A Toast to Globalization, Part 2: Considerations for Comparative Advantage

Types of Liquor.png

As a follow-up from my post the other day, I updated the “Liquors from Around the World” chart to include contributions from US states (I thank Daniel Kuehn for the idea), as well as the different types of liquor each area produces.

Of note on this map is how many states/countries produce multiple kinds of liquor (red) for sale in the Oakton ABC store.  When we discuss comparative advantage in economics, do we not stress specialization?  Are not Canada, the US, Brazil, France, Italy, India, and Mexico harming themselves by not specializing in one kind of liquor?

When David Ricardo formulated the idea of comparative advantage, he used the example of England and Portugal specializing and trading.  But, as Steve Davies discusses here, that is an oversimplification.  Countries do not trade; individuals do.  The implication of that is countries do not specialize; individuals do.  Only individuals can possess comparative advantages.  Countries cannot.  A country may have certain features that lead to individuals to specialize along certain lines (eg, Italy has a warm climate that produces fruit that can be used for cordials), but it is ultimately the individual that specializes.  Thus, a country may export many kinds of goods of varying levels of production (raw materials, intermediate, finished goods) and industries (ag, chemical, education, etc) and may import those very same types goods!

We must be very careful when discussing trade and comparative advantage and stress to readers and listeners that the term “country” is merely a shorthand convention.

A Toast to Globalization

Liquor from Around the World

This map shows the source of all the liquor sold at the Virginia ABC Store in Oakton, VA.  Nearly 40 countries in all.  They are (in no particular order):

  1. US
  2. Ireland
  3. Canada
  4. Italy
  5. France
  6. Mexico
  7. Germany
  8. Croatia
  9. Peru
  10. Russia
  11. Poland
  12. Iceland
  13. Sweden
  14. Nicaragua
  15. Finland
  16. Guyana
  17. Haiti
  18. Barbados
  19. Jamaica
  20. Venezuela
  21. Dominican Republic
  22. Guatemala
  23. Brazil
  24. Trinidad & Tobago
  25. Scotland
  26. England
  27. Japan
  28. Korea
  29. Spain
  30. South Africa
  31. Turkey
  32. Greece
  33. Austria
  34. Lebanon
  35. Netherlands
  36. China
  37. India
  38. Taiwan

What’s more: these countries are represented in a relatively small area: the retail front is not much more than 1500 square feet.

So, let’s raise a glass to globalization, which allows us to enjoy these beverages from around the world!

Update: Two more countries: Belgium and Latvia.  Map not updated

The Political Economy of Trade Policy Part 2: On the Presumption of Liberty

As with any model in any science, we need to ask the questions: “how well does this model reflect real-world observations? Are its assumptions likely to hold and are they key to the model?” Negative answers to these questions do not necessarily imply the model should be scrapped. All models, after all, are simplifications. Any model that could handle every possible variation would be unwieldly and thus not provide much insight. Further, as Harold Demsetz warned us, just because the real world differs from some theoretical outcome it does not mean that alternatives are necessarily better, especially when one situation is viewed through the lens of reality and the other through the lens of theory.

In the previous post, I discussed some of the political realities surrounding economic justifications for trade restrictions, primarily using the optimal tariff model as an example. Are these objections enough to recommend against using policy to try to influence patterns of trade, or am I simply making the Nirvana Fallacy?

It is certainly true that markets can fail (broadly defined as failed to achieve some optimal level or distribution) and these failures can be corrected through judicious government actions. However, these actions can cause more harm than they actually solve. Indeed, for something like an optimal tariff, even if done with the best of intentions, it can backfire and result in a much worse scenario without much effort. Further, these justifications can be misused or hijacked to give intellectual cover for essentially selfish goals.

However, the biggest issue with trade policy is mistakes can become systematic and entrenched. Aside from the reasons discussed above, most political systems, and democracies/republics in particular, are designed to be slow-moving. This means if a policy is determined to be detrimental, it may take a while to repeal or alter even if we assume no self-interest lobbying or other barriers preventing the legislation from being changed.

National trade policy also necessarily must be general. As such, it is likely to be geared toward the average person or firm. The policy may be too restrictive for some and too broad for others; it may lead to a rather substantial misallocation in resources. Consider the following example: Imagine a room with 10 people inside, five of whom are six feet tall and five of whom are five feet tall. The average height of the room would be five feet, six inches. If there is a policy to build a door in the room so people may come and go, how would the policy be structured? Maybe it is structured so that the door must be at least six feet tall, thus everyone can easily use it, but that’d mean less wall space for windows and pictures and other things, and for half the people it’d be too tall a door. Likewise, they could order the door be at least five feet, six inches (the average height), but then the tall people would find the door inconvenient to use while the short people would have no problem. The necessity of general rules is part of the reason why government action should be limited to negative rules (eg, do not steal) rather than positive rules (eg eat five servings of veggies a day).

