Sunday, September 16, 2012

Has Tim Worstall made the case for one-way free trade?


At Forbes, Tim Worstall attempts a critique (or, in blog parlance, a smackdown) of my last post, on one-way free trade. I want to thank Tim for taking the time to read and respond to my post; although this post is a counter-rebuttal, I don't want it to be taken as angry, resentful, or combative.

The first three quarters of Worstall's post is about the cost structure of the solar industry; since I don't actually know that much about silicon ingots, I'll leave this part alone. However, Worstall's conclusion - that "Yes, unilateral free trade is the answer" - is driven entirely by the last couple paragraphs of his piece. Since these paragraphs contain two or three major errors (depending on how you count), I'll just skip to that part and explain where Worstall goes astray. He writes:

[W]e really don’t care at all whether government can limit risk imposed on US firms. Because we don’t in fact care about US firms at all, at least not in the context of trade. We care only about consumers when discussing trade... 
[T]he sole purpose of all production is consumption. The only relevant question when dealing with...trade is what expands the consumption possibilities of the populace? Not who produces or how, who does the labour to produce nor who profits from it. But only and solely who gets to consume what? If trade increases that consumption then great, we’re all for trade. Which brings us back to the point made at the top about trade being voluntary. No consumer is going to purchase an imported item if it decreases their consumption possibilities. Thus unilateral free trade is indeed what we want simply because that is what best expands consumption opportunities: which is the point of the whole game in the first place. 
The error is in thinking that we care what happens to firms or producers at all.
If you didn't see the errors yet, take a minute now to re-read what Worstall wrote. If you still don't see it, read on.

Worstall is correct when he says this:
[T]he sole purpose of all production is consumption. The only relevant question when dealing with...trade is what expands the consumption possibilities of the populace?
To a first approximation, this is right. Consumption is what creates utility.

However, Worstall uses this fact to conclude that, when analyzing one market, we care only about the consumers in that market, when he says: "[W]e don’t in fact care about US firms at all, at least not in the context of trade." This is false. Consumption happens across the entire economy. Many things are consumed. And every person in the economy is a consumer (or else they would be dead).

So if you look at the market for solar panels, and you consider only what happens to consumers of solar panels, you are in error.

Remember that every producer is also a consumer. Producers purchase their consumption goods using the income that they get from producing things. If producers' income goes down, their consumption must go down too.  Supply-and-demand graphs show that "total surplus" = "producer surplus" + "consumer surplus" + "government surplus". So Worstall's idea that we can forget about solar producers when analyzing the solar market - i.e. that "total surplus" = "consumer surplus", and that producer surplus does not exist - is not correct.

Worstall's second error comes when he says this:
No consumer is going to purchase an imported item if it decreases their consumption possibilities. Thus unilateral free trade is indeed what we want simply because that is what best expands consumption opportunities[.]
To a first approximation, the first sentence is right. But the second sentence does not follow from the first, for at least two reasons.

Reason 1: Externalities. This is the easy one. Suppose I consume energy whose byproduct is toxic waste that  seeps into my neighbor's groundwater supply, poisoning and killing him but leaving me unaffected. My consumption decision has not decreased my consumption possibilities, but it has decreased the consumption possibilities of society as a whole, because my neighbor is now dead.

However, I only put this as "Reason 1" to get it out of the way. Externalities are not even the biggest reason why Worstall is wrong in concluding in favor of one-way free trade. The biggest reason is:

Reason 2: Harmful policies can harm the economy by preventing optimal consumption decisions from being made.

Here is a simple example, using only Econ 101 economics - no externalities, no funny stuff. Suppose there are only 2 countries in the world: the U.S., and China. The U.S. trades with China; on net, we export rice to China, and they export TVs to us. Now suppose that China's government, having been captured by producer interests, decides to protect its rice producers by putting tariffs on rice imports.

This policy will hurt the world, because it causes inefficiencies (deadweight loss). Chinese producers of rice will benefit. Recipients of Chinese government spending will benefit, because they will indirectly receive the revenue from the tariff. U.S. consumers of rice will be helped, because they will pay lower prices. U.S. producers of rice will be hurt, because they will be forced to charge lower prices for their products and will see their sales fall. In total, the harm to China outweighs the benefit to China, and the harm to the U.S. outweighs the benefit to the U.S. (if you don't believe me, imagine scaling up the Chinese tariff to infinity, so that the world reverts to autarky).

