Wednesday, April 14, 2010

The idea of comparative advantage is not dead!

Pascal Lamy on Krugman, Samuelson and comparative advantage:
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“At the outset, let me recognize Paul Krugman’s intellectual contribution to international trade theory — the so-called “new trade theory” — in which he shows that, even in the absence of productivity differences between two countries, trade benefits them both. He focuses on the presence of increasing returns to scale, in which a firm’s average cost per unit declines as production increases and underscores that consumers value variety in consumption. While the new trade theory reduces the role played by comparative advantage, it identifies new sources of benefits from trade that were not emphasized or recognized by the classical economists. More trade benefits all countries because specialization in production reduces average cost and consumers gain access to a wider variety of products. In contrast, traditional theories of trade assume the variety of goods remains constant even after trade-opening.
 
There is a much-cited paper by Paul Samuelson in the Summer 2004 issue of the Journal of Economic Perspectives which showed theoretically how technical progress in a developing country like China had the potential to reduce the gains from trade to a developed country like the United States. This paper appeared to be a dramatic about-face against the idea that open trade based on comparative advantage is mutually beneficial.

There is a much-cited paper by Paul Samuelson in the Summer 2004 issue of the Journal of Economic Perspectives which showed theoretically how technical progress in a developing country like China had the potential to reduce the gains from trade to a developed country like the United States. This paper appeared to be a dramatic about-face against the idea that open trade based on comparative advantage is mutually beneficial.

I emphasize the word “appeared” because subsequent analysis by Jagdish Bhagwati, Arvind Panagariya, and T. N. Srinivasan contradicted this view. In that paper, starting from autarky, China and the United States open up to trade and experience the usual gains based on comparative advantage. In the following part of the paper, Samuelson considers how technological improvements in China will affect the United States. In the case where China experiences a productivity gain in its export sector, both countries benefit. China gains from the higher standard of living brought about by the increase in productivity while the United States gains from an improvement in its terms of trade. In the case where China experiences a productivity gain in its import sector, there is a narrowing of the productivity differences between the countries which reduces trade; and as trade declines, so too do the gains from trade.

So what Samuelson has showed is not that trade along lines of comparative advantage no longer produces gains for countries. Instead, what he has shown is that sometimes, a productivity gain abroad can benefit both trading countries; but at other times, a productivity gain in one country only benefits that country, while permanently reducing the gains from trade that are possible between the two countries. The reduction in benefit does not come from too much trade, but from diminishing trade. Furthermore, even in this case, Samuelson himself does not prescribe protectionism as a policy response since, as he put it ,“what a democracy tries to do in self defense may often amount to gratuitously shooting itself in the foot”.

In my view, the analysis by Bhagwati, Panagariya and Srinivasan should convince us that the principle of comparative advantage, and more generally, the principle that trade is mutually beneficial, remains valid in the 21st century.”

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Lamy attempts to debunk some fallacies in trade discussions:

  • Fallacy #1: Comparative advantage does not work anymore
  • Fallacy #2: It is unhealthy for trade to grow faster and faster compared to output (there is a problem with the way we interpret (and measure )volume of trade and value addition)
  • Fallacy #3: Current account imbalances are a trade problem and ought to be addressed by trade policies.
  • Fallacy #4: Trade destroys jobs
  • Fallacy #5: Trade leads to a race to the bottom in social standards.
  • Fallacy #6: Opening up trade equals deregulation

It is worth reading the full text.

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