Magazine article Regulation

Brain-Focused Economics: More Than Just Comparative Advantage: Economists since Adam Smith Have Understated the Welfare Gains from Free Trade

Magazine article Regulation

Brain-Focused Economics: More Than Just Comparative Advantage: Economists since Adam Smith Have Understated the Welfare Gains from Free Trade

Article excerpt

When his administration imposed substantial tariffs on steel and aluminum imports in early 2018, President Trump ignored more than two centuries of economic thinking and research. That scholarship fortified Adam Smith's key insight in The Wealth of Nations: tariffs and other trade restrictions are (except under very narrow conditions) counterproductive. They restrict the scope of markets, curb scale economies (especially those generated through specialization of labor and other resources), encourage rent seeking, and ultimately undercut employment and synergetic growth in the jobs, incomes, and wealth of trading nations. (See "How's Your Trade War Going?" p. 4.)

As sound and powerful as Smith's free-trade arguments are, modern economists who have followed in his intellectual footsteps continue to understate the gains from unfettered trade. Accordingly, they also understate the short- and long-term economic damage done by the type of trade restrictions Trump has imposed, even without the compounding damage of retaliatory trade barriers erected by other countries.

What modern free-trade economists continue to overlook in trade theory is that market participants are not innately prone to hone their market decisions with the precision and correctness that conventional economic theory assumes. In conventional (neoclassical) economists' idealized models of economies, the competitive market forces let loose by open trading can't improve decision making. All decisions are assumed to be perfect, as in "perfectly rational."

In real-world markets inhabited by decisionmakers who have evolved flawed mental resources and thinking processes, competitive market forces can reduce decision-making flaws and thus lower production costs and raise real incomes by more than conventional economists have heretofore claimed. Flawed decisionmakers are led by competitive pressures, as if by an 'invisible hand," toward (not to) improved (not perfect) decision heuristics that, when adopted--even grudgingly--add to the otherwise achievable gains from trade.

Let me explain those audacious claims by returning to the conventional case for open markets and then by briefly laying out a few of behavioral economists' major findings on pervasive flaws in human decision making, captured--supposedly--in an array of identified mental "biases."

THE TRADITIONAL CASE FOR FREE TRADE

In The Wealth of Nations, Smith developed the essentials of modern free-trade theory. Countries will tend to export those products in which they have an (absolute) cost advantage and import those products in which they have a cost disadvantage. That means that trade between people in different countries can reduce production costs and increase the real incomes of all trading countries, achieved mainly through an improved allocation of world resources. Smith's reasoning had folksy roots: "It is the maxim of every prudent master of a family never to attempt to make at home what it will cost him more to make than to buy."

In the early 19th century, David Ricardo fortified Smith's case for free trade. Ricardo observed that mutually beneficial trades are possible even under seemingly unfavorable conditions, such as when one country has efficiency and absolute cost advantages in all goods produced than another country. He reasoned that comparative costs--not absolute costs--in production matter in directing the flow of goods in and out of countries.

To make Ricardo's point, suppose that the United States is more productive than China in both aircraft and smartphones and, consequently, can produce more of either in total and with the same resources. However, suppose that the United States can produce an additional aircraft by forgoing the production of a boatload of smartphones. An additional aircraft built in China, on the other hand, requires forgoing the production of 10 boatloads of smartphones.

If the U. …

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