Adam Smith-Free Trade Essay, Research Paper

In the earlier days of recorded history, nations traded to obtain more goods, especially those they couldn’t produce themselves, which seems like a logical enough motive. But by the 17th century, this motive for trade gradually eroded. The desire for goods was replaced by the desire to accumulate gold instead. This seemingly irrational motive for international trade, which came to be called mercantilism, colors some nations’ international economic policy to this day. Mercantilism flourished during the 16th and 17th centuries, especially in England, France, the Netherlands, Spain, and other West European countries. Mercantilist states felt that the primary objective of trading internationally was to export as much as possible while limiting imports and accumulating gold in return. They felt that gold (as supposed to goods) represented true wealth. By the 18th century it was generally acknowledged that a favorable balance of trade meant exporting more than importing and accumulating a surplus of gold in the process.

But in the Wealth of Nations (first published in 1776), the Scottish economist-philosopher, Adam Smith argued that nations, as well as individuals, gain when they specialize in what they can do best and trade. Not, however, by trading goods for gold, but goods for other goods. “The revenue,” he said, “of the person to whom it is paid, does not so properly consists in the piece of gold, as in what he can get for it or in what he can exchange it for” (Smith 499). This heretical statement set the stage for a controversy that has persisted for more than two hundred years. If Smith was right, as most economists nowadays believe he was, then there is no place in a rational world for measures to restrict trade through artificial barriers such as tariffs and import quotas.

Smith also elaborated how people gain by pursuing their own self-interest. “It’s not from the benevolence of the baker, the brewer, or the butcher that we expect our dinner, but from their regard for their own self interest,” Smith said in one of his most famous quotes (Pool and Stamos 8). People specialize in doing whatever they can do best and exchange it for something else. In the process more is produced and everyone’s income and standard of living is improved.

When applied to nations trading internationally the same reasoning applies. The theory that explains this is comparative advantage, it posits “that all countries benefit when nations specialize in what they produce most efficiently and trade their surplus production with other nations for what they can produce most efficiently” (Pool and Stamos 8). It has been around since English economist David Ricardo first developed it in the early 1800s, after he had thoroughly studied Smith’s work. Comparative advantage is perhaps best explained by the now-fabled example of the secretary and the lawyer who works in the same office. “Although the lawyer can type faster that the secretary, the lawyer does the legal work and leaves the typing to the secretary. Why? Because of comparative advantage. The lawyer can earn more doing the legal work and therefore allows the secretary do the typing” (Krueger 9). Then between them, according to the theory of comparative advantage, their total product is greater, as is their income. If the lawyer did her own typing, she would earn less and her secretary wouldn’t have much to do and both of their incomes would be smaller. By the same reasoning one nation can benefit from trading internationally even if it is more efficient (that is, it can “type faster”) in the production of all products than the nation with which it is trading. As Smith said, “Trade which is naturally and regularly carried on between two places, is always advantageous to both” (Smith 514). So international trade pays off even if one nation has an advantage in cost efficiency over the other.

Also, Smith elucidated the ways in which decisions made by individuals in a market setting can serve the social good “as if by an invisible hand,” the case for free trade has been very clear: it makes no sense to produce goods at home if other items can be produced more cheaply and exchanged for them. A nation’s productive resources are limited. When consumers demand are greater than quantities of one commodity, the nation must attract resources from other economic activities to increase domestic output for the good. When that good is relatively cheaper from a foreign source, trade provides an “alternative technology” to domestic production: it requires the diversion of fewer resources to produce goods with which to finance the importation of the commodity that it does to produce the product domestically. Living standards can thus be improved.

The efficiency case for free trade is simply the reverse of the cost-benefit analysis of a tariff.

(Krugman and Obstfeld 220)

“A tariff causes a net loss to the economy measured by the area of the two triangles; it does so by distorting the economic incentives of both producers and consumers” (Krugman and Obstfeld 220).

A number of efforts have been made to add the total costs of distortions due to tariffs and import quotas in particular economies.

