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Free Trade

A fundamental economic theory is that even considering just the initial (static) impact, countries gain from trade. Consumers in each country find that some products can now be imported at a lower real price than before and some producers can get more for their products. While some suppliers of goods and services can no longer compete in the global market, others find increasing opportunities in new markets. As long as all participants are free to adjust to their changing incentives, the gains to the economy outweigh any losses.

These gains from trade come from our differences, not our similarities; they derive from differences in abilities to create and preferences for what to consume. The greater the differences among trading nations or people, the larger the potential gains from trading. These gains are magnified if the changes over time (dynamic changes) are considered.

The two primary sources of the gains from trade are the gains to consumers and the gains to producers. Both result from the fact that a trading country is no longer constrained to making products and services to match only domestic demand. Now the total workers and machines in the two countries can be allocated to maximize the global production of goods and services, and consumers can now avail themselves to the fact that some products are produced elsewhere relatively more efficiently.

The term “relatively” is important, for media discussions of the potential gains in production often confuse absolute and comparative (relative) advantage. This distinction was clarified almost two hundred years ago by the British economist David Ricardo. Ricardo demonstrated this point in a simple example of England and Portugal, considering only labor costs. Each country is assumed to produce both cloth and wine. Portugal has an absolute advantage in both products; in an hour a worker can produce more of either cloth or wine than a worker in England. Yet, that does not mean England produces neither product. The key insight is that while it takes less labor to produce either cloth or wine in Portugal, the amount of cloth given up by switching a worker into wine production is not the same in both countries. Specifically, in Ricardo’s example, wine output in England drops by less if a worker is shifted into producing cloth. So, if Portugal focuses or specializes in producing wine, and England cloth, the maximum value of the two goods is produced in the two country world.

The gains to producers come, therefore, not from the fact that a country can produce goods and services at a lower absolute cost. Rather the gains come from using the total resources available (in Ricardo’s case just labor, in our example workers and machines) in the two countries to maximize the value of both products produced. The products and services available should rise with the opening of trade because resources can be used more efficiently. Production moves towards specialization, just as in Ricardo’s example. Producers in both countries find the value of what can be produced increasing. This increase is the production gains from trade.

Consumers are no longer constrained to purchasing what can be made at home. They now have the choice to import from the other country. It is the attempt to take advantage of bargain prices abroad that ensures the relative prices converge in the two countries. Consumers now give up fewer units of their production to purchase goods they desire. Naturally they feel better off. These are the consumption gains from trade.