Specialisation versus Diversification: Free trade and protectionism

Specialisation versus Diversification: Free trade and protectionism 1

Contents
Comparative Advantage ................................................................................................................. 3 Systematic Risk ............................................................................................................................... 5 Specialization versus Diversification ............................................................................................... 5 The Prisoners Dilemma and Infant Industries ............................................................................... 6 Regional Free Trade Agreements ................................................................................................... 6 Marginal Benefits of goods a and b; trade value inequalities ........................................................ 7 Market Making................................................................................................................................ 8 Free Trade and the GFC .................................................................................................................. 8 Summary ......................................................................................................................................... 9 Conclusion..................................................................................................................................... 10 References .................................................................................................................................... 10

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(*Note: apologies for the biased selection of cartoons.) What is the basis for free trade? Why are some governments (particularly the Australian) so pro free trade? What is free trade in theory and in practice and what are the alternatives? Ill attempt to explain the basics of free trade and the pro/ con arguments below. Briefly, free trade (as opposed to fair trade which is very different) is the free exchange of goods and services between countries. For free trade to exist there must be no government imposed controls on trade, be they tariffs or import quotas. The definition of governmental control can be expanded to include the subsidising of domestic industries, artificially inflating their profitability compared to the foreign equivalent. Fair trade, which I wont detail, is different to free trade. Fair trade usually involves an element of ethics in the trade process, such as the large trading partner not taking advantage of smaller one. Hence the inclusion of the word fair. It could be argued that fair trade and free trade are in opposition as free trade is about free market forces while fair involves ethically directed market forces.

Comparative Advantage
Free trade does have a theoretical reason for existence in classical economics. This is the same justification most governments will give for being anti-protectionist. This justification is comparative advantage.

Comparative advantage assumes that countries have an advantage in the production of certain goods versus the production of the same good or service in other countries. This advantage might come about due to presence of natural resources, serendipitous development of a high profit industry or cheap labour to name but a few. Hence an advantage to compared to another country. To illustrate assume a simple two country model; country A produces goods a and b and country B produces goods a and b as well. Meshed with comparative advantage is the concept of economies of scale. In its most basic form economies of scale is where the more you produce of something the cheaper it becomes to produce. Really this is just common sense, if you spend your day making shoes youll get better and quicker as you learn and improve your

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skills. Alternately if you make a pair every now and then some time will be wasted trying to remember what to do and where your tools are. This form of specialisation is the basis of mass production. From an accounting stand point the production of all goods and services require both fixed and variable costs. Fixed costs are constant overheads that must be paid irrespective of the amount produced, lease payments would be an example. Variable costs are dependent on production.

from being able to specialise each step of the production cycle. The most relevant example of this would be Australia. We are an exporter of minerals because we, as a country, happen to possess an abundance of resources. Additionally we have invested heavily in the infrastructure to process these resources. Free trade assumes that goods and services can freely flow between our two economies A and B. Coupled with comparative advantage this means that the country that is best at producing a produces a and the same for good b. In practice country A should focus on the production of good a and country B on good b. In theory this should mean that the populations of both countries have more of a and b for less cost, time and raw materials. If free trade does not exist then countries will be producing goods and services that they do not have a comparative advantage in. Thus total production will be less than efficient. People will have less of a and b than they could have. Protectionism is the artificial protecting of a domestic industry from foreign competing industries importing into your country. It can be direct or indirect subsidies, quotas, tariff imposition etc. Basically it is some action by the government to give local producers an advantage over foreign, usually at some cost to local taxpayers. This is an important

The more you produce the more your total variable cost rises. The sum of fixed and variable is your cost to produce a good. As fixed cost is a constant figure as I produce more goods then the fixed cost will be divided up amongst more and more items and will reduce as a per item expenditure. I.e. assume fixed cost is $100 and variable cost is $10 per unit. Last week I made 10 units so cost per unit is $20 (($100/10)+$10 = $20) the following week I made 20 so my cost per unit is $15 or (($100/20)+$10 = $15). The above is a very simplistic definition. As you produce more of a good your production should become disproportionally cheaper up to a point. Within reason, your per unit variable cost will reduce as more is produced. This could be from production efficiencies derived

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point, protectionism does impose a direct cost for the consumer. A tariff barrier, for example, means the cost of the import will directly go up by some percentage. Other methods are a little more subtle but will result in a financial imposition upon the taxpayer. This cost is usually very easy to calculate and is often used as a reason for not engaging in protectionist policies. Free trade has numerous costs which are hard to place a dollar figure against. These costs revolve around social engineering and the nature of risk. Ill detail some of the commonly recognised and other less common but still significant risks below.

contend with sovereign risk of two countries, not one and travel (and incumbent risks) is also much greater. That is the network is only as strong as its weakest link.

