Trade and World Output: Describe the Broad Pattern of International Trade

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The long-standing U.S. policy of supporting multilateral trade liberalization is consistent with well-established conclusions from economic reasoning and empirical evidence about the benefits of trade to all participating countries.

Benefits from Increased Exports and Imports

The most-direct economic benefits from international trade arise from the fact that countries are not all the same in their production capabilities. They vary from one another because of differences in natural resources, levels of education of their workforces, relative amounts and qualities of physical capital, technical knowledge, and so on. Without trade, each country must make everything it needs; including things it is not very efficient at producing. When trade is allowed, by contrast, each country can concentrate its efforts on what it does best relative to other countries and export some of its output in exchange for imports of products it is less good at producing. As countries do that, total world output increases. World output may also grow because of greater use of economies of scale, as a factory in one country can serve a market the size of two or more countries rather than one. Trade can benefit countries' economies in a number of other ways as well, such as by expanding the variety of goods available to businesses and consumers, by increasing competition and thereby reducing the extent of monopolistic pricing and the inefficiency that results from it, and possibly by pushing up the rate of productivity growth. Market forces generally ensure that all countries involved in the trade share in the benefits from the increased output.

The analysis of FTAs is a little more complicated than that of multilateral trade liberalization. The rules of the WTO (and before that of the GATT) stipulate that, except in relation to free-trade areas, countries may not impose a higher tariff against one member country than against another, and any reduction in a country's trade barriers must apply equally to imports from all other member countries. Accordingly, any reduction in a country's trade barriers will benefit the competitiveness of all imports equally, and any resulting growth in imports from a given foreign country will displace domestic production and not displace imports from other countries.

In the case of an FTA, however, the reductions in trade barriers increase the competitiveness of imports from the other parties to the agreement not only relative to domestic production but also relative to imports from other countries. Consequently, any resulting rise in imports from parties to the agreement may displace either domestic production or imports from other countries. Economists refer to the displacement of domestic production as trade creation because it results in a net increase in trade. They call the displacement of imports from other countries trade diversion since it does not increase trade overall but rather amounts to a diversion of existing trade.

The distinction between trade creation and trade diversion is important because the former is more likely than the latter to produce a net economic benefit. Although trade creation may hurt some sectors, it is almost always economically beneficial overall because it occurs only when the price of the import in question is lower than the domestic cost of producing the same good. Trade creation therefore allows the domestic economy to obtain the good at a lower cost than would be possible without trade.

Trade diversion is less likely to be beneficial to the importing country (in this case, the United States) in the aggregate, although some sectors are still likely to gain from it, because it results in the import's being obtained at a higher cost to the economy. The reason is that an import's cost to the economy is different from its cost to a domestic purchaser: the cost to the domestic purchaser equals the foreign country's selling price plus any tariff imposed on the import, whereas the cost to the economy equals the foreign country's selling price only. The tariff paid by the purchaser constitutes U.S. government revenue and therefore remains with the U.S. economy rather than going to the foreign economy.

As an illustration, suppose that before NAFTA went into effect, a particular product was imported from Chile and not Mexico, but that after NAFTA, because of the elimination of tariffs on Mexican goods, the same product was imported from Mexico and not Chile. The fact that the good was imported from Chile before NAFTA means that the price to U.S. purchasers was lower for the Chilean good than for the Mexican good. Since U.S. tariffs on the product were the same for both countries, the foreign country's selling price--the cost to the U.S. economy--must have been lower for the Chilean good than for the Mexican good. The implementation of NAFTA did not change that fact; the cost of the Chilean good to the U.S. economy remained lower than the cost of the Mexican good. However, the elimination of the tariff on the Mexican good meant that U.S. purchasers faced a lower price for that product than for the Chilean one, which was still subject to the tariff, so they bought the Mexican good even though its cost to the economy was higher.

In general, one would expect an FTA to result in some amount of both trade creation and trade diversion. If the trade diversion was sufficiently large relative to the trade creation, the agreement could conceivably end up being slightly harmful to the United States rather than beneficial (although, interestingly enough, the harm would come from imports that did not cause the pain of dislocating production by domestic industries). However, as more and more FTAs are negotiated, the later agreements become less and less likely to divert trade and more and more likely to reverse the trade diversion that resulted from earlier agreements. Returning to the example above, if NAFTA caused a rise in imports from Mexico at the expense of imports from Chile, the subsequent free-trade agreement with Chile would reverse that diversion of trade and eliminate the resulting harm. Ultimately, negotiating individual FTAs with all countries would eliminate all trade diversion and leave only trade creation--just as would happen if free trade with all countries was negotiated multilaterally in the WTO--and the United States and all other countries would benefit.

THE OUTPUT IN THE DEVELOPING COUNTRIES ALSO INCREASES WITH TRADE

New data shows that the developing world's share of global trade has surged to a 50-year peak. Rising oil and commodity prices coupled with vigorous global trade growth meant developing countries saw their share in world merchandise trade rise sharply in 2004 to 31%, the highest since 1950, according to WTO figures released this morning.

The data provides clear evidence that trade liberalization continues to play a growing role in economic activity and is increasingly important for development and poverty alleviation. More countries are engaging in international trade and participating more actively in setting and negotiating trade rules.

Most notable is the rise in Africa's exports, which grew by an impressive 30% last year, following on from rising strongly in 2003. This marks the highest growth in African exports since 1980. This trade growth has been associated with an improved expansion in production, which registered more than 4% growth for the continent in 2004. Economists predict it will continue at the same rate next year.

Trade is the engine by which countries can create wealth; it is key to sustainable development and a higher standard of living. While the trend is encouraging, trade expansion is still hampered by barriers which must be brought down for prosperity to spread. These barriers that exist are a colossal drag on economic growth. The best way to reduce these barriers and to ensure more equitable trading rules for all nations is to complete the multilateral Doha Development Agenda round of trade negotiations. If that proves impossible the advanced nations should opt for unilateral free trade, a policy which Britain chose in the nineteenth century when it was the pre-eminent global economic power. There is no reason why the major global economic powers of today, namely the U.S., E.U. and Japan could not implement such a policy without delay.

The world economy grew at 4% in 2004, the strongest annual growth rate in more than a decade. Global GDP last year was also more broadly based regionally than in the three preceding years, providing a solid foundation for acceleration in world trade growth. World merchandise trade rose by 9% in real terms in 2004, the best annual performance since 2000, and more than twice as fast as world output (GDP measured at market rates) in 2004. Trade growth in 2004 also significantly exceeded average trade growth recorded over the last decade.

This strong economic backdrop suggests that this is a good environment in which to open up the world economy completely. It might not be as good-as-it-gets, but it as good as it's been for a long time. Now is the time for G7 policy makers to seize the opportunity.

The trade creation effect is caused by the extra output produced by the member countries. This extra output is generated due to the freeing up of trade between them. Increased specialization and economies of scale should increase productive efficiency within member countries.

The trade diversion effect exists because countries within trading blocs, protected by trade barriers, will now find they can produce goods more cheaply than countries outside the trade bloc. Production will be diverted away from those countries outside the trade bloc that have a natural comparative advantage to those within the trading bloc.

THE THEORY BEHIND WORLD TRADE AND OUTPUT

The theory of comparative advantage is perhaps the most important concept in ...