The Science of Everything Podcast - Episode 56: The Gains from Trade

Episode Date: December 26, 2013

A discussion of the notion of trade and exchange, including the purpose of these activities, the gains from trade, and the role of comparative advantage. I also examine some recent trends in global trade, and briefly discuss some of the major global trade institutions such as the WTO and World Bank and their role in attempting to reduce trade barriers. The episode concludes with a brief discussion of the concept of 'Buy Local'. Recommended pre-listening is Episode 12: The Price System.

You're listening to The Science of Everything podcast, episode 56, the gains from Trade, and I'm your host, James Fodor. In this episode, we're going to discuss the concepts of trade and exchange, including the purpose of these activities, why people trade, and in looking at that, we'll discuss the gains from trade, and the very important concept of comparative advantage. We'll also take a look at some of the recent trends in global trade, how that's been changing in the past decades, and we'll briefly look at some of the major global trade institutions, including the WTO and the World Bank and their role in attempting to reduce barriers to trade,

such as tariffs and other such things. I'll then conclude the episode with a brief discussion of the concept of Buy Local, which I think is relevant to understanding the concept of the gains from trade. Recommended pre-listing for this episode is episode 12 on the price system, which will be helpful for understanding some of the concepts. So, let us begin. The first thing that I want to discuss, which I've mentioned before in a couple of the economics episodes, but I think it'll be, it's important to go over again,

is the concept of opportunity cost, because to understand the gains from trade and comparative advantage, it's really necessary to understand this concept of opportunity cost. So, when we think of a cost, we normally think of perhaps a price or something you have to pay, you know, how much does it cost to buy something, it costs $20 because I have to give $20 over to the person behind the counter in order to buy the thing. That's what we normally think of when we think of cost, we think of an explicit expenditure. But in economics, the concept of cost is broader than that, and hence we have this phrase, opportunity cost. Opportunity cost refers to whatever you give up, or specifically the value of whatever you give up, in order to get something. So, for example, if I have to go to the supermarket

to buy a loaf of bread, say the loaf of bread costs $2. The price of the bread is $2, that's the explicit cost, but the full cost, the opportunity cost of the bread, is more than $2 because you have to factor in the time and energy that I needed to go to the supermarket to buy the thing. maybe it took me 10 minutes, however much I value 10 minutes of my time, whatever effort or disutility I get from having to get up and go out and get the bread, that needs to be factored into the full cost. So when we're talking about the opportunity cost of that loaf of bread, that would include the $2 you spend actually buying the bread, plus the cost of the time and energy and whatever

else is necessary to purchase the bread. That's the full opportunity cost. The opportunity cost always consists of the value of the next best thing that you would have done or the value of the next best alternative that's foregone in order to get something. Another good example of this is the cost of going to university or to college. Again, the explicit cost is just the cost of tuition and textbooks and whatever else. But that's certainly not the full cost, because the opportunity cost would have to also factor in the lost income that you could have been earning if you were going, if you were instead working.

So this highlights the importance of considering the value of the next best alternative. It doesn't make any sense to look at the value of the fifth next best alternative or the 10th next best alternative, because if you didn't go to university, say, you wouldn't be doing the fifth next best thing. You would, if you're a sensible person, do the next best thing. You would always do the next best thing if you don't do the best thing. If the best thing is ruled out, then you go to the next best thing. And then if that's ruled out for some reason, you go to the third next best thing. So you always work down sequentially. That's why we always look at the value of the next best alternative foregone.

So if you don't go to university, let's say the next best thing you could be doing with your time and energies is working. And so when we're examining the cost of going to university, we have to factor in not just the explicit costs, but also the foregone earnings that you would have been able to get if you had been working instead. Starting up your own business is another good example. You can't determine if it's a good idea to start up a business just by looking at whether or not you're making a profit. You also need to consider what the opportunity cost of your time and energies are. If you weren't running a business, maybe you could be working for someone else and earning a certain salary, and so you're giving that up in order to run the business, so you have to include that as a cost of running the business. That's part of your opportunity cost. So opportunity cost is a very, very important concept, particularly in regards to trade, but in economics in general.

And any rational decision maker, in any situation at all, must always consider the opportunity costs of any decision they're making, including lost profits, lost earnings, lost production, lost time, lost pleasure. lost sleep, et cetera. Okay, so that's the concept of opportunity cost. Bear that in mind, because I'll be referring to it to a number of times throughout the remainder of the episode. So it's a useful thing to have in the back of your head. Now we'll move on to talking about the gains from trade. So this is the idea of what is the purpose of trade? Why do people exchange things with each other?

And particularly, why do we trade between different countries? Well, the main reason for trading between countries or trading between cities or people or whatever, is because of the gains from trade. So what are the gains of trade? Gains from trade refers to the net benefits that agents, so that could be people or countries or corporations, whatever, that agents gain from voluntary trading relationships between each other. In technical terms, it's the increase in producer and consumer surplus

resulting from lower barriers to trade. So where do these gains come from? They seem a little bit magical. Somehow, if I have an Apple and you have some money, and then we swap an apple and money, then, you know, we swap the apple for the money, then somehow we're both better off. Like, where does that gain come from? The gain comes from the fact that we each value the things that we are trading differently.

I have the money, but I prefer the apple. You have the apple, but you prefer the money. So if we each swap, then we're both better off. We both have a higher utility. Or another way of saying that is we gain in consumer surplus. I've talked about some of these concepts in previous episodes, so if they're a bit confusing, look back at some of the previous economics episodes. But the gains from trade fundamentally come because both parties have something that the other party wants and values more than what they currently have.

So by swapping around the resources or the goods that are in your possession, both parties can be better off. And this is known as the gains from trade. There are two different types of gains from trade, static and dynamic effects, or static and dynamic gains. Static gains refers to the increase in social welfare or increase in total utility that comes from maximizing natural. national output due to more optimal utilization of your country's resources. So, to break this down a bit, when a country engages in trade, they can increase the amount that they produce or the value of what they produce because of more efficient utilization of resources.

We'll talk about this more when we get to comparative advantage next. But for the moment, we'll just take that as given, that you can produce more or more valuable things as a country, or indeed as a city or whatever, if you trade rather than trying to do everything yourself. And so that, so engaging in trade yields this static benefit, because this is a one-off game. Say we go from being self-sufficient or as a country, a country that self-sufficient is known as an autarkic country, which is engaging in autarky that is not trading, just producing its own stuff. If you go, if a country goes from a state of autarchy to a state of trade, then maybe they gain 20% extra output or 50% extra output or something like that.

