Free Trade and Prospect Theory

FREE TRADE AND PROSPECT THEORY….Matt Yglesias (here and here) wants some concrete ideas about how to rebuild support for free trade. For some reason, his post reminded me of a basic problem that underlies an economic model called Prospect Theory, something I’ve written about before.

The problem discovered by the prospect theorists is this: the emotional drop from a monetary loss is considerably greater than the emotional lift from the exact same monetary gain, and in real-life situations (as opposed, say, to casinos), the difference is about 2:1. That is, the negative emotional reaction to losing $100 is about equal to the positive emotional reaction to winning $200.

In the case of free trade, this causes an obvious problem. Take NAFTA for example. Roughly speaking, one person losing a job due to NAFTA generates about the same emotional energy as two people gaining a job. Thus, if 1 million jobs are lost due to NAFTA and 2 million are gained, the emotional energy on both sides is about equal and I’d expect about 50% support in the population at large.

However, if the number of jobs lost is about the same as the number of jobs gained, the emotional energy of the losers is twice that of the winners. Support for NAFTA would then drop to about 30-40% even though there’s actually no net job loss due to the treaty. In fact, even if NAFTA produces a net increase in jobs it still won’t be popular. The increase has to be at least twice the decrease.

In other words, I’m not sure there’s really an answer to Matt’s question. We’re dealing with a fundamental property of human nature here, and overall support for free trade will only reach 50% or higher if it’s creating a lot more jobs than it’s destroying. Right now I doubt that the gain:loss ratio is higher than 2:1, which means the emotional tide is going to be negative regardless of what kind of PR campaign you start up.

There’s more to it than just this, of course, but I think you get the general picture. The simple answer is that we need a better economy that’s generating more jobs or else the country’s emotional energy is going to be fundamentally opposed to free trade. But that’s really the right answer anyway, isn’t it?

POSTSCRIPT: Needless to say, anyone who knows more about Prospect Theory than I do is welcome to chime in. If my amateur analysis is wrong, I’ll be happy to post rebuttals.

UPDATE: Bonassus has more.