Skip to 0 minutes and 8 secondsIn this step, we'll look at the basic economics of globalisation-- why nations trade. To really understand globalisation, we must understand the basics. And to do that, I invite you to suspend disbelief for the next few minutes. I'd like you to get ready to think abstractly because we're going to simplify to clarify. Remember the parable of the cannonball and the feather? That was about gravity, and we assumed away some complicating factors like air resistance to understand the real effect of gravity. When it comes to trade, the logical equivalent of gravity is called comparative advantage. I've been teaching this for about 30 years, and I've noticed that many students get shocked at the concept. It often goes something like this.
Skip to 1 minute and 0 secondsI say comparative advantage is the ability of a country to produce a good at a relatively lower price than someone else. And the student looks at me in disbelief and says, why is that important, interesting, or-- that I need to know it? And I say to him or her, because it is the fundamental reason countries trade, and it explains why nations export the goods they do. Moreover, it explains why all nations gain from trade. And then I see a big, blank stare on their face, and if they say it out loud, it's huh? Now, to get past that, I'd like to try something new today.
Skip to 1 minute and 45 secondsLet's talk about something completely different and then flip it back to show that we were actually talking about comparative advantage. Specifically, I want to talk about smuggling. A simple case study-- I'm going to look at smuggling between Italy and Switzerland in the 1940s and '50s, when cigarettes were smuggled for rice. So here you see the horses on the Alpine pass or guys carrying packs in the Alpine pass. Now, one thing to note, the key to this thought experiment, is that the Italian lira was not convertible. In other words, the Italian currency could not be switched into Swiss francs. It was worthless outside of Italy. So you had to pay for smuggled goods in terms of other goods.
Skip to 2 minutes and 32 secondsThat's what we call barter. You had to exchange cigarettes for rice. You couldn't sell cigarettes for money and then use the money, taking it out of Italy to sell it for something else. Now, to get our heads around what's going on here, we need to be more specific about the relative price of cigarettes in Italy and Switzerland. So if we look at this table here, we have the price of cigarettes and rice, and we're going to look at it in the two domestic markets, first of all in Italy. In Italy, we look to see a kilogramme of cigarettes costs 100,000 liras. This is, of course, just an example, and I've chosen the numbers to make the arithmetic pretty easy.
Skip to 3 minutes and 14 secondsA kilogramme of rice also costs 100,000 liras in Italy. Now, if you go over in Switzerland, a kilo of cigarettes costs 20 francs and a kilo of rice costs 40 francs. Now what we want to do is ask, how much rice must one pay to get a kilo of cigarettes in Italy and in Switzerland? We're going to do it a couple times. Let's start first with Italy. In Italy, it's easy. It's one to one. You need to pay 1 kilo of rice to get a kilo of cigarettes in Italy. In Switzerland, you pay 1/2 kilogrammes of rice to get 1 kilo of cigarettes. Let's look at that again. That means in terms of rice, cigarettes are cheaper in Switzerland.
Skip to 4 minutes and 2 secondsIt costs 1 kilo of rice per kilo of cigarettes in Italy, as we see that, one to one. It costs 1/2 kilo of rice per kilo of cigarettes in Switzerland. So we have to see that just the opposite works in terms of cigarettes, but rice is cheaper in Italy, so let's look at that. It costs 1 kilo of cigarettes to get 1 kilo of rice in Italy, as we said before, and it costs 2 kilos of cigarettes to get 1 kilo of rice in Switzerland. Now, what that means is that cigarettes are relatively cheaper in Switzerland, and rice is relatively cheaper in Italy. So what do you think is in the packs going from Switzerland to Italy in those photos?
Skip to 4 minutes and 53 secondsThe answer is obviously cigarettes. And what do you think is in the packs going from Italy back to Switzerland? And the answer, of course, is rice.
Skip to 5 minutes and 4 secondsThat is comparative advantage in some sense. It's why these countries are trading cigarettes and rice. Next question-- who gains from the smuggling? Suppose the smugglers split the difference, and they agree a price that's between the Swiss and Italian relative price. Let's suppose they exchange 100 kilogrammes of cigarettes for 75 kilos of rice. This is a higher price of cigarettes than in Switzerland but a lower price than in Italy. The Swiss win from this exchange. The Swiss are selling 100 kilogrammes of cigarettes for 75 kilogrammes of rice. They're selling high. They get 75 kilogrammes of rice for cigarettes that would have cost the equivalent of 50 grammes of rice in Switzerland. So do the mental gymnastics.
Skip to 5 minutes and 55 secondsThe Swiss trader has taken 50 kilogrammes of rice and turned it into 100 kilogrammes of cigarettes while he was in Switzerland. Then he went to Italy and turned the cigarettes into 75 kilogrammes of rice. Thus, with this trade, this smuggling, he's turned 50 kilogrammes of rice into 75 kilogrammes of rice. He's won, clearly. The Italians also win from this. The Italians sell 75 kilogrammes of rice for 100 kilogrammes of cigarettes. They're selling high. They get 100 kilogrammes of cigarettes for rice that would have cost them 75 kilos-- would have bought them only 75 kilos of cigarettes in Italy. So do the mental gymnastics for the Italian smuggler.