But the point is, that's going to be a static effect. It's a one-off gain. They don't gain that every year afterwards or something like that. It's a one-off gain resulting from a more efficient use of resources. So rather than producing something really expensive price here, we buy it from overseas for a much cheaper price and then produce something else instead. So we're using our resources more efficiently. But that's the static gains from trade, which are the ones people sort of mostly focus on.

But arguably more important are the dynamic gains from trade. These are a bit more subtle, but they're, as I said, arguably even more important. they are the benefits that you get from engaging in trade, which are manifested in an accelerated rate of economic growth. That is the rate at which the economy expands, or the rate at which you can increase production. And this results from faster transmission of new technologies and expertise, also greater competition. So instead of just competing with a couple of companies from your local country, you compete with countries all across the world. So there's an increase impetus towards increased efficiency and innovation and things like that. Also, the largest scale of production and bigger markets often allow reduction in price.

So if you're only producing a few thousand cars for the domestic market, that's probably going to result in a higher price per car than if you're producing millions of cars for the world market. So this profusion of technologies, increasing competition, greater scale of production, and various other factors all tend to lead to an increase in the rate of economic growth in countries which are more engaged in trade. And indeed, the statistical evidence bears this out that countries are open to trade grow more rapidly than countries that are not open to trade.

So, that's a bit about the gains from trade. That's why countries trade and why people and firms trade. Now let's talk about comparative advantage, which is probably the single most important concept that I wanted to discuss in this episode. Comparative advantage is one of the hardest concepts to understand in economics, I think, because it's very counterintuitive, or at least it is to a lot of people. So I'll try and do my best to explain it, and we'll see how we go. Before we get to comparative advantage, though, let me explain a related concept, which is a lot easier to understand, which is that of absolute advantage. So when we talk about advantage, we're talking about who can do something better. We could be comparing two people, or we could be comparing two businesses, or we could be comparing two countries.

It doesn't really matter. Usually the example is given with countries, but it works just as well with people that the concept applies, regardless of the scale. That's not relevant. So let's think about it in terms of countries for the moment. absolute advantage occurs when one country can produce things to produce more from the same resources. So that could be more output using the same number of workers or more output using the same amount of iron ore or more agricultural output using the same amount of land, anything like that. Exactly what the input is is going to vary from case to case. But the basic idea of absolute advantage is that if you have an absolute advantage in producing something,

you can produce more than the other person or the other country can using the same resources. Obviously, if you have more resources, then you can produce more, but that's not very interesting. What we're interested in is who is relatively more efficient. So if you can produce more with the same amount of resources, or equivalently, you can produce the same amount using less resources than you have an absolute advantage over the other person or the other country. So, for example, if we opened up a factory with a thousand workers and a certain amount of iron ore and steel and other things that were, and electricity uses input, if we opened up this same factory in two different countries, Mexico and the USA, let's say, and the American factory is able to produce twice as many cars as the Mexican factory.

That means the US factory has an absolute advantage of two to one relative to the Mexican factory, even though it's using the same resources and the same number of workers. Now, how could you have such an advantage? Well, an absolute advantage like that would be a product of more advanced technology or more efficient use of those resources, better management practices, all sorts of things like that. There are many different ways one can use a given amount of resources to produce output. So if you can manipulate the use of resources in such a way is to increase total output relative to your rival, the other country, the other person, whatever, then you have an absolute advantage over there. So this concept of absolute advantage is, I think, relatively easy to understand

because it's just about who can produce more with the same resources. Now, let's think about the concept of comparative advantage, which is related to absolute advantage, but different. So the concept of comparative advantage, That means that if you have a comparative advantage in something, if a country or a person has a comparative advantage in producing something compared to another country or a person, that means you can produce it with a lower opportunity cost. So I'll say that again. A person or country has a comparative advantage in producing a good, if they can produce that good with a lower opportunity costs than some other person or country. Now, what's important here is that it doesn't matter who is more efficient in the sense of producing more with fewer resources.

All that matters for a comparative advantage is what your opportunity cost is. A simple way of talking about comparative advantage is just to say that if you can produce something cheaper, then you have a comparative advantage in producing that thing. Absent differences in taxes or other things like that. But if it's just a product of market forces, then you can produce something more cheaper, then you have a comparative advantage in doing that. Now, you might think that comparative advantage and absolute advantage sound like the same thing.

I mean, surely if you can make something with less resource, You can be more efficient in making it, then you're going to have a comparative advantage. So aren't absolute advantage, comparative advantage, just the same thing? Well, the answer is no, they are not the same thing. They might be the same thing. They might happen to be the same thing in a particular case, but they needn't be. So the big difference is that comparative advantage incorporates the concept of opportunity costs, whereas absolute advantage does not.

So absolute advantage doesn't say anything about what I have to give up in order to produce something. Maybe I'm really efficient at producing cars. In fact, let's take our U.S. and Mexican factories example. We established that the US factory has an absolute advantage in producing cars because it can produce more with the same number of resources. However, what does the American factory, or maybe we can think about the American economy as a whole, what does that have to give up in order to produce those cars? Well, it has to give up a fair bit because if it wasn't using those workers and that land and the expertise and the raw material, the machinery, if it wasn't using all of that stuff to make cars, it could use it to make something else. pretty, that was quite valuable because the US is an advanced industrialized economy, and so it has lots of high value uses for its raw materials and for its labor. In other words, it has a very

high opportunity cost for using those things to produce something like cars, whereas perhaps the factory in Mexico has a much lower opportunity cost from producing cars, because if it didn't use that steel and those workers and the land and the other things for producing cars, presumably it would have used them for something else, but arguably, or at least let's say in our example, the other things that it would have been using those resources to produce would not be nearly as valuable as the cars. So what it's giving up is much less valuable than what America is giving up to produce the cars. And so this means that if the opportunity cost of the Mexican factory is sufficiently low, then it will have a comparative advantage in producing cars, even though the American factory

has an absolute advantage in producing cars. And again, this is possible because of the differences is in opportunity cost. The American factory can outproduce the Mexican factory 2 to 1, just purely in terms of number of cars produced per worker or per electricity use or something like that. But that's not really very important. When I go and buy a car, I don't care how many man hours it took to make or how much steel it used.

