The Hayek Memorial Pathway

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The picture above is what I like to call the Hayek Memorial Pathway located on GMU’s Fairfax campus.  This pathway is the result of thousands of students deciding to go the shortest path rather than the long paved path.  In other words, this path is a spontaneous order; the result of human action but no one person planned such a path.

Surprise!

At Cafe Hayek, Don Boudreaux has a blog post discussing the rather frequent argument used by some protectionists who object to foreigners owning American assets.  Don writes:

One of the facts that I pointed out [in Don’s recent debate with Ian Fletcher] is that a U.S. trade deficit is good for the U.S. insofar as such a deficit means that capital is flowing into the U.S. and creates new businesses (or bolsters existing businesses).  Think, for example, of BMW’s factory in Greer, South Carolina, or of any of the many Ikea stores across the United States.

In reply, Fletcher agreed that such investment is productive, and even that it’s beneficial for Americans.  “However,” he replied (and here I quote from memory), “it would be even better if those assets were owned by Americans.”

The core error in Fletcher’s reply is the assumption that the productive assets that are brought into being by foreign investment would exist in the absence of foreign investment.  Fletcher assumes, for example, that the successful Ikea store in Dale City, Virginia, would exist in the absence of Ikea’s decision to build and operate a store there.  Fletcher assumes, in other words, that the ownership of an asset is economically distinct from the creation of an asset.  But this assumption is plainly mistaken.  Nothing prevented Americans from building a large furniture (or other kind of) store on that very location before Ikea built its store there – nothing, that is, other than the failure of any Americans to have the vision or the willingness to do so.  Ikea’s entrepreneurial vision and willingness to take the risk of building a store in Dale City added tothe capital stock in America (and in the world).

To build upon Don’s point:

People like Fletcher treat assets and resources as if they are mana from Heaven, that these factories and stores and the like just fall to the Earth, waiting to be claimed by whoever walks by.  But goods and services are brought into existence and traded through human action. It’s man, not God, that transforms and produces. God just gave us the faculties to do so.

However, there is also a crucial element of what Israel Kirzner called “surprise” needed.  That is, being aware when an opportunity presents itself.  Allow me to explain via metaphor:

Two shoe salesmen land in a foreign country. Both notice no one in this country wears shoes. The first calls back to headquarters: “I’m headed home. There are no sales opportunities here. No one wears shoes!” The second calls back to headquarters: “Send me more people. There are lots of sales opportunities here. No one wears shoes!”

The point of this story is that entrepreneurial activity includes “surprise,” that is: being aware of an opportunity that presents itself even when not actively searching for it.  One of the salesmen, the one who thought no opportunity existed, had no such element of surprise.  The other did.

There’s no reason to assume that if Ikea hadn’t shown up, someone else would have. This isn’t a “search cost” thing (ie, other people did not simply look hard enough and Ikea just looked harder/longer), but rather an entrepreneurial surprise thing. Ikea spotted an opportunity and invested. It’s probable no one else would have spotted (or, at least spotted at the same time) this opportunity.

But let’s say more. Let’s say that some American firm did spot the same opportunity at the same time and were competing against Ikea for the same resources (land, labor, etc). Would it be safe to say that the community would be better off if the assets were owned by the American firm rather than Ikea? Not necessarily. Given that Ikea won the bidding war, that probably means Ikea had a higher value on the resources than the other firm. This, in turn, means that Ikea can likely produce more value out of the resource, which means providing value to the consumers of furniture. By being more efficient (that is, using fewer inputs to achieve the same or greater outputs), Ikea produces more value for the community than the other firm that lost the bid.

Economic growth occurs through the mechanisms of discovery and surprise (a la Kirzner) and resources going to their most valued uses.  We cannot take for granted either one of these processes.

Flaws of GDP when Discussing International Trade

Gross Domestic Product, better known by its acronym GDP, is frequently cited and understood by non-economists as the measurement of the economy.  But GDP is not the measure of the economy, it’s a proxy measurement for economic activity (creating a measurement for the economy is problematic because the economy is not something that can be measured in its entirety.  Its the grand sum of all human actions, some of which are measurable and observable and some of which are not).

One of the most commonly known things about GDP by non-economists is its accounting formula:

GDP=Consumption (C)+Investment (I)+Government Expenditures (G)+Net Exports (NX), with Net Exports being defined as the difference between imports and exports (Exports-Imports).

It is on this Net Exports figure I will focus the conversation as it is from whence the confusion about the effects of international trade on economic activity comes from.

Often in news reports, we will see a report along the lines of this:

US economy grows 3.0 percent in third-quarter  

The U.S. economy unexpectedly maintained a brisk pace of growth in the third quarter as an increase in inventory investment and a smaller trade deficit offset a hurricane-related slowdown in consumer spending and a decline in construction.

