Why Trade Wars Are Good For Trade

7 April, 2010

Economists know that international trade is mutually beneficial. Barriers, such as tariffs and quotas, reduce consumer choice and make goods more expensive. And after all, what business has the state in precluding your mutually beneficial exchange just because the counter-party is a foreign citizen?

Unfortunately, international disputes can put free trade in jeopardy. When states respond to apparent ‘distortions’ by slapping tariffs on incoming goods, they’re trying to retaliate. In reality, they’re hurting their own citizens. What good could possibly come of trade wars?

Today, the line between ‘foreign’ and ‘domestic’ producers is more blurry than ever before. The MacBook I’m typing on right now was sold to me by an Irish retailer, having been assembled in China from parts produced in Taiwan and Korea. It was designed by American engineers, and some of Apple’s profits no doubt return to private investors here in Ireland too. Who benefited from my purchase? Lots of people, some foreign and some domestic.

Even if international trade wasn’t integrated in this way though, tariffs and quotas would still hurt domestic consumers. Unfortunately though, there are strong interests aligned with governments throughout the world determined to restrict trade and maintain their dominant position in markets free from foreign competition. This is a simple example of a collective action problem: small groups of firms and workers find it easier to organise themselves than millions of disparate consumers – even when the benefits to the former are outweighed by the costs to the latter.

This isn’t the whole story though. Many consumers just support protectionist measures because they think free trade sends jobs overseas. They don’t understand the full benefits of free trade, and it is this ignorance that allows governments to retaliate and spur trade wars. Think of the Republicans complaining about China’s undervalued currency.

What have we learned? Firstly, game theorists would say that removing restrictions is a dominant strategy in determining optimal trade policy. No matter what the other guy does, you should always try to keep trade as free as possible. Secondly, some governments don’t determine their trade policy with regard to the greater good and will instead try to subsidise or otherwise benefit their exporters. Thirdly, if you give the irrational, ignorant public an excuse, they will try to slap trade barriers on your goods and services. So much for the dominant strategy.

What if  the public knew the truth and adopted the dominant strategy instead? Then foreign nations would suffer no punishment or retaliation if they imposed trade restrictions on our exporters. They would exploit this advantage by benefiting their favoured firms and importing goods into our markets. If we threatened to retaliate, they wouldn’t believe us – it’s not a credible threat because we know we’re hurting ourselves in the process.

So how do countries maintain a credible threat of retaliation under the status quo? By hiding the costs from the consumer, and exploiting his ignorance. If they knew the truth, would consumers suffer trade restrictions on imported goods in order to benefit a single exporting firm? Probably not. The threat of retaliation is only credible under the status quo because it’s not rational.

Revenge isn’t rational in general. If somebody does hurt you, it’s never optimal to follow through on a threat of vengeance. The threat of vengeance is only credible because the decision to pursue it is not rationally considered. So in a world with free trade on the edge of a knife, it’s not so bad that the public sometimes cry out for trade restrictions. If they didn’t, our deterrence of same would lack all credibility.

© The Free Marketeer 2010

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Signaling Theory, IKEA and Public Sector Strikes

3 December, 2009

The Irish Times explains why today’s planned public sector strike was cancelled. In the media, there was plenty of discussion over how the public sector workers were going to spend their strike day.

Last week, it was widely reported that there was a mass exodus from the city to places like IKEA. This irked many members of the public, but some felt it was reasonable to use the time productively. Why does the trip to IKEA damage the strikers’ cause?

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The Economics of €2 Spar Hot Chicken-Fillet Rolls

12 November, 2009

SandwichThe recession has brought down prices throughout the economy, in response to faltering demand. In Dublin, the most poignant example of this is Spar’s much celebrated €2 hot chicken-fillet roll.

But in the same shop, many prices haven’t fallen as much. Why is this? Like the canary in the coal mine, the €2 hot chicken-fillet roll acts as an indicator in case of recovering consumer spending.

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Economics of the Future

16 August, 2009

Flux CapacitorPaul Krugman has an interesting paper regarding interstellar trade, and the consequences of general relativity for arbitrage. He concludes that interest rates will equalise between planets, and that the opportunity cost of goods in interstellar trade should be measured using the inertial time-frame of the planets in question.

It became a question of perspective. If an individual perceives time passing at a different rate, or has the ability to do so, does this alter the concept of opportunity cost and how?

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Rolling Back the Rules of the Road

1 August, 2009

Traffic ConeThe Christian Science Monitor has a fascinating piece on how traffic laws cause accidents, by diminishing the attention that drivers pay to the roads and reducing their reliance on their own best judgement. Could their complete absence improve matters?

There is clearly a simple trade-off here. Drivers can choose to concentrate on the road, thus making them better equipped to react to unexpected occurrences and more aware of their surroundings. They could alternatively just trust the lights and the signs.

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Gambling Wages Away

30 June, 2009

Why is it that wages exhibit backward inertia? How come workers don’t demand that their wages be tied to inflation, and instead just take their chances with fixed nominal wage contracts? In their book Animal Spirits, George Akerlof and Robert Shiller discuss (amongst much else) the phenomenon of ‘money illusion’.

They argue that people are not perfectly rational when it comes to inflationary expectations and consequence wage demands, supported by empirical evidence. However, there may be more conventional explanations for the behaviours they observed.

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The Fairness Cartel

23 June, 2009

ScalesIn their book Animal Spirits, George Akerlof and Robert Shiller discuss (amongst much else) the phenomenon of ‘fairness’. In the wake of Hurricane Andrew, vendors declined to put up the price of plywood – although both demand and costs for the good had risen.

They claim this was a response to the precept of fairness, and how consumers react to behaviour which they deem to be ‘unfair’. In fact, traditional economic models have just underestimated the ability of individuals to manipulate the market.

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