Trade and the global economy

In part of my new MFin elective Understanding the Global Economy and Financial System I explore the changing views of economists on international trade, which has been one of the most powerful causes of global economic growth over centuries.


The traditional view of trade – correct but incomplete

The reason why trade works is specialisation. If everybody had to feed, clothe and heat themselves then they would have no time to get particularly good at any one thing. Even quite simple societies involve specialisation (farmers, blacksmiths, doctors, priests, soldiers) in which overall productivity is higher because people do one or two things well and trade with others for the rest of their needs.

This logic applies at every level in an economy. The idea of international trade is that productivity will be higher, the larger is the opportunity for specialisation. This idea is in Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations, still one of the most important and original books in the history of modern thought. Smith was the first person to identify the value of specialisation through the division of labour, which he said was limited only by the size of the market. So, the larger the market (more countries), the greater the potential division of labour and productivity gains.

Specialisation brings static benefits – avoiding the transaction costs of having to keep switching between activities (we now call this multi-tasking, and it’s as inefficient now as it always was) – and more importantly the dynamic benefit of learning by doing. If you do something a lot you get better at it and find ways to get better still.

Comparative advantage: specialisation at the country level

The earliest analysis of the benefit of international trade was by another classical economist, David Ricardo, who developed the concept of comparative advantage in the early 19th century. There were two important themes in this idea. Firstly, Ricardo was arguing against the widespread so-called mercantilist view that countries should maximise their trade surplus, meaning they accumulated as much gold or silver from international trade as they could. He argued that the purpose of trade was to improve overall income or wealth and that free trade would typically do this.

The second point is why free trade would typically be beneficial to both countries, not just the nation which “won” by running an export surplus over imports. It was already clear to most people that if two countries had complementary specialist skills, they could trade to mutual benefit. Suppose the UK is specialised in, and therefore good at, producing cloth; and that Portugal is good at producing wine. It seems obvious that they can do better by each specialising in what they’re good at and trading with each other: Portugal exporting wine and importing British cloth. This idea, that countries specialise in the activity where they enjoyed an absolute advantage, was already clear from Adam Smith.

But Ricardo showed that even if Portugal was relatively more efficient than Britain at producing both wine and cloth (which it was in the late 18th century but not for long, as the British textile industry began its rise to global dominance) there would still be mutual gains from specialisation. Portugal and Britain, he argued, should specialise in the activity where each had a comparative advantage. This would probably then, as now, mean Portugal put its resources into maximising wine production while the UK produced cloth. Even though Portuguese cloth would be cheaper than English cloth, the maximum wealth would be created by specialisation and trade.

This idea is not so obvious as absolute advantage but remained the base case for free trade for many years. It is true only under limited conditions (like all economic theories). It assumes that the technology of production is fixed or given, whereas of course it can and does change. It assumes full employment. It assumes that a country is happy to depend entirely on imports for some, possibly important resources.

Comparative advantage theory could be used to argue that less developed countries should stick to their comparative advantage in agriculture or other resources, and give up any attempt to produce their own manufacturing industry. In other words, just accept a static and historically given comparative advantage. It’s true that some countries which tried to challenge this wasted a great deal of resources (including several African nations which tried industrialisation after independence). But there are some very successful economies in Asia which defied the static view of comparative advantage and deliberately built up their manufacturing industries, using protection (i.e. blocking imports) to do so. Without such policies, South Korea would not be the rich nation it is today.

But a different approach to countering free trade was less successful. South Korea (and Hong Kong, Taiwan and later Thailand, Malaysia, Indonesia and mainland China) emphasised export-led growth. Several Latin American countries, embracing a set of theories known as dependency theory, tried to replace imports from richer countries with their own domestic production – import substitution.

This was much less successful. It seems clear now that having export industries means businesses are forced to be efficient, competitive, customer-facing and dynamic. Import substitution by contrast risks leading to uncompetitive, lazy businesses who know that they have a protected market and needn’t work hard to satisfy customers. So not all types of state intervention in free trade are helpful.

A related idea: trade driven by factor endowments

Ricardo’s comparative advantage largely concerned differences in national technology, broadly defined as  a way of doing things. A different explanation for international trade lay in the theory of differing national endowments of the factors of production, namely capital and labour. The idea is complementary to Ricardo’s and seeks to explain (part of) the origin of comparative advantage. A country abundant in labour will tend to develop advantage in goods which require more labour to produce. It’s the ratio of labour to capital that matters, what economists call the “relative endowment”. A big economy may have more of both than a smaller economy. But the theory predicts specialisation based on the relative abundance of factors.

There is little doubt that the relative scarcity of labour is important for explaining some economic development. While capital is relatively mobile, labour is not, except over longer periods or during episodes such as the north Atlantic slave trade. The economics of the Caribbean plantations and agriculture in the southern state of the US was obviously closely related to the (artificial) abundance of cheap labour. Less brutally, the huge emigration from Europe to the US affected the sort of economy that would be efficient in the early 20th century.

Now the US has lots of capital and labour, the latter owing to continued immigration. We see in the US both highly advanced manufacturing which uses a great deal of capital (including human capital) and labour intensive services (New York hotels have so many people running around, all hoping for a tip, that a Pakistani friend of mine refers to the US as the world’s richest third world country).

But factor endowments have limited explanatory power in today’s world. Likewise, traditional comparative advantage that relies on exclusive technology no longer fits. The know-how to do things is now portable and increasingly easy to discover internationally. Multinational companies take their technology (not just capital equipment but management skills) to any country they want to locate it. There is more to trade that needs to be explained.

