The Economic, Political, and Social Implications of International Trade on Equality
Dean Dudley1
The United States is in the final stages of negotiating the Trans-Pacific
Partnership (TPP), a massive free-trade agreement with Mexico, Canada, Japan,
Singapore and seven other countries. Who will benefit from the TPP? American
workers? Consumers? Small businesses? Taxpayers? Or the biggest multinational
corporations in the world?
- Senator Elizabeth Warren2
Changes to international trade policy always involve trade-offs. As Senator Warren
stated, there will be those who benefit from more open and freer trade; more ominously, many
will lose. Who wins and who loses depends on a number of factors, including a nation’s
economic, political and social institutions, factor endowments and geography. To effectively
evaluate changes to the current international trade environment, we must first understand the
economics of international trade. We can then consider how political institutions and social
norms distribute the costs and benefits of changes in international trade policy across individuals
and social subgroups. Finally, we will be in a better position to understand how inequality in a
given state impacts international trade policy, and how changes in the international trade policy
might increase or alleviate domestic inequality.
1
The views expressed in this article are personal and do not reflect the official policy or position of the United
States Military Academy, Department of the Army, Department of Defense, or the United States government.
2
Warren, Elizabeth. “The Trans-Pacific Partnership clause everyone should oppose.” Opinion, Washington Post,
(25 Feb 2014): Retrieved: https://www.washingtonpost.com/opinions/kill-the-dispute-settlement-language-in-thetrans-pacific-partnership/2015/02/25/ec7705a2-bd1e-11e4-b274-e5209a3bc9a9_story.html
2
The Economics of International Trade and Factor Price Equalization
Adam Smith’s Wealth of Nations (1776) revolutionized the way we think about
international trade. Smith started by outlining the productive advantages of specialization. As an
example of a complex production process – a task broken down into subordinate tasks so that
workers can specialize and become more proficient – Smith famously described a pin factory.
One worker extrudes wire, a second cuts the wire to length, a third puts a head on the wire, and a
fourth polishes the wire to a point, completing the pin. Smith contends that specialization allows
these four workers, working together, to produce more pins than if they were to work as
craftsmen, each manufacturing pins through all four steps.3
Smith and Absolute Advantage
Adam Smith also developed the concept of absolute advantage. Suppose England is
exceptional at producing cloth, and Portugal is truly exceptional at producing wine. England and
Portugal could find mutual benefit in specializing in the product they excel at making and trading
for the product they do not excel at making. If Portugal were to produce more wine by putting its
cloth makers to work in the vineyards, and England were to place its vintners in cloth factories,
both would be better off. Specialization ensures that more wine and cloth will be produced when
nations trade than when each country produces a wider range of products on its own.
From an economic perspective, the ability to produce more product with the same labor
input is unambiguously desirable. If England were always to produce wine more efficiently than
Portugal, Adam Smith says, its advantage would be “absolute.” But for absolute advantage to
3
Smith, Adam. Wealth of Nations. Amherst, NY: Great Minds Series, Prometheus Books, 1991. Originally
published as: Inquiry into the Nature and Causes of the Wealth of Nations. London: W. Strahan, 1776.
3
exist, there needs to be something that prevents the English from becoming good wine makers
and the Portuguese from becoming accomplished weavers. Perhaps some natural resource
specific to one of the production processes does not exist in a given nation; for instance, it may
be impossible to grow wine grapes in England’s climate or to graze sheep in Portugal’s. As a
result, “absolute advantages” in trade are relatively rare, and those that exist tend to arise from
geographic differentiation.
Ricardo’s Comparative Advantage and Its Legacy
David Ricardo’s On the Principles of Political Economy and Taxation (1817) added to
Smith’s notion of “absolute advantage” the more fruitful idea of “comparative advantage.”
Ricardo argues that conditions for international trade exist not only when, owing to an absolute
advantage, England produces a given good more efficiently than Portugal, and vice-versa. For
England and Portugal to trade, it is enough for the relative costs of specializing in cloth making
to be less in England than they are in Portugal; this alone would make England a cloth-exporting
nation. By the same token, if Portugal can focus on winemaking more easily than England can,
this “comparative advantage” is sufficient grounds for trade.4 The relative production cost
difference of comparative advantage, in Ricardo’s view, was sustained by a persistent difference
in production technology between trading partners.5
Modern economics has made considerable improvements to Ricardo’s theory. We now
understand that economic conditions other than technology differences can sustain a relative
4
Ricardo, David. On the Principles of Political Economy and Taxation. Library of Economics and Liberty,
Retrieved: http://www.econlib.org/library/Ricardo/ricP.html. Originally published as: On the Principles of Political
Economy and Taxation. London: John Murray, 1817.
