Global Trade Factors 101

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PHIL LEVY: He trades what and why?

I grew up in Wisconsin and I like bananas.

And to the best of my knowledge, there has never been a single banana grown in Wisconsin. Why is that, you ask? Bananas like warm tropical climates to grow in and that's not a very good description of Wisconsin. So I got bananas from Costa Rica, let's say.

Now, that begs a bigger question. Why was Costa Rica willing to send me bananas? They're nice people, of course. But if they're going to spend their days growing bananas, they'll want something in return.

Of course, Wisconsin can trade, let's say, motorcycles. Why would those be made in Wisconsin? Well, they require both physical capital, a fancy way of saying machines, and human capital, skills.

And Wisconsin has both of those.

So I've just told a story about why Costa Rica would have a comparative advantage in making bananas and, Wisconsin, a comparative advantage in making motorcycles. It had to do with either the technology behind production or with the different places, endowments of key inputs like warm weather in the case of the bananas.

The upshot of these differences would be that if we didn't have trade, bananas would be very expensive in Wisconsin relative to motorcycles. And the reverse would be true in Costa Rica.

Trade is what lets both Costa Ricans and the Wisconsinians be better off. So the first idea that we want to focus on in terms of why we trade is comparative advantage. So different places are able to make different goods relatively cheaply, and they're both better off when they swap.

All right, let's stick with that comparative advantage idea for a moment and add a couple of twists.

First twist, there are more than two places in the world. So Costa Ricans don't have to like motorcycles. Instead, they could send their bananas to Wisconsin, motorcycles could go to Spain, and Spain could send some real wine to Costa Rica. Same idea of comparative advantages before, but now, we get away from barter when two countries are just exchanging goods without money and we have a rich network of trade possibilities.

Second twist, I had the good people of Wisconsin making those motorcycles from start to finish.

What if instead, we apply the same idea of comparative advantage not just to the entire production of motorcycles, but to each of the various stages of motorcycle production? So the rubber, the tires, the engines, the seats, the mirrors, the electronics, all of it. If I really want to keep costs down, I could make each of those parts wherever it would be cheapest, say, in Canada, Germany, Japan, Malaysia. And then, I'd have the rest done in Wisconsin. Now, we're getting to the idea of global supply chains.

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INSTRUCTOR: What kind of factors could impact trade flows?

First, technology. We can use technology to describe anything that affected our comparative advantage. So if I used to have a production process that required lots of labor, for example, maybe sewing a garment, but then technological change means that less labor is required, that could change comparative advantage.

One of the reasons why China was thought to have a comparative advantage in textiles production was because it had been very labor intensive and China was abundant in labor. That will change as the technology changes. If you get to more sophisticated ways of producing garments with machines that can substitute for people, you'll put up less of a premium on labor abundance.

A second factor that can affect trade flows is policy.

If we slap 25% tariffs on the import of certain goods, it's very likely that those goods will look much less competitive or uncompetitive in the importing country.

Tariffs have been a big subject of discussion in the policy front. They're not the only policy that comes into play here.

Another common policy is quotas where a country will only allow a certain quantity of a good to come in. That tends to have the effect of raising the price. When you limit the supply, the price goes up. So it can be very much like a tariff.

Then you get some policies that are substantially more intricate, such as anti-dumping, which is ostensibly a response to countries selling at less than fair value or countervailing duty programs, which are means of retaliation against what are judged to be unfair subsidies. Each of those in the end is threatening tariffs. But they could have subtler effects because sometimes they can restrain trade even if no tariffs are actually applied just because of the threat of tariffs.

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PHIL LEVY: Third thing of what can change trade flows could be supply chain interruptions. One of the things we saw with the onset of the COVID-19 crisis was just how intricate a supply chain was. For a part to come from China to the United States, you needed Chinese factories to be open.

You needed workers in those factories. You needed the factories to be supplied with inputs.

You needed truck drivers to move the finished parts to the ports. You needed the ports to be functioning. And then finally, you needed vessels to carry the parts to where they were going.

In early 2020, we saw each of those stages suffer some interruption--

sometimes multiple stages at the same time. And trade flows suffered as a result, and you saw some major shifts.

Last thing I want to toss in here is that if you want to explain year-to-year fluctuations in trade, macroeconomics are important. The way to think about this, countries that are growing quickly tend to buy more of everything. Growing quickly, a higher GDP, equates to higher income. What do you spend that money on?

You spend it on a little bit of everything. You buy more domestically-produced goods, and you buy more imports.

The flip side of that is countries that slip into a recession tend to buy less of everything. They buy less of goods that are produced domestically, but they also buy less of imports. So that's what we saw with COVID-19, and we've seen this time and again. When economies stopped, demand fell off a cliff. That hurt domestic producers, but it also meant a big hit for imports.