New trade theory: increasing returns to scale

The world of comparative advantage is one in which countries exchange discrete objects based on their supposed productive efficiency. Country A produces wheat, country B produces TVs. While that was true for much of 19th century and early 20th century trade, by the 1970s economists had begun to notice that a great deal of trade was between rich countries which produced fairly similar things. So Europe, the US and Japan all traded manufacturing goods with each other. It  was hard to argue that any of them had clear comparative advantages. The reality was that consumers liked a choice among varied types and brands of cars, TVs, cookers and so on. These were produced by different companies in different countries, competing for the wealthy (by global standards) consumers in many different nations.

This form of industrial competition is known to economists as monopolistic competition, a situation where there are a lot of producers but the products are not identical (as they are in the textbook ideal of perfect competition). Branding, advertising, design are critical parts of modern manufacturing, though cost of production also still matters.

A second important economic concept enters the story here: increasing returns to scale. This means that average production costs fall as the scale of production rises. This is not a new idea but textbook economics and the economics of free trade tended to assume that returns might increase for a while but would eventually be constant or even falling. That meant little or no advantage to ever greater production. But the evidence of the 1970s and 1980s was that there were important cost advantages in scale, for which a larger market was needed.

The so-called “new trade theory” of the 1980s brought these ideas together and argued that large multinational manufacturing companies chased foreign demand through exports because it gave them lower average costs. The logic was of fewer but larger companies competing globally for consumers’ spending.

This was bad news for smaller or less economically developed countries which lacked a big home market. It suggested their fledgling manufacturing companies couldn’t compete with the existing leaders, in the major global industries such as car production. Nonetheless, some developing economies ignored the combined arguments of comparative advantage and increasing returns and built up their domestic car industries behind import barriers, reasoning that a flourishing car industry, with all of its associated component suppliers, was the only way to build a modern industrialised economy.

This might not have worked out (though once again South Korea was successful, through a mix of working with established suppliers such as General Motors, importing foreign expertise from the UK and patiently supporting domestic firms). But a new phase in trade was starting in the 1980s, which has changed the pattern of exports and imports.

Global supply chains

Everybody has heard of global supply chains, even though research suggests they are more accurately thought of as mostly regional. Multinational companies can now organise their production across multiple sites, factories and countries to achieve the lowest cost and greatest flexibility. This became possible through the use of advanced information and communication technology, chiefly the Internet. There are costs to creating and managing complex supply chains across many locations and countries. These costs have fallen with improvements in information connectivity.

So it’s now well known that companies can spread their production around the world to minimise costs. It means that a finished item such as a car, a mobile phone and even a humble t-shirt, may involve several different stages of production across many countries, with components, sub-assemblies and semi-finished goods repeatedly crossing their way across key borders such as the US/Mexico or Japan/South Korea/China.

But “global” is a slightly misleading label. Richard Baldwin and Javier Lopez-Gonzalez analyse data (see below) from input-output tables (matrices of flows of goods from one industry to another) and show that there are four main manufacturing hubs: North America, Germany, China and Japan. Each is at the centre of a network of trade flows which involve multiple import and export flows across the same national boundaries. Unsurprisingly in the last 20 years the balance has shifted away from North American and Germany towards China.

This shift appears as very large imports from China to rich countries (but also very large exports from South Korea, Japan and Taiwan to mainland China). But what matters for economic welfare is value added. This means more or less what it sounds like. If I buy some steel and turn into a fork, the difference between what I sell the fork for and what I paid for the steel is value added, which is either paid in wages or profit or taxes to the government. As is also well known from the work of Kraemer, Linden and Dedrick (2011), although the iPhone and iPad are assembled in southern China, most of the value added arises outside China, in particular going to Apple in the US (58% of the sales price of the iPhone in 2010 showed up as Apple’s profits – the amount that went to Chinese labour costs was 2%).

Assembling components is not a source of high value added, which is why China is trying (successfully) to move up the value chain, leaving low-cost assembly to the remaining low labour cost economies such as Vietnam. But it appears likely that low cost assembly will be replaced by automation before long, leaving low labour costs as a weak basis for attracting foreign investment. Shenzhen, the world’s largest manufacturing hub, is building on its original success as a cheap place to build things, and now turning into a centre of innovation in its own right.

The future of trade

Regional supply chains may yet become more global and more countries may join in, allowing a more complex and cheaper division of labour. Most trade is currently in goods but services are growing too. By their nature, many services (haircuts, restaurant meals) are local and cannot be traded. But many other services are amenable to digitisation and we may be in the early stages of the offshoring of many  services.

But there is also the possibility that trade growth, which has recently slowed, will reverse. Protectionist pressures in the US and to a limited extent in parts of Europe, may lead to barriers being erected to free trade. There is no doubt that the benefits of trade, which are enormous in aggregate, have not been spread evenly. Much of the decline in US high skill manufacturing jobs has been the result of technological change, but some has been caused by competition from China (or we should say, from Asian manufacturing supply chains centred on China). There is minimal chance of these jobs returning but that doesn’t mean politicians won’t try, possibly causing great economic losses as they do.


M. Melitz and D. Trefler (2012) “Gains from trade when firms matter” (Journal of Economic Perspectives Spring

Kenneth L. Kraemer, Greg Linden, and Jason Dedrick (2011) “Capturing Value in Global Networks: Apple’s iPad and iPhone”

Richard Baldwin and Javier Lopez-Gonzalez (2015) “Supply-chain Trade: A Portrait of Global Patterns and Several Testable Hypotheses” The World Economy

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