things, but it's not like consumers and workers are the same people or something.

 

[coloradoatheist]

Huh? Can any trade then be considered free because we use money to do it instead of straight barter?

Nations should be able to control barter, trade, whatever you call it.

Should some supranational power be able to determine that slavery is legal and force nations to participate?

Why at a nation? It's an artificial construct too. Why is your fate in life determined simply because of which side of a river you are born?

 

[untermensche]

Nations should be able to control barter, trade, whatever you call it.

Should some supranational power be able to determine that slavery is legal and force nations to participate?

Why at a nation? It's an artificial construct too. Why is your fate in life determined simply because of which side of a river you are born?

You are merely saying the richer nations should be able to control and exploit the poorer nations, the current system.

Nation is an artificial construct, but nations act in their interests not for fairness or justice.