Does Free Trade Bring Lower Prices?

Daniel Drezner has some nice things to say about me and my blog, but then takes me to task for understating the gains from free trade in a recent entry. He writes:

In focusing strictly on the employment effects, however, Rodrik elides the biggest gain from trade -- lower prices.

Since Drezner’s point reflects a common misunderstanding about the effects of trade, it is worth some explication.

Advocates of globalization love to argue that free trade lowers prices, and the argument seems sensible enough. Think of all the cheap goods from China that we can buy at Wal-Mart.  But anyone who understands comparative advantage knows that free trade affects relative prices, not the price level (the latter being the province of macro and monetary factors).  When a country opens up to trade (or liberalizes its trade), it is the relative price of imports that comes down; by necessity, the relative prices of its exports must go up!  Consumers are better off to the extent that their consumption basket is weighted towards importables, but we cannot always rely on this to be the case.

Consider your typical Argentinian for example, who consumes a lot of wheat and beef. Since these are export products for Argentina, free trade implies a rise in the relative price of the Argentine consumption basket. (The gains from trade are still there, of course, but they derive from the usual allocative efficiency improvements, not from lower prices across the board.) And in the U.S., the Wal-Mart effect has to be qualified to take into account the fact that the relative price of the goods that the U.S. exports (including for example agricultural commodities) is higher than it would have been absent trade.  Similarly, when the U.S. gets better market access abroad for its agricultural exports (a key demand under the Doha round), you can be sure that this will raise domestic prices for these goods, not lower them. 

Of course, if you are running a huge trade deficit like the U.S., you can have cheaper prices all around—for all to go on a consumption binge as long as the party lasts.  But this is hardly the argument we make when we teach the benefits of free trade. 

Postscript:  It is interesting that many of the commentators below have appealed to scale economies as an explanation of how production costs and prices can fall all around as market size expands thanks to trade. Yes, this is a possibility.  But scale economies raise a whole set of new conundrums (which is why I had stuck with the standard comparative advantage story). In particular, since scale economies are not compatible with perfect competition, we find ourselves in a second-best world with all kinds of strange possibilities. Opening up to trade can leave some countries worse off, and in general trade-distorting policies like tariffs and subsidies can make individual countries better off. So be careful how you describe the world we live in...

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[Richard H. Serlin]

Yeah, but there's also specialization and comparative advantage, greater competition (with proper anti-trust law), and if done right, in many cases, a decrease in corruption. I realize you want to encourage greater intelligence in free trade agreements and side agreements, and greater compensation of the losers in free trade (the gainers gains are typically much greater than the losers losses, but there can be a lot of losers). But please be careful not to discourage free trade in general. A man of your expertise obviously knows the great overall benefits it brings.

[Joe]

Exactly. The result of freer trade in the US has been a redistribution of income though I think that the biggest redistribution has not been accross borders but within the US income distribution. Witness the increase in Jack Welsh's income from outsourcing back office operations to India. Yes the citizens of India probably realized an increase of income but Jack really made out. Your countrymen thank you Jack as salaries have decreased and the median household has not nearly increased commensurate with the fact that the median American household now has two full time workers. Thanks Jack. You are a real American as are all the politicians and pundits that supported you venally selling your countrymen down the river.

[skeptonomist]

You seem to be saying that macroeconomics is independent of trade policy - "price level...being the province of macro and monetary factors". How can restriction or facilitation of trade not affect price level? If the only widget factory is in Vermont and the only frammitz factory is in New Hampshire, then doesn't the price level of widgets+frammitzes ultimately come down if there are no trade barriers between the two states? It is hard to separate scale, efficiency and specialization from the argument.

[Joe Buck]

What matters to a consumer is not the absolute price of a good, or even the relative price compared to other goods. What matters is the price relative to the worker's wage. Since free trade as currently practiced (except within the EU) allows goods to freely cross borders, but leaves most workers trapped in one country, the effect on purchasing power is likely to be negative. Not always, of course (shop at Wal-Mart, as long as you still have a decent job), but it shouldn't be surprising that support for free trade is highest in those professions least subject to outsourcing (journalists, for example).

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