Offshore outsourcing is very closely related to free trade. It’s so close, that your view on both is probably the same. However a lot of people with strong opinions about both, are unaware of the theory of free trade. With a gap like this, how can we expect rational discussion to occur between the two sides? This article was created to attempt to bridge that gap.
So what is free trade? Free trade is just a theory that states that when 2 countries choose to trade goods or services, BOTH countries will always end up better off (than if they had chosen not to do so).
That’s a very strong assertion, and one that not everyone would agree with. So exactly how does free trade justify this?
It does this by first pointing out something that everyone can agree on…that virtually every country has a different environment (economic, climatic, political, and social) than any other country. Everyone agrees that people with different skills and backgrounds will have different strengths and weaknesses. This idea extends that concept and says that the same is true for countries as well. (This is concept is sometimes called “comparative advantage”.)
In the U.S. we are very good at producing a lot of things. From the light bulb to todays high tech products, almost all of them were invented in the U.S. And everyone can also agree that we really stink at lo tech things like making canoes by hand (even though it is done very proficiently in some countries). We also are not so hot at some agricultural things like growing coffee beans, or harvesting bananas.
So if we were to choose not to trade at all…and we wanted bananas…we would be forced to some pretty extreme measures. Since the climate in the U.S. is not ideal for bananas (at least not those big, juicy types like the Chiquita bananas), we’d have to create immense greenhouses and artificially control the temperature. The money spent doing this, would be much more expensive than simply purchasing them from Brazil…leaving the country as a whole with less money to spend than it had just trade for them.
Worse, in order to convince even our own citizens to purchase our artificially grown U.S. bananas, the government would have to paying some of the banana growers’ expenses to lower the price and make it competitive. If that happened, the companies would be reporting profits, but in reality the country as a whole would still be paying for it…and we would be slowly sucked dry.
Again that is a pretty strong statement. Does it stand up when walking through some detailed numbers?
To keep things simple…lets pretend that there are only 2 countries in the world (the U.S. and Brazil) and 2 products in the world (cars and coffee). And to further simply things lets pretend that our billion dollar economy is actually only $100. So in a year, a person “running” our economy (which will be us), has $100 to “spend”. We could spend it on producing goods and services ourselves, or on purchasing them from other countries. Let’s also pretend that Brazil’s smaller economy gives it $10/year to spend.
What happens as the year goes on?
The U.S. is really good at manufacturing cars, because we invented the automobile. We also have an innovative hi-tech industry capable of creating world-class factories to create these cars. On the other hand, we aren’t so hot at growing coffee. We don’t have the best climate for it, and while our educational system is much more advanced than Brazils…it also means we don’t have hordes of lesser educated agricultural workers. Picking beans isn’t that mentally demanding, but even though our workers are over-educated for bean-picking, they will need and expect to be paid a higher wage.
Brazil on the other hand, is really good at growing coffee, because of its perfect climate and huge agricultural work force. And it could theoretically manufacture cars, but due to lack of a hi-tech industry, it would be very expensive and require a lot of things top be done manually. This of course means more defects which are expensive to fix.
If you like charts…here is what the above looks like numerically. Below is the cost of each country to create a car or coffee, and also what it could sell that product for.
Car (sells for $10) Coffee (sells for $2)
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Country
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U.S.: $5 to make each one $3 to make each one
Brazil: $50 to make each one $1 to make each one
If you’re in charge of Brazil, and you have to decide what your country is doing for the year…what do you do to maximize your scarce resources?
Maybe you would have aspirations to be a car manufacturer. What would be better for patriotism than a national car? So you decide to make it a national priority. You copy the designs of every car blueprint you can get your hands on and you create somewhat crude, but workable factories where the car is assembled by hand. Drawing your inspiration from Yugoslavia’s Yugo, you decide to call it the BrazilO. our $10 per year allows you to produce 1/5 of a car every year. It’ll take 5 years, so you won’t be able to pay the workers anything for the first 5 years. But that’s a minor detail…after all this is a national priority and they are willing to sacrifice a little for the greater good! And after 5 years, the first BrazilO proudly rolls off the assembly line to much fanfare.
However, the owner of the company tells you that there is a small problem. The BrazilO company spent $50 to make a car, but cars only sell for $10. BrazilO has got to start paying those workers after 5 years of nothing, but they can’t make their payroll without a profit. And if BrazilO fails, there will be a revolt on your hands…maybe even a coup (gulp)!