What I care about is how much it costs to make. And how much it costs to make really is dependent primarily, or in some sense only, but here we'll say primarily, on the opportunity cost. In other words, if a car took lots of steel and many man hours to make, but that steel and those man hours wouldn't have been used for anything else of value if they haven't been used to make the car. So in that case, the opportunity cost is effectively zero.

Then the car can still be quite cheap because they're not giving up very much to make the car. Whereas in the case of the... So suppose that's the case of the Mexican car, not much is being given up to produce the car. So therefore, the cost of the car is actually quite small. Whereas in the US case, a lot's being given up to produce the car, because those resources could have been used for something else that had a very high value. So therefore the opportunity cost is high, therefore the price of the car, the cost of the car is higher.

And the reason that opportunity cost translates directly into price is because I have to bid against all of the other people who want to use those resources. I wanting, me wanting the car, I have to bid, that is, you know, be willing to pay a high enough price so that I can get my preference, against all of the other people who wanted to use the same labor and the same resources that were in fact used to make my car. so the people who wanted to use those to make televisions, the people who wanted to use them in the financial industry, the people who wanted to use them in the building industry, wherever else people wanted to use those resources. I have to bid against all of those people

and offer a higher price for the car in order to get the factory to use the resources in the way that I want them to. Whereas in the Mexican case, I don't have to bid against all these other people because there aren't these other people who are wanting to use the resources. The opportunity cost,

the opportunity cost is much lower because there aren't alternative competing uses of the resources. That's what it means to have an opportunity cost. Therefore, I don't have to bid against all these other people. I only have to bid against very small value or very low value alternative uses of the resources. Hence, I don't have to pay a very high price for the car. So, this concept of comparative advantage is why so much manufacturing is outsourced from countries like America and Europe to countries to countries. It's not because, and this is really important to understand, it's not primarily because, say, the factories in India or Taiwan or wherever, or China,

it's not because they're more efficient in the sense that they can produce more per person. In some instances that might be the case, but primarily that's not the reason. The reason is that they have a lower opportunity cost, because the workers in China, if they weren't working in the factories, they'd be working in agriculture, which is what many of them were doing before, which is a very low value, very low value-added industry. And so their opportunity cost is much lower, whereas the workers in America or in Europe, if they weren't working in the factories, they have much higher value working somewhere else, even if it's only a service industry or something like that,

people in the developed countries are still willing to pay a very high wage in terms of, globally speaking, for workers in service industries and other places like that or in business or wherever else. So the opportunity cost of the labour of the workers is much, much higher in Western countries than it is in India or wherever else. So therefore, the opportunity cost of producing manufactured goods in Western countries is, for the most part, much, much higher

than in countries like India and China. Therefore, it's much cheaper to produce these goods in India and China. And so, therefore, India and China have a comparative advantage in producing these goods because they can produce them at a much lower opportunity cost. Now, there's another important thing to understand about comparative advantage, and also how it differs from absolute advantage. It's possible for one country to have an absolute advantage in everything, or conversely to have an absolute advantage in nothing.

So maybe, for example, if one country was just really sophisticated and advanced, maybe the US or, I don't know, Switzerland or something, it could have a comparative advantage in everything. That is, it could produce, sorry, it could have an absolute advantage in everything. That is, it could produce anything you could imagine using less resources than anyone else could. That's perfectly possible. Maybe it's so technologically advanced you can do that. Similarly, if you're really underdeveloped, really poor, really unsophisticated, very backward,

then you might have an absolute advantage in nothing. Maybe it's, you require more resources to produce the same thing than compared to any other country. That's possible as well. So you don't have an absolute advantage in anything. However, comparative advantage is different. It's impossible to have a comparative advantage in everything. Similarly, it's impossible to have a comparative advantage in nothing. Every country has a comparative advantage in something.

And the reason for that is because opportunity cost is always relative. If you're really good at doing everything, that means your opportunity cost of everything is very high. So if I'm really good at, say, agriculture and the industry, then if I put more workers into industry, I'm taking away lots of output from agriculture, because I'm really good at doing that as well. So if I'm really good at doing agriculture and industry, then my opportunity cost of both is very high. Whereas if I'm really bad at doing both, then my opportunity cost of both is low. And so what makes the difference is not whether I'm really good at doing things or really bad at doing things, but what makes the difference is in terms of comparative advantage is which I'm relatively better at doing. Maybe I'm really bad at everything.

Maybe I'm a developing country, which is really backward, has very old technology and unskilled labour force and so on. But perhaps my disadvantage in agriculture is less than my disadvantage in industry. That is, maybe I'm only one-tenth as efficient as Western countries at industry, but I'm one-fifth as efficient in agriculture, just to make up some numbers. In that case, my comparative advantage is agriculture. Even though I'm much worse at agriculture than the Western countries, I can still have a comparative advantage in that

because the opportunity cost agriculture for me is much lower than the opportunity cost of agriculture in the West. Because remember, Western countries are great at agriculture, but if they move workers from industry into agriculture to increase agricultural output, then they're giving up heaps of industrial output. They have a much higher opportunity cost,

whereas my opportunity cost is much lower because I'm hardly giving up anything to move extra workers into agriculture. And so therefore, I have a comparative advantage in agriculture, whereas the West has a comparative advantage in industry. it's not possible to have a comparative advantage in everything. In fact, the only way that is possible is if all the countries were exactly the same. They were exactly as good at producing everything,

or in exactly the same proportion. There was no relative difference in their ability to produce anything, which is just totally unrealistic and never going to happen, because it's never going to be the case that everyone's equal at everything. So as long as there are relative differences in your ability to produce different things, then there is going to exist comparative advantages. And as long as there are comparative advantages, everyone will have a comparative advantage in something.

So this is another important lesson about the whole outsourcing question. Some people are concerned that all of the industrial jobs or manufacturing jobs are being outsourced to India and China and other countries like that, then there won't be any jobs left for Americans. Well, although there are lots of complexities to this issue, certainly at a first level of analysis, this is false, because from looking at things from a comparative advantage perspective, it's not possible for India and China to have a comparative advantage in everything. They might have a comparative advantage in some things, for example, manufacturing,

but that means that Western countries must have a comparative advantage in something else. Now, exactly what that something else is might be slightly difficult to determine. It may be something like education or financial services or just business consulting in general, or it might be more advanced technology services or all sorts of things, a potentials. But the point is, it's not possible for one country to have a comparative advantage in everything. And so it's not possible for one country to be completely unemployed, but no one can get work because it's always cheaper to make something somewhere else. That's impossible.

