This is “Interpreting the Welfare Effects”, section 4.10 from the book Policy and Theory of International Trade (v. 1.0). For details on it (including licensing), click here.
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4.10 Interpreting the Welfare Effects
Learning Objective
- Understand how national welfare is affected by free trade in an immobile factor model and why compensation cannot assure everyone gains.
The real wage calculations show that some workers gain from trade, while others lose from trade. On the other hand, we showed that the economy is able to jump to a higher aggregate indifference as a result of free trade. The increase in aggregate welfare is attributable entirely to an increase in consumption efficiency. A reasonable question to ask at this juncture is whether the winners from trade could compensate the losers such that every worker is left no worse off from free trade. The answer to this question is no in the context of this model.
In the immobile factor model, there is no increase in world productive efficiency. The immobility of factors implies that world output is the same with trade as it was in autarky. This means that the best that compensation could provide is to return everyone to their autarky consumption levels. And the only way to do that is to eliminate trade. There simply is no way to increase the total consumption of each good for every worker after trade begins.
Sometimes economists argue that since the model displays an increase in consumption efficiency, this means that the country is better off with trade. While technically this is true, it is important to realize that statements about what’s best for a country in the aggregate typically mask the effects on particular individuals. The immobile factor model suggests that in the very short run, movements to free trade will very likely result in a redistribution of income with some groups of individuals suffering real income losses. It will be very difficult to convince those who will lose that free trade is a good idea because the aggregate effects are positive.
Furthermore, since there is no way for the winners to compensate the losers such that everyone gains, the model implies that the movement to free trade can be a zero-sum game, at least in the very short run. This means that the sum of the gains to the winners is exactly equal to the sum of the losses to the losers.
In the Heckscher-Ohlin model, we will show that income redistribution is possible even in the long run when an economy moves to free trade. However, in that case, free trade will be a positive-sum game in that the sum of the gains will exceed the sum of the losses.
Key Takeaway
- In the immobile factor model, because there is no increase in output of either good when moving to free trade, there is no way for compensation to make everyone better off after trade.
Exercise
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Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
- Of increase, decrease, or stay the same, this is what happens to the output of cheese in France in an immobile factor model when it moves to free trade.
- Of increase, decrease, or stay the same, this is what happens to the output of wine in France in an immobile factor model when it moves to free trade.
- Of increase, decrease, or stay the same, this is what happens to world productive efficiency in an immobile factor model when two countries move to free trade.
- Of true or false, compensation provided to the losers from trade can assure that everyone gains from trade in an immobile factor model.