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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LESSONS LEARNED #62: “The government’s great dilemma is that the middle class has both the money and the votes.” -Old Pithy

Posted by PITHOCRATES - April 21st, 2011

We’re Moving on Up

Those on the Left see the world through zero-sum eyes.  Especially taxes.  For example, let’s look at the taxes of a group of 100 people.  These one hundred can be broken down into three groups.  Poor (20), middle class (79) and rich (1).  With the following annual salaries.  Poor ($15,000), middle class ($50,000) and rich ($1,000,000).  Based on the 2008 tax tables (with a top marginal tax rate of 35%), they each pay $4,600, $17,000 and $454,000, respectfully.  The total each group pays, then, is $91,000 (poor), $1,342,000 (middle class) and $454,000 (rich).  Which is 4.8%, 71% and 24%, respectfully, of the total tax paid.  The largest group of people pays the largest percentage of the total tax burden.  The middle class.  (All numbers are approximate.)

Now, let’s do a little zero-sum analysis.  And figure out how to make the rich pay a larger share of the taxes.  Hmmm.  How about we raise the tax rate on the rich?  If we raise the top marginal tax rate to 45%, the taxes the one rich person pays goes from 24% to 28%.  And the taxes the middle class pay goes from 71% to 68%.  So, to reduce the tax burden on the middle class, we simply have to raise the top marginal tax rates.  Simple, right?  Wrong.  Because what happens in reality is the opposite of what most would think.  As you raise the tax rate on the rich, the total tax burden shifts from the rich to the poor and middle class.  Why?  Because of one fundamental flaw in their analysis.  Which is this.

http://www.youtube.com/watch?v=p9y4iXAso4I

Life is not zero-sum.  People don’t always stay in the same economic class.  They work hard.  Earn money through the years.  Some even save enough money to open a business.  And some of these do become rich.  And when they do, they pay a lot more taxes than they did when they were poor or middle class.  And this is the very thing that high marginal tax rates discourage.  Upward economic movement.  As the poor move into the middle class.  And the middle class move into the rich class.  This is why low, not high, tax rates shifts the tax burden from the poor and middle class to the rich.  Because low tax rates make more rich people to tax.

The Roaring Twenties were Kicked off by Tax Cuts

Andrew Mellon was a rich banker.  Who understood business.  Warren G. Harding tapped him to be his Secretary of the Treasury.  World War I was over.  And there was a huge war debt to pay off.  Taxes were high.  And the progressives wanted to raise them higher.  But Mellon was a conservative.  And he knew that you just didn’t stimulate economic activity with high taxes.  And that’s what paid the bills.  Economic activity.  People gainfully employed and paying taxes.  So he cut taxes.  They cut the top marginal tax rate from 77% to 25% (a cut of 68%).  Which gave us the Roaring Twenties.  Electricity, appliances, radio, you name it, the modern age had come.  Everyone was working.  And buying stuff.  Times were good.

Sure, you’re saying, but at what cost?  The economy took off into the stratosphere but the rich got a free ride.  With their tax rate cut of 200%, the poor and middle class must have been stuck with the tax bill.  Right?  Wrong.  With the lower tax rates, the rich found it cheaper and easier to pay taxes than to shelter it.  Also, the lower rates encouraged innovation (i.e., the modern age).  Lots of people got rich.  There was a lot of upward movement through the economic classes.  So there were more rich people paying taxes.  In 1920, the very rich paid approximately 30% of all federal income taxes.  That number jumped up to 62% by 1929.  That’s an increase of 108%. 

If the name of the game is funding government, you got to like what happened in the Twenties.  Because the government got fat on tax receipts.  And the richest of the rich were paying about twice the amount of taxes they were at the beginning of the decade.  That is a huge transfer of the tax burden from the poor/middle class to the rich.  And the federal debt?  It fell from about $26 billion to $17 billion.  That’s a decrease of about 35%.  Lower tax rates, tax burden transferred to the rich and a lower debt.  Wow.  Mellon was right.  Cutting tax rates on the rich works.  And it works very well.

The Eighties Economic Boom was Kicked off by Tax Cuts

Ronald Reagan was another conservative who understood business.  He defeated Jimmy Carter who was trying to win a second term.  But the malaise and stagflation of the Jimmy Carter years made him a one-term president.  To lift the nation out of recession, Reagan did like Andrew Mellon.  And cut taxes.  The top marginal rate dropped from 70% to 28% (a 60% cut).  And economic activity exploded.  Especially in Silicon Valley.  And the world went high-tech.  Electronics and computers entered our lives.  A new modern age had come.  Everyone was working.  And buying stuff.  Times were good.  Again.

At the beginning of the Reagan years the top 1% paid about 19% of all income taxes.  At the end of his second term they were paying about 27.5%.  That’s an increase of 44%.  Once again, tax cutsfor the rich transferred the tax burden from the poor/middle class to the rich.  As in the Twenties, the rich found it easier to pay their taxes rather than trying to shelter it.  Also, the lower rates encouraged a lot of entrepreneurial innovation.  We used the first cell phones and personal computers in the Eighties.  A lot of this innovation started small in someone’s garage.  And ended in an IPO on Wall Street as they took their companies public.  Lots of people got rich.  Creating a surge of upward movement through the economic classes.  Making many more rich people to tax. 

The Reagan years were an economic juggernaut.  A lot of people got rich.  But at what cost?  The debt exploded under Reagan.  So those on the Left jumped on this.  They say his tax cuts mortgaged our future.  Impoverished our children.  By not paying our bills along the way.  To that I say, “Nice try.”  That debt had nothing to do with the Reagan tax cuts.  It was a spending problem.  Federal tax receipts in 1980 were $517 billion.  After Reagan’s tax rate cuts, they jumped to $909 billion in 1988.  That’s an increase of about 76%.  Lower tax rates, tax burden transferred to the rich and a 75% increase in federal tax receipts?  Wow.  Reagan was right.  Cutting tax rates on the rich works.  And it works very well.

Conservative Policies Favor the Poor and Middle Class

So there are two great economic booms created by tax cuts.  Both periods lifted the country to a new modern age.  People’s standard of living improved across all economic classes.  And a lot people moved up through the economic classes.  Which is key to the success of tax cuts.  And the reason why those on the Left ignore this and focus instead on zero-sum policies.  Why?

Because the Left knows their economic policies don’t work.  But that’s okay with them.  For their policies aren’t about the economy.  Or your well being.  They are about political power.  There are more poor and middle class people than rich.  No matter how far you slash the top marginal tax rate.  So that’s where the votes are.  And a good way to get those votes is with class warfare.  The rich have an unfair advantage.  And with your vote, they will right that wrong.  Sounds good.  Especially if you’re not rich.  Or don’t know the history of high marginal tax rates.  Of how they transfer the tax burden from the rich to the poor and middle class.

Of course, there’s a problem with this strategy.  It transfers more and more of the tax burden to the people you need votes from.  And the more you choke off economic activity by taxing the rich, the more you starve the treasury of tax dollars from the rich.  Which means you have to come up with more and more clever ways to bleed the middle class.  And they don’t have a problem with this either.  What they have a problem with is that the middle class may figure this out one day.  And vote conservative.  Whose policies actually favor the poor/middle class.

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