The Market and International Trade

What we will discuss today

• A closer look at the illegal drug trade• Some downsides of liberal economic theory• Markets and states: the tension• Markets, states, and the Financial Crisis• What’s the difference between liberals and

conservatives?• Liberal theory of International Trade

Example: A “spontaneous” Market for Drugs

Efficiency• In an ideal economic system, goods worth more than they

cost to produce get produced, goods worth less than they cost to produce do not;

• In a perfectly competitive private property system, producers pay the value of the inputs they use when they buy them from their owners

• and receive the value of what they produce when they sell it. If a good sells for more than it costs to produce, the producer receives more than he pays and makes a profit;

• if the good sells for less than it costs to produce he takes a loss. So goods that should be produced are produced

• and goods that should not be produced are not.

Illegality distorts prices

• Hard-to-get drugs means demand is high but supply is restricted

• Raising the price artificially• Producers are rational….. So…….• High prices encourage production

Supply is abundant…..

Production costs are low…..

Processing is easy and cheap….

Demand is High and steady despite illegality

Market is large

Price should be low because production is cheap and demand high

Illegality represses demand and supply, raising the price

So It’s rational to produce cocoa…..

Corn: $150 per acreLivestock: few $ per acreCocoa: $5-10,000 per acre

What crop What crop would a would a rational farmer rational farmer grow?grow?

Cocoa trade is development policy

And rational to sell it…..

What should government do in the face of the rationality of spontaneous markets? It should ensure competition, not

suppress free markets

• Competition is the best!• Thus, the state should create laws to

ensure competition.• It’s the most efficient• Ensures the most freedom• Any other method the state uses to

guide economic activity will create huge problems. (like making certain activities illegal)

• If the state doesn’t ensure competition, monopolies will develop

Fred Hayek

So the State does have an important role:

• Limit working hours• Require certain sanitary arrangments• Provide social services• All three fully compatible with competition if

applied to all…..• The state’s main job is to “create conditions in

which competition will be as effective as possible, prevent fraud and deception, to break up monopolies-- these tasks provide a wide and unquestioned field for state activity. "

Why should the State ensure competition? Because Monopolies oppose freedom

• Because they limit alternatives for consumers

• Because they block competitors from entering a market

• And therefore block freedom of exchange

• Therefore governments must determine and eforce rules of competition……

So…applied to the drug trade: Illegality and high prices create drug lords with market monopoly. Monopoly

creates…..

Obscene profits for drug lords

Govt. efforts to make the market illegal means using the military to try to get rid of the market

And imposing Harsh Penalties for participating in the market

Irrational penalties……

Small drugDealers vs.RecklessDrivers…

And fostering corruption……

And creating a nightmare of jails filled with casual drug users…..

All adding up toGovernment Repression of Freedom

The Economic Liberal believes: The War on Drugs suppresses Freedom…

Furthermore and by the way…..Alcohol and Tobacco kill (more)

but are legal

Summary:• People make rational choices to produce and sell• Rational people create spontaneous markets,

even risking state efforts to destroy markets• Thus markets are “natural” and should be free• Exchange should be free• Price would not be distorted if exchange is free• Thus states should stay out of markets…..• Their job is to ensure competition• They will never be powerful or wise enough to

suppress natural and spontaneous markets

What are the downsides?

Some downsides that Liberal Theory tolerates

• Markets don’t ensure the same economic growth for everyone

• inequalities in income and wealth are likely• Inequality is likely to be tolerated in private

economic relations • because the growth will make everyone better

off even if there is inequality

That’s the market perspective: what’s the “state” perspective? Markets undermine state sovereignty

• States and markets have different purposes.• Markets can reduce the functions of the state• They can reduce state power• They don’t recognize territorial boundaries• They destabilize • national society

The liberal’s The Business Cycle (government’s only role: ensure competition)

•Prosperity•Transition•Trough•Recovery

II. So why the current financial crisis?Is it just a dip in the business cycle or is it the ABSENCE

of the government?

Fred Hayek again: Remember.The State does have an important role:

The state’s main job is to “create conditions in which competition will be as effective as possible, prevent fraud and deception, to break up monopolies– these tasks provide a wide and unquestioned

field for state activity.”

But what happened? Freedom from Governance…le to a Casino Economy

In the financial crisis, the absence of Govt regulation led to corruption

Let’s Follow the crisis….

