Are 90% of economists stupid?

September 16, 2010 10:39 PM

Economics: Is free trade good? 90% of economists say yes. But free trade depends on comparative advantage, and comparative advantage depends on capital immobility. And capital isn't immobile anymore; everyone invests everywhere now. So what gives?

As I understand it, free trade owes its overwhelming support from economists to David Ricardo's theory of comparative advantage. An assumption of Ricardo's theory is immobility of capital - that a capitalist would generally not invest outside the country in which he or she lived.

When Ricardo wrote this in 1817, it was indeed hard to invest outside one's own country. But it's way easier now. If Ricardo's assumption of capital immobility is no longer valid, then his whole theory of comparative advantage is no longer valid. And a big argument for free trade is gone.

One economist writes that capital immobility is not a "condition necessary for the principle to hold". But he doesn't reconcile this statement with Ricardo's theory, which his statement directly contradicts. Of course, more research has been done since 1817. Did someone discover that Ricardo was wrong?

To make a long story short: Since capital is mobile now, why are economists still so in love with free trade?

posted by Dec One to Science & Nature (30 answers total)

capital isn't immobile anymore; everyone invests everywhere now

It's not that simple.

In Australia, we're currently having a debate about mining resource rights. What it comes down to is how much mining companies should be taxed for the right to mine Australian minerals. The companies are holding out; the Government is trying to insist.

Simply put, if you want to mine Australian bauxite, you have to do it in Australia. You can't mine Australian bauxite anywhere else but where it is. Capital invested in lots of applications is extremely immobile. Australia retains a competitive advantage in minerals because there are lots of them under the ground, and because we've had a history of Governments who suck up to mining companies.
posted by Fiasco da Gama at 10:49 PM on September 16, 2010

Capital is more mobile than it was, but to leap from that statement to 'comparative advantage is bunk' is unwarranted.
posted by pompomtom at 10:55 PM on September 16, 2010 [1 favorite]

Well, my argument for free trade is so that we can eliminate quota/tariff policies that protect domestic producers at the expense of economies that can produce much more effectively. Oh, and which keep the domestic consumer price artificially high.

For example, beet/corn farmers producing sugar and corn syrup--excuse me, "corn sugar"-- enjoy the protection of import tariffs and quotas that effectively prevent shit-poor countries like Haiti from having an export market for cane sugar.

This sort of mind-numbing policy drives me crazy. I knew a guy whose family is involved in the US production of sugar, and while he was certainly passionate about the necessity for favoring US producers, his argument boiled down to the assurance of quality when sugar is produced domestically.
posted by holterbarbour at 11:00 PM on September 16, 2010

Capital has many forms. There's money / assets, as we know them, which is mobile. But there's natural resources that have to be extracted, and we haven't yet found a way to move mountains. There's also human capital, the knowledge people have. People are not yet perfectly liquid, and not yet perfectly mobile.
posted by pwnguin at 11:04 PM on September 16, 2010 [2 favorites]

OK so I'm not an economist, but I have done introductory economics course any number of times, so some of it must have stuck... comparative advantage doesn't rest solely on the immobility of capital, it rests moreso on the skills of the producers. Australian agriculture has comparative advantage due to cheap land as well as the highly flexible, innovative and capital intensive farming sector. These can all change (and comparative advantage isn't suggested to be immutable) but they're real for the time being. Australian mining has comparative advantage because of large rich ore bodies close to the surface, and becasue of sunk costs of development paid for already. These advantages aren't going away any time soon.

Australia had comparative disadvantage because it was a long way away from it's market (the UK). This changed when the market became Japan.

Australia is a safe country with strong laws and banking system, another comparative advantage.

The simple point is, free capital is certainly one factor reducing comparative advantage, but really it's not that big.
posted by wilful at 11:04 PM on September 16, 2010

Sorry if this is off-topic, chatfilter, but one thing that always strikes me markedly is the general reluctance of Americans to accept free trade, far more so than the relatively speaking left-wing Australians (and maybe the Europeans, I mean what is the EU common market?).
posted by wilful at 11:06 PM on September 16, 2010

Assuming I understand the question correctly, I believe Krugman won his Nobel based on his answer to this question. See here.
posted by mullacc at 11:15 PM on September 16, 2010

Comparative advantage doesn't rest on capital mobility. All that is required is that relative prices net of transport costs are different. This could be due to exogenous (given) technological differences, factor endowments, tastes or endogenous (emergent) economies of scale or specialisation.
posted by hawthorne at 11:17 PM on September 16, 2010

Response by poster: hawthorne: Ricardo said comparative advantage does depend on capital immobility. Are you saying Ricardo is wrong?
posted by Dec One at 11:23 PM on September 16, 2010

I think you're using too narrow a meaning for the word "capital". It isn't just money.

