Saturday, April 28, 2007

Does free trade lower prices?

Dani Rodrik debunks what he considers a myth:

Advocates of globalization love to argue that free trade lowers prices, and the argument seems sensible enough. Think of all the cheap goods from China that we can buy at Wal-Mart. But anyone who understands comparative advantage knows that free trade affects relative prices, not the price level (the latter being the province of macro and monetary factors). When a country opens up to trade (or liberalizes its trade), it is the relative price of imports that comes down; by necessity, the relative prices of its exports must go up!
Dani is right about the theory, of course. But I am more sympathetic to the "lower prices" summary of it than he is, for two reasons.

1. Defenders of free trade rarely are in a position of having to defend exports, because people think that exports create jobs. When people complain about trade, it usually about the alleged job-destroying effect of imports. This partial-equilibrium complaint naturally encourages a partial-equilibrium retort: imports lower prices for consumers. The losses to producers in these markets are more than offset by gains to consumers from lower prices. True, the full story can only be told in general equilibrium, where it is relative prices that matter for the allocation of resources. But the distinction between the absolute price level (determined by monetary forces) and relative prices (determined by numerous market supply and demand curves) looms larger in the minds of economists than laymen. The reason is related to my second point.

2. People sometimes instinctively treat the nominal wage as the numeraire. That may be because it is one of the stickier prices around. So maybe when we hear people say that trade lowers prices, we should interpret the statement as meaning that trade lowers the price of a basket of consumer goods for a given price of labor. That is, trade raises real wages. This is one simple way of translating the basic Ricardian model (in which trade expands both trading partners' consumption opportunities) into a language that is a bit more familiar to the general public.

Update: Dani responds. I disagree with Dani when he says:

there is no theorem that guarantees that the partial-equilibrium losses to import-competing producers “are more than offset by gains to consumers from lower prices.” My wheat-and-beef example in Argentina is exactly an instance where this supposition fails.

Back in his example, he says that "these are export products for Argentina," whereas in point 1 above I was describing a country that is a net importer of the good. For net exporters, prices do rise when a country moves from autarky to free trade. In this case, the gains to producers more than offset the losses to consumers. For readers who want to see a diagrammatic explanation of these two cases, see chapter 9 of my favorite textbook.

The more interesting and difficult issue that Dani raises is how many caveats economists should include in their analysis when they present their ideas as part of the public debate. All economic analysis involves simplifying in order to clarify. This is, in a sense, the very essence of building a model. The art in economics is drawing the line between simplification which clarifies and oversimplification which misleads. Without doubt, that judgment call is always tough. One has to be careful not to make the best the enemy of the good.