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11.2 Economic Efficiency Effects of Free Trade

Learning Objective

  1. Learn the major source of support for free trade across a variety of trade models.

The main source of support for free trade lies in the positive production and consumption efficiency effects. In every model of trade, there is an improvement in aggregate production and consumption efficiency when an economy moves from autarky to free trade. This is equivalent to saying that there is an increase in national welfare. This result was demonstrated in the Ricardian model, the immobile factor model, the specific factor model, the Heckscher-Ohlin model, the simple economies-of-scale model, and the monopolistic competition model. The result can also be shown if there are differences in demand between countries. Each of these models shows that a country is likely to have greater national output and superior choices available in consumption as a result of free trade.

Production Efficiency

Improvements in production efficiency mean that countries can produce more goods and services with the same amount of resources. In other words, productivity increases for the given resource endowments available for use in production.

In order to achieve production efficiency improvements, resources must be shifted between industries within the economy. This means that some industries must expand while others contract. Exactly which industries expand and contract will depend on the underlying stimulus or basis for trade. Different trade models emphasize different stimuli for trade. For example, the Ricardian model emphasizes technological differences between countries as the basis for trade, the factor proportions model emphasizes differences in endowments, and so on. In the real world, it is likely that each of these stimuli plays some role in inducing the trade patterns that are observed.

Thus as trade opens, either the country specializes in the products in which it has a comparative technological advantage, or production is shifted to industries that use the country’s relatively abundant factors most intensively, or production is shifted to products in which the country has relatively less demand compared with the rest of the world, or production shifts to products that exhibit economies of scale in production.

If production shifts occur for any of these reasons, or for some combination of these reasons, then trade models suggest that total production would rise. This would be reflected empirically in an increase in the country’s gross domestic product (GDP). This means that free trade would cause an increase in the level of the country’s national output and income.

Consumption Efficiency

Consumption efficiency improvements arise for an individual when changes in the relative prices of goods and services allow the consumer to achieve a higher level of utility. Since the change in prices alters the choices a consumer has, we can say that consumption efficiency improvements imply that more satisfying choices become available. When multiple varieties of goods are available in a product category, as in the monopolistic competition model, then consumption efficiency improvements can mean that the consumer is able to consume greater varieties or is able to purchase a variety that is closer to his ideal.

Although improvements in consumption efficiency are easy to describe for an individual consumer, it is much more difficult to describe consumption efficiency conceptually for the aggregate economy. Nevertheless, when aggregate indifference curves are used to describe the gains from trade, it is possible to portray an aggregate consumption efficiency improvement. One must be careful to interpret this properly, though. The use of an aggregate indifference curve requires the assumptions that (1) all consumers have identical preferences and (2) there is no redistribution of income as a result of the changes in the economy. We have seen, however, that in most trade models income redistribution will occur as an economy moves to free trade, and it may be impossible to redistribute afterward. It is also likely that individuals have different preferences for goods, which also weakens the results using aggregate indifference curves.

Key Takeaways

  • The main sources of support for free trade are the positive production and consumption efficiency effects that arise in numerous models when countries trade freely.
  • Production efficiency improvements mean that countries produce more goods and services with the same amount of resources.
  • Consumption efficiency improvements mean that countries consume a more satisfying mix of goods and services.

Exercise

  1. 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?”

    1. The term often used as a synonym for an improvement in economic efficiency.
    2. The type of efficiency improvement in which productivity rises for the given resource endowments available for use in production.
    3. The type of efficiency improvement relating to consumer choice adjustments in response to a policy change.
    4. The enhancement of this is what many economic models show will arise by moving to free trade.