Specialization versus Diversification

Systematic risk falls under the broader debate concerning specialization and diversification. Superannuation funds diversify to minimise risk. Diversification comes at the cost of not being able to take full advantage of the big growth investments. Conversely if all your investments back one company then youll be wiped out should it fail. Harking back to the previous network argument, if one specialised portion of the network fails the whole system fails. Specialisation creates efficiency but it also promotes weakness and a lack of flexibility. The situation globally is one of increased specialisation. Looking again at the example of Australia and this time with our major trading partner of China illustrates this point. The majority of Australias manufactured goods are produced in China. Australias weakness in local manufacturing makes us dependent on China for the majority of our manufactured products, in turn we are susceptible to risks from China. It is not inconceivable that China will experience some form of political turmoil similar to that of the recent North African civil unrest in the near future. Should that happen what will happen in Australia? For a further example look at Europe in the later half of 2011. The intermingling of the economies results in all of Europe being at

Systematic Risk
The free trade world system could be categorised as a network of interdependent nodes, all reliant upon each other. Each node in this network performs a specialised function which the network as a whole depends on to continue operating.

A basic rule of thumb is that the bigger a system is the greater the risk of the system crashing. Imagine a supply chain to produce a widget. If the raw materials for the widget are manufactured next door your risk is less than if those materials were manufactured in another country. The risk is greater because you have to

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risk from the financial problems of Greece, Spain and Italy.

The Prisoners Dilemma and the Infant Industries Argument

The prisoners dilemma is an aspect of game theory describing how individuals have an incentive to cheat despite there being valid reasons not to. This incentive revolves around the prisoners perception of risk. The theory is illustrated by a scenario where the police hold two prisoners in custody suspected of a crime. The prisoners are separated and despite the absence of evidence to convict both are offered a deal to inform on the other. Both prisoners understand the police have insufficient evidence to convict nevertheless they have an incentive to inform on the other BEFORE they are informed on by their accomplice. There are parallels to this situation and a countries tariff relationship with its trading partners. To illustrate, free trade provides financial benefits to both participants (a & b) however country A has a political incentive to place tariffs on imports from B to give an advantage to their home grown industries. Of course once one country has started imposing trade barriers the other country should follow suit to balance out the discrepancy in advantage. What this shows is that a free trade situation is fundamentally unstable. This particular argument meshes very well with the Infant industry argument against free trade. An infant industry is one that is starting out and by definition it will not have acquired the economies of scale of

the overseas equivalent. Following the logic of free trade, because this industry is not as efficient as the overseas alternative then it should not be pursued. This argument does not consider that while the new industry might be relatively inefficient at inception it can become more efficient and may develop economies of scale that exceed the foreign competitors. That is comparative advantages can change over time. As comparative advantages do change over time skills and industries that are at a disadvantage today may well prove to be at an advantage tomorrow. To remain viable an industry group must maintain a certain critical mass. If an industry shrinks too much then the loss of skills might be too much to be overcome. That industry might then be lost to that particular economy. The only way to resurrect it might be to rebuild from scratch which would require enormous quantities of both resources and time.

Regional Free Trade Agreements

FTAs are agreements between two or more countries. FTAs cover much more than trade flows, they can also detail foreign investment practices, IP and a host of activities which fall under the heading of trade. The best known example would be the NAFTA (North American Free Trade Agreement) between the USA, Canada and Mexico. Non-signatories to the agreement will usually be penalised by tariffs or some protection mechanism. The NAFTA regulations allow countries to be sued by corporations for obstruction to the free

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trade process. This type of agreement is dependent in their being equalities in the power and influence of member countries. In practice, power equality is not the case.

Marginal Benefits of goods a and b; trade value inequalities

Marginal benefit is an economists term to

As price increases suppliers of a good or service are eager to supply more. But as the price increases for the same good consumers will buy less. This concept ties in with our own common sense and has been well demonstrated time and again. Thats why retailers have sales. What will happen is that price and supply will oscillate around an equilibrium point due to the dynamic affect of a shifting price on suppliers and consumers. It is very unlikely that a stable price will be reached though day to day fluctuations should start to minimise. Of course that is dependent upon a situation of perfect information where suppliers and consumers possess sufficient information to make decisions. Why do consumers buy less and less of an item as the price increases? This is what the theory of marginal benefit attempts to explain. Marginal benefit is the additional,

express the additional satisfaction that a consumer will derive from the consumption of an additional unit of some

good or service. This concept is linked to the concept of supply and demand equilibrium and is an attempt to mathematize psychological responses for the convenience of economists. The relationship between price, quantity, supply and demand is usually graphed as per the image below.

subjective benefit a consumer derives from the consumption of one extra unit of good or service (UGS). As more and more is consumed this marginal benefit will tend to decline at some rate. To illustrate, the second can of Coke will not satisfy thirst to the same degree as the first can. The third can even

