Both parties will gain from a trade if the value to the buyer exceeds the price the seller is asking, and the price the seller receives exceeds the value he has for the good/service.
Returning to our beautifully hand-drawn graph (yup, we at a Force For Good are on the cutting edge of 19th Century technology), we can graphically show these gains from trade thus:
For every consumer price willing to be paid (as shown by the demand curve) that exceeds the price sellers are willing to receive (the supply curve) a trade is expected to occur, and the gains from these trades will be the difference between the price the consumer pays and the difference the producer receives. The sum of all these gains is the green triangle above, what we in economics call total surplus.* We see here what we have logically derived: trade is beneficial.
Up until now, we have been talking solely about interpersonal trade, one person trading with another. To derive a market demand curve, that is all people trading in this market, we simply sum all the individual demand curves together (∑D) and all the supply curves together (∑S). The logic is as follows: if one person is willing to buy one apple at $5, and a second person is willing to also buy just one apple at $5, then the market demand for apples at $5 is 2 apples. Same with suppliers. This summating function allows us to expand our specific conclusions derived from the past few posts to a more general claim: it doesn’t matter if the trade is inter-personal, inter-town, inter-county, or inter-state (note that externalities do not change this analysis. See the Coase Theorem). The conclusions are also true with the inter-national level, a topic which we will expand upon in the next blog post.
* Note that we could separate this out between consumer surplus and producer surplus, but for our purposes here, such a distinction does not matter. It does not change the analysis one wit.
Trade is mutually beneficial. This means that both parties benefit from the exchange; what they receive from the exchange is, in their estimation, of higher value than that which they must give up. In economic terms, the benefits are higher than the costs. The theory of exchange I just laid out here has two implications which help get us to the Laws of Supply and Demand: 1) there exists a price* that is sufficiently high that will induce someone to enter the market as a seller and 2) there exists a price that is sufficiently low that will induce someone to enter the market as a buyer.** Graphically, these implications give us the old standard supply and demand diagram:
Look at the sublime beauty of this hand-drawn graph.
Now, consider what is going on with the points where Supply are valued less (that is, the price suppliers are willing to supply at is lower than the price buyers are willing to pay), say at points A and B in the above graph. Sellers value the quantity in question at Pa and consumers value it at Pb. Since Pb>Pa, a trade will occur (the buyer values the good/service higher than its current owner) and the gain from trade is Pb-Pa. (Nota bene: on the right-hand side of the graph, where the value of supply is greater than the value of demand, no trade will occur).
These gains of trade will be discussed in more detail in the next blog post.
*A quick note on price: We tend to think of prices in monetary terms, but they needn’t be. A price is just whatever it costs to acquire something. Prices represent opportunity costs.
**For a neat proof and thorough discussion of this point, see Investment, Interest, and Capital by Jack Hirshleifer, Chapter 1, especially pages 4-15
Let me begin by precisely defining what I mean by trade: trade is the voluntary exchange of resources between two or more parties. Note that we are discussing voluntary exchange. That means involuntary exchange (eg theft, slavery, anything where at least one of the parties object) is not considered. When we consider the definition of trade I use here, then the title of this blog post becomes a tautology. Another condition, this time deriving from the “exchange” part of “voluntary exchange,” is that trade involves swapping resources. With that in mind, non-exchange interactions (eg, charity) are not considered here. None of this is to say involuntary exchange or non-exchange interactions are unimportant, just the opposite, but they are beyond the scope of this series of blog posts.
Keeping with the tautology, what does “mutually beneficial” mean? It means that all parties involved stand to gain. Both Smith and Jones have something the other person wants and they trade because both of them gain from that trade. The implication here is that all parties to trade are, at all times and everywhere, both suppliers and demanders (both producers and consumers). In a trade situation, it is impossible for one of the parties to only be a consumer or only be a producer since to trade one needs to give something up before he can get something in return (in the second-to-last section, when I discuss international trade, this distinction will become important when addressing some of the fallacies of tariffs).
Trade is mutually beneficial. Combine that with ever-present scarcity, and it leads us to the supply and demand curves, which are covered in the next blog post.
Most conversations about trade begin in the middle. The conversation revolves around international trade, about people in one nation trading with people in another. The conversation revolves around GDP and regulations and tariffs and tribunals and all these things tangentially related to trade, but never about trade itself. The problem with starting the conversation in the middle like this is we miss the all-important fundamentals that are developed in the beginning part of the conversation. For economists, this gloss isn’t a problem; we’ve been trained and trained on trade. But for presidents, politicians, pundits, and prophets, this gloss is problematic. They do not understand the basis upon which trade is built, the logic of the argument because they miss it (I suspect this is a good amount of the reason opinions diverge so strongly between economists and the man-on-the-street on the nature of international trade). Therefore, I offer this blog post as a humble contribution to the conversation.
