Sunday, May 28, 2006

Unregulated International Trade Unjustified By Comparative Advantage (Part 1)

1.0 Introduction

Why are tariffs, protectionism, etc., bad ideas - at least according to incorrect introductory mainstream economics teaching? Because of the theory of comparative advantage. This series of five posts demonstrates this argument is logically invalid when applied to an economy with produced capital goods and a positive interest rate. I explain a numerical example illustrating the argument in Metcalfe and Steedman (1974).

That is, economists have known for almost a third of a century that the theory of comparative advantage does not justify a lack of tariffs. Most economists have just shamefully ignored this argument.

Consider equilibrium prices in an autarkic economy. These prices convey to agents seemingly possible rates of transformation between, say, corn and ale. Prices on the international market may differ from these autarkic equilibrium prices. If so, the (firms in the) country under consideration will end up specializing somewhat in the production of those commodities in which the country has a comparative advantage. And this comparative advantage is determined by comparing equilibrium autarkic prices with prices on the international market.

On the other hand, consider the Production Possibilities Frontier constructed for the economy in an autarky. The slope of this frontier at any point shows the rate of transformation in the economy between commodities when nobody in the country engages in international trade. This frontier is constructed from data on technology and information on the quantity of resources available; prices do not enter into its construction. Deviations of equilibrium autarkic prices from the slope of this frontier create the possibility that a country specializing according to the theory of comparative advantage may be worse off. The imposition of a tariff can change the incentives of agents and shift the frontier outward in such a case.

Suppose commodities are produced with inputs that are themselves the result of prior production. That is, capital goods are used in production. And suppose the rate of interest is positive. Then deviations between equilibrium autarkic prices and the slope of the Production Possibilities Frontier can arise. A country may be worse off when the firms in that country engage in international trade under such circumstances. A numerical example demonstrates this point.

  • Metcalfe, J. S. and Ian Steedman (1974). "A Note on the Gain From Trade", Economic Record (Reprinted in Fundamental Issues in Trade Theory (edited by Ian Steedman), Macmillan, 1979.)

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