5
Over the last ten years, for instance, the United States has significantly increased domestic crude oil production
and decreased oil imports, due to innovative new oil extraction technology. As the new “fracking” technology
disperses across other oil producing areas, however, the United States may return to trading for oil instead of
producing it.
4
production cost differential between nations. Bertil Ohlin’s Interregional and International
Trade (1933) explained how comparative advantage could exist between countries with identical
technology. Ohlin posits a very special world - one in which labor, capital, and output markets
are perfectly competitive.6 No single economic agent has pricing power. The marketplace sets
the wage paid to labor, the return to capital, and the price of the products. Labor owners are paid
the share of the output produced by labor, capital owners the share of the output produced by
capital; the price of the product is driven down to both the cost to produce another unit (marginal
production cost) and the minimum average total production cost. There is no economic profit.
Since the product price represents its marginal production cost, comparative advantage and
potential gains from trade require only a price differential between two countries.
Who Benefits from International Trade?
There is much more to be said about the economics of international trade, of course, but
with this much in view let us return to Senator Elizabeth Warren’s question: Who reaps the
benefits and who absorbs the costs of international trade? The answer that emerges from
economic theory is fairly clear. In our example, both England and Portugal, gained from trade.
Consumers within these countries pay lower prices on imported goods and higher prices
on goods their country exports, but the fall in prices exceeds the increase in prices in their
country’s respective export market. So, an Englishman would pay more for clothes but much less
for wine; a Portuguese would pay more for wine but much less for clothes. (Englishmen who
drink naked benefit the most.) Consumers in both countries could consume more wine and cloth
than without specialization and trade.
6
Ohlin, Bertil. Interregional and International Trade. Cambridge, MA: Harvard University Press, 1933.
5
Producers of export goods – English cloth producers and Portuguese vintners -- gain
through higher prices and an expanded consumer base. Their counterparts – English wine
makers, Portuguese clothiers – face stiffer competition from cheaper foreign imports and absorb
the losses. The production costs and benefits are transmitted to the input owners – that is,
laborers and capitalists. If English labor is scarce and high-priced relative to Portugal – clothmaking requiring fewer hands and more machines than wine-making - English wages will fall,
and Portuguese wages will increase. By contrast, relatively abundant and low priced English
capital will have its returns bid up, while Portuguese capital will see reduced returns. Paul
Samuelson, in his factor price equalization theorem, predicts that the returns to English and
Portuguese capital and labor will tend to converge.7
It is hard to pin down the aggregate effects of free trade, the product price changes and
the input income changes, on specific individuals. But from the perspective of politics and
policy, the question of who benefits and who loses – Elizabeth Warren’s question – is often most
important. First, it is important to note that most people receive income from both the labor and
the capital markets. That is, most have wage income, some of which they spend immediately,
and some of which they set aside as savings that will earn interest, dividends, or capital gains in
the capital market. The young tend to get more expendable income from wages than the old,
while the old live off of income from capital. In our example, therefore, trade would hurt young
Englishmen more than their elders; in Portugal, pensioners would suffer more than the young.
What happens if Portugal’s elderly population votes at considerably higher rates than the young
(as is common in advanced democracies)? Will Portuguese policymakers pursue trade policies
that benefit Portugal as a whole, or policies that benefit their constituents who vote even while
7
Samuelson, Paul. “International Trade and the Equalization of Factor Price.” Economic Journal 58, no.230, (June
1948): 163-184.
6
harming those who do not? In the same vein, if Portugal’s weavers have a powerful union to
promote their interests, Portugal’s trade policy may reflect the union’s interests (e.g., not sending
weaving jobs to England) rather than the interests of Portuguese consumers. Also, individuals
are both consumers and producers, capitalists and laborers – but individuals do not possess these
economic identities equally. Some produce more than they consume; some earn more from
returns on investment than from wages or salary. And all, even in democracies, have different
levels of access to and influence on the instruments of trade policy. As a result, the politics of
international trade policy are as complicated as the economics are straightforward. Economic
theory suggests that the overall impact of trade, on the nation rather than specific individuals
within it, is positive. Political theory suggests that the positive overall impact of trade is realized
only under certain conditions. Elizabeth Warren, a politician rather than an economist, is right to
ask who benefits from trade – a question that gives economists considerably less pause.