Capital investment is a kind of capital. That means you spend that money to buy equipment, pay for a building to put the equipment in, hire a work force, and train them to use that equipment. Then they start turning out goods, and when you can sell them you start getting some of the money back.

But for a lot of kinds of capital investment, the payback time can be measured in decades.

If you decide to pick up and move, it ain't so simple. Moving all the equipment will be enormously expensive, and it may simply not be worth it. You can sell it to someone else -- but then that means the capital investment remains where it is. It just means someone else owns it.

It is possible for manufacturing companies to pick up and move. It does happen. But it isn't easy and it isn't cheap and what usually brings them to that point is if the business environment where they're currently operating becomes really monumentally awful, with huge taxes, overbearing unions, and an unreasonable regulatory burden. That's what made the car companies bail out of Detroit.

But it takes a huge perceived advantage of the new location over the old one to make it worth while. I remember reading a business book one time which tossed off this aphorism: "For purposes of the accounting cycle, two moves equals one fire."

So capital isn't as mobile as you think.

Now having said all that, I don't understand why capital immobility has anything to do with the benefits of free trade. The arguments I've seen are simply this: in the long run it is to the ultimate benefit of everyone that everything be manufactured as cheaply as possible. That includes manufacturing it where it can be produced the most cheaply.

(Where "cheaply" means "most inexpensive", not "crappiest".)

That principle remains true whether capital is mobile or not.

"Are you saying Ricardo is wrong?" I'm saying he's entitled to his opinion, but I don't share it. Your question is the first time I've even heard of the man. No argument for free trade I've ever read even mentioned him, and none of them have ever talked about capital mobility.
posted by Chocolate Pickle at 11:42 PM on September 16, 2010 [2 favorites]

"Are you saying Ricardo is wrong?" is not a wholly constructive way to talk about this -- Adam Smith was wrong on some points as well. Disciplines often have foundational documents that are important for framing how the discipline evolved but the actual concrete insights of said documents don't always age well. That doesn't mean that they didn't help knowledge accumulate or progress. Finding an error or inconsistency in Ricardo does not mean "90% of economists" are wrong or stupid. I am unfamiliar with how this debate has played out, but I can assure that a) the discipline and/or idea of free trade does not rest entirely on this assumption of Ricardo's, that b) theory has been developed to an immense degree since 1817, and c) this is not the way to approach foundational texts vis a vis their relationship to contemporary thinking.
posted by proj at 11:55 PM on September 16, 2010 [4 favorites]

Dec One: "Ricardo said comparative advantage does depend on capital immobility. Are you saying Ricardo is wrong?"

Euclid assumed lines had to be parallel when proving theorems about geometry. While it's not always true, it doesn't invalidate most of his findings. Ricardo's assumptions can be more than required while his conclusions remain valid.
posted by pwnguin at 12:01 AM on September 17, 2010

But it's way easier now.

Care to quantify 'way'?

Capital, overall, is still insufficiently mobile to counter comparative advantage. Legislative, institutional, political, social and physical factors prevent us from simply moving capital around as we would wish and exploiting it as we choose. For all the talk of globalisation, it's still quite difficult to move people, money, technology, intellectual property and natural resources around willy nilly, and when you can, transaction costs quickly make these propositions unattractive.

If capital were truly mobile, there'd be no multinationals. I could use whatever my firm needed over there from right here. Doesn't happen.
posted by obiwanwasabi at 2:08 AM on September 17, 2010

An article. Nutshell: we have a long, long way to go before savings and investment rates reach zero correlation and long-term interest rates are equalised. Therefore, full capital mobility is nowhere in sight.
posted by obiwanwasabi at 2:12 AM on September 17, 2010 [2 favorites]

Actually, the fact that capital is mobile between countries can be seen as another form of trade (economists refer to intertemporal trade). It's easy to see the advantages of this type of trade, where you can build up your economy faster than out of domestic savings, while the other guy gets a good return. Comparative advantage does not have to play a role here.

One precondition for intertemporal trade to work, though, is that the borrower can pay you back. And that can only happen if (regular) trade is allowed. So rather than taking away the case for free trade, mobile capital requires it.
posted by thijsk at 3:17 AM on September 17, 2010

Response by poster: Thanks, all. Great answers so far. It seems my question splits into two pieces:

1. Is capital really mobile now? Answer: It's more mobile than it was in Ricardo's day, but it's still very, very immobile. I was thinking of capital only in terms of cash money and not in terms of mines, factories, human capital, etc. That was dumb.