(Note how we see Worstall's first error in action; the loss to U.S. producers matters because those producers are also consumers! U.S. rice consumers benefit from the Chinese tariff, but total U.S. consumption falls!)

Now let's consider the following possible U.S. policy: The U.S. government says "China, unless you remove these protectionist policies, we will retaliate by imposing import tariffs on TVs exactly equal and opposite to the tariffs that you have enacted."

Suppose that this threat is credible. China's government is captured by TV and rice producers, so China's government's best response is to eliminate its subsidies and tariffs. The whole world benefits, the United States benefits, and China as a whole benefits. The total consumption possibilities of the United States (and of the world) have been expanded relative to the case of U.S. unilateral free trade.

Note that this example does not rely on externalities, on irrational consumer behavior, on coordination problems, fixed costs, or anything else. It is a pure Econ 101 trade problem with two countries, two goods, supply curves that slope up, and demand curves that slope down. 

So this simple example shows how one-way free trade may be a losing policy, if governments behave strategically. Which was the whole point of my earlier post.

(Note: To anyone who read this post and said "But, consumers can be irrational and short-sighted!", or "But, there are production externalities and coordination problems!", or "But there are transaction costs!", I say: Yes, yes. The point of this post is to show that you need absolutely nothing beyond Econ 101 to show that one-way free trade may be the wrong move.)

Update: Adam Ozimek has some good comments.

27 comments:

  1. Martin5:09 PM

    Noah, I agree with you on points #1 & #2 in the comments on the previous thread.

    Let me however provoke you a bit here:

    For why not say instead "China, unless you remove these protectionist policies, we will retaliate by a nuclear strike on Beijing."? Provided the threat is credible, this policy should have the same effect.

    Is unilateral trade still a losing policy when compared with this option or am I missing some important difference with your example above?

    I think it really does matter why it is credible, and this will depend on "externalities, on irrational consumer behavior, on coordination problems, fixed costs, or anything else".

    Or making good on the threat should at least not make the US worse-off. Neither the TV-tariff, nor the nuclear strike has that property.

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    1. Oh, and you are wrong:

      Or making good on the threat should at least not make the US worse-off. Neither the TV-tariff, nor the nuclear strike has that property.

      First of all, as any intro game theory course should teach, U.S. policy irrationality (willingness to engage in self-harm) can produce a globally optimal equilibrium in a game like this.

      Second of all, the credibility requirement that the punishment be non-self-harming in every period is not necessarily true in a repeated game.

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    2. Martin5:51 PM

      Sure, I don't dispute that, I believe the example given is usually with Nixon pretending to be crazy, however, I thought we had excluded irrationality?

      Further if we're playing a repeated game, wouldn't it be optimal for both parties to play "free trade" from the start?

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    3. Sure, I don't dispute that, I believe the example given is usually with Nixon pretending to be crazy, however, I thought we had excluded irrationality?

      Depends on what we define as "rational". Remember, in the example, China is not maximizing its total surplus. Nixon, also, might just enjoy nuking other countries more than he enjoyed anything else. This would make him "crazy", but would it make him "irrational"? You decide... ;)

      Further if we're playing a repeated game, wouldn't it be optimal for both parties to play "free trade" from the start?

      If a credible threat of U.S. retaliation exists, then yes!

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    4. In fact, you've hit on the whole point of my example... ;)

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    5. Martin6:34 PM

      I think usually we try to explain behavior that looks irrational at first in terms of constraints rather than in terms of preferences.

      In the example, it seems, you give a public choice explanation for the existence and disappearance of tariffs; that seems perfectly rational to me. Nixon being "crazy" on the other hand for crazy's sake is, I think, not generally how economists want to explain things ;).

      "If a credible threat of U.S. retaliation exists, then yes!"

      Ok, I think we agree then, I just wonder what that means now :P.

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    6. I think usually we try to explain behavior that looks irrational at first in terms of constraints rather than in terms of preferences.

      There is a symmetry between the two...

      Ok, I think we agree then, I just wonder what that means now

      I think the really interesting question, and one for which I don't have an answer, is:

      How can free trade be enforced in a world in which some actors do not pursue unilateral free trade policies?

