Comparative Advantage and Free Trade

Posted by PITHOCRATES - May 21st, 2012

Economics 101

Mercantilism benefited only Protected Industries which Profited Handsomely from Higher Consumer Prices  

The Age of Discovery ushered in the era of mercantilism.  An era of trade.  But protected trade.  Tariffs, quotas, protectionism, restrictions, subsidies, etc.  You name it they used it.  To favor their trade position and their domestic industries.  And to restrict that of everyone else.  For mercantilism was a zero-sum game.  You only did well if others did not.  A thought that still has traction today.  Especially in older, inefficient industries.  That cannot compete with international competition that provides better quality at lower prices.  Such as textiles.  Steel.  Automobiles.  The Americans protected these industries in the face of better foreign competition.  Which only hastened their decline.

A protected industry has no incentive to improve.  When protective tariffs raise prices of lower-priced and higher-quality imports consumers buy the inferior domestic goods.  Because the tariffs make the better goods more costly.  So when a business has a captive audience their only focus is in maintaining that protectionism giving them that advantage.  Not improving their quality.  Or improving their productivity to lower their prices.  Why?  Because they don’t have to.  So prices continue to rise to pay for inefficient labor and management.  And quality continues to decline due to the lack of real competition forcing them to continually provide a better product.  By improving designs.  Production methods.  And making capital investments in new machinery and equipment.

This is the cost of protectionism.  Poorer quality and higher prices.  Because of the misguided belief in the zero-sum game of mercantilism.  There was a reason why mercantilism was abandoned for free trade.  Because free trade was better.  For consumers.  Giving them lower prices and higher quality.  Whereas mercantilism benefited only those protected industries which profited handsomely from those higher consumer prices.  And the government officials who granted those favorable protectionist policies.

The Consumer gets Lower Prices AND Higher Quality thanks to the Division of Labor, Specialization and Comparative Advantage

As civilization advanced so did the division of labor.  People began to specialize.  Instead of growing our own food, making our own tools, spinning our own pottery, etc., we did only one thing.  And did it well.  Then we traded the things we made for the things we didn’t make.  This division of labor created a middle class.  And this middle class would take their goods to market to trade with other middle class artisans.  At first bartering with each other.  Trading good for good.  Then they introduced a temporary storage of value into the economy.  Money.  Making those trades easier by reducing search times.  Trading your goods for money.  And your money for goods.  Making life a lot simpler at the market.

Let’s take a closer look at the division of labor.  Let’s consider two artisans.  A toolmaker.   And a potter.  Both are skilled craftspeople.  And can make an assortment of goods.  But each excels at one particular skill.  The toolmaker can make 10 plows a day.  But if he makes 2 pottery bowls he can only make 4 plows in that same day.  The potter can make 12 pottery bowls in a day.  But if he makes 3 plows he can only make 5 pottery bowls in that same day.  Each can make more of their specialty.  But when they try to make other things in addition to their specialty they can’t make as much of their specialty as before.  So there is a cost to the toolmaker to make pottery.  To make 2 bowls cost the toolmaker 6 plows.  And there is a cost to the potter to make tools.  To make 3 plows cost the potter 7 bowls.  So the economy as a whole is better off when the toolmaker and the potter focus all of their energies in their own specialty.  When they do we get 10 plows and 12 bowls in one day.  When they don’t we only get 7 plows and 7 bowls.

We call this economic principle comparative advantage.  Where we look at economic output.  Which is what matters.  The more we bring to market the better it is for consumers.  Because greater quantities mean lower prices.  And when these skilled craftspeople focus on their specialty they improve the overall quality of the goods they bring to market.  So the consumer gets lower prices AND higher quality.  Thanks to the division of labor.  Specialization.  And comparative advantage.

We will always Have Jobs regardless the Size of our Imports for Having a Job is the Only Way to Buy those Imported Goods

If you multiply this over and over again to represent all the individual economic exchanges throughout the world you see why free trade is better than the protectionist policies of mercantilism.  Because it provides consumers with greater economic output at lower prices and higher quality.  This is why nations practicing free trade have the highest standards of living.  Because their people can walk into large department stores and fill their carts with inexpensive, high quality goods on a moderate paycheck.  Which could never happen if the mercantilists had their way.

