Economy 16-01-2024 17:33 11 Views

On Comparative Advantage and International Capital Mobility

Two decades ago, economist Paul Craig Roberts joined forces with Sen. Chuck Schumer (D-NY) to warn of globalization in the modern world. In their January 6th, 2004 New York Times op-ed, “Second Thoughts on Free Trade,” Schumer and Roberts noted that the case for free trade prominently features the principle of comparative advantage, the discovery of which is credited to David Ricardo (1772-1823). Schumer and Roberts also noted that Ricardo explained the operation of comparative advantage using the assumption that capital cannot flow across international borders. These authors then concluded that the case for free trade in the 21st century is invalid given the ease with which capital now crosses international borders. As Schumer and Roberts summarized their case,

When Ricardo said that free trade would produce shared gains for all nations, he assumed that the resources used to produce goods – what he called the ”factors of production” – would not be easily moved over international borders. Comparative advantage is undermined if the factors of production can relocate to wherever they are most productive: in today’s case, to a relatively few countries with abundant cheap labor. In this situation, there are no longer shared gains – some countries win and others lose.

A day after this op-ed appeared, Roberts, at a Brookings Institution event, offered this prediction if the U.S. government didn’t severely restrict the offshoring of operations – especially those employing white-collar workers – to low-wage countries: “The United States will be a Third World country in twenty years.” Because no such significant restrictions were imposed, and because the United States twenty years later is obviously not a third-world country, it’s tempting to ridicule Roberts’s prediction as a gross failure and leave matters there.

Roberts’s prediction did indeed fail terribly. Being an economist, he should have known better than to offer such an absurd prognostication. But twenty years later the same myth about comparative advantage is being peddled by a younger generation of protectionists. Especially notable among these protectionists is Oren Cass, who is not an economist. He recently pronounced:

Ricardo knew well the limits of his own model, observing that his wine and cloth hypothetical worked only because of ‘the difficulty with which capital moves from one country to another.’ If Portugal were the low-cost producer of both, ‘it would undoubtedly be advantageous to the capitalists of England and to the consumers in both countries, that under such circumstances, the wine and the cloth should both be made in Portugal, and therefore that the capital and labor of England employed in making cloth, should be removed to Portugal for that purpose.’ The saving grace, he believed, was ‘the natural disinclination which every man has to quit the country of his birth,’ feelings ‘which I should be sorry to see weakened.’ Introduce Ricardo to Apple’s Tim Cook or Tesla’s Elon Musk, and he might disavow comparative advantage on the spot.

It’s true that, when explaining the operation of comparative advantage, Ricardo assumed that capital does not migrate internationally. But it is not true that the ability of capital to migrate internationally nullifies the principle of comparative advantage. Nor does this ability in any way weaken the case for free trade.

Ricardo’s Example

It’s useful to review Ricardo’s example of comparative advantage. In it, Portugal can produce both wine and cloth using less labor than is required in England for the production of each good. Specifically, to produce a ‘pipe’ of wine in Portugal requires 80 workers, while to produce a unit of cloth requires 90 workers. To produce a ‘pipe’ of wine in England requires 120 workers, while to produce a unit of cloth requires 100 workers. Superficially, it appears that the Portuguese can produce both goods at a lower cost than can the English, causing the Portuguese to have nothing to gain by trading with the English. But look more deeply. What matters is the cost in one country of producing each good compared to the cost in the other country of producing each good. And, importantly, cost is the amount of one good foregone when a unit of the other good is produced.

The amount of wine the Portuguese sacrifice for every unit of cloth they produce is 1.125 ‘pipes,’ which is greater than is the amount of wine – 0.833 ‘pipes’ – the English sacrifice for every unit of cloth the English produce. Compared to the English, the Portuguese produce cloth at a higher cost – that is, they sacrifice more wine to produce each unit of cloth than do the English. The English, therefore, have a comparative advantage over the Portuguese in producing cloth. As for wine, the amount of cloth the Portuguese sacrifice to produce one ‘pipe’ is 0.89, which is obviously less than the 1.2 units of cloth the English must sacrifice to produce a ‘pipe’ of wine. The Portuguese have a comparative advantage over the English in producing wine. If each country specializes in its comparative advantage and trades with the other, the people of both countries gain.