      I think that the answer to this is not easy, and not short, and maybe not unique. But we need to know this, in order to know if protectionist policies can ever contribute to freer trade in the long run.

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    7. Martin7:47 PM

      Well, it seems to me that whether or not the threat of the 'US' is credible, the result will always be that the 'US' chooses to play "Free Trade". When it's not credible, 'China' plays "Tariff", when it is, 'China' plays "Free Trade".

      I would therefore change the focus of the question and ask: why do so many countries play "Tariff"? Is that really due to the absence of credible threats - we see plenty of retaliations or threats of - or is it due to something else?

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    8. Oh it's probably due to something else. This example isn't realistic at all. The point of this example was to show that A) consumption in a single tradable goods sector does not equate to the present discounted expected value of economy-wide consumption (a fact that also seems to have confused you a bit in the previous post), and that B) strategic trading behavior does not require externalities or any other market failures in the "U.S." (i.e. the country whose problem we're modeling) in order to hold. These were in response to Tim Worstall at Forbes, but they incidentally served as good examples to illustrate some of the things I was trying to explain to you in the previous post (e.g. why risk to the consumer in one market does not equal risk to consumers in all markets).

      In reality, tariffs probably emerge for two broad classes of reasons:

      1. Public choice mechanisms (e.g. special interests)

      2. Funky stuff like externalities and transaction costs that really do make protectionism a fairly good development strategy

      I bet there's a lot more (1) than (2) out there, but I bet there is some (2). See Dani Rodrik for ideas on what exactly those externalities might be.

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    9. Martin8:05 PM

      Don't get me wrong, I think the question whether protectionist policies can contribute, to be an interesting one, but wouldn't you agree with me that the ultimate goal is raising welfare by whatever means rather than just by protectionist policies? And doesn't this mean that we should focus on the raison d'ĂȘtre of tariffs first?

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    10. Martin8:19 PM

      Noah, with regard to the previous post, I think we were talking at cross-purposes there if that was what you were trying to explain to me. Figures. I tried to keep those things separated.

      With regard to B), I don't get that completely why that does not require externalities etc. I still have the feeling you need to sneak that in, for many cases, by assuming that it is credible to threaten retaliation. I am assuming pure wealth maximization on part of the 'US'.

      As for 1 & 2, I agree, though I wonder about the effectiveness of 2, as from what I understood from a quick glance there were not many empirical studies supporting that claim, and that it was mostly wishful thinking. I'll have a look though at Rodrik. Thanks!

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    11. Third reason for protectionism is insurance against a single-supplier catastrophe. Suppose we had switched to importing all our soybeans from the area around Tokyo, because it was the most efficient soybean producer.

      Then Fukushima happens.

      Uh, problem, folks. One purpose of protectionism is to avoid putting all your eggs in one basket.

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  2. I've noticed the economists don't factor in two things that are important in practice:

    1. offshoring, and offshored jobs being replaced by lower wage jobs.
    2. the effect of lower wages on consumption.

    Why is it that these real world impacts so often disappear when economists discuss free trade?

    It seems like the obvious rejoinder to :

    "No consumer is going to purchase an imported item if it decreases their consumption possibilities. Thus unilateral free trade is indeed what we want simply because that is what best expands consumption opportunities."

    The trade off between the money in your pocket that you have to spend today on a good you need, and the possibility that in a few years you might lose your job because your firm goes overseas to manufacture, due to lower prices for consumer goods, involves an informed judgment of future trends that it does not seem reasonable for consumers en masse to master.




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  3. Anonymous6:28 PM

    I say: Yes, yes. The point of this post is to show that you need absolutely nothing beyond Econ 101 to show that one-way free trade may be the wrong move.

    Wait a second here. Are you saying that causes of market failure are not part of Econ 101?

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    1. Horribly, having taken Econ 101 and 102 in the 1990s, I can tell you that they have *not* been part of Econ 101 even at supposedly good schools (Carleton College, look it up if you don't recognize it -- Veblen went ).

      And it's not even the professors' fault -- the professor actually knew all about market failure, thought it was important and *common*, and even encouraged me to study it outside of class.

      It's a problem of curriculum design driven by bogus "standards" in the economics profession.

