Given the tastes and relative endowments of the two economies, we know that the relative price of agricultural goods will be lower in the economy with a relative abundance of agricultural land. Hence, that economy will export the agricultural goods and, in the process, domestic supply will shrink. If so, it will lead to an increase in the domestic prices of agricultural goods in the exporting country. The opposite happens in the economy with a relative abundance of oceanfront. It will necessitate importing of the agricultural goods, and the increased supply leads to a decline in the relative price of agricultural goods. The process continues until the relative price of the agricultural goods is equalized in the two economies. At that point, there will be no arbitrage or profit opportunity. The world market will be in equilibrium [1].

On the production side, the effect is completely different. In the economy with an abundance of agricultural land, the opening of trade allows the producers of the agricultural goods to sell their product at a higher price in the world/foreign markets. As a result, they are now able to pay higher wages to workers in the agricultural production. Resources will be diverted away from the marine sector and into the agricultural sector. A similar argument leads us to conclude that the oceanfront abundant economy will now produce more marine products at the expense of agricultural products. By virtue of the differences in endowments, the two economies concentrate their production in the goods and services in which they have an endowment comparative advantage and import the goods in which they do not have a comparative advantage. Here we end up with another important insight. Ironically, in this example, the opening of trade leads to a divergence between production and consumption in both countries [2].

The diversity on the production side and harmonization on the consumption side is to be celebrated; every country is made better off. They get more of what they want at a lower price and they sell more of what they produce at a higher price. It does not matter where the goods are being produced, what matters is their availability.

We have illustrated one simple example where harmonization and diversity are being simultaneously celebrated. The key point here is that the diversity and harmonization are not necessarily independent of each other and attempting to control one may adversely affect the other and make society worse off. Attempts to increase the domestic production of one good result in inefficiencies and a decline in the production of other goods. This is a point that is commonly missed by policymakers, especially when they discuss international trade and outsourcing. Politicians tend to ignore the other side of the coin.

One can gain insights as to why outsourcing has become such a major political issue by focusing on the incentives and the impact of the costs and benefits of outsourcing, currency manipulation, and the trade balance on the well-being of special interest groups. The benefits of outsourcing—lower prices and higher profits—are spread out among shareholders and consumers. Consumers see lower prices and shareholders see higher profits. The rising stock market, if strong enough, offsets any protectionist pressure generated by the fear of job losses due to an increase in imports or job outsourcing. The investor class understands that a rising tide lifts all boats. The politics of the special interest groups explains why it is that during good times when the economy is expanding that free trade forces prevail.

In contrast to the diffused benefits of outsourcing, the costs are concentrated on a particular special interest group (i.e., the displaced employees). The dispersion of benefits and the cost concentration affect the politics of outsourcing. Our own research shows that protectionist pressures are directly related to a loss of jobs. Import penetration is usually equated with job losses that could be avoided if goods were produced domestically. The politics of special interest groups explains why outsourcing concerns may give rise to an increase in protectionist pressure and why these pressures are higher during tough economic times.

In addition, the pressure is not uniform among different companies. For example, larger companies are more likely to have multiplant facilities all over the world and, thus, may be the ones taking advantage of outsourcing. In turn, smaller companies are likely to be single plant facilities that are threatened by the outsourcing. Not surprisingly, multinational companies and small manufacturing companies would tend to be on opposite sides of this issue. It should not be surprising that politicians catering to the union vote are likely to be the sponsors of protectionist legislation. Dozens of bills to protect US jobs have been introduced in state legislatures and in Congress. Some are a variant of the traditionally protectionist local content laws. Finally, there are also bills that would restrict companies from bringing foreign workers to the United States on guest visas to do jobs previously done by Americans. This is an ironic piece of legislation, for it is these same employees who we do not let immigrate permanently who came here to get training and then go back and work in the outsourced industries. The question is whether these people, if allowed to stay, would start their businesses here and thus provide employment opportunities locally. Some point to Silicon Valley as the test case. Yahoo, eBay, and Google among others were started by immigrants. Some 40% of patents in the United States are awarded to immigrants [3].

Nevertheless, trade skepticism and populist sentiments run high on Capitol Hill and there are other strains of protectionism that show up. Even President Obama, who signed the previously mentioned deals, has chimed in. On the issue of taxation on foreign earnings of US corporations, President Obama argued that deferral encourages US corporations to build facilities and create jobs overseas rather than here at home. In other words, it results in an outsourcing of jobs. In fact, during the presidential campaign, then candidate Obama raised that issue. As president, during his joint session of Congress, he made it clear where he stands. He pledged to “restore a sense of fairness and balance to our tax code by finally ending the tax breaks for corporations that ship our jobs overseas.” whether policies aimed at improving the trade balance, saving jobs in particular industries, or whether increasing the domestic diversity of the production base does in fact result in higher domestic employment and “reduce economic dependency” is an empirical issue. There are also some solid theoretical arguments as to why these policies will not deliver the goods.

Before we get into the theory, let’s look at some of the evidence that is readily available. One implication of the protectionist view is that as the trade balance worsens, imports would increase relative to exports and that, in turn, would result in a net export of jobs. Hence protectionist logic would call for a negative correlation between the trade deficit and the unemployment rate. A worsening of the trade deficit should be associated with a rising unemployment rate. Yet, as we look at the data reported in Fig. 10.1, we find that the protectionist hypothesis does not hold water. When the trade balance worsens, the unemployment rate declines. Put another way, an improving trade balance is associated with a rising unemployment rate.

Presumably, outsourcing accelerates as we sign free trade agreements and open our economy to international trade. Yet, as we look at the data in Fig. 10.1, we can see a downwards-secular trend for the unemployment rate. The decline in the unemployment rate accelerated after the signing of North America Free Trade Agreement (NAFTA). A casual look at the data suggests that rather than causing more unemployment, the opening of trade reduced the unemployment rate. This is a clear contradiction of the protectionist view of the world.

Our explanation for the result is a simple one. Protectionists focus solely on the narrow, direct effect of policies in a particular industry, rather than the economy as a whole. Outsourcing does in fact reduce domestic employment in the particular industry where outsourcing is occurring. The outsourcing also opens up the opportunity for outsourced workers to move to other industries where they may produce higher valued products. This latter effect counteracts the outsourcing. We showed earlier that the opening of trade leads to a divergence of production and a convergence of consumption. The divergence of production may be inadvertently interpreted as a loss of jobs. Yet as we show, the decline in one industry is more than made up by an increase in the employment and output of other industries. Protectionist policies, by harmonizing the production and consumption of an economy, clearly reduce trade flows and could very well end up reducing the divergence in consumption choices which would, in turn, reduce the overall well-being of the global economy as well as market valuation. This is an important point. The Obama administration’s focus was on fairness issues and was determined to address certain apparent disparity issues by enacting policies that attempt to harmonize the distribution of income. Whether these polices succeeded in doing so remains to be seen. Our bet is that these policies will have negative consequences for economic efficiency and market valuation. The question is whether the electorate is willing to accept the implicit trade-off in policies.