A Consultant's View

Prairie Trail Software, Inc. ............................................................. October 2009

The Economics of Trade

Over the last decade, there have been a couple of best selling books purporting to show that trade has significantly changed. Both of these books, the "Long Tail" and the "World is Flat", mistake changes in the costs of trade and for a fundamental change in trade practices.

Don't get me wrong. There are very important things to learn about these two books, but not necessarily what the authors propose.

To understand both phenomena, we have to go back to the basic nature of trade. Trade happens when one person exchanges something of value with another person. That trade consists of two parts: identifying what and how highly each person values something, and the actual transfer. Trade is a combination of information transfers and transfers of value between two (or more) entities.

What made the "Long Tail" and the "World is Flat" ideas possible were dramatic cuts in the cost of energy, information, and capital flow. The Internet has cut the cost of information by standardizing the presentation of information. It used to be difficult and expensive to move money around the world. Now, the costs of moving money have been cut by the central banks of nearly every country. This reduction in the cost of capital flow has been happening behind the scenes, but has been critical to the expansion of trade. But central to both the "Long Tail" and "The World is Flat" ideas was the cut in the costs of energy. When oil was at $10 a barrel, it was very cost effective to have a central warehouse and overnight all shipments to anywhere in the country. With cheap oil, we could easily move items around the world and provide overnight satisfaction to a customer.

Edward E Leamer analyzed trade practices for the Journal of Economic Literature. In his research, he found that no matter how people thought things were changing, the ratios were still the same. People purchased goods and services from places far away in the same proportion as they had before. What changed was that more goods and services were being purchased. As foreign trade partners became more prosperous, the amount of trade between us and them went up, but in proportion to the GDP. In places that had been very marginal before, now the new prosperity was noticeable. In places that had been very active before, there was even more trade and the same proportions of trade was going out to the margins.