Think about the reason why that's impossible. Imagine that everything was, imagine that we had this bizarre situation where somehow everyone in America was unemployed because no one can compete with things in China. Well, what would the opportunity cost be of hiring a worker in America to produce something, anything? agriculture, financial services, manufacturing anything. Well, the opportunity cost is basically zero because they weren't doing anything else, were they? You're not taking them away from anything because we've just said they're unemployed.

So therefore, the opportunity cost of doing this in America, producing anything in America, in this imaginary example where all Americans are unemployed, is zero, or basically zero. Whereas in China, what's the opportunity cost of producing something extra? Well, we don't know, but it's certainly going to be more than zero because they're all busy producing everything that's not being produced in the US. So therefore, we've just established that in this hypothetical example, example, where everything is being outsourced to China, that the opportunity cost of producing stuff in the US is less than the opportunity cost of producing stuff in China, which means,

therefore, that the US rather than China would have a comparative advantage, and therefore it would be cheaper to make things in the US than in China. Now, obviously, we would never get to that situation. The point is to illustrate why you couldn't get to that situation, because as, essentially, as things to outsource to China, the opportunity cost of producing things in the US is going to, or certain things in the US is going to decline, and the opportunity cost of producing things in China is going to increase because the value of the things that they are using their workforce for is increasing as they're able to sell and export things to Western countries. And so at some point those are going to equilibrate, at which point you're not going to have

any further outsourcing to China because the opportunity costs are relatively equal. So it just simply cannot be the case that all of the jobs of any country are outsourced to another country, whether you're talking about outsourcing to developed countries or from developed countries or whatever. It's just impossible from a comparative vantage point of view. countries will always have a comparative advantage in something, and therefore there will always be some area of employment for that country to engage in. Now, there are certainly other factors there, which we just don't have time to get into about complexities and wage and sticky wages and other things like that, but again, we're just looking at the trade aspect for now. So the pattern of trade we expect to see as a result of comparative advantage is that each country will produce the thing, or even regions within different countries, will produce what they have a comparative advantage in.

Because that means they're producing at the lowest opportunity cost, which means, in turn, that resources are being used most efficiently. Obviously, if India can produce, well, let's say if China can produce manufactured goods at a much lower opportunity cost, whereas America can produce financial services or whatever else, at a much lower opportunity cost. cost that China can, then it makes sense to have all the financial services done in America and all of the manufacturing done in China. Again, I'm just using simple examples here to illustrate the point. Because, but the point is, if that pattern of production prevails, then the total opportunity cost of the whole world goes down, and therefore the entire world's resources are being used more efficiently, which means you can get more output from the same resources, and hence everyone is better off. That is why that both the US and China are able to both benefit

from trade. Then that doesn't mean that every single person in the country benefits. Obviously, the American manufacturer workers who are losing their jobs, they personally don't benefit, at least not in the short run. But, because remember, there are static and there are dynamic effects, and so those are playoff against each other. Everyone benefits from the dynamic effects, but not everyone benefits from the static effects.

But anyway, both countries are able to benefit, because they're both gaining access to a more efficient allocation of resources, which means that the total pie, the total size of everything that's produced, the total amount of stuff that we have, gets bigger because we're using our resources more efficiently. We've found a way to make stuff without giving up as much. That's a different way of saying opportunity cost is lower. As a result of that, everyone is able to benefit. China is able to benefit and the US is able to benefit. In engaging in trade in this way, they have lowered their opportunity costs, therefore increased the total output, and they are both then able to take a portion of that increased output for themselves, and hence both benefits.

So it's not a zero-sum game, is what economists tend to say. In other words, if China benefits, that doesn't mean the US loses. Again, there are certain circumstances where this might be the case. But in general, in international trade, it simply isn't the case because of the concept of comparative advantage. Each country will specialize in producing what they have the lowest opportunity cost of producing, thereby reducing the total opportunity cost of the whole world, and therefore increasing the total amount of output that the whole world can produce. And hence everyone, or, you know, everyone on aggregate, can be better off. And again, what I've been speaking about in terms of comparative vantage is mostly focusing on the static benefits, the one-off benefits of trade. There are also the dynamic benefits that I mentioned before, and those compound over time so that it gets sort of more and more, the benefits of this sort of open trade increase over time, and everyone will benefit from those. Okay, so hopefully that was a relatively clear explication of the principle of comparative advantage, and that really underpins why we have so much trade, particularly global trade, but it also works to understand domestic trade as well.

You know, so why I specialize in doing something, while other people specialize in doing other things and we trade, because it allows us to have a comparative, to do things that we are relatively good at doing and then outsource the other things that we're not as good at doing. You know, so that's why you have someone come to mow your lawn, and instead of mowing your own lawn, mowing your own lawn, it's cheaper because they specialize in doing that.

Okay. Now, there's a couple of other aspects of trade that I want to discuss. One is the concept of middlemen. These are traders, like retailers and wholesales, merchants and so on, who buy things and then move them around or change them in a fairly subtle way and then sell them again. So basically they're just a conduit for goods and services. They buy from one person, they move them perhaps, and then sell them on. Merchants and intermediaries in general have generally been reviled throughout history

because they're seen as being parasites. They're seen as not contributing to anything. They just buy low prices and sell at high prices. They just make a profit at the expense of everyone else, right? I mean, who needs them? They're just leeches sucking resources from the rest of society without contributing anything. Everyone knows that, right? Well, it's not so simple. So perhaps that happens sometimes, but in general, middlemen actually fulfill a very important function. To understand that, probably the easiest one to think about is the supermarket. The supermarket, where you buy goods and where you buy food, is an intermediary. They don't really produce anything. All they do is buy their inputs from wholesalers or perhaps direct from manufacturers or farms or whatever, and then sell them onto consumers at a markup. So it doesn't seem like they're actually providing anything, but in fact, they're are. What they provide is a very important service, which is that of engaging in all of these large transactions and bringing things, bringing the goods that the consumers are interested into a single central location. Imagine if you had to go to all of the different farms or

factories to buy all of the different consumer goods or even just foods that you consume. So you have to go to a dairy farm to buy a dairy products. You have to go to a meat farm to buy meat products. You have to go to different farms to buy different fruits and vegetables, some of which overseas, by the way. You have to then go to various different manufacturing plants to buy different types of processed food. Who knows how many trips this would be, dozens, hundreds of trips to different places

all over the city or indeed all over the country? That's completely infeasible, obviously. So it's much easier if one person or one company does this brings all the goods together in a single place and raise them out in a relatively attractive and comfortable, nice environment to make selection and purchasing of this. these goods as easy as is feasible.