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  4. Noah,

    your example supposes that China is big enough to affect the terms of trade (lower world prices of rice). It may be reasonable to assume so, but nevertheless the assumption should be highlighted. But does what China is doing amount to a tariff or a subsidy? If it is the latter, then ECO 101 suggests that there will be a net benefit in the U.S. from this transfer from Chinese taxpayers. If the Chinese want to subsidize American consumption why should we object? Wouldn't it be better to implement a redistribution scheme that divides the spoils more evenly (e.g. assists producers who are hurt?)

    Finally, on the solar panel issue, you may want to read this story:
    http://articles.cnn.com/2012-08-22/politics/politics_obama-solar-poster-boy_1_obama-transition-team-barack-obama-obama-policy

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    1. your example supposes that China is big enough to affect the terms of trade (lower world prices of rice)

      It's a two-country example. If U.S. import and export prices are fixed wrt the actions of China, then Chinese trade policy cannot affect the U.S. at all.

      But does what China is doing amount to a tariff or a subsidy? If it is the latter, then ECO 101 suggests that there will be a net benefit in the U.S. from this transfer from Chinese taxpayers.

      That's right. I just wanted to show how Tim Worstall's argument breaks down. This example doesn't work in the case of a subsidy, and it may or may not work in the case of a currency peg.

      If the Chinese want to subsidize American consumption why should we object?

      In the real world? Because this example is not even close to realistic. In the real world, several "exotic" things could make Chinese subsidization of U.S. consumption a bad thing (they involve externalities and/or irrationality). However, Worstall, in his article, pooh-poohed the use of such non-standard things, so I wanted to make an example that showed the possibility of strategic trade with no such weird stuff.

      Concerning trade in the real world, I don't claim to know much about it, but I think the profession is too biased against the possibility of efficient trade restrictions. So whenever possible I try to question the conventional wisdom, even though it's not my field at all.

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  5. The US could tax TV imports and use the proceeds to subsidize rice producers, undoing most of the market distortion, not quite as efficient as free trade, but more efficient than one way free trade.

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    1. This is essentially what would occur under floating exchange rates if China was not hoarding dollars. Any free lunch is just an offset against an eventual crisis during which it must be repaid in short order.

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  6. Anonymous8:06 AM

    Noah,

    Not an economist here, although I would be interested in understanding the economics of the solar industry. You are probably more interested in the trade issues, but I thought a few bits of information might help.

    Firstly I thought that you [as a physicist] might like to know that your critic is off by about three orders of magnitude with wafer thickness. According to AMAT (who make wire saws for wafering) "Today, a solar wafer is about 170-190 microns thick, about half the thickness of a decade ago".

    He's also about 50% off with his silicon prices (see http://pvinsights.com/ for weekly spot prices). The big guys are still making money at $20/kg, and I doubt that anyone hasn't already renegotiated old supply agreements.

    Quibbles aside his analysis of the silicon prices makes much more sense than yours does, $400 per kilo was in supply constrained times (after the IC scrap supply became inadequate), it took a while for all the new capacity to come on line. Now it has and prices are way down. This has parallels to the base metals and hard rock mining industries, which are famously cyclic. Note also that most of the poly suppliers are not Chinese [see http://www.greentechmedia.com/research/report/polysilicon-2012-2016/] so the segment of the value chain that has seen the biggest price declines is the least susceptible to Chinese subsidies, indeed the Chinese are threatening protecting their poly companies. This doesn't seem to fit with your thesis.

    All that is just the poly; wafer, cell and module conversion costs are also all down, and poly costs aside my guess is that this is largely due to scale. This might have been enabled by easy money from the Chinese govt, but it was also enabled by demand driven by [mostly European] consumption subsidies. Either way it seems to me that this is going to be good for the world [if not for the workers or shareholders of US solar start-ups]. Most analysis I've seen of this market points to a learning curve trending almost monotonically downwards, it isn't clear to me how we could end up with this turning back up in a big way. Can you explain how you envisage this happening? If your assumption is that the Chinese haven't invented anything, then if they decide to jack up the prices wouldn't be easy to set up operations elsewhere? [remember the biggest solar manufacturing equipment suppliers are still in the West, mainly German and the US, and much of the research knowledge is in the West].

    Sure potential solar investors might have been scared off. But the flip-side is that all the naysayers who insisted PV was always going to be too expensive are now on the back foot. Grid parity is happening, and it is way faster than anyone expected thanks to these price decreases.

