In 2000, the United States of America exported $776 billion in goods, while importing $1.223 trillion in goods from other countries.  In other words, international trade in goods alone is a significant portion of the nation’s $9.963 trillion GDP. (http://www.cia.gov.)  This paper discusses the theory of comparative advantage, which explains why it is in the best interest of a nation to engage in free trade.  This paper also provides a brief overview of U.S. policy toward international trade.

Comparative advantage is a concept that is pervasive in economics.  It is not limited to international trade, but comes into play anytime one person exchanges the fruits of her labor for those of another’s.   The fascinating point about comparative advantage is that it explains why it is in the best interest of parties to trade, even if one of the parties is more productive than the other party in all relevant areas.

For example, imagine that Bill, with his skills and the tools he owns, can produce either 800 lbs of food or 4 pieces of furniture per week, or a combination of the two products.  Jim is less skilled and owns fewer tools.  Jim can produce 600 lbs of food or 2 piece of furniture per week.  Thus, Bill is more efficient at producing both food and furniture.  However, the opportunity cost that Bill must pay if he produces one piece of furniture is 200 lbs of food.  The opportunity cost to Jim to produce one piece of furniture is 300 lbs of food. 

If Bill specializes in the production of furniture, and Jim specializes in the production of food, in one week, 600 lbs of food are produces along with 4 pieces of furniture.  If both parties tried to split their production equally between food and furniture, a total of 700 lbs of food would be produced, but only 3 pieces of furniture.  Assume that the Bill and Jim specialize and agree to exchange food for furniture at a rate of 250 lbs of food for 1 piece of furniture.  Bill can exchange a piece of furniture and receive 50 lbs more food than he could have produced by shifting his own resources into the production of food.  Likewise, Jim can obtain a piece of furniture by giving up only 250 lbs of food, instead of the 300 lbs that it would have cost him to produce the piece of furniture on his own.  Both parties are better off, even though Bill is more productive in at producing both food and furniture.

This same principle holds true for nations.  Even if one nation has an absolute advantage over another nation in producing all products, it is still in the interest of both nations to trade, because of the differences that exist in their underlying opportunity costs.  For example, it may take weeks of labor for India to produce a rug.  In the United States, the same rug could be produced by relatively skilled workers on computerized machines with the use of a small amount of labor, capital, etc.  So, why would the U.S. import rugs from India?  While the cost to produce the rug in India seemed high (several weeks of labor), the cost of producing high-tech airplanes in India would be astronomical.  The country simply lacks the educated population, factories, associated infrastructure, and technology needed to produce commercial aircraft.  To develop all of these things, India would require an incredible diversion of resources from other areas of its economy, if it is even possible.  Thus, it is still better for both nations to trade.  The U.S. is better off importing rugs from India, and India is better of buying high tech airplanes from the United States.

U.S. trade policy is an area riddled with inconsistency.  While the U.S. is the world’s champion of free trade, we still have thousands of tariffs, quotas, and other restrictions in place.  Most of these restrictions are responses to special interest groups that argue that the nation is injured by allowing free trade in their particular industry.  However, looking at the big picture, since the end of World War II the primary thrust of U.S. trade policy has been to increase free trade.

After World War II, at a time when U.S. GDP was roughly half the world’s GDP, the United States recognized the tremendous cost that had been paid by a world that did not support free trade.  In the early 1930s, in reaction to recession, the world’s governments engaged in a round of tit for tat as one country after another retaliated against other governments by placing restrictions on trade.  In the Unites States, the primary legislation restricting trade was the Smoot-Hawley Tariff Act signed into law by President Hoover on June 17, 1930.  Arguing that Americans should not be forced to compete against cheep foreign labor, the Act imposed dramatic tariff increases on scores of items.

Within two years after the passage the Smoot-Hawley Tariff Act, international trade constricted by two thirds.   The world plunged into depression, and the economic crisis played into the hands of rising political figures such and Hitler and Mussolini, as well as those arguing for greater military control in Japan.  In other words, there was a connection between restrictions on world trade and the death of millions of people in a second world war.

In 1948, the United States pushed for the establishment of the General Agreement on Tariffs and Trade (GATT).  The goal of GATT was to reduce trade restriction through multi-lateral negotiations on trade.  The primary operative rule was called “most favored nation” status, and required that all GATT members receive the best treatment that a member nation granted to any other member nation.

GATT did not establish any institutions to enforce trade agreements.  Rather, GATT was marked by rounds of negotiation.   Each round generally took several years to reach agreement on additional reductions in trade restriction.  From 1986 to 1994, the final round of GATT (the Uruguay Round) was conducted.   The Uruguay Round concluded in with the establishment of the WTO in 1995.  The WTO for the first time offers dispute resolution and enforcement mechanisms to ensure that member nations comply with WTO trade rules.

It was the United States, more than any other nation that pushed for the establishment of the WTO, and the free trade policies that it represents.  In fact, the establishment of the WTO is arguably part of the spoils reaped by the United States through its victory in the Cold War.  With the death of Russian communism and the Chinese increasingly moving toward markets, the arguments for an alternative to Capitalism seemed to fade rapidly.  The United States used its new found leverage as the World’s only super-power to push for the establishment of institutions supporting free markets, including the establishment of the WTO.

However, as American free trade ideas seem to dominate the post-Cold War world, even the United States has trouble remaining intellectually pure.  This can be seen by looking at the WTO’s web site (http://www.wto.org).  There are several countries that have filed complaints with the WTO Dispute Resolution Body in opposition to the U.S. restrictions imposed during 2002 on foreign steel.  In an election year, with close congressional races in steel producing states, intellectual purity appears to be sacrificed to political expediency.

Negotiations to reduce trade restrictions are often analogized to arms reduction negotiations.  One country is only willing to reduce their restrictions in exchange for reductions by other countries.  This has been the pattern with GATT, and now the WTO.  One nation fears that it will be at a disadvantage if it reduces its own restrictions without a concession from another nation.  Economists have supported these negotiations, because they do at least reduce restrictions.  However, since the nation that imposes the restriction reduces its own national welfare, simply by imposing the restriction, a better analogy to describe trade negotiations is one person threatening to shoot himself in the foot unless his opponent agrees not to shoot his own foot.