And if you have one person doing this and then the consumers just going to that place and buying them, it's much easier. So that is the value or the service, that middlemen, in this case specifically we're looking at supermarkets, that's the service they provide. It's bringing all the goods into one place and arraying them in an attractive way and making it easy for consumers to access them. And consumers are willing to pay something for that. They're willing to pay the markup that the supermarkets require.

That is the higher price that the supermarket charges. as opposed to buying direct from the farm or direct from the manufacturer. Because the markup is relatively small, consumers are willing to pay for it, because they get a substantial benefit from only having to go to the one place instead of having to go to all of these other places all over the country. So that's the value of a retailer, and it doesn't just apply to supermarkets.

I just use that as an example. It really applies to any type of shop. You go there and have a selection of many different brands and product lines and qualities that you can select from as opposed to having to go to all of the manufacturers individually and then compare those, which would just be much less convenient. Middlemen provide other services as well, other than just collecting things together. They often transport goods from one place to round, but clearly that is a service,

because transportation costs money. Another thing they do is engage in, is bear some of the risk. So, for example, they buy something where it is relatively cheap, and then maybe transport it or store it for a certain period of time, and then sell it at the later time, hoping to get a higher price. But when they do that, they're always taking some risk. Perhaps the price won't go up as much as they had hoped, or perhaps it will even go down.

So they're bearing some risk there. And the reason people are willing to pay for that is because people generally don't like bearing risk themselves. So we'd prefer that someone else could bore that risk and then just be willing to pay a certain markup. Now, in general, middlemen can only stay in business if the service that they provide, whether it's bearing risk or transporting goods or collecting them in a single location or whatever,

they can only stay in business if the value of that exceeds the markup that they are charging consumers. If the value did not exceed the markup, then consumers would just do business directly. They would buy goods and transport them themselves, or they would just go straight to the manufacturer, as indeed some people do, because they find it to be cheaper. But if it was a bad deal for everyone, then the middlemen would just go out of business. Okay, so that's a bit on middlemen,

and the important role that they play in the economy. Now we're going to have a brief look at some trends in global trade and a bit on trade institutions and the role that they play. So you've probably heard of the phrase globalization. That's the term that's used a fair bit now, maybe a little bit less than a couple of years ago. I don't know. Globalization refers to the increasing scale

and internationalization of pretty much everything, of politics, of culture, but particularly of business and trade. Globalization is not really new. It's been going on for hundreds of years. So, you know, ever since in the 15th century, the European explorers began to try and find an alternate trade sea routes to India and they began to explore off the coast of Africa and eventually discover the new world and so on and so on.

That sort of began the modern process of globalisation. But modern globalisation is usually dated to the end of World War II when a number of international organisations were founded whose purpose was to facilitate greater global trade and cooperation, things like that. And part of this was in response to World War II. There was a desire not to have a return to the sort of autarkic, self-sufficiency-minded mindset that prevailed during, say, the 1930s and 40s, particularly with Nazi Germany and Imperial Japan.

So there was a desire to move towards greater integration and cooperation and trade for mutual benefit. And so we had a number of these organizations formed, in particular the World Trade Organization, or the WTO, the International Monetary Fund, the IMF, the World Bank, and also the GATT, or the GAT. And I can't remember what that stands for. But the purpose of these organizations, well, each of them had a slightly different. purpose, but the basic purpose was to promote trade and economic cooperation between different countries. And so as a result of this, the amount of global trade has increased dramatically

since World War II. Indeed, since the end of World War II, the amount of world trade has grown much more quickly than world production has, something like two to three times as rapidly. So obviously you expect trade to increase as countries get richer and produce more stuff, but world trade has increased dramatically more several times as much as you would predict simply based on the growth in production. So this is a clear indication that trade's becoming more important, especially international trade. Partly this is due simply to lower transportation costs, containerization and other things, but it's also in large part due to the work of particularly the WTO.

And one of the main focuses of the World Trade Organization is to liberalize global trade by reducing trade barriers. And we'll come back to that in a moment, but trade barriers are things like tariffs and quotas which restrict trade between countries. The World Trade Organization's main purpose is to try and organize international agreements for countries to reduce these barriers to trade so that we can have more trade and more specialization and hence increase productivity. And there have been a series of agreements that have been made by lots of different countries in the past few decades, each of which further lowers barriers to trade, or at least that's the idea. And so part of the reason for this dramatic growth in world trade has been the success of the World Trade's efforts to liberalize trade. Another important of these organizations is, as I mentioned before, the IMF, the International Monetary Fund. The purpose of this organization is to promote monetary cooperation and secure financial stability in the world, and also to facilitate international trade and promote economic growth.

Most countries in the world are members, as indeed most countries in the world are also members of the World Trade Organization. The IMF activities are a bit broader than the WTO, so they do participate, I think, in some trade agreements, but they're also involved in making loans to poor countries. and to countries in various financial difficulties. So, for example, if there's a currency crisis, they might organize a loan to stabilize the currency of a particular country. They also, as I said, organized developmental loans to help countries in Africa and Southeast Asia and so on, develop their economies.

They provide expert assistance for economic reforms and development programs and things like this. The World Bank, which is another of these organizations that I mentioned, is kind of similar to the IMF, although they have a more specific focus on making loans to developing countries for the purposes of economic growth. So the IMF does some of that, but the World Bank is more specifically focused on doing that. Again, most countries in the world are members of the World Bank.

In addition to these three main international organizations, the WTO, the IMF and the World Bank, there are also localized trade blocks or trade agreements or treaties between groups of countries to establish some sort of special trading relationships or often lower trade barriers and things like this, or sometimes to adopt a common currency. So the European Union is probably the most famous of these. Many of the countries in the European Union have abolished border restrictions between them so you can move freely across the borders. They have effectively adopted free trade amongst the countries, it means there's no real restrictions to transportation of goods or services and sale of them between the different countries.