2. Was Ricardo wrong about capital immobility being required for comparative advantage - and if so, why? This seems much harder to answer. There seem to be no shortage of people contradicting his assumption - the economist linked in the OP; @hawthorne, @proj and @pwnguin in this thread. But what I can't find is someone saying why he's wrong. I can't find: Ricardo wrote that capital immobility is a requirement for his theory of comparative advantage. In subsequent years, theories published by the economist Xxxxxx argued that capital immobility is not required, because....

Thanks again for the great answers.
posted by Dec One at 5:34 AM on September 17, 2010

A small point about capital mobility: if there were perfect capital mobility there would be no capital movement (just revaluation of various assets).

Was I saying Ricardo was wrong? Yes and no. His was only a model. It was simple and showed that if there were relative price differences (due in his case to technology) there were gains from trade. As long as those price differences remain - in Ricardo's case, as long as capital movements didn't eliminate them - there would be gains. We certainly now know that quite mobile capital is not the same as completely mobile capital and that all sorts of things that might not be so in a fully mobile world are with us to stay.

There have been many, many other models (Heckscher–Ohlin, "new" trade theory etc). There has been lots of work about factor mobility as a substitute for trade. But the idea that if there are for whatever reason differences in relative prices there is comparative advantage and potential gains from trade is unaltered.

And take those Wikipedia pages with a big grain of salt.
posted by hawthorne at 6:20 AM on September 17, 2010 [1 favorite]

I teach this in Econ 101. I don't think any economists would say Ricardo is wrong. What Krugman and other say is he only has part of the story. Krugman's text includes Ricardo's model in one of the first chapters, but points out that it doesn't capture everything like economies of scale and that there are more than two goods. It's still a useful theory.

But because of geography capital will never be perfectly mobile (unless something drastic changes). In a two good case (coffee and wheat) for Canada and Costa Rica). For example, the opportunity cost (or what you would have to give up) to grow coffee in Canada will always be so high that Costa Rica will always have a comparative advantage in coffee and Canada in wheat.
posted by akabobo at 6:31 AM on September 17, 2010

Suppose capital can be moved costlessly; labor is still quite immobile. The US has a well-educated labor force, China has (for now) a poorly-educated labor force. Doesn't it make more sense that the US design and produce computers, while China produces plastic dinner plates, instead of both countries having to do both?

As to whether free trade is "good" or not, were businesses/countries able to make themselves better off by shutting out the outside world, they would probably do it, no?
posted by deadweightloss at 7:14 AM on September 17, 2010

90% of economists? It's the rare economist who thinks free trade is bad; unlimited capital mobility may be another thing as it brings on problems for financial stability of countries in extreme situations. Enough to counteract free trade though?

Take a look at some of Dani Rodrik's work,
posted by stratastar at 7:55 AM on September 17, 2010

I think the fundamental reason that people believe that free trade is good are that it allows an area to use its natural resources (whether people, minerals, location) to the fullest.

And that restraints on free trade are artificial barriers to a marketplace that create winners and losers for reasons besides their natural talents and resources. Sometimes this can be a short-term good, most of the time not.

Over simplified example: the US won't buy Cuba's sugar, we won't sell our corn to them. They have to pay more for corn, we have to pay more for sugar. If those restraints weren't in place, we'd both be paying less for the stuff we want, and we'd both be making more money because we have a larger market for the things we can make cheaply. We'd all have more money to spend on other things.
posted by gjc at 8:14 AM on September 17, 2010

I am an economist, and I agree with akabobo: Ricardo was not wrong, but he did not have the whole story. I taught comparative advantage for years without once referring to mobility of capital. All you need to comparative advantage is different opportunity costs. I used a variation of this story from Mankiw's text (granted it is outrageously simplified and you should see Krugman and other recent work for a fuller picture, but it is a good illustration of how different opportunity costs could be the only necessary condition):

Should Tiger Woods Mow His Own Lawn?
(from Principles of Microeconomics by N Gregory Mankiw)

Tiger is a great athlete. One of the best golfers to have every lived. Most likely he is better at other activities too. Tiger is probably in better shape than most: He can run faster, lift more, and work quicker. For example, Tiger can probably mow his lawn faster than anyone else. But just because he can mow his lawn fast, does this mean he should?

To answer this question we can use the concepts of opportunity cost and comparative advantage. Let's say that Tiger can mow his lawn in 2 hours. In the same two hours he could film a television commercial for golf clubs and earn $100,000. By contrast, Joe, the kid next door can mow Tiger's lawn in 4 hours. In that same 4 hours he could work at McDonald's and earn $24.

