Plain Sense Economics

We read/hear in the news media about changes to the U.S. trade deficit. This page from the Census Bureau shows that in the month of October, 2007 the trade deficit was $57.8 billion. That’s large in anyone’s book, but it is not ballooning as it has in earlier months. Two forces (at least) are at work…higher oil prices means we pay more for imported oil which increases imports, and the fall in the international value of the dollar has made our exports cheaper to foreign buyers, thus increasing exports. For the moment these offset each other, roughly. We’ll discuss the implications of a trade deficit in another posting. The question du jour is “why bother to trade?”

The United States has a large and diverse economy and we could, if we chose, be fairly self-sufficient. Yet it is in our economic interest to buy goods from overseas, and to sell them. The underlying principle is comparative advantage. Trade theory suggests (demands!) that an individual or a nation who has the lowest opportunity cost for producing a good should produce and sell that good to others with higher opportunity costs.

Here’s my down home example. Let’s say that I am faced with mowing my lawn and that it takes me one hour to do the job. A neighborhood kid, who is still learning mowing tricks, might take two hours to mow my lawn. So far, I win the comparison, and in fact I am said to have absolute advantage – I am better at mowing my lawn than he is.

Now, though, let’s look at opportunity costs. If the neighborhood kid spends two hours mowing my lawn he gives up two hours of other neighborhood employment. Maybe he charges $7 an hour to mow, rake, wash cars, etc. If he mows my lawn for two hours he gives up the chance to earn 2 x $7 = $14. On the other hand, if I don’t mow my lawn I can work on web development projects and earn $110 an hour. That $110 is my opportunity cost – what I give up in order to mow my lawn. The kid’s opportunity cost is $14. We say that the neighborhood kid has comparative advantage because his opportunity cost is lower.

I bet we can all agree that it makes sense for the kid to mow my lawn (excluding non-pecuniary benefits I may gain from being outdoors and getting some exercise…) while I sit inside and work on more remunerative projects. Note this is true even though I have absolute advantage – I am better at mowing my lawn than he is. I can pay him $10 an hour and we’ll both be better off.

Comparative advantage can come from situations like the neighborhood kid. A nation may have little else it can do with its scarce resources, so has a low opportunity cost. In the early days of the growth in technology jobs in India, the typical educated Indian had few other opportunities to create economic value. So their wages were low. Technology made it easier to “ship” work to India, via fiber optic cables and coordinated with sophisticated software. India had, and still has comparative advantage in software design, call center staffing, and a variety of other services. If we follow the same logic as in the lawn mowing example, trained workers in the United States have greater opportunity costs – they can in theory produce more economic value if they let the Indians “mow the lawn.”

Comparative advantage can also accrue to a nation that has unusual, high levels of raw materials or other scarce resources. Saudi Arabia has lots of oil. It makes sense for them to retrieve it and sell it to others. A nation may also have a unique set of experienced workers – like the Swiss watch makers of days gone by. The presence of important scarce resources or the accumulation of specific skills means these countries can produce those goods and services with lower opportunity cost than others.

I’ll devote a whole separate post to the various arguments against free trade, but let’s face the main concern shared by the voting public here in the U.S. – jobs. Everyone seems to know someone, or has read about someone who lost their job to outsourcing overseas. To the American worker who has lost their job to someone with lower opportunity costs outside our borders, the spirit of free trade seems pretty misguided. And there is no question that individuals, and communities are hurt by the forces of comparative advantage. The bigger picture suggests that our U.S. economy is better off if we can release those scarce resources to other, better uses. Some communities that lost manufacturing jobs have figured out how to change their economic base towards some industry that values their particular skills and resources. Companies that save money by outsourcing can take those savings and reinvest them in their company operations, or invest in new products and markets, or even just pay their owners higher dividends.

As an economy our country has faced these pressures of outsourcing and off-shore operations from the time we ceased being a set of colonies. We’ve lost comparative advantage in cotton and other agricultural products, manufacturing, and now services. Each time we have retooled our economy to make better use of those resources released by trading with other countries and have seen our national income rise. A compassionate society will work to support those dislocated by increasing trade. We can invest in job training, relocation, new business investment, and research into new products and services.

If, however, we choose to shut the flow of foreign goods and services from overseas we will be mowing our own lawn.