And they have adopted common trade policies towards external countries and a wide variety of other policies as well, designed to facilitate trade within the European bloc. And as you also probably know, they've adopted a common currency to the euro. Another prominent free trade agreement is NAFTA, the North American Free Trade Association, between Canada, the US and Mexico, which is a free trade agreement, which was signed, I think, in 94 or something like that, again, whose purpose was to promote trade between these three countries, lower trade barriers, and so on. There are many other such treaties and organizations as well, but those are two of the most well-known ones.

Now, a bit more of an explanation of what we mean by trade barriers. So, as I said before, trade barriers are generally laws or other types of legislation or government interventions that restrict trade, particularly between countries, although it can be within countries as well. So the most common one of these is a tariff. A tariff is just a tax on imports, which serves to raise the price of imports above what you would otherwise pay, and therefore serves to discourage people from buying those imports. So, you know, it might be cheaper to buy imports from another country, but then if there's a massive tax levied on them or even a substantial, tax, then it's no longer cheaper and you just buy domestic. Generally, the purpose of tariffs is, well, to raise money for the government, just like any other tax, but also to keep out foreign competition.

The idea is that one should, for whatever reason, protect one's local industries from foreign competition, and so you levy taxes on the foreign competition, but you don't levy the same taxes on the domestic firms. This is the important difference. If you levy the same tax on all firms, foreign or domestic, then it doesn't really make any difference. That's not a tariff. It's only a tariff if you specially levy it.

or place it on foreign imports and not on domestic production. Then it becomes a tariff, and it becomes a barrier to trade. It makes trade more difficult and more expensive because you're effectively giving domestic producers an artificial advantage over the foreigners. Reducing tariffs is one of the main focuses of the WTO, and since the 1930s, average world tariffs have fallen to about 20% of their previous levels, so one-fifth of their previous levels, which I think is quite an impressive achievement, actually. So, and again, this is one of the big reasons for the dramatic acceleration or dramatic increase.

the total amount of global trade since the 30s and 40s, because of this dramatic reduction in average tariff levels. It's important to understand that consumers in the country levying the tariffs almost invariably lose out because they have to pay higher prices as a result of the tariff. So suppose I could buy something for $50 imported from Japan, but then there's a $50 tariff levied on it. Now I have to pay $100 for it if I want to buy it imported, and then maybe I have a choice between paying the $100, $50 plus the $50 tax, or buying it for $90 from a domestic producer. Well, I go the $90 for a domestic producer, and so imports go down. But also, I have to go from paying $50 for an import to $90 for a domestically produced one.

So as a consumer, I lose out. The only reason you ever will need tariffs is if a country's domestic industries are uncompetitive. So if, to take our example, suppose that the US producer could produce and sell the good for $40, whereas the Japanese version cost $50. Well, then I would never even think about buying it from Japan. and I would just buy it from the American one because it's cheaper. In that case, the tariff is irrelevant because I wouldn't have bought it from there anyway. It's already more expensive, so that the tariff doesn't make any difference.

So tariffs only ever do anything if they are acting to reduce efficiency by keeping out lower-priced competition and therefore propping up or sustaining relatively uncompetitive domestic industries. And this is a bad idea, economically speaking, because it means that you're misallocating resources. The fact that Japan can sell something cheaper than the American firm should be telling you, as an economist, we know that it's telling us that Japan has a lower opportunity cost of producing this thing, and we have a higher opportunity cost. That means that if we make it here, we're giving up more than if we let the Japanese make it and then buy it from them.

And that's silly. Why would you get something, if I want this good, why would I get it by giving up more when I could have got it by giving up less? If you've raised it in those terms, tariffs essentially don't make any sense at all. And most economists, as a result, oppose most tariffs because they are inefficient. They distort the allocation of resources so that we have to. to give up more stuff to get the same thing. Or, put differently, we get less from our resources than we could otherwise have gotten

if we had used them more efficiently. There are other factors about tariffs, like, for example, many developing countries levy tariffs because it's easier to collect those type of taxes than other types of taxes, and therefore if you cut the tariffs too much, the governments can't collect revenue from other sources, and therefore the government programs suffer. And this is a lesson that was sort of learned by the WTO and the World Bank, the hard way, because they were arguably insufficient. sensitive to the local conditions. And there's certainly many valid criticisms of these three

organizations, by the way, but I don't want to get into that details too much of that. I just want to point out there are sometimes valid reasons for tariffs, and if that's the easiest and most efficient way of collecting a tax, then that might be one justification. Certainly for developed countries, that isn't the case anymore. Another justification that's sometimes given for tariffs is that it's necessary to protect this industry for reasons of national security. So, you know, we can't risk losing this industry and only be able to rely on imports, because then if we have a war, or some other crisis, then we won't be able to use it domestically.

That's more of a political argument than an economic argument, but the main thing we would be concerned about is whether that is indeed the case, whether it is a national security issue to be able to produce this good, or whether that's just a convenient excuse that the lobbyists from that industry are using to continue to receive effectively a subsidy from the government. That is, the industry likes it when you levy tariffs on their things, because it means they don't have to compete with cheaper foreign producers. So, of course, then they're going to hire their lawyers to make,

make good arguments that seem plausible about why it's essential for national security or national identity or whatever that you keep producing this thing domestically. So one has to be cautious of that. Anyway, so that's tariffs. Another type of trade barrier are called quotas. And this is where instead of levying a tax on an import, you just say you're only, where you or the country's a whole, is only allowed to import X number, a thousand or a million or whatever, of this particular good in a given year. And once you've imported that many, then you can't import any more. Quoters and tariffs are really exactly the same as one another. Or in other words, they have the same effect. They're implemented in different ways. One says you have to pay a tax. The other ones doesn't say

you have to pay a tax. It just says you can't buy more than this amount. But it doesn't matter. If you think back to supply and demand, it doesn't matter if you restrict the quantity or if you restrict the price. It does the same thing. The effect is exactly the same. You get a reduction in the amount of trade. You get an increase in the price. So the effects are the same either way. The only difference is that in the case of a tariff, the government gets the money, whereas in the case of a quota, the domestic producers get all the extra revenues. So quotas make even less sense than tariffs because you don't even have that effect of government revenue generation. So they generally use a bit less than tariffs because of that fact, although that's sometimes

