How Trade Actually Works

Somehow, Bernie Sanders and Donald Trump both managed to sell far-right, conservative trade policies to both the progressives and the conservatives. It’s not hard to see how: trade economics are far-abstracted from most people, and the isolated microeconomic effects are easy to showcase as a threat. Fear draws votes like nothing else, and telling people their lives and livelihoods are on the line is a great way to get elected.

Here we explain how trade can be so good yet so easily cast as bad, what the remedy should be, and how trade economics actually works. We use abbreviated abstractions and thought experiments because nobody wants to read a 470-page blog post in an attempt to develop a Ph.D. in macroeconomics. Real-world evidence consists of huge piles of mathematics and a lot of economists repeatedly being proven wrong about NAFTA destroying jobs.

Structural Change

Everything which makes the individual consumer wealthier also makes the nation wealthier. These things—technical progress and trade—involve structural change, or the reorganization of the factors of production. Such reorganization must impact someone, somewhere, negatively, which gives trade conservatives their cudgel.

In truth, even an entire collapsed city represents roughly 0.05% of the American economy. If your factories flee to Mexico or China, that’s all the damage. Immediately we must ask: why not just fix it?

While those 0.05% of Americans lose their jobs, the other 99.95% get richer. Some at the top get a lot richer, while consumers in general see lower prices relative to wages—so long as minimum wage keeps up—and thus can buy more goods and services. This reduces poverty.

So here’s a question: if 99.95% of us are, say, 0.5% richer, why can’t we all be 0.45% richer and shuffle the other 0.05% to compensate those impacted by structural change?

This is exactly what the American Citizen’s Dividend proposes. It’s also part of the purpose of universal healthcare, universal family care, unemployment insurance, welfare, and other social insurances and needs-based programs. Most of us are richer, and we’re so much richer we can compensate those who were in the path of progress so they can recover and share in the new wealth. Again, sharing in the new wealth includes a structural minimum wage.

The threat that your job might be the one to run off to Mexico overrides the abstract macroeconomics of progress—of greater wealth, higher standards-of-living, and lower poverty. It’s hard to sell the idea that growth means change and change might mean we as a society must take care of you from time to time. It’s exceedingly easy to sell the idea that lower costs mean higher profits and the rich are cutting our throats to make themselves richer while we get poorer.

Thought Experiment: Cars and Planes

Most folks can easily shrug off Ricardo’s theory of trade economics by claiming it’s all academic. Wikipedia effectively summarizes it in one graphic, and it looks like some kind of magic.

The blue triangle depicts Home’s original production (and consumption) possibilities. By trading, Home can also consume bundles in the pink triangle despite facing the same productions possibility frontier.

So let’s imagine the United States and China can both make cars and airplanes, and see how we get from blue to pink on both sides.

Assume the United States expends the same resources to make either one airplane or one thousand cars. Thus the United States can make ten airplanes and zero cars, ten thousand cars and zero planes, or five airplanes and five thousand cars.

In China, the manufacture of one airplane could instead produce merely one hundred cars. China, with the capacity to produce ten airplanes, can instead produce one thousand cars.

These are the same cars and the same planes made to exactly the same quality specifications. China just happens to be comparatively better at making planes: they sacrifice the capacity to make fewer cars for each plane.

Okay, what do we do about it?

If each nation allocates resources evenly, the United States can produce five airplanes and five thousand cars, while China produces five airplanes and five hundred cars. That’s ten airplanes and 5,500 cars.

Let’s trade with China.

The United States instead produces ten thousand cars, while China produces only ten airplanes. We still have ten airplanes, but also ten thousand cars. That’s a net gain of 4,500 cars while expending the same resources.

Already we see just how we’re doing the same work yet getting more simply by trading.

Impacts on Consumers

How does trading cars for planes affect each trading partner?

  • China can import 4,500 cars for the cost of, at most, 500 Chinese-made cars. An American car costs the Chinese consumer a minimum of 1/9 that of purchasing a Chinese car.
  • America can import 5 planes for the cost of, at most, 4.5 American planes.

Notice there are minimums and maximums here. The prices can fill that broad gap just about anywhere, and will rarely turn out optimal. Competition tends to drive prices to the lower end, although new trade theory (below) reduces competition and still lowers prices.

Wages and Exchange Rates

There’s another issue: these are comparative advantages. It might very well require twice the Chinese labor to make an American plane, and it’s still only a good deal for America below 90% of the price of an American-made plane. It’s still worth trading.

In such a situation, exchange rates will adjust such that the Chinese wage, in American dollars, is only 45% of the American wage. Rather than 1/9, that American car will cost the Chinese worker 1/4 of what a Chinese-made car will. That still means they labor for only 25% as long to purchase a car.

Often we hear about the exploitation of third-world labor, yet we don’t talk about the crisis of unemployment they’d face without these or other jobs. We certainly don’t discuss why those wages are so low, or talk about how quickly those wages are growing, or the simple increase in standard-of-living among these workers.

The comparative advantage explains many of these things. It also cuts off an important argument: that trade is only sustainable (cheap) because labor and environmental standards are lax in these countries. Trade would be profitable for both sides even with strict environmental standards and basic labor practices. You’re never going to get trading-partner wage parity, but you can get GNI-share wage floors (and a lower exchange rate).

New Trade Theroy

There’s one more component to trade theory: Paul Krugman’s New Trade Theory, for which he was awarded the Sveriges Risbank prize in Economics in honor of Alfred Nobel.

New Trade Theory simply observes that accumulation of the factors of production can provide a type of wealth-creating structural change. If you want to make large-body airplanes, you need a lot of resources in huge factories to make not a lot of units. With only two such factories in the world in two different countries, the cost of making large-body airplanes falls thanks to economic efficiencies of scale.

This is why Ford and GM no longer make everything in one place. Making all the different factory parts and all the different cars in one factory involves a lot of work stoppages, retooling, and other labor-wasting effort. Interchanging common parts and making a narrow range of things in each dedicated factory keeps the assembly line rolling, and the cost per unit falls.

Because the United States is busy trying to fix a nursing shortage and build a STEM workforce, we run a little short on labor, so we have Mexico and Canada and China make a lot of cars and car parts, and we ship things around. We’ve also gotten extremely productive in manufacture, able to manufacture far more with a smaller labor force, so manufacture in general has grown less while other industries have grown more.

Put all of that together and you see a lot of odd things happen. You see entire industries vanish even as they get bigger. You see cheap shirts coming out of China, made from fabric dyed in Indonesia or India, dyed from textile manufacture in the United States, woven from cotton grown in the United States or Egypt. You see language like “Assembled in Michigan” on cars that are made in Japan, Germany, the United States, Mexico, China, Sweden, and Canada, with materials and parts shipping repeatedly back and forth between these nations just to make one vehicle.

You see people with little grasp beyond that their job might go to China, because even the economists can’t really get their heads around trade.

Those people are prey for deceptive politicians with conservative trade policies.