In this example, Tiger's opportunity cost is $100,000 and Joe's is $24. Tiger has an absolute advantage in mowing lawns because he can do the work in less time. Yet Joe has a comparative advantage because he has the lower opportunity cost. The gains in trade from this example are tremendous. Rather than mowing his own lawn, Tiger should make the commercial and hire Joe to mow his lawn. As long as Tiger pays Joe more than $24 and less than $100,000, both of them are better off.
posted by Matty_P at 9:23 AM on September 17, 2010 [1 favorite]

That's an excellent example, Matty_C.

Will the kid be using his lawnmower or Tiger's?
posted by notyou at 10:04 AM on September 17, 2010

er. Matty_P.

Sheesh.
posted by notyou at 10:25 AM on September 17, 2010

Well I guess it doesn't matter; since lawnmowers have wheels, the capital in this case is especially mobile! I didn't even think of the illustration being especially apropos in that sense.
posted by Matty_P at 12:26 PM on September 17, 2010

When it comes to capital investment, the more usual way to implement mobility isn't so much to pick up all the machines and ship them somewhere out of state, as it is in management of the upgrade cycle.

When a company determines that its ability to operate profitably in a given location is declining, it may stop doing regular upgrades there, and otherwise neglect ongoing capital investment in favor of using that money to create new factories elsewhere. That's what the car companies did when it became clear that the Detroit area was no good. The manufacturing plants there were allowed to become obsolescent, and the car companies began to build new plants in places like Tennessee where they had been offered lower tax rates, and where there were no unions, and where workers were willing to accept lower pay.

Or in Mexico, something other companies had experimented with, but which I think is largely considered a failure now. These days the most common place to do this is China. That's where GE makes its light bulbs now.

But that's a process measured in years, not in weeks. It's slow and expensive and risky, and that's why the comparative advantage between the two places has to be huge in order to justify that risk.
posted by Chocolate Pickle at 2:00 PM on September 17, 2010

Well, Matty_P, I was thinking Tiger and the Kid could enter into some kind of capital purchase arrangement in which Tiger sells his lawnmower to the Kid, with Tiger carrying the paper and the Kid offering a discount to Tiger until the note is paid.

Meanwhile, the Kid can either use the lawnmower to mow other people's lawns, or if he's clever, he can rent it to the Kid on the Next Block who he's heard is keen to mow lawns* on a per lawns mowed basis, which, if figured right, should at least exceed the cost of the monthly principal and interest payment due Tiger. If the Kid on the Next Block proves to be an exceptional lawn mower, the Kid does even better.

This works for the Kid so long as the Kid on the Next Block doesn't get so far ahead he buys his own mower, but the Kid** has some ideas about how to prevent that.


-------------
*Yes, even Tiger's lawn.
**The Kid's Sister bakes cupcakes.
posted by notyou at 3:05 PM on September 17, 2010

Response by poster: Thanks for the additional great answers. One correction to the OP: I tried to link to this page from the third paragraph after the break ("One economist...") but I realize now it did not work. That paragraph doesn't make a lot of sense without the link. Sorry!
posted by Dec One at 3:32 PM on September 17, 2010

Ricardo said comparative advantage does depend on capital immobility. Are you saying Ricardo is wrong?

Well, things like Matty_P's example rely on the assumption that the kid next door is not, and cannot become, an athlete comparable to Tiger Woods. We make this assumption for the sake of making clear explanations, and because we think it's probably true.

A key idea of comparative advantage is that it's beneficial for both countries when country A and country B trade, even if country A is more efficient at producing everything. However, if you could simply pick up all the workers, factories and machines from country B and put them down in country A, so there were more people and machines working at the country A efficiency level, the results would be better yet, wouldn't they?

In practice probably not - doubling a country's population would probably have complicated effects! But when you have to start explaining things with this taken into account, your explanations become a lot more complicated than the 2x2 grids of Wikipedia's comparative advantage explanations. So when you want to make a simple 2x2 grid explanation, you prefix it with the words "assuming capital is immobile" by which you mean "ignoring the possibility of moving workers, factories and machines between countries".
posted by Mike1024 at 4:23 PM on September 17, 2010

Well, things like Matty_P's example rely on the assumption that the kid next door is not, and cannot become, an athlete comparable to Tiger Woods.

It also relies on the assumption that Tiger can fetch $100k for any arbitrary two hour period. That argument only holds out for people who have a queue of people at the door willing to pay them their going rate at any arbitrary time of the day. Just because Tiger got paid $100k for two hours doesn't mean he can necessarily get paid $100k for every two hour period.

So, even if you do get paid $100k for two hours work, if you can't come up with a gig for the particular two hours in question, you might be better off doing it yourself.
posted by HiroProtagonist at 11:30 PM on September 19, 2010