    Externalities are obviously important, but [as someone not drinking tap water in China] my guess is that a few polluted rivers in China (or marginally more polluted) are a small price to pay for an atmosphere that has less CO2. If the Chinese loose money on every panel they make, and put some US coal miners out of a job in the process (and lost some of Sand Hill Road's money), global GDP might go down a bit - but the integral under future global happiness might be higher due to the climate being more stable, do you really see this as a Bad Thing?

    Seems like the rice/TV model might be too simple. Very likely I'm missing the point here, as I know literally no economics. Since you do, I value your take.

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  7. Anonymous2:48 PM

    This is why economists have to use models to get a handle on international trade. Any assertion can be justified if you have the right implicit assumptions about country size, number of goods traded, nature of goods traded(final/intermediate), whether there are non-traded goods or not, intermediate goods, number of countries, consumer preferences convex or not, economies of scale, etc...

    Of course we cannot "prove" that one-way free trade is always optimal, but as a rule of thumb it is seems better than little or no trade which is where a cycle of retaliation will get you.

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    1. "Better"? For what definition of better?

      As I noted above, autarky is more *stable*, which has a lot of value in itself -- if you look at Maslow's hierarchy of needs, it falls under "security".

      Now, if you can increase *stability* with "one way free trade" -- for instance, if you open your small country to supplies of key products from twenty other countries -- then even one-way free trade starts to seem consistently valuable.

      But if you are just allowing your entire passenger railcar manufacturing industry to vaporize, while it gets eaten up by a total of five companies with approximately ten total factories worldwide, it's not at all clear to me that you've improved anything, even if the foreign producers are "more efficient". (Real example, though the industry was allowed to vaporize through means other than tariffs, by temporarily eliminating the entire domestic demand.)

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  8. I think its really important to consider the effects of various national policies on markets for emerging technologies. Here, we made the big mistake of tying incentives for renewables to production tax credits, which have to be periodically renewed. While this has had some effect on solar panels, it is nowhere near as dramatic as the effect on the similar situation in wind energy, where the planning cycle is much longer. http://www.awea.org/newsroom/pressreleases/layoffs continue.cfm Here is a case where uncertainty in policy has a huge negative effect on markets.

    The second major area is national grid policy, where the complexity of permitting, power contracts and grid access have stretched the development of wind farms to several years. And, with all this talk of the 'Smart Grid' what is essentially going on is aimed at reducing consumption (definitely a good thing) but in such a way as to allow utilities to minimize development of new generating capacity (such as renewables) and long distance power transmission by placing the burden on consumers, which is a decidedly bad thing.

    I have written about grid distribution issues earlier, including 'America Back on Track, an Electrifying Idea at: http://somewhatlogically.com/?p=60 and 'CCA's, Coal and Nukes' at http://somewhatlogically.com/?p=57 which also contains links to a very prescient American Institute of Physics article on what is wrong with the current grid, and accurately predicted all the problems that arose from deregulation. It also includes maps, and a great description of the 'Reactive Gigawatt that circles lake Erie' which is not a monster designed to frighten the bed-time storytelling for the children of high-voltage engineers but a creation of the self-serving deregulation of the Bush years.

    I strongly recommend the article, with its maps and accessible technical and market descriptions to anyone who wants to understand why it is so essential that we develop, as is being done in much of Europe, modern high voltage DC distribution on a national basis. Here's an example of a project in Africa, a 950km link between Namibi and Zambia, stabilizing two weak national systems. http://tinyurl.com/8naeyev There are a few smaller interconnects in the US, and Canada has major HVDC distribution, much of which comes cross-border to the states from Quebec Hydro.

    Trade policy has a lot to do with where we buy stuff, but little to do with how we use it. And if we are to follow Noah's advice and use natural gas as a bridge to renewables, as Sweden and some other European countries are already doing, it will be boom and bust in the energy business again. Years ago, I purchased a bumper sticker in Wyoming that said "Please God, One More Energy Boom" and below that, in small letters, "(We promise not to screw it up this time)". How do you think we're doing with the fracking boom so far? Seems we're mirroring the early days of Texas oil boom, and have already created a short term glut. In the 30's the Governor of Texas used the National Guard to shut down rampant overproduction from wildcatters in the East Texas Oil field, and the Feds eventually had to step in to stabilize the mess. Yergin's book, 'The Prize: The Epic Quest for Oil, Money and Power" is an excellent reference.

