Sacrificing the Ends for the Means

Throughout his writing career, Frederic Bastiat repeatedly emphasized that consumption is the end goal of economic activity, that the consumer should be the focus of economic analysis.  While each man is both producer and consumer, man produces so he can consume.  In other words, production is the means and consumption is the ends.  This makes sense if we look at our own lives: we go to work so we can afford our homes, food, cars, clothes, etc.  We don’t consume our clothes, cars, food, homes, so that we can work more!

Although not considered much of a theorist, Bastiat was a bit ahead of his time with this emphasis.*  It would be another 50 years before the commonly-recognized supply and demand curve we use today was developed by Alfred Marshall.  Using the Marshallian Curve, we can explore Bastiat’s** insights with regard to international trade.

Let’s ask the question: what happens when we impose a tariff on international trade?

First, let’s start with our standard supply and demand curve:

20170406_093528

The green-shaded areas are “consumer surplus,” or what the consumer gains from the international trade.  The orange is domestic producer surplus (what domestic producers gain).  Domestic producers supply some of the quantity demanded (Qs) and the rest is made up in imports (Qd-Qs).  The total societal surplus is the green and the orange areas added together.

What happens when we impose a tariff?  This:

20170406_094005

Green is, as above, consumer surplus.  Orange is producer surplus.  Added in here is the blue area (tax revenue) and red (deadweight loss).  What’s going on here?  Much of what we have is a transfer of wealth: producers gain (from the consumer), government gains (from the consumer).  But where does the deadweight loss come from?  The consumer!  Not only is there a total reduction in welfare in the society (not merely a redistribution), but it all comes from one segment, the segment that is the ends of all production.  The entire welfare loss is borne by the consumer!  

The implications of this analysis are stunning, at least from an economic perspective: you reduce the ends to get more means; Protectionism results in more effort for less welfare!  The supposed blessings of scarcity that protectionism promises never materialize.

*Nor should Bastiat be considered a theorist.  He wasn’t.  He was a great distributor of economic ideas, but didn’t form any himself.

**And Say’s, Smith’s, and Ricardo’s

Destroy the City to Save the City

Commenting on this blog post, a “Daniel DiMicco” says:

Your commentary couldn’t be more misleading and dead wrong. Rather than the picture you paint, the Steel Industry is the “canary in the coal mine”. It is the case study for the Massive trade Mercantilism and cheating that China is perpetrating on the USA’s entire Manufacturing sector. Your propaganda doesn’t pass the smell test!

Below is my response:

Daniel Dimicco:

You say that the steel industry is the “case study for the Massive [sic] trade Mercantilism [sic] and cheating that China is perpetrating on the USA’s entire Manufacturing sector.”

Presumably, this means China’s low steel prices are harmful to the American manufacturing sector.

However…what would happen to the US manufacturing sectors that are dependent on steel? Like auto-making, construction materials, and the like? They’d face higher price pressures from any resulting tariffs you demand. Assuming they can’t adjust prices, this would mean they’d need to cut adjust costs elsewhere…perhaps lay off workers, perhaps cut hours, all kinds of things. They’d be negatively impacted by your steel tariffs.

Even if they could adjust their prices, now you’re looking at the effects on the consumers of these steel products. They’d start looking for more cheap substitutes or simply cut back on the amount they purchase. This would weigh on the manufacturing sector as well (as well as the consumers).

In short, your effort to save one canary will kill off several others.

On a related note, I found a picture of protectionists celebrating a tariff hike:

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The Ricardian Insight on Trade

Is it possible for a nation to become impoverished by trade by outsourcing everything?  Some people seem to think so.  For example, see this comment by a “William Ryan” on this Carpe Diem blog post:

Then we can just let China and Mexico make everything for us so the few at the top can hoard all profits and prosper from.

The problem with this sentiment is that it is mathematically impossible.  If we stick with the standard theory of trade (and one which these folks appear to accept), then the actor that produces something at the lowest economic cost will specialize in that production.  However, it is impossible to be the lowest-cost producer in everything.  “Lowest economic cost” is a relative term.  If one has a lower economic cost at one thing, s/he necessarily has a higher economic cost in another thing.  The example we gave yesterday of Bananaland and Fisherland provide a mathematical example of this concept.

This insight was developed by David Ricardo 200 years ago.  It is still relevant today.

On Bananas, Fish, and Trade

Commenting on this blog post, Warren Platts writes:

If imports were stopped by a stroke of a pen, there would still be a trillion dollars of pent up demand per year from American consumers. If the demand for goods couldn’t be satisfied with imports, domestic manufacturers would take up the slack, creating jobs. Things would be more expensive, sure, but the GDP would grow a lot faster, more people would have good jobs.

Warren’s argument, while common, is incorrect.  Imports, which do satisfy demand, generate more demand for other products by virtue of the fact they are of lower economic cost.  As Warren says, if these imports were stopped, “things would be more expensive.”  This inherently means that there are not “trillions of dollars in pent up demand per year,”that American manufacturers can simply “take up the slack.”  Rather, those trillions of dollars are released by the imports and would become constrained by the forbidding of such.