easy to implement. So quotas and tariffs probably receive the most attention in regards to trade barriers because they are sort of the most obvious or the most overt, but there are other types of barriers to trade as well, and these are often more subtle. So one type of, one such type of trade barrier are subsidies to domestic producers, which give them an advantage relative to foreign producers. This is almost like just the exact inverse of a sub, sorry, of a tariff. In other words, instead of taxing the foreign guy, we won't tax the foreign guy, but we'll give a subsidy to the domestic guy, allowing them to sell at a lower price and also make higher profits for themselves. This is a barrier to trade in exactly the same way, because it gives the domestic producers

an artificial advantage relative to the foreign producers and therefore misallocates resources. The opportunity cost is higher because we have to not only pay the, the consumers not only pay the price of buying the good, but they also pay an extra. extra element to the price through their taxes that are used to being subsidized that business. And a really good example of this are farm subsidies in developed countries, especially US and the European Union, which have very substantial farm subsidies. And many developing countries have complained bitterly about this in recent trade agreements because they're arguing that there's too much of a focus on tariff reductions, which is mainly

what the developing countries have used, but not enough of a focus on subsidies, which are mainly what developed countries have used to prop up their domestic agricultural industries. Really, the effect of subsidies is just as problematic in terms of trade as tariffs and other things, because it's restricting trade and it's distorting the allocation of resources. So there's generally little justification for these sorts of subsidies, although, again, arguments about national security and such things are raised as well. Another example of barriers to trade are local content laws. Generally, this applies to media or TV stations and other things like that,

in that they must air a certain proportion of their content that has been produced domestically, so they can't just air 100% of their programs from imported material. They have to air 20% or whatever percent with domestic stations. And there's usually some argument about protecting national culture or something like that. Again, that goes a bit outside of the purely economic side of it, but what you'd have to be worried about is whether it's really an issue of protecting national culture or an issue of protecting the profit margins of

powerful local media interests who have who are able to afford influential lawyers to push these sorts of laws through. The economists would worry about that sort of thing. Another way of thinking about this is one always has to look at the opportunity cost. How much are we paying in terms of lost benefit from the programs that we would like to see

to protect this national culture or whatever it is the way to think by protecting through local content laws? What's the opportunity cost? What are we giving up and is it worth it to give this up? A couple of other types of trade barriers include government procurement policy. So this is an interesting case where it can be written into certain laws or either explicitly or just sort of be an implicit practice that when the government

needs to buy something or needs to engage in some sort of contract with a private company, it has a preference for local products or for local firms over foreign ones. And I think a number of US programs have this preference for local firms over foreign ones. I don't know exactly which ones, but I'm pretty sure I've heard about that before. Again, this is just another variant of barriers to trade because there's no justification in terms of resource use, why you would prefer domestic to foreign. What we should always prefer is that which has the lowest opportunity cost, because that means that if we use the one with the lowest opportunity cost, we can use resources more efficiently. And having a preference for local over-imported or foreign products simply acts as another barrier to trade which reduces resource-sufficiency use.

And another type of trade barriers, which can sometimes be relevant, are packaging, labeling, and other safety laws. These are interesting because they have certainly a valid purpose, but they can sometimes be abused or at least have the unintended consequence of being biased, foreign importers. So an example of this is if you require certain packaging or labelling or safety standards for imported goods which are easier for domestic supplies to meet than for foreign suppliers then that is going to give a preference to domestic suppliers thereby introducing a barrier to trade. So this is one thing that I think the European Union has tried to do which is make is to reform these sorts of packaging and labeling law so that they're

consistent between countries so you don't have this artificial barrier to trade. And then you get these sort of ridiculous questions coming up, like whether tomato sauce counts as a vegetable, because, you know, what proportion of vegetables does a product have to use before it gets counted as a vegetable product, and therefore is subject to this certain type of regulation and packaging laws, and that has to be the same across different countries, because otherwise you'll get a differential cost differential here and there, and all sorts of the other rather silly questions in my view, but also necessary because, you know, these laws have to be made. But the point is these sorts of difficult questions in class.

and labelling property can result in barriers to trade intentionally or unintentionally. So this is one thing that legislatures should be aware of when they're making these types of laws. Okay, so in the last couple of minutes, I just want to talk about the concept of buy local, which is, I think, important given the topic of this episode. The concept of buy local or local purchasing is that one should prefer to buy things that are produced locally goods or services, especially food. There's a big focus on food, but it's not limited to food. locally produced goods should be preferred to those produced further away.

Now, one important point here is that advocates of this buy local position generally don't mean that you buy a local when it's cheaper or when it's fresher or if it tastes better because you would just do that anyway. That's just buying local because it's better. In other words, because it's obviously better for tangible reasons, in which case you're just buying a higher quality or cheaper product. That's obviously not very interesting. Obviously, if you really value freshness, you buy local because it's fresher.

Generally, what buy local advocates mean, though, is that even if this isn't the case, even if it's more expensive and doesn't taste any better, you should still buy local, or should you have a preference for buying local, because of other reasons. There are other reasons aside from taste or freshness or price that should induce you to buy local. That's sort of what at the core of the argument is, because if it's just a question if it's fresher, well, then that's just that you're just saying that the consumer should buy higher quality if they like the quality, but, you know, they would do that anyway. Now, one reason given for this is that locally produced goods require less transportation, which means less greenhouse gas emissions, and therefore it helps the environment. Another argument given in favor by local is that it supports the local community, because the profits stay in the community, the tax revenue stay in the community. You have local jobs, more likely to help out local charities as a result of revenues generated in the community. The profits don't go to some faceless overseas company or something like that, and then it used to benefit other people that they are retained in the community.

That's sort of the second class of arguments, the type of community ones. And the third class of argument is given for buy-local is that buying local promotes better working conditions, especially for farmers and factory workers, because in other countries, especially in like the third world, you have factory farms and sweatshops and the conditions are much worse. So it's better to support local mum and pup stores and local fresh farm, you know, local small-scale farms and that sort of thing because they have better conditions for workers, and it's a nicer, nicer thing to have. So these are the three broad classes of argument, so environmental, community, and sort of work conditions. There may be others as well, but these are sort of three main ones that I've come across.

Now, my purpose here is not to say whether these arguments are right or wrong or whether one should or should not buy local, because that incorporates too many issues of value judgments for it to be a strictly scientific question. What I do think is relevant, though, is that when people make these sorts of claims, one needs to consider the opportunity costs of what one is doing in all of these cases. So that's what I really wanted to highlight in this issue here, is that if you're thinking about buy local or if you find these arguments persuasive, ensure that you're incorporating the concept of opportunity cost into your decision.

