By Dragan Miljkovic, Professor

Agribusiness and Applied Economics Department

The relationship between free trade on one side and productivity and technical efficiency gains on the other has been perceived differently in public policy circles, compared with trade economists.

The sentiment often echoed by trade liberalizers is the expectation of productivity gains due to technical efficiency change following trade liberalization.

This position is summarized by Daniella Markheim of the Heritage Foundation: “Free trade allows a country to compete in the global market according to its fundamental economic strengths and to reap the productivity and efficiency gains that promote long-run wealth and prosperity.”

Economists, on the other hand, have long realized that this relationship is more complex than what appears at first glance because productivity growth has technological change (TC) and technical efficiency change (TEC) components.

The TC represents a shift of the production possibility frontier (PPF), which is the point at which an economy is most efficiently producing its goods and services and, therefore, allocating its resources in the best way possible. TEC indicates a country’s movement toward or away from the PPF (it is about changes to the gap between actual and potential outputs).

It has been determined that trade openness may not have the same effect on TC and TEC because trade typically does not lead to negative TC but can give rise to a positive or negative TEC. This in turn makes the impact of trade on productivity uncertain and the relationship between trade openness and technical efficiency especially intriguing.

There is a lack of consensus among economists on the impact trade liberalization has on technical efficiency. That’s because there are no systematic theories that link trade policy to technical efficiency.

New trade theorists, such as Nobel Prize Laureate Paul Krugman, rediscovered scale economies as a rationale for trade but limited it only to cases of imperfect competition. Scale economies are not the only argument for trade liberalization made by the pro-liberalizers. Protection is known to lead to a higher concentration in the domestic market. Their argument then runs that noncompetitive market structures are presumed to not be conducive to improvements in productivity and technical efficiency.

On the other hand, liberalization reverses incentives by creating a more competitive environment. However, this relationship between market structure and innovation is one of the hotly debated and disputed areas in industrial organization.

Another argument used by pro-liberalizers is that inward-oriented regimes and macroeconomic instability go hand in hand. Macroeconomic instability often leads to output falling below full capacity, which is detrimental to growth in measured productivity.

In addition, the overvaluation of domestic currency and shortages of imported inputs discourage domestic firms from trying to benefit from scale economies through foreign markets. However, these arguments have nothing to do with trade policy.

The reality is that when technological performance is inferior due to mismanagement of macroeconomic policy, countries should change their exchange rate and fiscal policies. The inclusion of trade liberalization in the policy package likely is driven by ideology rather than economics. Indeed, once attention is focused on trade policy, it becomes extremely difficult to sustain the case that trade liberalization, as a general rule, must have a positive impact on technical efficiency.

My colleague Saleem Shaik and I studied the impact of trade openness on technical efficiency in the U.S. agricultural sector with an aim to further contribute to this debate. The results of this study indicate that overall trade openness does not have an impact on technical efficiency in U.S. agriculture.

Our results changed when trade openness was divided into export and import shares. These results indicate that lesser trade protectionism, with an increase in the share of agricultural imports in the agricultural gross domestic product (GDP), had no impact on technical efficiency. A change (an increase) in the share of agricultural exports in agricultural GDP led to a large increase in technical efficiency. The implications of these results are very important.

Substantial resources have been spent in the U.S. through the last several decades trying to ensure a barrier-free access to international agricultural markets for domestic producers. The Uruguay Round of General Agreement on Tariffs and Trade negotiations and subsequent World Trade Organization negotiations are the most recent and telling examples of such efforts.

The U.S. also engaged in a variety of regional trade agreements such as the Canada-United States Free Trade Agreement and North American Free Trade Agreement. These negotiations often were motivated by the claim of free trade leading to increased productivity and technical efficiency in U.S. agriculture.

Given that this underlying motive for free trade exists and based on our results, the cost of free trade negotiations, from an agricultural producer’s point of view, is justifiable and producers should bear the cost.

NDSU Agriculture Communication – Oct. 16, 2013