Exports increased at a 2.3 percent rate in the third quarter, while imports fell at a 0.8 percent pace. That left a smaller trade deficit, leading to trade adding 0.41 percentage point to GDP growth.  (Source)

However, this reporting, which states that the trade deficit affects GDP which leads many non-economists to the conclusion that international trade and imports are bad for the economy, is incorrect.  it is based off a misunderstanding of the GDP calculations.  To explain why, we need to understand exactly what GDP is:

GDP stands for Gross Domestic Product.  “Domestic” is the key word there.  We’re focusing on consumption, investment, government expenditures, and exports of domestically produced goods.  So, why are imports in the equation at all?  Why not just simply sum all the consumptions, investment, government expenditures, and exports of domestically produced goods?  Simple: we don’t know what proportion of these components contained imports and what proportion contained domestic goods.  But we do know how many goods/services were imported.  So, we can simply subtract out the imports from the equation to give us the true GDP factor.  In other words, imports are an adjustment factor, not a component of GDP!  Without the import adjustment factor, we’d be overestimating GDP.

I think a simple numerical example will help explain:

For the sake of simplicity, assume a closed economy (no international trade) and only one type of activity, Consumption.  Thus:

GDP=C.

Since all goods are produced domestically, we can say:

GDP=Cd, where Cd stands for Consumption of domestically produced goods/services.

Assume Cd=5.

Thus: GDP = Cd, GDP = 5.

Now, assume the economy opens and only imports (that is, they have a trade deficit).  GDP is now:

GDP=C-Imports (I).  However, C = Cd+Ci, with Ci defined as consumption of imported goods.

Let’s say imports = 6.

Our GDP formula is GDP=C-I.

Rewritten: GDP = Cd+Ci-I

GDP = 5+6-6

GDP = 5.

As we can see here, once we adjust for imports (which is necessary because we’re dealing with gross domestic product), GDP does not change because of the trade deficit!  It is incorrect to say that imports reduce GDP, QED.

To be clear, there may be secondary effects imports have on GDP (say, for example, imports drive out domestic producers, which can reduce Cd, which can reduce GDP), but it is not a given that imports reduce, as I have shown here.  But even then, it is not necessarily a bad thing if GDP falls because of more imports.  GDP is a proxy, not a measurement, of economic activity and well-being.  If one is made better off by buying imported goods rather than domestic goods, then that will not show up in GDP, but it is a real gain nonetheless (for an explanation of this point, see the previous posts in this series).

Update: Here is Pierre Lemieux on this very same topic.

International Trade

The previous blog posts have discussed how trade benefits the traders.  We began with the observation that people act purposefully.  Then, we developed that observation to answer the question “why do people trade” and found that people trade because such a transaction is mutually beneficial.  That led us to a graphical representation of the question: the supply and demand diagram.  Finally, we were able to show the gains of trade that occurred.  At the end of this blog post, we touched on the claim that these gains from trade do not depend on the geographic or political location of these actors (gains from trade do not change whether the trade is inter-neighborhood, inter-town, inter-state, or inter-national).  I will now expand on that point.

Trade occurs because both parties benefit and thus gains from trade are realized.  The gains may not always be exactly perfectly realized the way they are depicted in the supply and demand model, but it is a very accurate representation of the economic gains.  Given the sheer repetition of human action and competition of buyers with buyers and sellers with sellers, gains will tend to be maximized.  If Joe values apples more highly than Sally, Jow can bid away Sally’s apples; he can offer her some kind of compensation to part with her apples.  Likewise, if Sally is competing with Brian to sell Joe apples, and Brian values his apples less than Sally (ie, he charges a lower price), then Brian can bid away Joe from Sally.  Brian views what Joe offers as more valuable than both apples, and more valuable than the value Sally puts on her apples, so there are gains from trade (apples moved from their least valued use to their more valued use).

Gains from trade hold in an international setting, too.  One of the chief objections put forth by protectionists scarcityists is that international trade is one-sided and that all the benefits accrue to just domestic consumers and foreign sellers.  Therefore, it is only the foreigners who pay the price for tariffs, and tariffs can result in a higher net benefit.  Absent some heroic assumptions, this cannot hold true.  Why?  Because of gains from trade!  If the gains to domestic producers were able to offset losses to domestic consumers, then domestic producers could simply bid away the domestic consumers from the foreign competitors.  Consider Joe, Sally, and Brian again.  Joe and Sally are both citizens of Motonia and Brian is from Hogeland.  If Joe buys apples from Brian, then Brian offers him the best deal.  However, if Sally can offer Joe a better deal, then she can simply bid away Joe’s business from Brian by willing to charge Joe a lower price.  You would get a higher net benefit by this action.  If Sally is unwilling to bid away business, then we can conclude her gains would not offset Joe’s losses, and the total surplus would shrink compared to trade with Brian.  From a net benefit perspective, international trade does not matter (nota bene: this same logic holds if we adjust the scarcityist claim and they try to make it an externality argument, that Sally’s job loss makes things a net benefit.  See the Coase Theorem).

There are other scarcityist arguments against free trade that I will not address here; they tend to be political or legal in nature, and that is beyond the scope of these blog posts.

Here ends the substance of this series on trade.  The next post will discuss trade and GDP, highlighting some of the flaws of GDP and why how it is currently understood by most non-economists is incorrect.  The following post will be a recap of all I have written.

Gains from Trade

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:

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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.

Supply & Demand

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:

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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

Trade is Mutually Beneficial

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.