THE IMMORTAL ADAM SMITH, PART 6

“The natural advantages which one country has over another in producing particular commodities are sometimes so great that it is acknowledged by all the world to be in vain to struggle with them. By means of glasses [i.e. windows], hotbeds, and hot walls, very good grapes can be raised in Scotland, and very good wine too can be made of them at about thirty times the expence for which at least equally good can be brought from foreign countries. Would it be a reasonable law to prohibit the importation of all foreign wines merely to encourage the making of claret and burgundy in Scotland? But if there would be a manifest absurdity in turning towards any employment thirty times more of the capital and industry of the country than would be necessary to purchase from foreign countries an equal quantity of the commodities wanted, there must be an absurdity, though not altogether so glaring, yet exactly of the same kind, in turning towards any such employment a thirtieth, or even a three-hundredth part more of either. Whether the advantages which one country has over another be natural or acquired is in this respect of no consequence. As long as the one country has those advantages, and the other wants them, it will always be more advantageous for the latter rather to buy of the former than to make. It is an acquired advantage only, which one artificer has over his neighbour, who exercises another trade; and yet they both find it more advantageous to buy of one another than to make what does not belong to their particular trades.” (WN, IV.ii.15, emphasis added)

The 15th paragraph of Book IV, Chapter 2 of The Wealth of Nations (quoted in full above) deserves a blog post of its own. Here, the father of economics introduces the concept of “absolute advantage” to present one of the most powerful and irrefutable arguments in favor of free trade. Put simply, when firms in country A can produce goods X, Y, and Z at a lower cost than firms in country B, then both countries are better off when they allow free trade in X, Y, and Z.

But is this ingenious argument really true? Is it better for a country like Scotland to import cheaper claret and burgundy from France than to promote local industry by growing her own grapes and bottling her own wine at home? Or to borrow a more contemporary example, is it better for the European Union or the United States to import cheaper electric vehicles (EVs) from the People’s Republic of China than to manufacture them in Europe or in the U.S.?

Adam Smith openly acknowledges that free trade will harm local firms. (See specifically Book IV, chapter 2, paragraph 16: “If the free importation of foreign manufactures were permitted, several of the home manufactures would probably suffer, and some of them, perhaps, go to ruin altogether, and a considerable part of the stock and industry at present employed in them would be forced to find out some other employment.”) But at the same time, Smith’s resounding answer to both of the questions above is an unqualified and absolute “YES”!

Recall Smith’s First Law: wealth is a function of capital. When a country prohibits or otherwise restricts the importation of cheaper goods like foreign wine or Chinese-made EVs in order to promote the domestic production of such goods or to protect local firms, Smith’s First Law invites us to take a step back and look at the big picture: what will the overall or “macro” effect of such trade barriers be? In a nutshell, Smith’s First Law teaches us that the overall effect of trade restrictions is simply to divert the flow of domestic capital into the production of those goods that would have been imported into the home market but for the restrictions on trade. To see this, ask yourself the following counterfactual question: what would have happened had there been no trade barriers in the first place?

In the remainder of Book IV, Chapter 2 of The Wealth of Nations, the father of economics does two more things: (1) he devotes special attention to food markets, such as cattle, corn, and salt, and (2) he identifies two important exceptions to the general rule that trade barriers are bad. I will turn to Smith’s analysis of food and agriculture markets in my next post and then conclude this series next week by taking a closer look at Smith’s two exceptions to free trade …