Free Trade Theory

The theory of comparative advantage, developed by David Ricardo in 1817, is one of the most powerful and counterintuitive ideas in economics: even if one country is more productive than another in every industry, both countries gain from specialization and trade. The more productive country should specialize in whatever it produces most efficiently relative to other goods; the less productive country should specialize in whatever it produces least inefficiently. Total output rises, and both countries consume more than they would in autarky.

The theorem is mathematically valid under its assumptions. The assumptions include: full employment (workers displaced from import-competing industries find equivalent employment in export industries), factor immobility across countries (capital does not move to exploit wage differences), similar technology levels, and transportation costs low enough to allow specialization without eliminating its gains. The real world satisfies these assumptions imperfectly at best and in some cases not at all.

The most consequential departure from the model's assumptions is capital mobility. Ricardo assumed that while goods move across borders, capital (and labor) do not -- comparative advantage is national, not arbitrable. In a world of mobile capital, the logic changes: manufacturers can move production to wherever wages and regulatory costs are lowest, regardless of comparative advantage. The offshoring of production is not a vindication of Ricardo's theory -- it is what happens when his assumptions are relaxed in ways favorable to capital but not to workers.

Free trade is not about what economists have demonstrated about aggregate output. It is about who captures the gains and who bears the adjustment costs -- and those questions are political, not technical.Dani Rodrik, The Globalization Paradox (2011)

The standard welfare analysis of trade liberalization shows aggregate gains with distributional costs: export-sector workers and consumers of imported goods gain; import-competing workers and import-substituting firms lose. The standard policy prescription is to use some of the aggregate gains to compensate the losers -- through trade adjustment assistance, extended unemployment benefits, retraining programs, and place-based investment. In practice, the United States has consistently implemented trade liberalization and consistently failed to provide adequate adjustment assistance. The gains have been captured; the compensation has not been paid.

This gap between the theory and the practice of trade liberalization explains much of the political backlash against globalization that has characterized the past decade. Workers in manufacturing communities that lost employment to import competition experienced real economic harm. The promise that they would find equivalent employment in export sectors was not fulfilled. The economists and politicians who promised adjustment and failed to deliver it forfeited credibility that has not been restored by pointing to aggregate GDP figures.