Introduction: David Ricardo and the theory of comparative advantage

Perhaps the most important, and counter-intuitive, insight in international economics was made by 19th century classical economist David Ricardo, who formulated the theory of comparative advantage.

While the conventional wisdom prior to Adam Smith and David Ricardo was that mercantilist-style protectionism was the appropriate policy in regards to international trade, Ricardo’s theory of comparative advantage showed that this simply was not the case. Ricardo made the profound insight that even if a given country’s trading foreign partner was more competitive than it domestic producers in every way, the opportunity costs of the home and foreign countries would differ such that both countries would gain from trade if they specialized in producing goods and services in which they had a “comparative advantage.”

This gain would be a result of exporting the goods which the domestic country could produce at a comparatively lower opportunity cost and import the goods in which it had a comparatively higher opportunity cost. Thus, the efficiency gains from trade should boost consumption and welfare for all countries engaged in trade.

(I encourage you to look up the ‘theory of comparative advantage’ on wikipedia if you don’t think I’m being clear here.)

Trade raises living standards: the evidence

There is a considerable amount of evidence that trade and economic integration with the world fosters economic efficiency and development. Figure 1 demonstrates the relationship between changes in the natural log of the trade share of GDP (x-axis) and the natural log of Gross Domestic Product (GDP) per capita (y-axis).

There is a clear positive correlation between the two variables, but obviously correlation doesn’t equate with causation, and simple correlations may be prone to endogeneity bias (i.e higher trade flows may be caused by higher levels of GDP per capita rather than the other way around.)

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In a rigorous study published by the National Bureau of Economic Research, Feyrer (2009) used the exogenous variation in trade generated by the 1967 to 1975 Closing of the Suez Canal, which facilitates around 7.5% of world trade, as a natural experiment to identify the causal effects of trade on income per capita.

He found that the elasticity of income per capita with respect to trade’s share of GDP was approximately 0.25. In other words, a 1 percentage point increase in trade’s share of GDP lead to a 0.25 increase in income per person, a significant effect.

Free trade and economic development: the evidence

The fact that participating in more international trade results in more economic growth implies but does not necessarily prove that reducing barriers to trade (i.e reforms towards free trade) will lead to more rapid economic development. Thankfully, a number of economists have attempted to tackle the empirical question of whether or not free trade actually results in more economic growth or a higher level of economic development.

For example, Vlad Manole and Mariana Spatareanu found, as shown in Figure 2, that there is a significantly negative relationship between the level of trade protection (i.e tariffs, quotas, and other trade barriers) of a country (on the y-axis) and its income per person (GDP per capita) on the x-axis.

According to these authors, “lower trade protection leads to higher levels of income per capita. The results are robust to accounting for geography-related, and institutional variables as well as correcting for possible endogeneity in estimation.”

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Probably the most famous study on this matter was produced by Roman Wacziarg and Karen Horn Welch. Using quantitative analysis and a thorough review of country-specific case studies of free trade reforms, Wacziarg and Welch found that after countries reformed their trade policies in favor of freer trade, average investment and economic growth surged quite dramatically.

The trend in economic growth before and after free trade reform is shown in Figure 3. There is a clear acceleration in growth post-reform. According to Wacziarg and Welch, “countries that liberalized their trade regimes experienced average annual growth rates that were about 1.5 percentage points higher than before liberalization.” (This is a significant contribution to economic development.)

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Gonzalo Salinas of Oxford University and Ataman Aksoy of the World Bank conducted a similar exercise to Wacziarg and Welch, but used a slightly different methodology (which they felt was superior) and also constructed counter-factuals to compare how economic growth might have evolved had the countries examined never reformed their economies.

They came to even more optimistic results, stating that, “annual per capita GDP growth rates increased by up to 2.6 percentage points after the trade reforms, compared to a counterfactual that takes into consideration the evolution of several growth determinants.”

Lastly, and in my view most convincingly, economists Antoni Estevadeordal and Alan M. Taylor compared countries that drastically cut tariff rates on imported foreign products used in domestic production to those that didn’t (both before and after the reform.)

Prior to the reforms, the non-reforming and reforming countries had similar trends in economic growth. However, as shown in Figure 4, once the reformers started cutting their tariff rates around 1990, their growth accelerated while the economies of non-reformers stagnated.

According to the authors, the reformers had their income per person grow over 20% larger in the long-run in comparison to the control group and that, “the impact of tariff reduction looks quite beneficial and has a plausible magnitude consistent with theory.”

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Consumer benefits

Consumers, especially lower and middle income ones, gain a considerable amount of purchasing power thanks to low-cost imported goods. For example, a study by the National Bureau of Economic Research found that middle income consumers can buy 29 percent more goods and services as a result of the access to low-cost imports from foreign countries (and low income consumers can buy 62% more!)

The gains from free trade additionally accrue to us in the form of expanded product variety. While Bernie Sanders would seem to think this is a bad thing, most Americans don’t. In fact, Seminal research by Christian Broda of the University of Chicago and David E. Weinstein of Colombia University, found that the variety of imported goods increased three-fold from 1972 to 2001.

The value to American consumers of this import induced expanded product variety is estimated to be equivalent to 2.6 percent of national income, about $450 billion as of 2014. That’s not exactly small change.

(It’s also quite entertaining to consider the fact that the same people telling free market economists that government needs to regulate business to prevent monopoly are actively campaigning to raise trade barriers in order to reduce the pressure of foreign competition on domestic businesses.)

Conclusion

Certainly, some people are harmed by foreign competition induced by free trade. The costs of free trade are concentrated and extremely visible. When a manufacturing company goes out of business as a result of foreign competition, it’s hard not to notice.

The benefits of free trade, on the other hand, are widely dispersed and not as visible. They come in the form of consumer prices which are considerably lower than they otherwise would be and a larger economy. Almost certainly, the large benefits of free trade outweigh the costs.

Perhaps this is why, according to a poll conducted by the University of Chicago, 85% of top economists agree (and 0% disagree) with the statement: “Freer trade improves productive efficiency and offers consumers better choices, and in the long run these gains are much larger than any effects on employment.”