We also need to consider the knowledge problem. The actual level of knowledge necessary to accomplish these optimal policies is both dispersed and not even necessarily consciously known to the people holding the knowledge. Acquiring both the necessarily knowledge and acquiring it in a timely fashion are impossible. What’s more, what statistical information we can gleen has some major caveats attached. Economic data is collected primarily though the use of surveys to a sample of individuals and firms and then extrapolated to the aggregate level. However, as with any survey, these surveys are subject to the same caveats, assumptions, and error terms as anything else; they may not truly represent the real economic activity they are trying to measure. Further, as additional statistical techniques are run on them, the error terms must get larger and larger, not to mention the potential for error from sampling issues, violations of various assumptions, and the like.

With all these potential for errors, which are not limited to just the political realm, we are faced with the question “how to contain damage from failures?” As mentioned above, government rules quickly become systematic and entrenched. This means that an error in government policy could quickly affect the entire society. If, for example, government bets that the Next Big Thing is going to be autonomous cars and pours subsidies into their development, and then people decide they don’t want autonomous cars for whatever reason, the American taxpayers are held holding the bag. If the various government-supported firms go under, the taxpayers will not be reimbursed, nor have anything to show for the spending of funds that could have gone toward education, health care, infrastructure, or other uses. The error would be felt (to varying degrees) nationwide. Conversely, if a private firm makes the same bet and are subsequently proven wrong, the ones who feel the loss most acutely are the firm itself: the owners, the shareholders, and those who did business with them. The losses would be generally confined to those individuals and firms. Because of these potential losses, these private firms are more likely to be careful with their spending and their projects than would government-sponsored entities.

It is from the expectation of failure and not success that I argue for the presumption of liberty in policy. With managed trade policy, while there is the potential for upside, there is a rather substantial risk of a large downside, too. Should that downside occur (a very probable event in my opinion), it’s effects would be systemic and hard to remove. Conversely, if private individuals and firms make errors, they would be the primary recipient of the downsides. Thus, I argue that free markets are more robust to error than government is. This is not an argument from Nirvana, but rather from Hell.

The Political Economy of Trade Policy (Part 1)

Writing at EconLog, Scott Sumner makes the following point in his excellent blog post entitled “Keynesian Fiscal Policy is Dead“:

Many non-economists do not understand fiscal policy; they view it as something that can be applied on a sort of ad hoc basis. But things don’t work that way, as Keynesian fiscal policy requires a countercyclical (full employment) budget deficit.  It’s a full-fledged policy regime that must be maintained over time, not a gesture to be employed at a point in time.  You can’t say “let’s do fiscal policy this year”.

Scott’s point can be expanded to include trade policy as well.  Trade policy is, likewise, not something that can be applied on an ad hoc basis.  Consistent and predictable rules are necessary to maintain trade.  What’s more, theoretical economic trade management (eg, an optimal tariff) requires an extreme level of precision and consistency.

But can we assume such consistency in policy?  I think not, especially in a democracy/republic.  If one of the parties does not buy into said policy regime, then maintaining it is virtually impossible, unless that party is deliberately kept out of office.  Or, if the two parties have differing points of view on the goal of trade policy.  If one group wants an optimal tariff and the other wants tariffs to match international taxation regimes (both, in theory, legitimate tariff goals), those two policies will be at odds with one another.  How the regime is established will depend on who is in power at any given time.

How likely is it, even with the same party in power, that the policy remains consistent?  That is not so clear.  Politicians, especially in a system where they face voter pressure, are subject to various whims; as Adam Smith puts it: “[statesmen] whose councils are directed by the momentary fluctuations of affairs (WN 468).”  Even if we assume consistency in policial parties, inconsistency in various affairs should give us pause when assuming consistency over time in policy goals.

But, even if we assume consistency in policy goal over time, we run into the issue of policy adjustment.  For example, an optimal tariff depends on how sensitive domestic consumers are to changes in price; if they are highly sensitive, then an optimal tariff would be extremely low.  If they are not very sensitive, then an optimal tariff could be relatively high.  But, this sensitivity adjusts over time (Second Law of Demand).  This would mean that the optimal tariff level would need to be adjusted periodically (ideally, constantly) to compensate for this changing sensitivity.

However, firms and individuals adjust to policies.  With any policy, we run into Gordon Tullock’s transitional gains trap.  Firms and individuals will fully capitalize the monopoly gains they get from policy protections, leading them to do no better than before the policy was initiated.  What this also means is that if the policy were to be changed or removed, these firms/individuals would face the potential for major losses.  It would be strongly in their interests to keep the policy from changing.  Furthermore, since these losses to the entrenched firms/individuals would be highly visible and concentrated, but the benefits dispersed among the entire society, it would be a relatively easy pitch for these entrenched interests to keep the policy in place.