    This is why we need an evolving national HVDC grid, which would make energy generation truly competitive, but just as with Roosevelt's TVA and REA projects (see http://somewhatlogically.com/?p=48) nothing is going to happen until Washington escapes from regulatory capture and leads the way.

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    1. Second sentence, next to last paragraph should read, "And if we don't follow Noah's advice....

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  9. The Theory of Comparative Advantage still holds, of course. Ceteris Paribus, if either country opens itself up to trade more, both will benefit. Unilateral free trade is good. If you ignore ceteris paribus, you can say anything you want. Yours is free trade plus less free trade is bad. This does not mean unilateral free trade is bad: it means some, not necessarily related, things in this world are worse than free trade is good.

    Also, if you trade freely, causing GDP to rise, and people use the money to buy tigers, and the tigers eat the people, causing GDP to fall, I suppose you could say you have found a flaw in the Theory of Comparative Advantage. I doubt that I will get a Nobel Prize for this insight.

    What you have to defend is that gimping your own trade policy can be used effectively for the aim you are trying to promote. We might restrict trade to purposely reduce the resources of both countries, for example ending oil imports to Imperial Japan. There is a reason we have restrictions on trade in weapons. We don't want some countries to be able to attain their preferred consumption preferences.

    Sometimes we pass trade restrictions to manipulate regimes into doing what we want, like not being Castro. That basically never works, but we keep trying. Trying to use it to get good trade deals is a worse reason, which also won't work. International Relations doesn't work like that. A country's trade policy is it's sovereign decision, and countries generally don't let other countries interfere with their sovereignty, though America seems to pretend otherwise. Thinking that you can manipulate other countries like this is what starts trade wars, or actual wars too come to think of it.

    For your example of using protectionism against China, why not look at the history of Sino-American trade policy. According to the WTO deal, China was supposed to respect human rights or we'd cut off access to our market. And they blew us off. Because screw us, that's why. This is how countries act in the real world. When you threaten them, the last thing they do is "respond to incentives". We don't, nor should we.

    If a country levies tariffs against us, that's bad. But it's no reason to make things worse by levying tariffs against us ourselves. Sometimes other countries don't do things that would make us both better off, that's just life. Sucks we're not an empire that can get everything it wants all the time, right? The real way to fix this is, I think, by liberalizing trade and then getting richer until they say "hey, let's do what they're doing!".

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    1. The common explanation of retaliatory tariffs in Political Economy, which I suppose you could call a defense, doesn't have to do with the incentives of other countries, but rather our own. Liberalizing trade benefits a country, but its benefits are generally diffuse (for consumers), and it's costs concentrated (for producers). Those concentrated and clearly politically privileged groups are a interest that has to be overcome. To do this, you make a deal with the leaders of another country who are also trying to liberalize trade.

      So you make a swap. Since when they liberalize it will benefit your producers, and their benefits are concentrated, they will become involved enough to create a pro-free-trade faction for you to overcome your own country's irrationality. The same the other way round. By liberalizing trade as a "deal", rather than unilaterally, you are making the politics easier. It isn't about the economics.

      Whether or not they actually follow through on their side of the bargain doesn't matter so much. It matters that you got the deal. I suppose if exporters won't be able to expect that the deal won't stick, this trick to overcoming the diffuse benefits/concentrated costs problem will have problems. But new tariffs are not the answer. After you got the deal, the last thing you want to do is throw it away. The exporters are a tool to help you help your country's importers.

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  10. richard11:32 PM

    At Kids Prefer Cheeze, I commented on the piece of Mr Worstall:

    ---
    In the forbes article Mr Worstall says that wafers are 80-200 nm thick. Please note that is ridiculous. A human hair is 70 micrometer thick, 500 times thicker.

    You can't saw a slice of an ingot 80 nm thick. You would be a very rich man if you could.

    I can't judge the rest of his arguments but this simple error tells me the guy is quoting stuff he seriously does not understand. Any phisics undergrad could have told you this.

    What does this tell you about Mr Worstall?
    ---

    http://mungowitzend.blogspot.tw/2012/09/on-price-dynamics-of-boiled-sand.html#links

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