The old inefficient industries want tariffs to increase the costs of those goods we fill our shopping carts with.  Including the food we eat.  And the cars we drive.  They use lofty arguments about protecting American jobs.  But those protectionist policies destroy jobs by increasing costs for businesses throughout the supply chain.  Raising consumer prices everywhere.  Reducing the amount of things we can buy.  Meaning businesses can’t grow and create new jobs.  Or they have to cut back production and eliminate existing jobs.

There’s also a lot of talk about the balance of payments.  Which actually meant something during the days of the gold standard.  For any trade deficits had to be paid for with gold.  But we don’t have the gold standard anymore.  Governments everywhere abandoned it in favor of irresponsible government spending.  So we don’t have to pay for trade deficits with gold.  Most money today is just electronic entries in a computer.  International capital flows have never been greater.  There are currency markets where people actively trade the world’s currencies.  So trade deficits don’t mean the same thing they once did in the mercantile world.  Then there’s the argument that if all our manufacturing jobs go overseas there will be no jobs for Americans.  If we import everything and export nothing there will be jobs everywhere but here.  Sounds like a problem.  But can that happen?  Not unless we get those imports for free.  So we will always have jobs regardless the size of our imports.  For having a job is the only way to buy the imported goods in those department stores.

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Business Cycle

Posted by PITHOCRATES - February 13th, 2012

Economics 101

When you have a Captive Audience you can Charge whatever Prices you Want

Go to a football game lately?  Hockey?  Basketball?  Baseball?  It’s a pretty expensive day out.  Especially if you eat while in the stadium.  Those concession prices are pretty steep.  In fact, people say that stadium food is some of the most expensive food anywhere.  I don’t.  I say it is some of the highest quality and some the most fairly priced food you’ll find anywhere…in the stadium.

Stadium food is convenient food.  And that’s what you’re paying for.  Convenience.  Because it’s too great of an inconvenience to leave the stadium to buy a more reasonably priced hotdog someplace else.  And despite what the critics say of concession pricing, those concessions have long lines.  Because people may say the prices are too high.  But deep down they know what a bargain they are.  Delicious food cooked and sold only steps away from their seat.  It’s better than at home.  And there’s no cleanup.

When you have a captive audience you can pretty much charge what you want.  Because the market is fixed.  Stadiums charge a fortune for those concession spaces.  Because running a big stadium is expensive.  And it’s not really used all that often.  I mean, there are only 8 home games in the regular season in football.  Doesn’t give the stadiums much time to earn revenue to pay for these expensive things.  So they charge high fees wherever they can.  So the concessioners have to pass that cost on to the customer.  As all businesses do.  And when you have a captive audience it’s a whole lot easier to do this.  Because, where else are the people going to go?

Competition Increases Quality and Lowers Prices for Consumers

Let’s look at this in another way.  Say you have a friend who works for a catering company.  He drives a ‘roach coach’.  He stops at the factories and local construction site to sell food to hungry workers.  He sees the money these trucks make.  Considers his paycheck.  And thinks he’s tired of making his boss rich.  So he buys a truck for himself.  And looks for his own territory.

Now let’s say you go on an evening bike ride on weekends.  And you come across your friend.  He’s found some prime real estate to park his roach coach on.  In the median of a boulevard across from an automobile assembly plant gate.  Where he has a captive audience.  Hungry workers working the midnight shift with no place else to buy delicious food.  Business is good.  You stop by on your bike ride and buy a snack and chat.  Then one night you noticed a beat up Ford Pinto pull up in the median not far from your friend’s truck.  He pops the hatch.  And you start smelling something.  Something good.  Fresh pizzas.  And hot fresh subs.  This guy owns a pizzeria.  And just closed for the night.  After filling his car with fresh pizzas, hot fresh subs and soda.  And just like that business wasn’t so good for your friend anymore.  For fresh pizza and hot fresh subs are more delicious than the sandwiches and cans of stew your friend was selling.  But one thing the Pinto didn’t have that your friend did.  Ice.  He was selling warm soda.  Or trying to.  Your friend had cold soda.  And that was just what the doctor ordered on a hot, humid, summer night.  Your friend was now sharing his captive audience.  Selling less than he was.  And at lower prices because of this new competition.  But he was still able to turn a profit and make his truck payment.

