Free Trade and Comparative Advantage

International Trade Free trade, based on the theory of comparative advantage, is a textbook ideal that does not exist in the real world. Free trade would be entirely uninhibited. When Ricardo imagined the idea, just to make the concept work he had to ignore things like transaction costs, transportation costs and other real life variables. Thus, today, where such variables exist in near-infinite complexity, free trade would be impossible, and the best we can do is to work toward it, which is the objective of modern trade agreements.

The basic principle of free trade via comparative advantage is that two countries can trade with each other in the goods/services in which they have comparative advantage. Even at the time the idea was proposed, it would have been evident that free trade was only an ideal, and could not exist in perfect form in the real world. First, different nations trade in different currencies, which must be exchanged through intermediaries.

This alone brings about a transaction cost, and such costs can distort the comparative advantage equation -- a comparative advantage that exists on paper may not exist once transaction costs are taken into account. Moving goods around the world also costs money. It may be perfectly reasonable on paper that Tokelau should produce the world's supply of coconuts, but in practice getting coconuts from Tokelau to other markets may be inefficient. Once transportation costs are factored in, getting coconuts from Thailand might make more sense for most countries.

In the real world today, such externalities are of near-infinite complexity. With as many nations as there are, and as complex as the economies of such nations are, it would be nearly impossible to determine the precisely perfect global trade patterns to leverage comparative advantage. We can only guess as to which countries have comparative advantage in which goods, vis-a-vis which other countries. The market, ideally, would sort it out, but markets lack perfect efficiency for any number of reasons.

Markets are run by governments, and even the leanest sovereign state needs some sort of structure, and that structure must be financed somehow. That creates an externality, because ultimately commerce pays some sort of cost associated with the maintanence of a sovereign state -- taxes and fees. Another externality is information asymmetry. People involved in trade have some knowledge about what countries have comparative advantages, but that knowledge is not perfect, and likely never will be. So information asymmetry is another source of market inefficiency.

There are others -- trade is not done with countries, but with companies. While countries negotiate trade deals, companies execute trade, and ultimately that split in roles creates inefficiencies -- gaps in information, gaps in policy preferences, and more. We are, however, working towards free trade. Starting with GATT and continuing to today's bilateral and multilateral agreements, and the WTO, barriers to trade are being lowered. Advances in information technology are lowering information asymmetry, too, and transportation is as cheap and efficient today as it has ever been.

So while free trade does not truly exist, and never can because it is a paper ideal, most nations today are working towards it. Nations do trade based on comparative advantages and absolute advantages that they identify. Companies in particular do business based on absolute advantages because intercompany trade does not require the trade-offs that occur in the model of comparative advantage. But countries do pursue comparative advantages.

The text highlights the trade-off between low-skill labor goods like textiles, which are no longer produced in America but are acquired overseas, while America exports high-value goods, cultural property (like movies and music) and other goods in which it has either comparative or absolute advantage around the world. Absolute advantage is fairly straightforward -- countries win trade by being the best at something, where externalities do not distort the trade equation. Comparative advantage occurs within the framework.