Thursday, March 02, 2006

Problems With Comparative Advantage

Remember way back when when Chuck Schumer and Paul Craig Roberts published an op-ed in the Times arguing that in our brave new world with mobile factors of production, Ricardian comparative advantage no longer determined trade flows? And s0 we couldn't be guaranteed of the welfare enhancing capabilities of trade? Now knowing a bit of trade theory, I can tell you that this is insightful only insofar as you've only ever seen intro. econ.. For, you see, the other two work-horse models of international trade both show that some people get screwed by international trade. It is only because of the simplicity of public discourse about economics -- due, perhaps, to economist's ideological conviction that free markets are best -- that this is both surprising and novel to most people.

Your basic international trade theory consists of three vaguely related but quite different models: Ricardian models, Heckscher-Ohlin models, and specific-factor models. Only in the Ricardian models with one factor of production is trade Pareto optimal and so makes everyone better off. This is because wages are determined exogenously by technology and so everyone gets paid the same regardless.* With trade, then, you allocate resources more efficiently and so produce more and so everyone is better off. Trade flows are determined by relative productivity of countries.

In Heckscher-Ohlin models of two factors (with two countries and two goods), both countries have the same technology and it is different relative amounts of the factors that determine trade flows. But here trade doesn't benefit everyone: the Stolper-Samuelson theorem states that in an H-O framework, the scarce factor of production is always made worse off by trade. This is because you will export the good that embodies more of the factor in which you are abundant. In moving from autarky to free trade you shift production towards that good and in so doing make the production of both goods have a higher proportion of the abundant factor, raising the returns to the abundant factor and, it turns out, absolutely lowering the returns to the scarce factor.**

In one version the specific-factors model, you have one factor that can't move between sectors in the economy (is specific) and one that can. The specific factor in the sector that produces the good that is imported is made absolutely worse off by trade. So if you have labor in pants and labor in cars, and capital that can move betweeen, if you import pants, then the labor in pants is made worse off. This is because each unit of labor in pants now has less capital to work with and so is less productive and so is paid less. Alternatively, both factors can be specific and then the one that is scarce will lose.

So in two of our three work-horse models, you have that the factor abundant in the production of (H-O), or specific to, the import-competing sector is harmed by free trade. It is very easy to see the parallel to present worries about free trade: suppose that the U.S. has two factors, skilled and unskilled labor, then in two models you'd find out that unskilled labor gets screwed by trade (because we're abundant in skilled labor and, presumably, skilled labor is more mobile than unskilled labor). Only in Ricardian models which assume that all labor is the same does everyone do well.

What to make of all this, though, depends. As Henry cautioned, results from theory are only useful insofar as you think that the model captures the aspect of fundamental importance in the world. It turns out that the Heckscher-Ohlin model does a terrible job of describing actual trade flows, and that Ricardian theory does a lot better (basically, productivity has more importance in determining trade flows than factor endowments). And empirical work has shown that you can't attribute much of the change in worker's wages to trade (which also says that you can't attribute much welfare gains to trade either); that is, it is the increasing importance of technology that has resulted in increased wage gaps between skilled and unskilled labor, and not trade. So, sure, know that there are theoretical arguments that say that free trade isn't quite as fantastic as economists will claim. But don't be so sure that this makes it the case that these are the models that are actually relevant.

Two additional fun facts: first, you can get more sophisticated versions of these models, like Krugman's*** specific factor model with monopolistic competition, where it can happen that everyone does benefit from trade (though, depending, the scarce specific factor might lose). Second, Jones**** puts together a Ricardian model in which if you have a footlose factor that can move between countries -- like, say, capital -- then trade flows are determined sometimes by comparative advantage and sometimes absolute advantage (returns to capital). This endorses the Schumer Roberts point that with footloose capital comparative advantage no longer rules. However, it's unclear what applicability this has to the plight of unskilled workers in the US today (though it might: I just haven't thought about the model enough).

*Though you'll often get hand wavy talk of adjustment costs and all that, but that doesn't obviate the basic point that everyone is better off.
**The why of this is slightly obscure and difficult to grasp. But it's true, trust me.
***Krugman, Paul 1981. 'Intra-industry specialization and the gains from trade', JPE 89: 959-973.
****Jones, Ronald 2000. Globalization and the Theory of Input Trade. MIT Press. (chapter 2)

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