The Political Institution of Property Rights and Income Distribution
To understand how returns to economic activity are distributed across societal or political
class, the fundamental economic pressures outlined above must be overlaid with political
institutions and social norms. We assumed above that the owner of productive resources, labor
and capital, had an absolute property right to them. What does it mean to have a property right?
Thrain Eggertsson’s Economic Behavior and Institutions explains property rights as a bundle of
three sub-rights that can be variously assigned and protected through a government’s exclusive
use of coercive power. These sub-rights include: 1) The use right, 2) The right to the return or
income generated by use, and 3) The right to dispose of or transfer ownership.8
8
Eggertsson, Thrain. “Economic Behavior and Institutions.” Cambridge Surveys of Economic Literature. London:
Cambridge University Press, 1990.
7
The way these rights are assigned and enforced by the government defines a country’s
fundamental economic system. There are two basic entities to which these rights can be
assigned: individual citizens or the sovereign. When all three property sub-rights for the
productive input capital are assigned to individuals, the economic system is called capitalism.
When all three are assigned to the sovereign, the economic system is called socialism. Modern
western economic thought presupposes capitalism, in that the three property sub-rights are held
by individuals. In practice, modern welfare states limit these property rights through regulations,
taxes, and transfer payments.
The logic of Samuelson’s factor price equalization applies only when individuals hold the
property rights to the productive inputs. Since the world is large and contains many productive
input owners, the individuals must compete and accept the returns the market offers. There are
fewer sovereigns. When the sovereign owns all of or some substantial portion of the property
right to productive inputs, there is a good chance that the sovereign has some market power, the
ability to price fix and change the returns to productive inputs. Do sovereigns accept factor price
equalization or do they actively oppose economic forces to achieve some other societal end?
Consider the case of Portugal in the scenario we have developed above. If the Portuguese
sovereign owns the relatively scarce and high return capital in Portuguese cloth manufacture,
does the sovereign allow trade knowing that the return to capital in Portugal will fall through
factor price equalization? If the sovereign restricts trade, Portuguese workers will not reap their
respective wage gains, and there will be a sustained income differential between England and
Portugal. Other sovereigns have allowed returns to capital to fall in order to raise wages,
however. China, and India, both countries with substantial sovereign influence in capital
ownership, have chosen to expand trade relationships with the rest of the world. Both countries
8
are labor-abundant and capital-scarce, like Portugal in our example. As a result of their
sovereigns’ policy decisions, the Chinese and Indian middle classes have grown, and the income
of two of the world’s largest populations is converging with income levels in the affluent world.9
Similar trade to income growth patterns were seen in Japan, South Korea, and other “Asian
Tiger” nations. All of these examples provide broad support for wage equalization through
international trade.
Other developing regions, however, have not experienced the same success. Wages in
Central Asia, Africa, and Latin America have not converged with those of the developed world.
Why not? Conflict, geography, education, income inequality, colonial legacies, or some mix of
all of these, are given as reasons. To the extent that geography is crippling, there is little to be
done about it. Conflict, education, an income inequality, are outcomes from a political-economic
system; they are symptoms, not causes. The fundamental cause we need to consider, then, is the
legacy of colonialism.
European colonies were extractive in nature.10 The colonial power would strip productive
resources, agricultural products, natural resources, and labor, from its colony, designing
governance institutions with a view to this purpose. Frequently a small settler class was installed
to control a much larger indigenous class. Using its coercive force, these oligarchies would strip
labor property rights from the workers and natural resource property rights from native owners.
This foreign oligarchy was the colony’s de facto sovereign.
9
Kharas, Homi. “The Emerging Middle Class in Developing Countries.” OECD Development Center Working
Paper, no. 285, (January 2010): Retrieved: http://www.oecdilibrary.org/docserver/download/5kmmp8lncrns.pdf?expires=1439167000&id=id&accname=guest&checksum=BEF
6BA19779DAE8F9C23C0C072620236.