Then the Pinto guy took it up a notch.  One night, as the workers headed out into the median on break, he pulled out a tub filled with ice.  And soda.  “Cold soda,” he barked.  “Ice cold soda.”  This squeezed your friend’s sales even more.  He had nothing left to compete with but price.  So he lowered his prices even further.  Barely breaking even.  Then one night someone else pulled up on the median.  A beat up AMC Gremlin.  Some kid just out of high school got out.  Popped the hatch.  And started barking, “Fresh McDonald Big Macs.  French fries.”  And, of course, ice cold soda.  The kid didn’t have a lot.  But what he had he was selling at a nice markup.  Which was enough for him.  Because he had no overhead.  And made enough to by some beer later that night.  A very modest sales goal.  But it split that captive audience three ways.  Soon your friend was losing money.  Then the economy went into recession.  And they discontinued the midnight shift.  Your friend lost his truck.  And went back to driving a truck for his former boss.  The Pinto guy increased his pizzeria’s delivery radius to make up for the loss business.  And hired the Gremlin kid to help with those deliveries.

The Business Cycle is a Natural and Necessary Part of the Economy and is the Only Way Supply adjusts to Demand 

From the perspective of the workers increasing competition made things better.  Competition gave them more variety.  Higher quality.  And lower prices.  Over time that competition gave them more value for their money.  This microcosm of the economy was booming for awhile.  Others jumped in.  Making investments.  Increasing their inventories.  But eventually they expanded too much.  Supply exceeded demand.  Some inventory went unsold.  Prepared food not being something you can return these people had no choice but to cut their prices.  To reduce those burgeoning inventories.  The guy with the highest overhead, your friend with the catering truck, was the first to fail.  Then the market collapsed completely with the elimination of the midnight shift.  So the other two had to shutter their operations there.

We call this the business cycle.  It’s the boom-bust cycle of the economy.  From good economic times (boom) to recessions (bust).  It’s the natural ebb and flow of economic exchange.  When the market presents a demand to be met supply flows into it.  At first prices and profits are high.  Like at a stadium with a captive audience.  Then competition moves in.  Unlike at a stadium.  That demand is now split between the competition.  Each sells less.  And profits less.  To try and increase sales they try to offer better value for the money.  Tastier food.  Colder soda.  Etc.  When that doesn’t work any longer they start lowering prices.  But because supply built up so much as eager competitors joined in get a piece of that action supply grew so much it exceeded demand.  And no amount of price cutting can fix that.  Only a recession.  To reset prices and supply to meet market demand.  Which means some businesses fail.  Those who don’t lay off employees.  To reset their prices and production to levels that meets demand.

Monetary and fiscal policy tries to massage this business cycle.  By softening the recession part of it.  By lowering interest rates.  To encourage businesses to invest and expand production.  And hire more employees.  Or by increasing government spending.  Creating jobs by building roads and bridges.  Or by simply giving more money to consumers (via tax cuts or stimulus checks) to encourage them to buy more.  Thus encouraging businesses to hire more workers.  To meet this ‘higher’ demand.  Of course, in our example, this wouldn’t have helped our three businesses.  None of them would have borrowed cheap money to increase supply.  Not when supply already exceeded demand.  In fact no amount of monetary or fiscal policy action would have helped.  It certainly wouldn’t have added back that midnight shift.  Unless the government started buying cars for people.  Which might have put people back to work on that midnight shift.  But such an expansion of government spending would have increased taxes.  So high that it would have reduced economic activity elsewhere.  As it transferred this money out of the private sector and into the public sector.  Saving a few jobs at the cost of consumers everywhere paying higher taxes.

The business cycle is a natural and necessary part of the economy.  It’s how supply adjusts to demand.  And the only way supply adjusts to demand.  Thanks to prices.  That automatic mechanism that tells businesses exactly where supply should be.  And by interfering with this you make markets operate blindly.  Unable to know when supply exceeds demand.  So supply keeps increasing even after it already exceeds demand.  Creating bubbles.  And when the bubble bursts prices plummet.  To unload those burgeoning inventories.  Making recessions longer and more painful than they need be.

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