By way of example, let’s say we have two countries: Bananaland and Fisherland. In autarky (that is, no trade), Bananaland can produce 50 fish or 50 bananas.  Fisherland can produce 100 bananas or 200 fish.  If each country divides their time evenly between each activity, Bananaland can produce and consume 25 bananas and 25 fish.  Fisherland can produce and consume 50 bananas and 100 fish.  In this autarky, the price of bananas in terms of fish is 1 in Bananaland and .5 in Fisherland (in other words, Bananaland needs to give up 1 fish to produce 1 banana.  Fisherland need only give up half a banana to produce 1 fish). The two countries open trade with one other and, given that both countries want to consume the same number of bananas after trade as before (an assumption made for simplicity; doesn’t change the story if we relax this), then the citizens of Bananaland agree to send 25 bananas for 37 fish (a price of .68).  To satisfy this, Bananaland stops producing fish and produces only bananas (they produce 50 bananas).  Fisherland cuts back on banana production to 25 but ramps up fish production to 150.  The day comes and the two trade.  Now, Bananaland consumes 25 bananas and 37 fish.  Fisherland consumes 50 bananas and 113 fish.  Their total economic well-being (crudely called “GDP”) is Bananaland: 62 (25+37) and Fisherland: 163 (50+113).

Bananaland, convinced their getting a bad deal following the lack of fishing in their country (remember, what was once a thriving industry) and the low prices they now pay, elect a protectionist on the grounds that he (and he alone) will “Make Bananaland Great Again!”  He promptly forbids all imports of fish from Fisherland.  They go back to their autarky ways.  Since Bananalanders now pay higher prices for their fish and more resources are devoted there than elsewhere, they can only consume 25 fish and 25 bananas.  Their GDP falls to 50!*  There was “pent up demand,” but the higher costs the various citizens now have to pay to even just consume the same amount they did before eats up that “pent up demand.”  The domestic manufacturing simply cannot supply it.

Adam Smith first explored this concept way back in 1776, and David Ricardo formalized it with the theory of Comparative Advantage.  Trade occurs for the simple reason that it provides people with better outcomes than other alternatives.  Other alternatives simply cannot provide the desired outcomes.

Update: I realized, as reading though this, I made a small math error.  It has been corrected.

*It’s worth nothing a similar decline happens to Fisherland, a nation where they can produce much higher levels than Bananaland.  Their GDP falls to 150.  Even their manufacturing cannot satisfy the “pent up demand.”

Even Under Mercantilist Theory, Trump is Wrong

Donald Trump is, to put it nicely, a fact-challenged person.  Makes sense; populists typically are (for example, see my many many posts on Bernie Sanders).  One of his arguments for his tariff schemes is that the US is “losing” at trade.  That argument is based off of a long-since-discredited economic theory known as Mercantilism, where the wealth of a nation is created by exports (Mercantilism was first challenged by Adam Smith in 1776, and later empirically discredited by David Ricardo in the 1800’s and subsequent waves of economists in the 1900’s and 2000’s).

But, even if we assume Trump is right about exports, he is still wrong on the facts.  The United States is, according to the World Factbook, the world’s largest exporter (excluding the EU).  The US exports $2.14 trillion of goods and services each year.  The closest competitor is China, who exports $1.51 trillion goods/services.  US exports are 41.7% higher than our closest competitor.  The US’ export market is the 8th largest economy in the world.  We export more than 196 countries produce.

Even under Mercantilist misunderstandings, the US still stands tall.

On (Im)Perfect Subsitution

Another Econ 101 mistake people make, especially with regard to immigration and international trade, is some form of “foreigners (immigrants) can do all the work we do but for much lower prices!  Without subsidies/tariffs/minimum wage, they’re just going to take all our jobs!”  Other versions of this include “if a bunch of immigrants enter the nation, they’ll drive down wages!  Law of Supply and Demand!”

Both the above arguments make the same mistake, namely they assume foreign labor is a perfect substitute for domestic labor.  They treat all labor (or all low-skilled labor) as a homogeneous blob, one part easily replaceable with another.  But, alas, that is not the case, as price theory can show us.

Looking simply at the wages of laborers, we should ask the question “why do immigrants/foreigners command lower prices than domestic workers?” The fact that there hasn’t been wholesale replacement of domestic labor with foreign means we can rule out any cultural/biological/cost-of-living reasons such as “lower cost of living in 3rd world” or “they have a lower standard of life and thus demand lower pay” etc.  If this were indeed the case, domestic companies could just pack everything up and ship it overseas (that is, stuff that can’t be staffed by immigrants) and make tons of profits (while I have no doubt some people believe that is what is happening, the data say otherwise).

What’s more likely is that foreign workers and immigrants are simply less productive than domestic workers.  Immigrants coming into the country, legal or otherwise, face major barriers, not the least of which is the language barrier.  The manager at McDonalds cannot simply fire an American order-taker making minimum wage and hire a foreign worker for half the cost. The foreigner, simply by virtue of not knowing the language, will be less productive, thus his lower salary.  A similar argument for offshoring can be made: foreign workers, by virtue of less capital augmentation, will be less productive and thus command lower salaries.

In short, foreign workers/immigrants are not perfect substitutions for domestic labor!

It may make sense for some firms to replace/augment domestic labor with foreign labor, but the mere fact it is cheaper is not the reason why.  David Ricardo’s powerful idea shows there are times it is prudent to replace more productive resources with less productive resources, but to do so on a large scale with disregard to opportunity cost is a recipe for disaster, and why firms and individuals do not do it.

Trump’s Tariffs Can’t Make America Great Again

For all his talk about “Make[ing] America Great Again,” Trump’s two man proposals, limiting trade (via punitive tariffs on “unfair” or “cheating” nations) and limiting immigration (via walls and watch lists) stand in direct opposition to that goal.  This blog post will focus on the first item (trade) and a follow-up post will focus on immigration.

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