10
Acemoglu, Daron and Simon Johnson. “Unbundling Institutions.” Journal of Political Economy 115, no. 5
(October 2005): 949-995
9
As these colonies escaped from control of their European masters, a small oligarchy of
indigenous colonial power supporters were often the only ones with governance skills. They
became the new sovereign. To the extent that the old colonial property rights framework
remained in place, the new sovereign extracted returns to both capital and labor. In the Chinese
case, the sovereign redistributed the returns to the citizenry. Often the sovereign redistributed the
extracted returns to the oligarchy. Even if the post-colonial nation traded freely in the
international markets, and returns to labor did converge with the developed world, workers
would not see the convergence in their wages, as sovereigns were able to extract the gain through
direct taxation, wage controls, and certification and licensing fees. Arcane bureaucratic
processes also allowed bribery and extortion to serve as confiscation tools.11 The impact of
extractive and exclusive economic and governance institutions is well documented, in general, in
Daron Acemoglu and James Robinson’s Why Nations Fail.12
The colonial legacy of extractive oligarchies can help us to understand why conflict,
education, and income inequality inhibit the convergence of income in the developing and
developed worlds. When wages do not reflect the return actually earned by labor, workers do not
have incentives to perform in accordance with the needs of the economy. In particular, workers
have a diminished incentive to increase their human capital through education; workers will not
expend resources to increase a return that will not be realized by the worker. Thus, education,
both general and job specific, will not be invested in by workers.13 Internal conflict can also
have its roots in the systematic extraction of returns. Ronald Wintrobe’s Rational Extremism
11
An excellent example of a sovereign extracting returns from a productive process is the taxi medallion system
practiced in some of the United States’ cities. The system restricts capital participation, putting downward pressure
on wages paid to the laborers in the industry. The dearth of competition from outside capital owners allow medallion
owners to transfer driver returns to themselves through monopsonistic input pricing.
12
Acemoglu, Daron and James Robinson. Why Nations Fail: The Origins of Power, Prosperity, and Poverty. 1st
edition, Crown Publishing Group, New York, NY: Crown Publishing Group, 2012.
13
Becker, Gary. Human Capital: A Theoretical and Empirical Analysis, 3rd Edition, Chicago, IL: University of
Chicago Press, 1993.
10
discusses how different forms of systematic exploitation can lead a marginalized subgroup to
extreme political behaviors.14 Conflict results when the sovereign appropriates returns to labor,
disadvantaging some subgroup of the polity and institutionalizing wage differentials or income
inequality. In our example, the Portuguese wine sector workers whose wages are below the
return to their labor, and who cannot recapture their labor return property right through
conventional political channels, may rise up to accomplish this end through extreme political
action. Conflict, education, and income inequality are thus three sides of the same triangle, at the
center of which are extractive oligarchies left behind by colonial powers.
Social and Cultural Norms, Implicit Property Rights, and Income Distribution
There are less formal institutions that constrain property rights to productive inputs.
These are not codified constraints enforced by the coercive powers of the sovereign, but social
and cultural constraints enforced by peer pressure and membership exclusivity of social classes,
religious groups, and ethnic and racial groups. They emerge as stereotypes, occupational
segregation and avoidance of types of economic activity.
Stereotypes, whether racial, ethnic, gender or social class based, attach human capital
attributes to individuals through a group identity. Consider the belief that the Chinese are
exceptionally competent in mathematics, women are excessively emotional, or the poor are
ignorant. These human capital stereotypes, when accepted by the general society, imply to
potential employers that it would be problematic to hire a Chinese artistic director, a woman
manager, or a poor professor. This initial bias, regardless of the actual human capital content of
the individual worker, restricts that individual’s use right to labor and, by extension, the return to
14
Wintrobe, Ronald. Rational Extremism: The Political Economy of Radicalism. Cambridge: Cambridge University
Press, 2006.
11
labor for a social subgroup. Even if the use right is not absolutely foreclosed and an employer
“takes a chance” and hires a stereotypically disqualified worker, the employer will extract a risk
premium against the stereotyped human capital deficiency, and the worker will not receive the
full return to the labor provided. As explained by Gary Becker in The Economics of
Discrimination, as more risk premium taking employers hire lower wage stereotypically
disqualified but human capital proficient workers, the stereo type will fall.15 In cases where the
stereo types are well enforced by social and cultural norms, the expropriation of labor return will
persist as evidenced by the long standing wage penalty absorbed by women worldwide.16
As social subgroups are occupationally segregated into their stereotypical employment
type, their choice of human capital formation is constrained by their occupational opportunity.