And I just want to illustrate that, I think partly to illustrate the gains from trade and also to illustrate the concept of opportunity cost. I think this is a good example. So again, I'm not trying to make an argument about whether biolocals a good idea. I'm just trying to illustrate how we can use opportunity cost, I think, to potentially make better decisions. Okay, so looking at first the environmental argument. So considering opportunity cost in relation to this argument, you would have to ask, well, what are we giving up when we pay a higher price to purchase goods that are made further away? Well, we're giving up a certain amount of money by paying the extra cost.

What could have we done with that money instead? Well, one thing we could have done with it is donate it to some sort of environmental charity who could have then used it to promote an environmental cause. That might be more effective than paying a higher price for a locally produced good and therefore reducing greenhouse gas emissions. It all depends on how effective you think these different methods of reducing greenhouse gas emissions or whatever are. and you can't necessarily say that without looking at the actual figures. But the point is, in order to make the correct decision, you would need to factor this in.

You need to factor in the opportunity cost of what you're giving up. The economists would generally say that it's better to levy a tax on things like, say, greenhouse gas emissions, have some sort of carbon tax. Because then in this way, if you levy the tax at the right, if the tax is set to the right level, then people will automatically buy local to the exact right amount. In other words, if it's just slightly more expensive to produce locally than overseas, then when you incorporate the tax, it actually becomes cheaper to produce locally, again, if you incorporate the tax into the analysis, and therefore people just buy locally naturally for those type of things.

But for things where it's really, really expensive to buy locally, then people will still buy from overseas, because even when you incorporate the tax, it's still cheaper to buy overseas. So generally an economist would prefer a tax on, say, greenhouse gas emissions or pollutants or something like that, because it's a more efficient way of ensuring that you buy local just to the right amount. It certainly wouldn't be optimal to buy everything local, because that would be very inefficient, that would completely give up the advantages of, remember,

comparative advantage. The opportunity costs of buying everything local would be far too high, and therefore a tax would allow us to determine exactly, just looking at the price, exactly how much buying local should be done. Again, that's assuming the tax is set at the right level and is enforced properly and these other things. Now, of course, if there is not such a tax, then that changes the analysis. But regardless, one still has to factor in the opportunity cost of what you could have done

with those funds, and whether buying local is the best way of, promoting the environmental objectives that you're trying to fulfill. So moving on to the second argument about promoting community. Now, here it's also very important to consider the opportunity cost. So first of all, we have the same situation as before. You could buy the more expensive local product and then hope that there's some sort of flow-on-effective local jobs or whatever. Or you could simply buy the cheaper non-local good and then donate the price difference to some sort of local community group or a shelter for the unemployed or something like that.

Arguably, that's going to be much more effective because you can donate the entire price difference. to the local community group of your choice rather than just hoping that some proportion of it is going to eventually make some sort of difference. Now, there might be cases where that that doesn't hold, but still, the main point is one needs to consider that opportunity cost. What are you giving up in purchasing the more expensive, the more expensive non-local product? Well, you're giving up the opportunity to make a donation to some sort of local community group, for example. Also, the issue of retaining more profits and having more jobs in your community is potentially true. what one has to consider, though, is that means less jobs and less profits in some other community. Whether you think that it's more important to have jobs and profits and benefits to your community

compared to someone else's community, that's more of a moral question that we can't answer here. But again, the point is, you just have to consider that in your analysis. Maybe you don't care about communities on the other side of the world or on the other side of the country, and so that's not relevant to you, in which case, you know, would still make sense to buy local. But if that is relevant, you can't ignore that decision. You can't ignore that consequence when you're making the decision. So again, this issue of opportunity cost, what are you giving up to buy a non-local product? You're giving up the possibility to donate to a local community.

You're giving up the benefits and extra jobs and profits and so on for some other community somewhere else. And the third reason that we discussed for buy local was that it promotes better working conditions for farmers and factory workers and so on. So once again, one must consider the opportunity cost. So first of all, what are you giving up if you buy a more expensive non-local good and buy a local good instead? Well, first of all, you're giving up the possibility of making some sort of charitable donation to a charity that helps people in the third world, or helps improve working conditions, or helps to treat malaria or something like that. That might be more effective than just paying a higher price for a local good

and hoping that that has the same effect. Also, another important fact is to consider that, although the working conditions in farms and sweatshops in other countries might not be as good as they are here, if they didn't have the factories or if they didn't have those jobs, then they would, in most cases, be doing something even worse. So a classic example is that, you know, if the people can't get jobs in the factories, well, then what do they resort to to, what do they have to resort to enough money to survive? They have to resort to prostitution, or they have to resort to theft, or they have to resort to really hard agricultural labor, which is even worse. So the point is, consider the opportunity cost.

What are you giving up when you buy local instead of buying overseas? Well, you're giving up the jobs and the benefits that the people in these factory farms get. And they might not necessarily agree with you that that's been a net gain. They may not like their jobs that much, but they like it compared to the alternative. So it's always a question compared to what. So the conditions in these factories and sweatshops and whatever might not be great, but it might be better than the alternative. And again, that might not always be the case,

but the point is one should at least consider that when making the decision. You always have to consider the opportunity cost about what's being given up. So again, the main point I wanted to make here is not an argument against buy local per se, but merely to point out to use this as a topical application of the principles of comparative advantage in the gains the trade to illustrate that we, that in making these sorts of arguments and making these decisions about whether to buy local or to buy foreign, to buy non-local, we must, if we want to make the correct decision and, you know, make a decision consistent with reason and science, we need to factor in all of the relevant costs and not just the ones that we can see most obviously. and so that therefore requires

taking into consideration opportunity costs that is the cost of what you give up to get something and when you buy non-local when you buy local instead of non-local if you're paying more for the local compared to what you would have otherwise paid then you're giving up something and you have to consider what that is

and how valuable it is compared to what you're getting okay so that's all we have for this episode I hope you learnt a few things if you like the podcast then jump on to iTunes and give us a favourable review I've had a few but more are always always helpful in spreading the word of the podcast.

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My address is FODs12 at gmail.com. That's F-O-D-S-1-2 at gmail.com. Thank you for listening, and I'll talk to you next time.