Skip to 6 minutes and 41 secondsHe's taken 75 kilogrammes of cigarettes and turned it into 75 kilogrammes of rice in Italy. And through the smuggling, he's changed that rice into 100 kilogrammes of cigarettes. So taking it altogether, he's turned 75 kilogrammes of cigarettes into 100 kilogrammes of cigarettes, so he's obviously won from it. To sum up, who gains from trade? The answer is they both do. The Swiss get a deal, and the Italian gets a deal. This is what I like to call a two-way buy low, sell high bargain. It's only possible because the relative price of the cigarettes compared to the rice is different in the two nations. Try it yourself. You can change around the numbers.
Skip to 7 minutes and 31 secondsAs long as the relative prices are different within the two countries, there can be a gain from-- both parties can gain. So what does this have to do with comparative advantage of trade? The simple fact is free trade is legalised smuggling. The logic of why people smuggle goods from one country to another when the relative prices are different is exactly the logic of why countries trade. That's the law of comparative advantage, and it explains why countries trade. It explains why they export the goods that they do export and import what they do import. And it explains why all nations can gain from trade.
Trade is legalised smuggling
How smuggling can explain the basic force behind trade
This video uses the example of smuggling between Italy and Switzerland in the 1950s to illustrate how trade is a buy-low-sell-high opportunity for all nations engaging in trade.
Trade is driven by the fact that some things are abundant and thus cheap in some nations while being scarce and thus expensive in others. As long as this is true, nations will find trade almost irresistible.
Moreover, each nation gets a bargain out of this since they are exchanging things that they think are relatively inexpensive at home for things that are relatively expensive at home.
The video and readings work through an example of how this works.
Summary of the video
Just after WWII, few European currencies were ‘convertible’, i.e. they were basically worthless outside their own nation. A French or US bank, for instance, would not exchange Italian lira into dollars or French francs. As a result, smuggling involved barter, i.e. the exchange of one good for another.
A lively smuggling trade was organised between Switzerland and Italy involving Italian rice exchanged for cigarettes from Switzerland. The Italian rice part is easy to understand – northern Italy is ideal for rice farms – but a tropical product like tobacco from alpine Switzerland?
The Swiss franc was one of the few convertible currencies, so Swiss traders could easily get US dollars to buy tobacco from Latin America and have it shipped to Basel and from there overland to the Italian border. In fact, Swiss cigarette factories were often located near the Italian border to facilitate the trade and indeed the Swiss factories developed special packaging for smuggling. The cartons had 25 packs (instead of the standard 10) to minimize the weight of the packaging and they were wrapped in tar paper to protect them from weather.
The Italian government, by contrast, made it very difficult to import cigarettes since it had the national monopoly on tobacco and was trying to spare its scarce dollars to buy essential goods like medicine and fuel.
Naturally, in Italy the price of cigarettes was high relative to rice, but it was low in Switzerland. Some illustrative (i.e. made up) relative prices are shown in the table. It shows the local currency prices, but since lira were worthless outside Italy, the prices that matter are relative prices. Here the table shows that a kilo of cigarettes is worth a half kilo of rice in Switzerland, but a whole kilo in Italy. This relative price difference opened up an opportunity for smuggling as shown in Figure 1.
A Swiss-based smuggler could buy 100 kilos of cigarettes locally for 2,000 CHF, hire some strong young men to bring them over the Albrun Pass to Italy and exchange it for rice. What would the smugglers get for their efforts?
The Italian participants would surely refuse to pay the full Italian price of 100 kilos of rice for the 100 kilos of smuggled cigarettes since they could get that price legally. The Swiss smugglers would refuse anything less than 50 kilos. Just to be concrete, say the deal is struck at 75 kilos of rice for the 100 kilos of cigarettes. To finish the cycle, the Swiss load up their packs with the rice, return to Switzerland and sell the 75 kilos for 40 francs per kilo. Or perhaps somewhat less since the Swiss purchasers would need an incentive to buy from smugglers instead of the local store. To be concrete, suppose the Swiss smuggler gets 30 CHF per kilo of rice. Overall, the relative price moves from 1 to 4/3 in Italy while the relative price is Switzerland moves from 2 to 3/2.
Who won from this smuggling?
Clearly the Swiss side won, since they turned their original investment of 2,000 CHF into 3,000 CHF. Strange as it may seem, the Italians also won. The Italians got 100 kilos of cigarettes for the price of 75 kilos of rice. That is, they paid just 7.5 million liras, instead of the full price of 10 million liras. In this sense, the smuggling is a ‘buy-low-sell-high’ opportunity for both the Swiss and the Italians.
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