Method in Trump’s madness? What economic theory teaches us about tariffs
Trump’s tariffs have sent the world into a frenzy but there could be method yet. Economic theory shows that tariffs can in some cases reduce prices, writes Paul Ormerod
The reactions to President Trump’s tariffs have been frenzied, to say the least. The headline on many of the stories about them might well have read “The end of the world is nigh!”.
But once the dust is settled, it is by no means as obvious as most commentators suggest that the world will be worse off. A somewhat different pattern of international trade will emerge from which consumers might well benefit.
The basis of economic trade theory
The striking feature of international trade in manufactured goods between developed economies is that much of it involves what is known in the jargon as intra-industry trade. In other words, countries both export and import products which are in the same industry. BMW, for example, makes cars in Germany and sells them to France. In France, Renault makes cars and sells them to Germany.
Until the closing decades of the 20th century, the economic theory of international trade essentially ignored this important empirical phenomenon. Its main concern was to explain inter-industry trade.
The idea goes back at least 200 years to David Ricardo who created the basis of trade theory in economics over the next two centuries. Ricardo used a simple illustrative example of a world of just two countries, England and Portugal and in which there are only two commodities, cloth and wine.
If England could produce cloth more efficiently than wine and Portugal wine than cloth, he showed that it made sense for England to specialise completely in cloth and Portugal wine. This creates a world of inter-industry trade. England exports only cloth and Portugal only wine.
A very neat aspect of his theory is that Ricardo demonstrated that this trade pattern would arise even if England could produce both products more efficiently than Portugal.
The last 40 years or so have seen a flurry of work in economics to explain why the phenomenon of intra-industry trade is so pervasive. A key paper was by future Nobel Laureate Paul Krugman in 1980. In essence, his theory was based on the concept of increasing returns. The more a company produces, the more its efficiency rises.
But the main point in the context of the Trump tariffs is that much economic trade theory, certainly that of Ricardo himself, assumes that capital is not mobile. English firms do not set up subsidiaries in Portugal, and vice versa.
Why tariffs sometimes reduce prices
Yet the world is dominated by multi-national firms who produce in many countries. BMW, for example, has eight plants in Germany, but it also builds cars in, for example, the United States, Mexico, South Africa and South America.
Confronted by an increase in tariffs on trade, large multi-nationals have the option of either setting up new production facilities or increasing the output of those which already exist in the country which is imposing the tariff. Rather than export the product from its domestic plant, the firm exports its capital to produce abroad.
Bob Rowthorn, formerly head of the economics department at Cambridge, was one of the first to analyse this phenomenon in a paper in the Economic Journal in 1992.
A crucial factor in the decision of a firm is the size of the market into which it exports. The larger the market, the more likely it Is to develop production capacity abroad. Rowthorn presciently envisages a world of three large trading blocs: North America, Europe and East Asia. Intra-industry trade within each bloc will grow strongly, but even in the absence of tariff increases, it is not at all certain that intra-industry trade between the blocs will do the same.
A range of outcomes is possible, but tariffs can, paradoxically, result in lower prices and a better outcome for consumers arising from decisions on where to locate production. There may well be method in Trump’s seeming madness.
Paul Ormerod is an honorary professor at the Alliance Business School at the University of Manchester and an economist at Volterra Partners LLP