The world we live in is incredibly complex. Sometimes it helps to create an imaginary world where we can think about economics in simplified terms. Below we create an island in the Pacific Ocean where we can explore the effects of productivity, trade, and migration, the big three of Globalization.
The Island: A Thought Experiment on Productivity
In a first thought experiment we can apply the principles of competitive equilibrium (balanced supply and demand) we discussed above to see what happens when there is a sudden increase in wheat production (i.e. productivity) and no international trade and essentially no government intervention.
The Island is a small place with a total population of 4 million people. Three million people live in small cities along the heavily populated north coast and pursue nonagricultural professions from fishing to banking. The remaining million people are spread through the southern three quarters of the Island and grow the staple wheat which feeds the island.
During a normal year, the Island’s small farmers grow enough wheat to feed the entire population, and sell their wheat to buy fish, tractors, shoes, and the other goods and services produced in the city. But the year we’re looking at is far from normal. The agricultural research station at Island University introduced a new variety of wheat seed in time for the annual planting, and now the farmers are suddenly growing twice as much wheat as usual per hectare. Labor productivity is defined as the amount of a particular good or service you can produce with say an hour of labor. Since the same amount of machines and labor can harvest the new wheat, wheat farming has suddenly become twice as productive.
As a result of the huge harvest of wheat, the price of wheat falls. There’s only so much you can do with wheat and farmers, desperate to dispose of their harvest, have to underbid each other to sell. The demand curve for wheat falls off sharply. Farmers go broke and many of them have to sell their land to corporate farming entities with deep pockets. The price of agricultural land falls precipitously. The displaced farmers have to look for jobs in the city which causes a major labor glut and a fall in the wages of unskilled workers.
On the other hand, all the non-farmers have had a major boost to their effective incomes since the price of wheat and everything made from wheat has gone way down.
Is this sudden increase in productivity beneficial overall? The answer in the short term is far from clear. Farmers have been badly hurt, and wages for unskilled workers have declined.
In the long run, things look a bit different. The cost of wheat is permanently lower, so everyone has more income to spend, manufacturing and services have expanded in response to increased demand, and the displaced farmers have found employment in these new jobs. In short, there are more goods and services in the economy than before, gross domestic product (GDP) has increased, and in principle this growth in GDP could make everyone better off. Of course, whether everybody is better off depends on income distribution, which we will discuss further later.
This extreme example is like a speeded-up version of the industrial revolutions[1]. Charles Dickens’ depictions of Britain during the initial industrial revolution give a bleak picture of what can happen when productivity increases without any protective measures. Eventually of course, the industrial revolutions lead to enormous increases in productivity from which we all benefit, and many protections have been put into place to ameliorate the pain of the process.
The above thought experiment omitted government action and international trade. Let’s now look at how the undesirable blows of this productivity increase could have been softened.
First of all, what are some of the things the farmers might do themselves?
The farmers could band together, and all contribute half their wheat to a big bonfire. But they’re not organized and it’s likely there would be a lot of cheating. They could get their trade association to push alternate uses for wheat, like brewing beer and making glue. To help the beer sales they could start an advertising campaign to get teens to drink more sweetened alcoholic wheat drinks. It’s unlikely that any of this would be more than marginally effective.
What government interventions might help?
The farmers have a disproportionate representation in the government because they are spread over three quarters of the land. They have used that legislative clout to get a bunch of non-free-market support for agriculture. In particular there are agricultural price supports and when the glut of wheat hits, the government is obliged to keep buying wheat to prop up the price. The result is that the entire “extra” wheat is bought by the government and stored in massive silos where it will eventually rot. In the meantime, the farmers all benefit from an enormous transfer of income from the city folk who have to pony up the money to buy the “extra” wheat. And since the farmers are now producing twice as much wheat and selling all of it, they have a great incentive to keep on producing too much wheat. The entire benefit of the productivity increase in wheat is thus lost[2]. Clearly this is not the way to handle a productivity increase. Other government programs could soften the blow of the productivity increase without essentially negating its benefits of increased income and GDP. These programs involve income transfers to distribute some of the extra national income produced from the winners (most of the population) to the losers (the displaced farmers and unskilled workers). Such programs include unemployment benefits, minimum wage requirements, and other transfers. It is also possible for the government to take measures to increase employment, either directly through spending money on public works or services, or indirectly through stimulating demand through tax or interest rate cuts. These measures would help ease the painful adjustment process resulting from the increased productivity in wheat.
The Island Thought Experiment: Including Trade
Up to now, we have not allowed The Island to trade. Maybe the Island’s population is extremely protectionist and there is little trade with the rest of the world. But now let us change this and suppose that The Island in fact has healthy trade relations. What happens now when the wheat harvest suddenly doubles due to the productivity increase?
With free trade, The Island’s farmers are free to sell their extra wheat in the world market. The Island is a small place and its entire wheat harvest, even doubled, is a very small part of the world harvest, and so selling half internationally will have almost no effect on the price of wheat. The world price of wheat is high enough that the farmers can ship their wheat and still make a tidy profit since their cost per bushel has gone down by half. Suddenly the farmers are rolling in dough, the cash kind. They go on a spending spree, employment picks up, and with it wages. Imports also go up to balance the additional exports[3]. The net result is that everyone on The Island gets richer and employment increases. We will, for the moment, ignore the ominous possibility of the new wheat seed being adopted worldwide through “technology transfer”.
The above thought experiment shows that productivity increases, especially sudden ones, can cause short term economic pain but in the long run increase overall output. Trade can help smooth such dislocations, and government actions can help with the shock of transition.
[1] There have been several “industrial revolutions” as major productivity changes occurred. The initial one was water powered, the second used electric power to expand production, etc. There has also been an ongoing agricultural revolution which has greatly reduced the number of workers needed to grow an abundance of food.
[2] This example may seem laughable, but similar programs have in fact been instituted in the USA and other countries. See for example Malone, Kenny. 2021. “Big Government Cheese (CLASSIC).” NPR, May 21, 2021. https://www.npr.org/2021/05/21/999144678/big-government-cheese-classic.
[3] For a small country like The Island, exports and imports will tend to balance out over time through, you guessed it, the supply and demand for their currency. If the country imports more than it sell, it’s currency will have to go down relative to other currencies so that the relative costs of its goods go down and it sells more abroad.