Estimated Cost of Protection

(% of national income)

Brazil (1966) 9.5

Turkey (1978) 5.4

Philippines (1978) 5.2

United States (1983) 0.26

(Brazil: Balassa; Turkey and Philippines: World Bank; United States: Tarr and Morris)

It is noteworthy that the costs of protection to the United States are measured as quite small relative to national income. This situation reflects two facts:

1. The U.S. is relatively less dependent on trade than other countries.

2. With some major exceptions, U.S. trade is fairly free.

By contrast, “some smaller countries that impose very restrictive tariffs and quotas are estimated to loose as much as 10% of their potential national income to distortions caused by their trade policies” (Krugman and Obstfeld 221). There is a wide spread belief among economists that calculations of the kind reported in the table, even though they report substantial gains from free trade in some cases, do not represent the whole story. In small countries in general and developing countries in particular, many economists would argue that there are important gains from free trade not accounted for in conventional cost-benefit analysis.

In addition, any free-market economy faces a menu of choices from which it must choose as it allocates scarce resources to produce needed goods and services. The cost of producing more of one good is producing less of another. This important concept is analyzed using a production possibility frontier.

For example, suppose that a group of marooned islanders faces the choice of spending all their time fishing or picking coconuts. If they devoted all their resources to fishing, they could catch 200 fish a week, as shown below, point A, whereas there were no coconuts being harvested.

The Production Possibilities Frontier

A

Then suppose that the group decided to assign some of their members to picking coconuts instead of fishing. If they pick 25 coconuts the number of fish being caught falls to 180, as shown at point B. So the cost of those 25 coconuts is the reduction in fish caught by 20. Of course, several other options are available as shown at point C and D. Allocating resources at point C yields 150 fish and 50 coconuts, whereas point D yields 100 fish and 75 coconuts. Every change in the mix of goods produced involves the cost of other opportunities foregone. This is the choice all societies face as they allocate resources among thousands of competing uses and opportunities. But, whatever the case, this society cannot produce at point F, which is beyond its production possibilities frontier. Why? Because the frontier defines its production limits given its available resources and technical know-how. But, those constraints change when international trade is involved.

As I explained before, international trade benefits both parties. The basic tool of production possibilities frontiers shows how nations are limited in their choices between producing one product or another or a combination of both. As I have shown, when they choose to produce one, they forego the opportunity to produce the other. For example, let’s assume that a nation can produce any two given products. It could produce corn and copper, bananas and refrigerators or guns and butter. The problem comes in deciding what combination to produce. Each nation’s labor and natural resources determine the tradeoffs available, and its level of technology.

The U.S. is not very efficient at producing many products. Let’s take, for example corn and copper. The U.S. is very efficient at producing corn, but not very efficient at producing copper. It can clearly gain by concentrating its effort on producing corn and trading them to some other nation that can produce copper more efficiently. These are examples of what is called absolute advantage. If absolute advantage exists when one nation uses fewer resources in production, it is clearly more efficient that another country in the production of a good. But, the other country may be distinctly superior in the production of another good. In such a case it is easy to see that both nations would gain from specializing and trading internationally when each does what it can do best and trades the results.

Trade under Conditions of Absolute Advantage

Without trade, countries are limited by their production possibilities frontiers. With trade, countries can consume beyond their domestic production capacity.

(Pool and Stamos 49)

Trade under conditions of absolute advantage is shown in the upper panel, which illustrates the relative production possibilities of the U.S. and Chile with respect to corn and copper production. Both nations can produce both product but the U.S. is four times more efficient at producing corn (by a ratio of 12/3), while Chile is four times more efficient at producing copper (by a ratio of 12/3). In isolation without trade between them, each would have to divide their production efforts between the two products.

Trade between the U.S and Chile would benefit both countries by allowing consumers in each country to purchase a combination of corn and copper that are on their consumption possibilities frontier. The lower panel shows that consumption possibilities in crease for consumers in both countries when each specialize in producing the good in which they have a comparative advantage and then trades with the other. It clearly shows that they are much better off by engaging in trade than by trying to produce both goods in isolation.

Free trade creates income for the community by reallocating jobs and capital from lower productivity to higher productivity sectors of the economy. The gains from trade are the gains from a more efficient allocation of the nations productive resources. The point of all this is that countries gain from specializing and trading: productivity is increased, incomes are higher because more is sold, costs are lower, and consumption is higher. Therefore, everybody gains from free trade.