• 3. Deregulation of financial markets

• 4. Easy money • easy mortgages as bets on in housing prices +

• No regulation/ oversight: Run of CDOs and derivatives + borrowing to buy them (betting on in value) + rating fraud + easy insurance (AIG) highly leveraged banks

Housing supply overwhelms demand housing prices fall + mortgage defaults

CDOs lose value + Bank stock prices fall credit drys up Begin the bailout

(hopefully) more credit (hopefully) save businesses and jobs (hopefully) economic growth

So the state did not do it’s job, even according to Liberals…….

• Absolute Freedom is impossible (it’s anarchy)• So the economy needs to be governed: Does

that mean that markets aren’t natural? Is there a contradiction in Liberal Theory?

III. let’s clear up come confusions (or at least make them even more confusing)

• Why are liberals opposed to conservatives?– Social conservatives – restrict individual freedom– Social liberals – increase individual freedom– Political conservatives—increase market freedom– Economic conservatives—classical liberals

• Political Liberals– evolution of the term “liberal”

IV. Liberalism and the International Economy

• A. Goal-efficiency, growth, and good life for all.

• B. Perspective: The Liberal sees the international system as the appropriate arena for economic activity.

• C. Instruments—by which global efficiency and welfare are to be produced: Comparative advantage.

Theory of Comparative Advantage

Specialization +

Trade

Production without specialization and division of Labor

Wine Cloth

England

3 5 (Total production =8)

Portugal

9 6 (Total production=15)

Total goods produced = 23

Production with specialization before trade

• Before Trade: Resources put where they are most efficient (specialization

Wine Cloth

England 1 10

Portugal 16 0

Total goods produced = 27 note: efficiency increases total number of goods available

With Specialization and Trade

Wine Cloth

England 5 6 (available goods =11)

Portugal 12 4 (available goods =16)

Total goods produced is still 27 but each country is better off than before trade and both are better off than before “efficiency”

England trades Portugal 4 units of cloth for 4 units of wineExchange rate is 1 to 1.

Assumptions of Ricardo’s Theory

• assumes static givens in a country’s economy • and doesn’t discuss technology as a factor of

production.• labor theory of value • What? David Ricardo

Labor Theory of Value

• The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it. What every thing is really worth to the man who has acquired it, and who wants to dispose of it or exchange it for something else, is the toil and trouble which it can save to himself, and which it can impose upon other people.(Wealth of Nations Book 1, chapter V)

Hechscher-Ohlin-Samuelson modernizes Ricardo

• This model maintains that a nation’s comparative advantage is determined by the relative abundance and most profitable combination of its several factors of production, such as capital, labor, resources, management, and technology.

Krugman expands on Hechscher-Olin and wins Nobel Prize

• Krugman noticed that the accepted model economists used to explain patterns of international trade did not fit the data. – The Hecksher-Ohlin model predicted that trade would be based

on such factors as the ratio of capital to labor, with "capital-rich" countries exporting capital-intensive goods and importing labor-intensive goods from "labor-rich" countries.

• Mr. Krugman noticed that most international trade takes place between countries with roughly the same ratio of capital to labor. – The auto industry in capital-intensive Sweden, for example,

exports cars to capital-intensive America, while Swedish consumers also import cars from America.

Paul Krugman Defends Free Trade

• "Ricardo's Difficult Idea,”• People will specialize in producing the goods and

services in which they have a comparative advantage.

• The result is that we never need to worry about low-wage countries competing us out of jobs;

• the most they can do is change those goods and services in which we have a comparative advantage.

Free Trade leads to growth in Exports

Krugman: Free Trade is the cause of economic development in poor countries

• “The raw fact is that every successful example of economic development this past century--every case of a poor nation that worked its way up to a more or less decent, or at least dramatically better, standard of living--has taken place via globalization; that is, by producing for the world market rather than trying for self-sufficiency.” (Krugman in Slate 1999)

Comparative Advantage is Dynamic• While the United States has long imported oil and

other raw materials from the third world, we used to import manufactured goods mainly from other rich countries like Canada, European nations and Japan.

• But recently we crossed an important watershed: we now import more manufactured goods from the third world than from other advanced economies. That is, a majority of our industrial trade is now with countries that are much poorer than we are and that pay their workers much lower wages (Krugman 2007)

Sum: Effects of Free Trade• Efficiency Growth Good life for everyone• Harmonious International Relations• Role of the State: To let producers produce most

efficiently—to separate politics and economics: • the key actors for liberals are firms and

consumers, not states.• Commerce Peace Why? • Efficiency should be the basis of all political

relations• Does Free Trade make the state obsolete?