Another point worth quickly mentioning in relation to the previous paragraph: most trade policy models assume no resources spent on lobbying.  If we relax that assumption and assume that firms/individuals do indeed lobby, either for or against various trade policies, then any potential gains from these policies are quickly eaten up in the costs of lobbying.  Further, because of the aforementioned dispersed costs and concentrated benefits, the entrenched interests would be willing to spend more on lobbying than the people harmed by the policy,* which could potentially cannibalize all potential gains from the policy and then some.

*This point may require some explanation.  Assume a society of 10 individuals.  A policy is proposed that could improve the wellbeing of one member by $200, but only through the cost of the rest of society by $300 (or $33.33 per person).  Therefore, the one member would be willing to spend up to $200 to lobby for this policy, but each individual may only be willing to spend up $33.33 to lobby against.

Today’s Quote of the Day…

…is from Adam Smith’s 1783 letter to William Eden, Lord Auckland, to which Prof. Smith responded to a question on whether or not England should have preferential and different duties on other nations (page 271-272 of the Liberty Fund’s Correspondence of Adam Smith):

I shall only say at present that every extraordinary encouragement or discouragement that is given to the trade of any country more than to that of another may, I think, be demonstrated to be in every case a complete piece of dupery, by which the interest of the State and the nation is constantly sacraficed to that of some particular class of traders.

JMM: Indeed so.  As I wrote before, when there is ambiguity of purpose, when multiple excuses may be given for various government handouts, we must expect that there is going to be abuse and “dupery” and firms and individuals vie for such handouts.

A Discussion on Transaction Costs

This post is a riff on a recent op-ed column by Don Boudreaux at the Pitt Tribune “Minimum Wage & Technology.”

As Don writes:

When I explain to my students that minimum wages prompt firms to substitute technology for labor, they often react as if this greater reliance on technology is an upside of the job-destroying nature of minimum wages. But my students are mistaken.

This attitude is often portrayed as justification for all kinds of government interventions: minimum wage, labor restrictions, scarcityism, etc.  Technology is a sign of advancement, so we must advance!

But advancement is not a costless procedure.  Not only, as Don points out in his article, is there costs to developing said technology, but there are also costs to implementing and adopting such technology.  If a self-help kiosk is installed at a fast-food restaurant, its costs are more than just the new machine: it needs to be wired, staff trained (which reduces their productivity in the meantime), company policy created (and all other kinds of backroom stuff), etc.  All these things take time and resources; they all have costs.  If these costs, plus those that Don mentions in his article are higher than the benefits, then the intervention in the market, even if it produces newer technology, is a net loss.

This is an important point that is implied in the above discussion but I want to make explicit: just because there is a hypothetical “better” outcome, it does not mean that the market has failed!  If that outcome does not occur because the transaction and transition costs are too high, then the current outcome, with all its flaws, is the most optimal.

Indeed, there is really only one condition under which we can say with any certainty that a true market failure has occurred: if the outcome is suboptimal, and the transaction costs were misestimated, and this misestimation should have been known to the market participants.  This is an extremely high bar to reach, one that is made all the higher given it requires a huge judgment call on the part of the analyst.  In a sense, the analyst ends up begging the question since he has to assume his judgment and knowledge and subjective evaluations of the costs and benefits are equally shared by the participants (or he knows their inner workings).

Among economists of all stripes, the presumption of liberty, that is the promotion of free markets even when they are imperfect, remains predominant for exactly the reason discussed here: the knowledge of transaction and transition costs are highly personal and their existence gives the economist pause whenever discussing “welfare enhancing” policies specifically designed to control economies.

The Ambiguity of Purpose Leads to Abuse

The case for free trade is not absolute.  There are many reasons, theoretical and practical, where an exception to the general rule of free trade may be desirable.  Reasons of national defense, of terms of trade, of national welfare, can all be justifiably given for tariffs.  As I and others have discussed elsewhere, these exceptions have high hurdles to clear and rely on some rather strong assumptions, but they remain, at least in theory, justifiable.

But it is important to note with these different justifications is they are all mutually exclusive.  The national defense justification is a tariff high enough to prevent competition into the domestic industry.  The terms of trade argument, on the other hand, is a sufficiently low tariff designed to generate welfare gains and force other countries to lower their prices.  In other words, one tariff is designed to decrease imports and the other to increase imports.  These are, obviously, at cross purposes.

Even if these justifications are intellectually impeccable, they remain tactically useless for a simple reason: when scarcityism admits multiple justifications, any number of rent-seeking firms can exploit these various justifications for personal gains.  In other words, multiple conflicting justifications can be given by various firms, and all hope of improving national welfare goes out the window; the more exceptions carved out, the more rent-seeking individuals and firms will seek to exploit them.  As rent-seeking increases, more and more resources are devoted away from satisfying consumer wants and toward rent-seeking.

The presumption of liberty, that is a tendency to allow free trade vs controlled trade, remains strong even if it is, in theory, the option that has lower welfare because of the potential of rent-seekers to exploit ambiguity in a national policy to promote welfare.