Suppose the Portuguese sell each ‘pipe’ of wine to the English for one unit of cloth. For each unit of cloth they buy from England, the Portuguese, effectively, get the labor of 90 Portuguese workers (the amount of labor required to make a unit of cloth in Portugal) for only 80 Portuguese workers (the amount of labor required to make a ‘pipe’ of wine in Portugal). Better for the Portuguese to buy cloth from England. For the English, by producing cloth to buy a ‘pipe’ of wine from Portugal, they get the labor of 120 English workers (the amount of labor required to produce a ‘pipe’ of wine in England) for only 100 English workers (the amount of labor required to produce a unit of cloth in England). Better for the English to buy wine from Portugal. Both countries gain from trading.

The counterintuitiveness of this account is arresting. But notice that it’s really only arithmetic. Ricardo’s example simply shows that the cost – that which is forgone – of producing cloth in Portugal is greater than is the cost of producing cloth in England, while the reverse is true for wine. As long as the English and the Portuguese each wish to consume both wine and cloth, the English can get wine at the lowest possible cost by first producing cloth and exchanging some of it for Portuguese wine, while the Portuguese can get cloth at the lowest possible cost by first producing wine and exchanging some of this wine for English cloth.

If the costs of production of one or more products differ from country to country – which, as a practical matter, will always be so – the people of different countries mutually gain by specializing at producing what they produce at a comparative advantage and then trading with each other.

Nothing Essential Is Changed by Capital Mobility

What does capital mobility have to do with the above?

Ricardo implicitly assumed that the reason the Portuguese require less labor than do the English to produce both cloth and wine is that conditions in Portugal for the production of each of these goods are more favorable than in England. If capital could easily move from England to Portugal, cloth makers would relocate from England to Portugal where they could produce cloth using less labor. With wine and cloth now both produced in Portugal, these two goods would no longer be exchanged internationally for each other.

English textile mills would be idled and English textile workers would lose their jobs. But it doesn’t follow that capital mobility renders the English people as a whole ‘losers’ from international commerce. Nor does this mobility nullify the operation of comparative advantage.

Idle capacity and workers are assets that can be used to produce other products. Entrepreneurs would seize on England’s currently idled resources and workers to produce some other good, say, beer. If these entrepreneurs acted wisely, the English would soon produce beer at a lower cost than can the Portuguese. The English would trade beer to the Portuguese in exchange for wine and cloth.

The important point here is that international mobility of capital does nothing to eliminate the gains from specializing according to comparative advantage. This mobility might well change the distribution of comparative advantages across countries, but unless a country literally becomes depopulated, it will not eliminate comparative advantage or the mutual gains that arise from specializing and trading according to it. Even when capital is internationally mobile, therefore, tariffs erected to obstruct trade damage the countries that impose them.

Paul Craig Roberts, Oren Cass, and other protectionists have only one possible response, which is this: When capital moves from the home country to another country, the home country’s new comparative advantage is worse than the one it lost. But this response fails. If Portugal could produce both wine and cloth at a lower cost than can the English, Parliament would make the English people poorer, not richer, by compelling them to acquire cloth at prices higher than they would pay were they to purchase it tariff-free from Portugal.

Protectionists will retort that, while Portugal might currently have a comparative advantage over England at producing both wine and cloth, if Parliament protects English cloth producers – thus giving them reason not to relocate their operations to Portugal – they will improve their efficiency at producing cloth in England, ensuring that in the future England will have a comparative advantage at producing cloth. One year ago in this space, I examined this particular protectionist argument and found it severely wanting. But even if this protectionist argument were valid, it’s not an argument against comparative advantage or international capital mobility. Instead, it’s an argument that government officials can determine better than can markets which particular industries should thrive, and which should not, in the home country.

Coda

A final point is worth making if only to reveal more fully just how deeply confused protectionists are about economic reality. When protectionists such as Oren Cass insist that international mobility of capital renders free trade dangerous for America, their specific concern is that capital flees from high-wage America to lower-wage foreign countries. Yet these protectionists also incessantly complain about America’s ongoing trade deficits, apparently unaware that whenever a country runs a trade deficit capital is flowing into that country. And so even if, contrary to fact, the international mobility of capital renders free trade harmful to some countries as it continues to benefit others, because the United States has for nearly a half-century now run an unbroken stream of annual trade deficits, Americans are unambiguously among the beneficiaries.

Other news