Gains from (Internal) Trade

Businessmen generally dislike foreign trade for the goods they produce while favouring it when it concerns their raw materials. Protectionism has long been supported by emotional appeals to nationalism, protection of traditional culture, and the virtues of "self reliance". An understanding and appreciation of the gains from trade has been a bit of an inside secret amongst economists. As Paul Krugman puts it, "the appreciation that international trade benefits a country whether it is `fair' or not has been one of the touchstones of professionalism in economics".

Why is trade beneficial? The problem with not trading is the opportunity cost of deploying resources to produce one thing when they can better be used to produce another. While firms in the US certainly have the technology to make shirts more efficiently than firms in India can, it is beneficial to both sides when labour/capital in the US is deployed instead towards making computer hardware and labour/capital in India is deployed towards making shirts. The resulting resource allocation is superior, for both sides, than one where each practised self reliance.

I often meet laypersons who feel it is morally right for India to protect (say) Indian scooter manufacturers. Every economist keeps a quiverful of arguments to use in rebutting protectionists, and I owe one of my best arguments to David Friedman. I say that there are two technologies through which we can make scooters.

In this example, trade is "a technology". Using seeds to make scooters is an alternative technology that trade makes possible. Both technologies are perfectly reasonable methods through which scooters can be made. As the economist Steven R. Landsburg would put it, there is no reason why the State should favour the scooter producers in Poona over the scooter producers of the Punjab.

When a country starts out from a state of isolation from the world, and it then undergoes trade liberalisation which eliminates protectionism, the major changes which are expected are: (a) some industries will die out and others will become globally competitive, and (b) there will be a jump in the level of GDP of the country, in response to the gains from specialisation.

The point of this article is to apply the same reasoning within India, between the various states of India. We can think of an early scenario as being one with significant barriers to trade, in the form of expensive transportation. Expensive transportation is a trade barrier which serves to protect a factory in Gujarat from producers in Maharashtra.

Over the last twenty years, we have seen a huge increase in the transportation industry within India. The volume of goods that are moved over railways, roads, air, and waterways have all grown enormously. In this process the transactions costs paid in transportation, which are like customs tariffs, have dropped. The economic impact of this "trade liberalisation" is exactly like that mentioned above: many local factories will be unable to survive, trade will generate greater specialisation, and we will see higher GDP. In this sense, the steady improvements in transport and communications within the country are a fuel for GDP growth in exactly the same sense as trade liberalisation is a fuel for GDP growth.

This approach helps us decipher India's stock exchange industry. Traditionally, each stock exchange was a sheltered monopoly in its own area. The rise of modern telecom, a superior method of transportation, eliminated the trade barriers. This meant that investors in Delhi could use STD calls to place orders at a market in Madras. It also meant that the NSE could use satellite communication to be present in Delhi, competing with DSE for orders from Delhi. The exchange industry used to be local, like cement, but improved transportation made it national, like cars. As is generally the case with reductions of trade barriers, this new competition has increased specialisation - Delhi brokers now spend less time in running exchanges and more time in running brokerage firms.

Ravi Narain of NSE has described the effect of NSE VSATs on finance in a small town as being comparable to the opening up that comes from the first railway line to the town. The common feature of both events is a sharp drop in barriers to trade; the satellite dish does for financial services what the railway line does for goods.

One sector which has seriously gone astray in India in this regard is agriculture, where government interventions impose onerous, and irrational, barriers upon the movement of agricultural products. These barriers produce inferior cropping patterns as compared to what is attainable.

This approach tells us what is wrong with octroi, which is a barrier to trade within India. Octroi is as harmful for India as customs duties. In the US, there is a remarkable provision in the constitution (it is remarkable because it was put there long before the economist David Ricardo first understood the idea of gains from trade). The US constitution forbids any law or government action which is "a barrier to inter-state commerce". This provision is carried to its logical conclusion, whereby the sales tax defined by Assam would not be charged to goods made outside Assam and sold in Assam. This constitutional provision is a gem of good economics; it would cut through the politics that surrounds issues like octroi or the free movement of agricultural commodities.

Another inference from this approach concerns the greater potential of coastal areas over inland areas. Ports are cheap to build, and hence inland areas will generally suffer from a higher degree of "self reliance" than coastal areas. Cheap transportation (i.e. low transactions costs) in coastal areas gives them a higher degree of specialisation. Coastal areas will harness these gains from trade and obtain higher levels of GDP.

This perspective yields an insight into the advantage that large countries have in economic development as compared with small countries; it gives us a reason why India is better off united than broken into many small countries. If India was a continent with 25 countries, the political frictions amongst these countries, coupled with the widespread illiteracy about economics, would have ensured high levels of protectionism. The 25 countries would all have suffered from a high level of "self reliance", and obtained poor levels of productivity as a consequence. A single country has a major edge insofar as it is taken for granted that goods should move freely within the country, even by those who would believe that India should not open up to imports.

By the same token, Europe has accomplished something momentous by eliminating trade barriers. There is perhaps very little to be further gained through transition into a single country. The higher GDP that could be gained by uniting under one flag is fully realised by the free flow of goods and services.

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