Free Trade: Domestic and Foreign
JULY 01, 1964 by DEAN RUSSELL
Dr. Russell is a member of the staff of the Foundation for Economic Education and Director of the FEE School of Political Economy. This article is one in a series of lectures delivered at the Centro de Estudios Economico Sociales in Guatemala City, April 6-10, 1964.
The most persuasive argument I ever heard for protective tariffs was offered by an Egyptian student. He pointed out correctly that the low production of the Egyptian workers is due primarily to their primitive tools. He informed me that (contrary to general belief) the low production standards in Egypt actually result in high labor costs when measured on a realistic per unit produced basis. He then argued that the workers in the underdeveloped nations just couldn’t possibly compete against industrial workers with their efficient machines and the resulting high production and low labor cost per unit. And he concluded that if the government didn’t protect the low-paid Egyptian workers against competition from the more advanced industrial nations, most of them would soon lose their jobs to the high-paid men with the machines.
Actually, my Egyptian friend’s argument for protection against so-called expensive foreign labor is not any more valid than are the arguments by my own countrymen for protection against so-called cheap foreign labor. In reality, the trade itself necessarily causes real wages to rise in all nations that participate. In order to understand this better, let us start with a statement that is not subject to argument: No person in Egypt or Guatemala or the United States will voluntarily trade with a person in another country (or even next door) unless he puts a higher value on what he gets than on what he gives up. And thus both parties to any trade (domestic or foreign) necessarily benefit (or at least expect to benefit) from the trade.
Actually, there is no exclusively economic or theoretical justification for discussing domestic and foreign trade separately; they are identical in all respects—except for the purely arbitrary and artificial interventions of government. For example, in the United States, a manufacturer in southern California has no particular difficulties in trading with a company in northern Maine, some 4,000 miles away. But when the same manufacturer tries to trade with a company in Tijuana, Mexico—perhaps 4 miles away—he encounters all sorts of frustrating and noneconomic prohibitions and compulsions that have been devised by the two governments.
The problems of transportation and distance (as such) are not something peculiar to international trade. Nor do differences of language and religion constitute special problems in trading across national boundaries.
For example, a Catholic manufacturer who speaks only Italian in Lugano, Switzerland, has no problem at all in trading with a Protestant retailer who speaks only German in Zurich. But when he attempts to trade with his Italian cousin just across the border (both speaking the same language and belonging to the same church), he encounters problems that are often insurmountable. All of these problems are, without exception, created by government and are thus completely artificial and unnecessary.
Canada offers an example of how vast distances, different wage scales, different languages, different religions, and different racial and cultural backgrounds present no real trade problems at all. But let a Canadian try to buy an automobile from Detroit, just across the border!
Even different moneys (lira, peso, dollar, or whatever) present no real problem to any trader—if the various moneys can be freely bought and sold. But when this is forbidden, problems do appear; again, however, they are artificial problems and are due entirely to governmental rules and regulations.
At Home and Abroad
Any argument for free trade and the division of labor within a nation is automatically and necessarily an argument for free trade and the division of labor internationally. If a person advocates free trade domestically, he cannot logically advocate protective tariffs and other similar measures that prevent goods and services from moving freely across national boundaries. It is simply not true that a nation and a people are made more prosperous by compelling themselves to pay two and three times as much as they need to pay for the goods and services they want. It just does not make sense to improve the means of moving goods from one nation to another, and then to cancel out the savings in transportation costs by passing laws to hamper the resulting trade. I am convinced that such contradictions arise more from lack of understanding than from evil intentions.
For example, the idea of creating and protecting domestic industries and jobs by restricting foreign imports is still generally found at the bottom of most arguments for protective tariffs. This objective is at least understandable. And it is unquestionably true that if it were not for government protection against foreign competition, many persons in Guatemala and the United States would lose their jobs. Further, a considerable number of companies in both nations would be forced out of business and would suffer heavy losses of capital. But the persons who are quick to point out these economic realities seem unaware of the multitude of jobs and industries in Guatemala and the United States that actually depend on foreign trade.
For example, the advocates of protective tariffs in my own country dramatize the story of the jobs and industries that are destroyed or threatened by the $16 billion of yearly imports into the United States. But they just ignore the far larger number of jobs and industries that are involved in our $20 billion of exports—automotive and electrical equipment, steel mill products, machine tools, coal and cotton, petroleum products, and many others. In a manner of speaking, prohibitive tariffs could destroy 20 United States jobs and companies for every 16 saved or created. And worse still, the companies most likely to be injured by restrictive trade policies are our most efficient ones that tend to pay the highest wages. The advocates of protective tariffs completely ignore the obvious fact that foreigners cannot continue to buy from us unless they are permitted to sell to us.