Let’s begin at the beginning: Why do people act? They act because they must feel, given the information they have at the time, that their action serves some desired end/purpose. In other words, that action is purposeful. Given purposeful action, why do people trade? What causes Smith and Jones to exchange their goods with one another? The answer is obvious (by which I mean its literal interpretation (derived from observation) as opposed to its more colloquial use of “trivial”): Both Smith and Jones benefit from this trade. If either party did not benefit, then no trade would happen. It is from this first principle that we must build the conversation around trade, but it is this first principle that much of the political conversation ignores.
In the coming days, I will be posting a series of blog posts exploring trade from the first principle that trade is mutually beneficial. The outline is as follows:
–Trade is Mutually Beneficial
–Supply and Demand
–Gains from Trade
–Problems with GDP
A popular argument against free trade is that the logic of trade requires identical (or at least similar) rules/institutions between the trading parties. Dani Rodrick recently made this argument, and you can see Don Boudreaux’s response here. There is absolutely nothing in the logic or argument for free trade that necessitates similar institutions between the partners. Only one thing is required: both parties benefit.
However, for both parties to benefit from trade, they must inherently be different from each other. If the two were identical, then no trade would ever occur. Diversity in tastes, in endowments, in incomes, even in rules, are desirable and, to differing degrees, necessary. The idea that trading partners must be similar to one another, including in their belief structures, undermines the logic of trade.
Moving from the individual level to the national level, institutional diversity helps show actual costs and benefits of various institutions. For example, if the whole world were as protectionist as Red China in the 1950’s, no one would know what a horrible scheme that is as the whole world would have looked like massive starvation. Fortunately, the Chinese realized their mistake and have become rapidly more open-trade, thus leading to their huge economic gains lately, but it was the fact that institutional diversity existed that such folly was understood. If a given national government decides not to allow peaceful trading between their citizens and another group of citizens, then their citizens are harmed and the true costs of their institutions, as well as their true benefits, are not known.
Diversity is a necessary ingredient of trade.
…is found in a letter from Frederic Bastiat to Richard Cobden (leader of the Anti-Corn Law League) dated 8 April 1845. The letter can be found on page 58 of the Liberty Fund’s collection of Bastiat’s correspondence, The Man and the Statesman (emphasis added):
Since you have permitted me to write to you, I will reply to your kind letter dates 12th December last. I have been discussing the printing of the translation [of Cobden’s speeches and pamphlets] I told you about with M. Guillaumin, a bookseller in Paris.
The book is entitled “Cobden and the League, or the Campiagn in England in Favor of Free Trade.” I have taken the liberty of using your name for the following reasons: I could not entitle this work “The Anti-Corn Law League.” Apart from the fact that this would have a barborous sound for French ears, it would have brought to mind a limited conception of the project. It would have presented the question as purely English, whereas it is a humanitarian one, the most notably so of all those which have brought campaigning to our century.
By presenting the issue of free trade as a humanitarian issue rather than a sectarian or nationalist issue, he demonstrates the universality of the principles of free trade. Many opponents of free trade like to argue that free trade is conditional. They may argue that free trade requires “transnational rule-making institutions.” Or that trade only is good if one nation (ie the nation of the speaker) benefits. Or that free trade needs to be “fair” (whatever that means). But Bastiat makes no such prerequisites. Bastiat and Cobden both argue that free trade is not an English concern, not a French concern, not an American concern, but a human concern.
The Anti-Corn Law League that Cobden was part of was founded in opposition to the Corn Laws, a series of mercantilist legislation that raised the price of food within Great Britain by restricting imports. Given this legislation occurred at the same time as the Irish Potato Famine, the Corn Law, by artificially increasing scarcity of food, likely caused many deaths in Ireland from the famine. The Corn Laws contributed to a humanitarian crisis. We are seeing similar situations going on in Puerto Rico, where scarcity is increased because of the Jones Act, and Houston and Florida where scarcity is increased because of anti-price-gouging legislation. Free trade is a humanitarian concern, not a sectarian concern.
University of Chicago economist Richard Thaler wins the 2017 Nobel Prize in Economics for his contributions to behavioral economics.
Personally, I am happy with this outcome. Thaler is a very good economist whose recognition is long overdue (his sometimes co-author and frequent collaborator, Daniel Kahneman, won the Prize back in 2002).
Over at Marginal Revolution, my GMU professor Tyler Cowen has a great write up on Thaler’s work, including some areas I did not know about.
Two books of Thaler I highly recommend are The Winner’s Curse and Nudge (co-authored with Cass Sunstein, another person worth reading). Both are fascinating, and challenging looks at the standard assumptions of economics and provides surprising insights.