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less so and so on. For a consumer to carry on purchasing the UGS price must fall so that satisfaction can be maintained. This concept is illustrated by the first packet of chips being much better than the third! A consumer will carry on purchasing up to the point where the marginal benefit of the UGS is equal to the marginal benefit of the dollar value of the product in cash. By the way money has a marginal benefit too. Why is this important? Most UGS will have differing marginal benefits. Free trade will only work when there is equal trade between countries. That is marginal benefit of good a equals the marginal benefit of good b. If this is not the case then there is net shift of value from one country to another. This is because good a has a higher marginal benefit then good b. Higher marginal benefit means people will buy more of a than b. More a bought will result in a trade imbalance, the country desiring a must borrow or potentially sell off capital to raise funds to buy the additional UGS required. They cannot just sell more of b as due to its lesser marginal benefit they must disproportionately cut bs price to increase quantity sold. This graph illustrates the point. The area within the dotted lines represents the value of trade, simply calculated by multiplying Price by Quantity. In this example UGS b earns less than UGS a. Selling more will flood the market and given the slope of the demand curve force price down and probably reduce the area of the revenue box. This situation becomes

extreme when one country is significantly larger than the other. Country a makes furnishings and timber products, country b produces lumber from tree felling. Another way of stating the comparative marginal benefit example from previous would be of the concept of value addition; finished goods have more value added to them than the raw materials they are comprised of. Manufacturing, machining, moulding, etc adds value far in excess of the raw materials (lumber) injected into a product. That is a finished good will cost disproportionately more than the raw materials it is comprised of. So country a will generate more revenue than country b. This is called a trade imbalance and means a net influx of wealth into country a, in part, at the expense of country b.

Market Making
This is a situation where one country is so much larger than its trading partner that is able to dominate the market. If country A is significantly larger than country B then A can exert influence over the domestic industries of B. This situation is edging into the fair trade arena and may not be a free trade related issue.

Free Trade and the GFC

An interesting point that is often overlooked is that free trade and globalisation are strongly linked. Globalisation, again in theory, is a good thing. This is because globalisation and the reduction in regulation in financial markets means that finance can now easily cross borders. So a country can now more easily attract foreign investment to start up local industries and create jobs. Reduced

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regulations means money can go where its needed and everyone wins. Great in theory. The reduction in financial regulation from globalisation was also a direct cause of the Global Financial Crisis. Reduced regulatory controls resulted in a swathe of banks and investment houses investing heavily in a sector they knew nothing about. Risk was high but the rate of return was enormous. Inadequate regulatory controls allowed these companies to gamble with peoples savings and mortgages. The damage caused by financial globalisation will be felt for years to come and has had a direct and dire impact on many peoples lives.

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Summary
Free trade is the flow of goods and services between countries unimpeded by non-trade related costs like tariffs, quotas etc. Fair trade is the ethical trade of goods and services, where one partner does not take advantage of the others relative weakness. See Fair Trade Coffee as an example. The principle theoretical and practical advantage of free trade is comparative advantage. This results in efficiencies of production being achieved from specialisation and mass production. That is; more for everyone using less resources.

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Free trade has considerable risks though. Such as:Systematic risks from specialisation making one country vulnerable to political fluctuations in another. The incentive to cheat. Free trade creates a financial incentive for one country to impose protection before the other to try and derive a short term political and/or economic benefit. Free trade is inherently unstable. Infant industries would find it near impossible to commence operations due to the advantages of established industries. Comparative advantages can change over time. Specialisation can lead to a loss of skills. If there is sufficient loss of skills then that industry might not be recoverable. Trade value inequalities. Value of a might be less than b. Ultimately this will lead to a net shift in wealth from the producers of a to the producers of b. Value addition to a < value addition to b means trade imbalance. Market making. One country is so much larger than the others that they distort trade in their favour due to their sheer size. Globalisati on is a good thing in theory. The practice of globalisation is not quite so rosy. See GFC.

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Conclusion
Free trade is a good thing. It results in people having more for less. However to look at the direct cost benefits free trade as being the only decider on an optimal trade policy overlooks the many significant social benefits that protectionism possesses (or costs that free trade has). It is hard to put a dollar value on these benefits, suffice it to say they are, for the reasons cited, worth having. Diversification versus specialisation is one facet of the protectionism discussion that is often overlooked. As an investor you would not put all your money in one company. Why then as a country would you rely upon one industry? The real question becomes what is the appropriate level of protection that will permit a country to possess the social benefits of protection whilst still enjoying the economic benefits of free trade? I believe that free trade is so popular a policy because it is so easy to put a price on the cost of protection. As an economic rationalist argument free trade is very hard to beat. The costs of free trade are far more subtle and do not have as direct or immediate an impact as those of protection. Instead the cost of free trade will take time to make itself felt in the gradual whittling away of domestic industry. Again the economic rationalist approach would be to consider that to be a reallocation of resources to more efficient sectors of the economy from the less efficient. I would argue that a strong manufacturing base is an essential element of any

developed economy. Unfortunately I am not able to definitively say what percentage of an economy should be devoted to manufacturing. For Australia, much is made of the fact that the numbers employed in manufacturing have not fallen from 10 years ago. Australias population has grown over that time which means manufacturing has fallen as a percentage of total employment. If this trend is not reversed or stopped Australia will be known for only two things; a tourist destination and a bunch of holes in the ground. The writing is on the wall.

References
Many, many Wikipedia. references. But mainly

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