A Huge Market
In reality, the absence of tariffs and similar trade restrictions among the 50 states in my country goes a long way to explain why our level of living is so high. This absence of internal trade restrictions permits and encourages competition, natural specialization and division of labor, survival of the most efficient managers and companies, and especially the free movement of labor and capital from one industry and one section of the nation to other industries and sections. The final result of all this is better jobs at higher pay for all employees, lower prices for all consumers, and perhaps even higher profits for those owners and managers of capital who are capable of operating in a free and competitive economy.
Just as free trade among the states of the United States has brought this result, just so would free trade among the nations of the world bring similar results to all of them. To help us understand why this is so and how it would work, let us refer briefly to the concept of trade according to the principle of "comparative advantage" as developed by David Ricardo.
This comparative advantage idea is often confused with an absolute advantage, such as coffee produced in Guatemala but not in the United States. But according to the Ricardian example, two nations must produce the same two (or more) products before this principle applies. And still following Ricardo, the comparison is always first made within one of the nations alone. The comparison concerns the "substitution ratio" or "alternate opportunity cost" of producing domestically one of the two products instead of the other. Then exactly the same comparison is made domestically within the other nation. Whenever the physical cost or substitution ratio for the two products in one country differs from the same cost or substitution ratio for the same two products in the other country, a "comparative advantage situation" exists. Each nation can then profit by concentrating on producing one of the products at home and trading a part of it abroad for the other.
Delivering the Paper
Now I am well aware that the above explanation of Ricardo’s comparative advantage principle of trade is too condensed and complicated for general lecture purposes. So I will merely refer you to any textbook on international trade for the full development of it. I will here confine myself to applying the same idea in more familiar situations and in less technical terms. But even so, the reality behind my examples and conclusions are still Ricardian.
Here is my first example of Ricardo and his comparative advantage idea in modern dress: As I write these words, I can see my "newspaper delivery boy" plodding slowly toward my door. He is late as usual. And perhaps the reason I am watching him is to see if he will again step on another one of my prized flowers planted along the sidewalk. Now if you will look upon him and me as representing two nations—and let lecturing and delivering newspapers represent the two products produced in both countries—I can illustrate quite simply the essential idea behind Ricardo’s law of comparative advantage.
Positively and beyond any shadow of a doubt, I can deliver newspapers more efficiently than my paper boy can. Since I can deliver more of them in a given period of time, I can earn more money than he can. And since I would be much neater and much more pleasant while doing the job, doubtless the traditional "tips" would be larger for me than they are for him. In short, the market would pay me more to do that delivery job than it now pays him.
I’ll also hazard the guess that I can make better speeches than my paper boy can. I know, however, that he can make speeches; in fact, he made a couple of them to me when I recently suggested that he should not leave my paper on the open porch during a rain storm. Thus, I will here maintain that I can do both of these jobs better than he can; I have an absolute advantage over him in delivering lectures and in delivering newspapers. Even so (and to get at Ricardo’s point), he has a comparative advantage over me in delivering newspapers. And based on what the market will pay me to deliver newspapers and to make lectures, I have a comparative advantage over him in the speech-making business. Here is how it works.
The Scope of the Handicap
Let’s say the market pays my paper boy 50 cents an hour to deliver papers. My guess is that he would earn almost nothing as a speech-maker, but let’s be generous and allow 5 cents an hour. To follow Ricardo, his substitution ratio is 50 to 5 or 10 to 1. That is, in the same amount of time, he can earn 10 times as much delivering newspapers as he can earn by making speeches.
I am confident that the market will pay me better for both jobs. Let’s say I could earn $1 per hour delivering newspapers, and $20 an hour as a lecturer. Thus, for every hour that I spend delivering newspapers for $1, the alternate opportunity cost to me is the $20 I could earn as a lecturer and teacher. Thus, it clearly pays me to devote my full working time to lecturing, teaching, and writing instead of delivering papers. Even though I can do a better job than my "competitor" in delivering newspapers, he still has a comparative advantage over me; or, technically, his comparative disadvantage is less in delivering papers than in delivering lectures. The fact that I have an absolute advantage in both categories is of no consequence. As the Ricardian principle illustrates, I will continue to pay my so-so paper boy to deliver my newspaper because (comparatively) my advantage over him is far greater in lecturing than in delivering papers.
