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Just in the first three months of 2016 the following has transpired:

  • France has passed a levy on palm oil imports informally known as the “Nutella Tax”.
  • Russia is planning to introduce a similar tax equivalent to USD 200 per tonne.
  • Switzerland is negotiating a free trade agreement with Malaysia. Alas, for weeks now strong voices are calling for an exemption of palm oil from the agreement.

palm-oil-noAll of these measures are officially justified on environmental and nutritional grounds. Like a broken record, the alleged adverse effects of palm oil production and consumption are being repeated. Never mind that most of those allegations have successfully been refuted from numerous angles.

Thus, sadly, at the end of the day the measures listed above (and there are more) amount to nothing less than trade policy designed to keep palm oil out of the respective domestic markets.

“None of my beeswax”, you might say. Why should this be of concern to anybody other than those producing palm oil? After all, the countries imposing the restrictions are only exercising their right to protect themselves.

But are they? Is there no harm in protectionism that goes deeper?

It is time to revisit the theory of free trade!

Throughout the ages, economic scholars have evangelized over the boon of free exchange to humanity. Two hundred and forty years ago, in 1776 Adam Smith, often called the founder of economics, published the first edition of “The Wealth of Nations”. In this classic text, in the chapter “Of Restraints Upon The Importation From Foreign Countries Of Such Goods As Can Be Produced At Home”, he writes:

“It is the maxim of every prudent master of the family, never to attempt to make at home what it would cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom.”

To exchange one thing I can make cheaper than others for another thing someone else can make cheaper than myself is pretty intuitive. This is what has become known as “absolute cost advantage” in trade theory.

However, what about countries that have an absolute disadvantage across all products they produce at home? That is a question another hero in the history of economics, David Ricardo, tried to answer some 40 years after Smith.

The most beautiful idea

The result, Ricardo´s Theory of Comparative Advantage some call “the most beautiful idea in economics” because it shows that even countries that produce nothing cheaper than the competition benefit from trade. How does this work?

Ricardo in his day considered trade between England and Portugal in the commodities cloth and wine. Just to make it a little more modern let us consider Malaysia and France to be the countries in our little model and wine and palm oil the commodities.

The following table illustrates the standard textbook example of Ricardo´s theory. Just for the sake of the argument, the assumption is that France and Malaysia each produce both, palm oil and wine. But Malaysia is more productive in both products, requiring only 90 hectares to produce 1,000 liters of palm oil and 80 hectares to produce 1,000 litres of wine.

theory-comparative-palmoil

Source: own elaboration based on the textbook example of the Theory of Comparative Advantage

The table simply shows that in a situation where no trading takes place, each country would produce 1,000 liters of palm oil and 1,000 litres of wine. Both countries together then would produce a total of 2000 litres of oil and wine each.

The beauty of comparative advantage enters with one of the central concepts in economics: opportunity cost. Simply speaking, that is the cost you incur for giving up one opportunity for another. In our example opportunity cost can be stated as what it costs a country to give up the production of one product in favour of the other product. For instance, you could ask what it costs France in terms of palm oil to specialize exclusively on wine production? That cost is expressed in the ratio 120 divided by 100.

Lower opportunity cost means less resources are necessary. For our example, the resulting opportunity cost comparing palm oil and wine for the two countries are:

theory-comparative-palmoil2

Source: own elaboration

Leave aside that there are some more assumptions in this model (for example, obviously in reality France just for climatic reasons cannot produce palm oil). The main point of all this still holds: based on opportunity cost France enjoys a comparative advantage in producing wine while Malaysia enjoys one in producing palm oil.

The surprising result if both countries specialize in the product with the lowest opportunity cost is this: France produces more wine alone, and Malaysia produces more palm oil alone than initially the two countries produced together![1] That leaves Malaysia in a good position to import wine, and France to import palm oil. And both sides win.

To cut a long story short, free trade is beautiful because of an effect that may seem almost miraculous: although Malaysia might be able to produce vegetable oil and wine at a lower cost than France, trade between both countries leads to a larger overall welfare compared to a state of isolation.

Free trade is good; protectionism is bad

Now, this is significant, indeed. Because what it means is that protectionism hurts not only the party that is being locked out, but also the side that supposedly is on the receiving end of the protection.

The harm done by protectionist measures is manifold. Because of the workings of comparative advantage explained above, the number of jobs created by free trade far outweigh those protected by restricting trade.

Furthermore, history is replete with examples of industries losing their competitive edge over time because they led a sheltered life behind trade barriers. Just ask Latin America where in the second half of last century import substitution policies resulted in several “lost decades” for the region, marked by low economic growth and rising inequality.

Carried to an extreme, such mercantilist policies can amount to a “beggar thy neighbor” approach that in less enlightened times has caused more than one armed confrontation. Ironically, it was a Frenchman, 19th-century economist Frédéric Bastiat (1801–1850), who said: “When goods cannot cross borders, armies will.”

Surely, the protectionist measures against palm oil taken or contemplated by France, Russia, Switzerland and others will not lead to the mobilization of actual armies. But certain countermeasures cannot be ruled out.

And the times in which we live certainly call for less nationalism, not more.

That much is for sure.

[1] For a detailed explanation of this effect you can watch this video: https://youtu.be/Pd_qs8ueIWw

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