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Posted by on Feb 1, 2011 in Economy, TG Roundup

Why Free Trade?

Economists have been touting free trade as beneficial to national economies around the world. Here is my attempt to show the merits of free trade through a simple hypothetical example.

Take two countries- India and Russia. Let’s say India is capable of producing a lot of rice due to natural irrigation advantages, while Russia is capable of producing a lot of oil due to its natural oil reserves. For simplicity, assume both Russia and India use rupees as common currency.

Now let’s analyze two scenarios:
1) India and Russia are closed economies and don’t trade at all.
2) India and Russia freely trade with each other

CLOSED ECONOMY
India
Let’s say it costs Rs. 10/kg to produce rice in India
Let’s say it costs Rs.100/gallon to produce petrol in India
Total cost to produce one kg of rice and one gallon of petrol in India = Rs. 110

Russia
Let’s say it costs Rs. 100/kg to produce rice in Russia
Let’s say it costs Rs. 10/gallon to produce petrol in Russia
Total cost to generate one kg of rice and one gallon of petrol in Russia = Rs. 110

FREE TRADING ECONOMY
Now, let us open up the border and let India and Russia trade freely.

Let’s say the cost of transportation of rice from India to Russia is Rs. 10 and similarly cost of transporting petrol from Russia to India is Rs. 10.

Therefore, Russia sells petrol to India for Rs. 20/gallon. Similarly, India sells rice to Russia for Rs. 20/kg.

Here is how costs looks in this free trade scenario:

Cost of rice in India: Rs. 10/kg
Cost of Russian oil sold in India: Rs. 20/gallon

Total cost of one kg rice and one gallon of petrol in India: Rs. 30 (if you recall it was Rs. 110 in the absence of free trade)

Similarly, the cost of one gallon of petrol and one kg of Rice in Russia will be Rs. 30 as well.

As you can see, free trade is a win-win proposition for both the countries involved in the transaction. What I offered is a simplistic scenario with exaggerated prices and common currency to showcase the merits of free trade. In real world scenario, trading is much more complicated. For example, foreign exchange rates, weather, wars, accidents, government policies, make trading a complex subject.

Now, let’s look at a few other variables. When you export rice to Russia, there is less rice available domestically. As a result, it would cause the price of rice to go up in the Indian market. This is when governments often intervene and say we are going to stop the exports, because commodity prices are going through the roof. However, we often miss the other side of the equation. By stopping rice exports, you are stopping the imports too. An import cannot happen unless we give something of equal value back to the seller. In other words, we can’t import oil from Russia without exporting rice or some other thing of equal value. So, stopping rice exports, will hit us hard as we will have to rely more on Rs.100/gallon oil that is generated in India. Hence, export controls are counter-productive and rarely effective.

Now let us change the scenario. Governments impose all sorts of duties on imports under the guise of helping local economy. In fact these are rarely people friendly policies.

Let’s say, Indian government imposes a duty of Rs. 20 on every gallon of oil coming from Russia. What is the consequence?

Your cost of 1 gallon of oil will go up from Rs. 20 to Rs. 40 (Rs.10 for a gallon of Russian oil, Rs. 10 for transportation from Russia, Rs. 20 of import duties)

What is the downside? Instead of going for more rice production, where we have a natural advantage, artificial inflation of oil prices will cause people to go for unproductive oil exploration.

Free trade at times may appear counterintuitive. Restrictions that many countries impose on imports or exports and currency manipulations actually work against the country’s own economy. Many claim that China gains from its currency manipulation, wherein it artificially keeps its Renminbi value low. I have a completely different take on it. I think China would have benefitted even more if it did not manipulate the currency. China today sells its products at a price lower than what the market is willing to pay for its products. China’s growth did not come via currency manipulation. Chinese growth came from opening up of its markets to the world and adopting principles of free trade and capitalism- albeit in a limited fashion. There is enough evidence to show that any country that dares to even tinker with free market capitalism and free trade has enjoyed enormous economic prosperity. Some of the other countries that come to mind are Taiwan, Hong Kong (pre-1997), Singapore, and South Korea.

1 Comment

  1. “What I offered is a simplistic scenario with exaggerated prices and common currency to showcase the merits of free trade. In real world scenario, trading is much more complicated.”

    Indeed! Even President George Bush, one of the most pig-headed right-wing ideologues – not to mention a powerful one at that – hit steel exporters to US with hefty tariffs when domestic steel makers were hurting. Likewise, he yielded to the farm lobby and made Ethanol as a mandatory additive to gasoline. In reality, the benefits of Ethanol as an additive are not that conclusive. Furthermore, it takes a lot more energy to produce Ethanol than the benefits it offers. Ironically, this dubious mandate was also combined with protectionist a policy – hitting Ethanol imports (mostly from Brazil) with excessive tariffs.

    At an individual level nothing can be more pig-headed than blind adherence to an impractical ideology. When a powerful dictator on the left, a la, Stalin or a powerful and influential political appointee on the right, a la Greenspan, cling to these impractical ideologies, devastating results occur. We have seen this. In both cases, the ideologies were not implemented as they were supposed. Why? It is impossible to implement any ideology by anybody without some personal interpretation of that ideology.

    Take out the 20% extremes on the left and the right – I am speaking for the 60% in the middle. Your ‘simplistic’ ideology is not just impractical – in the hands of the powerful forces, it is downright dangerous.