Women become nurturing nurses instead of physicians because the larger society will not
support them as physicians, and they cannot see themselves as physicians. This constraint has no
relationship to an individual’s actual human capital potential. By restricting women to fewer
occupational opportunities, the oversupply of women into these few fields, depresses the wages
in these fields and produces persistent wage inequality by social subgroup. Market economics
suggests that were the social norms relaxed, competent women would exit nursing and become
physicians, driving down the return to a physician’s labor and driving up the return to a nurse’s
labor.
Coming back to the trade example between England and Portugal, assume that the
workers in the wine industry in England, through occupational segregation, are all Catholic,
while cotton workers are all Anglican. As trade opens between Portugal and England, and
English wine prices are depressed by lower priced imported Portuguese wine, the number of
15
Becker, Gary. The Economics of Discrimination, 2nd Edition. Chicago, IL: University of Chicago Press, 1971
Bergman, Barbara. “Occupational Segregation, Wages and Profits When Employers Discriminate by Race and
Sex.” Eastern Economic Journal 1 no.1-2, (April, 1974) 103-110.
16
12
English wine making jobs falls. The Catholics are not able to find employment in the cloth
industry because of social norms. A surplus of unemployed wine makers drives down the return
to labor for Catholics. Exactly the opposite is true for the Anglicans working in the cloth
industry. The apparent result of trade is massive income inequality internal to England, but is the
source actually trade, or societal norms?
Implications of International Trade on Equity
The simple world of the economic theorist – in the case we have considered, a world of
two inputs, two outputs, and two countries - is not the world we see around us. Nevertheless,
this hypothetical world offers some elucidating lessons. The economics of trade tend to equalize
returns to labor and capital. Not living in the world of an economic theorist, when considering
trade policy, we must take into account societal and political institutions that may countervail the
income equalizing pressures. Policymakers who ignore the effects of explicit governmental and
implicit societal property right institutions can craft trade policy that exacerbates income
differentials within their own and their trading partners’ countries. Trade theory assures there
will be net gains derived from trade liberalization to all trading partners. There will be, as
Elizabeth Warren implied, winners and losers within each trading country. Economic pressures
allocate gains and losses across consumer type through price changes (imported goods’ domestic
prices fall and exported goods’ domestic prices rise) and across productive resource owner type
through changes to returns to capital and labor. Explicit and implicit property rights institutions
can redistribute those gains and losses across societal sub-group, from focusing losses on one
group and gains on another, to spreading the gains and losses across all or to concentrate the
gains and losses on particular societal sub groups. Given the interaction of economics,
13
governance, and societal norms, all three need to be considered when tackling the question of
trade policy that promotes income equity worldwide.
14
Recommended Readings
Berg, Andrew and Anne Krueger. “Lifting All Boats: A critical survey of recent studies on trade
liberalization.” Financial Globalization: A compilation of Articles from Finance & Development.
Washington, DC, International Monetary Fund (April 2007): 66-69.
http://users.nber.org/~wei/data/FinGlobal-F&D.pdf
Dabla-Npris, Era, Kalpana Kochhar, Frantisek Ricka, Nujin Suphaphiphat, and Evridiki Tsounta.
Causes and Consequences of Income Inequality: A Global Perspective. Washington, DC,
International Monetary Fund, Strategy, Policy, and Review Department. (June 2015)
https://www.imf.org/external/pubs/ft/sdn/2015/sdn1513.pdf
Dollar, David and Aart Kraay. “Trade, Growth, and Poverty: How has increased participation in
international trade affected developing countries economically?” Financial Globalization: A
compilation of Articles from Finance & Development. Washington, DC, International Monetary
Fund (April 2007): 70-73.
http://users.nber.org/~wei/data/FinGlobal-F&D.pdf
Santos-Pauliuo, Amelia. “Trade, Income Distribution, and Poverty in Developing Countries: A
Survey.” United Nations Conference on Trade and Development. Discussion Paper no. 207 (July
2012)
http://unctad.org/en/PublicationsLibrary/osgdp20121_en.pdf
15
Watkins, Kevin and David Dollar and Aart Kraay. “Making Globalization Work for the Poor:
Point - Counterpoint.” Financial Globalization: A compilation of Articles from Finance &
Development. Washington, DC, International Monetary Fund (April 2007): 81-86.
http://users.nber.org/~wei/data/FinGlobal-F&D.pdf