Doug Irwin
Free Trade Under Fire
Trade improves economic performance not only by allocating a country's resources to their most efficient use, but by making those resources more productive in what they are doing. This is the second of John Stuart Mill's three gains from trade, the one he called 'indirect effects.' These indirect effects include 'the tendency of every extension of the market to improve the processes of production. A country which produces for a larger market than its own can introduce a more extended division of labour, can make greater use of machinery, and is more likely to make inventions and improvements in the processes of production.'
In other words, trade promotes productivity growth. The higher is an economy's productivity level, the higher is that country's standard of living. International trade contributes to productivity growth in at least two ways: it serves as a conduit for the transfer of foreign technologies that enhance productivity, and it increases competition in a way that stimulates industries to become more efficient and improve their productivity, often by forcing less productive firms out of business and allowing more productive firms to expand. After neglecting them for many decades, economists are finally beginning to study these productivity gains from trade more systematically.
The first channel, trade as a conduit for the transfer of foreign technologies, operates in several ways. One is through the importation of capital goods. Imported capital goods that embody technological advances can greatly enhance an economy's productivity. For example, the South Carolina textile magnate Roger Milliken (an active financier of anti-free-trade political groups) has bought textile machinery from Switzerland and Germany because domestically produced equipment is more costly and less sophisticated. This imported machinery has enabled his firms to increase productivity significantly. Between a quarter and half of growth in U.S. total factor productivity may be attributed to new technology embodied in capital equipment. To the extent that trade barriers raise the price of imported capital goods, countries are hindering their ability to benefit from technologies that could raise productivity. In fact, one study finds that about a quarter of the differences in productivity across countries can be attributed to differences in the price of capital equipment.
Advances in productivity are usually the result of investment in research and development, and the importation of foreign ideas can be a spur to productivity. Sometimes foreign research can be imported directly. For example, China has long been struggling against a devastating disease known as rice blast, which in the past destroyed millions of tons of rice a year, costing farmers billions of dollars. Recently, under the direction of an international team of scientists, farmers in China's Yunnan province started planting a mixture of two different types of rice in the same paddy. By this simple technique of biodiversity, farmers nearly eliminated rice blast and doubled their yield. Foreign R&D enabled the Chinese farmers to increase yields of a staple commodity and to abandon the chemical fungicides they had previously used to fight the disease.
At other times, the benefits of foreign R&D are secured by importing goods that embody it. Countries more open to trade gain more from foreign R&D expenditures because trade in goods serves as a conduit for the spillovers of productive knowledge generated by that R&D. Several Studies have found that a country's total factor productivity depends not only on its own R&D, but also on how much R&D is conducted in the countries that it trades with. Imports of specialized intermediate goods that embody new technologies, as well as reverse-engineering of such goods, are sources of R&D spillovers. Thus, developing countries, which do not conduct much R&D themselves, can benefit from R&D done elsewhere because trade makes the acquisition of new technology less costly. These examples illustrate Mill's observation that 'whatever causes a greater quantity of anything to be produced in the same place, tends to the general increase of the productive powers of the world.'
The second channel by which trade contributes to productivity is by forcing domestic industries to become more efficient. We have already seen that trade increases competition in the domestic market, diminishing the market power of any firm and forcing them to behave more competitively. Competition also stimulates firms to improve their efficiency; otherwise they risk going out of business. Over the past decade, study after study has documented this phenomenon. After the Cote d'Ivoire reformed its trade policies in 1985, overall productivity growth tripled, growing four times more rapidly in industries that became less sheltered from foreign competition; Industry productivity in Mexico increased significantly after its trade liberalization in 1985, especially in traded-goods sectors. Detailed studies of India's trade liberalization in 1991 and Korea's in the 1980s reached essentially the same conclusion: trade not only disciplines domestic firms and forces them to behave more like a competitive industry, but helps increase their productivity.
