Question

In economics, we learn about production and relationship between input and output through a simple production function with two factors of production, namely, labor and capital. As simple as it is, this equation is very useful for both understanding and studying the dynamics of economic growth. For example, if we assume the production function of the whole economy is Q = f (K, L), where K is the economy’s stock of capital, L is employed labor and Q is the economy’s output,  an increase in either labor or capital or both would lead to the growth of the output. We can also grow the economy by increasing labor productivity; that is the amount of output produced by one unit of labor during one production cycle. Following the 2008 financial crisis, which led to a partial collapse of the US financial system, the US economy, as well as the economies of many other countries, went into a severe recession. Although most of these economies have been recovering, the wages of the middle-class income groups in most industrial countries have not been increasing much. In fact, in the US, for example, from the mid-1980s until very recently wages stagnated, and the wage increases of the past two years have been very modest and hardly kept up with inflation. This has resulted in some level of discontent about the state of the economy in most industrial countries. Some observers attribute this structural changes caused by free trade and globalization and technological automation. As a result in some countries, including the United States, sentiments against free trade and globalization seem to be on the rise. President Trump's trade policies appear to be reflective of such sentiments.

Do you agree that we should restrict trade and adopt protectionist policies and, possibly, discourage the development of automation technologies to protect middle-class jobs? Do you think such policies would lead to higher wages?

Answer 1

From Adam Smith to Ricardo to IMF have advocated free trade policy as driver of economic growth. Trade allows more efficient allocation of resources globally. And as demonstrated by Samuelson and Stopler, trade bring factor prices equal across trading countries. This means that labor having same productivity across countries would earn same wages.

Developed countries face resistance from labor unions against free trade as low skilled labor there gets wages higher than what their productivity commands. Such low skilled labor in developed countries face challenge from not just outside low waged labor but also from rise in use of automation in their own country that can replace low productivity workers.

Adopting trade protection to allow domestic labor to get higher wages would encourage other countries to erect similar trade controls. Thus the exporters of developed countries would face loss of profits. And, loss of profits of exporters is higher than gain of importers from trade protection. This is because only free trade is Pareto Optimal Solution.

Also, if trade controls are put in place, then domestic firms using automation can replace firms using low productivity unskilled labor. And by restricting automation use, there would be brake on growth. According to Solow model, growth in welfare measured in terms of rise in per capita output, occurs via technology improvement.

However, this does not mean there should be free trade. Free trade causes joblessness. To prevent negative effects of free trade, government must tax the exporters suitably and use the proceeds to skill labor from firms in importing sector. This would help migration of labor resources from less efficient importing sector to more efficient sectors. This is how economy progresses and welfare improves.