So, as the Brazilian government, you give Braizlo Corp a little “help”. You subsidize the car industry by paying $45 from your treasury. (Thank goodness your predecessor forgot to take a little bit of gold that was stashed in his bank account before he was forced out). That does the trick! Now it only costs BrazilO Corp $5 to make the car…the “same” price as it costs those U.S. manufacturers. So BrazilO sells the car for $10 and makes a profit…and you look like a genius to your fellow Brazilians! Only a few people actually notice that as a country, you still had to pay $50 for that car…it just came from a different pocket. And as a country, you’ve lost 500% (100%/year). If you’re smart, you’d realize that a few more “successful” years like this one and the Brazilian treasury will be empty, and you’ll need to find a new job. Preferably out of the country.
That didn’t turn out so well. So instead let’s imagine that you choose to take a different course of action and grow coffee instead. You’re really good at that, so you can create 10 units with your $10, and they sell for $2 each. So at the end of just the 1st year the Brazillian Coffee Company has spent $10 and earned back $20…a profit of $10. Instead of losing money, your country is now $10 richer than it started off. And who knows…maybe with that $10 you might even buy a fancy new U.S. car for your personal transportation?
Compare the 2 scenarios. In the first, you chose to do something you weren’t good at, and you lost 100% of your money each year with your subsidy. In the second, you focused on what you were good at, and made so much money that you actually ended up having enough money to buy a car with the excess. It’s like the difference between night and day.
Some might argue that this is obvious for Brazil. But what about the reverse situation for the larger country. Surely that is a different story…right? Let’s see…
As the U.S. president you have decided that you our dependency on foreign coffee may eventually cause a coffee crisis to occur if we were to get into a dispute with Brazil. With our armed forces practically living off of the stuff…national security is at stake. So you decide that as a country, we are not going to trade for our coffee…but instead are going to grow it all ourselves.
The challenges are large, because the U.S. climate just isn’t suited to growing coffee…at least not the kind anyone will drink. But by putting the best engineering minds to work on the problem, you are able to turn excess land in Arizona into the largest greenhouse in the world. Amazingly the climate is pretty close to what occurs in Brazil. And then you inspire our top biochemists and geneticists to bridge the rest of the gap by creating a new breed of coffee bean that will grow and taste exactly the same as Brazillian coffee, even under those slightly different conditions. It’s a triumph of modern science.
Once the coffee beans ripen, we have to pick them. The workers we have available are graduates of our U.S. educational system, and they are a bit over qualified for this low-skill job. Even though it’s mindless, they expect and need to be paid a higher wage…otherwise they won’t be able to afford to eat. Starving citizens don’t make for good press reports, so you decide it’s best for all concerned to simply hire as many as you can. Unemployment drops to less than .01% and everyone hails you as a rain maker.
There’s a small nagging problem though. All of these scientific marvels didn’t come cheaply. Fortunately you’re able to write off all the research costs using obscure budget methods so that no one realizes what happened until the year 2050…which is AFTER they’ve already completed your bust addition on mount Rushmore.
However, there’s still a problem. The U.S. Coffee Company accountant informs you that operating the greenhouses and paying all the workers means that it costs us $3 to operate to grow 1 unit of coffee. The problem is that Brazillian coffee is selling at only $2. If something isn’t done quickly, the politicial fallout could be of biblical proportions.
So you fix the problem in the usual way. You denounce Brazil for unfairly taking advantage of the budding U.S. coffee industry. It’s unjust that arbitrary chance has given them a position closer to the sun during the growing season! You are going to step in and protect U.S. workers and companies. You proudly announce that the U.S. Coffee company is going to be subsidized! It will pay only $1 for each unit of coffee, because U.S. tax payers will pay the other $2. The press hails you as a “compassionate coffee-er” and your poll numbers soar! And instant success follows. The U.S. Coffee company quickly announces that the 33 units of coffee they made, fetched $2 a piece and the profit is $66-$33=$33. You score another political notch in your belt.
Unfortunately, a lonely accountant in the OMB secretly tells you the bad news. The country as a whole is still paying $3/unit…the $2 is just being paid from the taxpayers instead of the U.S. Coffee company. So as a country we are spending $99 to earn $66—which means we’re bleeding a $33 loss each year. He tells you that those tax cuts that you planned for the next term are not looking quite so “doable” after all. And neither is your salary nor his. He’s not so happy about that and you’re afraid he might leak it to the press. Oh boy.
What would be a smarter thing to do? Let’s say that you chose to stick to doing what you could do best…manufacturing cars. Now you can make 20 of them and sell them for $10 each. Your $200 of revenues - $100 of expenses = $100 of profit. With that amount of money, not only is the country much better off, but the excess could be used to buy 20 units of coffee.
Again, look at the huge difference. In the first example you subsidized coffee and you lost $33/year. In the second, you stuck to what you were good at and made $100/year.
This is the idea behind free trade. Whether you agree with it, or disagree, I hope this helped in your understanding of the theory.