It Still Pays To Trade
And so it is with trade between nations. As Ricardo pointed out, one nation can be more efficient in every category than another nation—and yet because of a comparative advantage, it is still profitable for the more efficient nation to trade with the less efficient nation. But how does one discover these comparative advantages among the various nations in today’s world?
Well, first, it is necessary that you and I and everyone else can freely buy and sell and exchange the moneys of the two nations being compared. For when free exchange is permitted, then prices and wage rates in the two nations will tend to be based on reality instead of wishful thinking. And when trade is based on reality, comparative advantages are not hard to find. Select two jobs or two products that exist in both nations. Now examine the wage rates and prices paid in one of the nations for the jobs or products. Now compare the wages and prices for the same jobs and products in the other nation.
Unless the comparative substitution ratios are identical (highly unlikely), trade will occur between the two nations. Each nation will concentrate on the production of the item in which it has the greatest comparative advantage (or the least comparative disadvantage). Both nations will profit from this trade, even when one of them has an absolute advantage in producing both products.
Abundant Supply of Labor
Comparative advantages can be found in general categories as well as in specific products and services. For example, I am confident that, compared to the United States, the cost of capital is higher than the cost of labor here in Guatemala. If so, the United States enjoys a comparative advantage over Guatemala in capital costs, and Guatemala enjoys a comparative advantage over the United States in labor costs.
Given this situation, one would logically expect "labor intensive" products to go from Guatemala to the United States, and "capital intensive" products to flow from the United States to Guatemala. And I am confident that such would be the case, if our two governments would abolish the trade restrictions that each has placed against the other. If this were done, both nations would necessarily profit thereby.
Again, this comparative advantage principle works the same between persons within a nation as it does between nations. For example, the famous showman, Billy Rose, was also a champion typist. But he operated on the principle of comparative advantage when he hired a typist and devoted his own time to producing shows and writing newspaper columns. The fact that he could type faster and better than his secretary is beside the point. Both he and she enjoyed a higher level of living because of that division of labor, just as the level of living in any and all nations rises when trade is permitted to operate according to this principle.
Likewise, a surgeon may know how to wash his surgical instruments better than does the person he actually hires to wash them. But obviously, everyone profits by his decision to devote his full time to the job (surgery) at which he enjoys the greatest comparative advantage, as measured by the price the market will pay him for performing the two tasks.
As another familiar example of how Ricardo’s comparative advantage idea works in everyday life, take the insurance salesman who pays a man $1.50 an hour to work for him in his yard during the day. Let’s assume that the caliber of the work done by the yardman is not as good as the owner himself could do—or, at any rate, thinks he could do. So why doesn’t he do the work himself and save $1.50 an hour? The answer is that he would not necessarily save $1.50 an hour but might actually lose $3.50 an hour by working in his own yard. That development is due to the fact that his average hourly earnings as an insurance salesman are $5. He has a comparative advantage selling insurance instead of raking leaves. The pricing mechanism of the free market shows this beyond any shadow of a doubt.
And so it is with trade among nations. Every nation enjoys a comparative advantage in some product or service, even though it may be due only to some institutional or historical reason. That nation (and the people in general in that nation) would enjoy a higher level of living if it specialized in those goods and services in which it enjoys such an advantage.
Let the Market Decide
How can we citizens of Guatemala and the United States discover which are the products and services in which each enjoys a comparative advantage? Easy! Just remove all artificial restrictions against trade, including monetary exchange. Then observe what the importers and exporters in Guatemala do. I doubt that many of them can explain to you Ricardo’s comparative advantage principle, but every one of them will search the world’s markets to see what and where he can buy most advantageously. Nor do any of them need to hear this lecture in order to know where in the world the most profitable demand exists for Guatemalan products and services. While the producers and buyers in Guatemala and the United States may not be able to explain the Ricardian theory on which they operate, they will still quickly indicate to us which products and services enjoy a comparative advantage in which nation. You and I need only follow the free market price signals in our buying and selling.
We are foolish indeed to continue to impose tariffs and other restrictions against trade between our nations; the only result of such misguided and uneconomic governmental interventions is that we pay more and get less.
If an employee asks for a raise because his wife has borne him a new baby and the employer refuses on the ground that the infant does not contribute to the factory’s effort, the employer acts as the mandatary of the consumers. These consumers are not prepared to pay more for any commodity merely because the worker has a large family.
LUDWIG VON MISES, Human Action