Evaluating the Controversy between Free Trade and Protectionism
This chapter argues for economic free trade through the lens of trade theory. While free trade may not be optimal, many consider it to be the most pragmatic policy option for a country. During the 19th and 20th centuries, policymakers asked whether free trade was in everyone's best interest. The modern case for free trade argues that government intervention in trade is impractical. Free trade is not always the best policy choice when the objective is to maximize national welfare. Free trade is pragmatically, rather than technically, optimal because it is attainable and most likely to produce the highest level of economic efficiency.
Free Trade and the Distribution of Income
Learning Objectives
- Recognize that a movement to free trade will cause a redistribution of income within the country.
- Understand how compensation can relieve the problems caused by income redistribution.
A
valid criticism of the case for free trade involves the issue of income
distribution. Although most trade models suggest that aggregate
economic efficiency is raised with free trade, these same models do not
indicate that every individual in the economy will share in the
benefits. Indeed, most trade models demonstrate that movements to free
trade will cause a redistribution of income between individuals within
the economy. In other words, some individuals will gain from free trade
while others will lose. This was seen in the immobile factor model, the
specific factor model, the Heckscher-Ohlin model, and the partial
equilibrium analysis of trade liberalization.
There have been two
general responses by economists concerning the income distribution
issue. Some have argued that the objective of economics is solely to
determine the most efficient policy choices. Introductory textbooks
often suggest that the objective of the economics discipline is to
determine how to allocate scarce resources toward production and
consumption. Economists describe an allocation as "optimal" when it
achieves the maximum level of aggregate economic efficiency. Put in
these terms, economic analysis is "positive" in nature. Positive
economics refers to studies that seek to answer questions pertaining to
how things work in the economy and the subsequent effects. Positive
economic analysis does not intend to explain what "should" be done.
Issues pertaining to income distribution are commonly thought of as
"normative" in nature, in that the concern is often over what the
distribution "should" be. If we apply this reasoning to international
trade, then, issues such as the appropriate income distribution are
beyond the boundaries of the discipline and should be left to
policymakers, government officials, or perhaps philosophers to
determine.
Perhaps a more common response by economists
concerning the income distribution issue is to invoke the compensation
principle. A substantial amount of work by economists has been done to
show that because free trade causes an increase in economic efficiency,
it is generally possible to redistribute income from the winners to the
losers such that, in the end, every individual gains from trade. The
basic reason this is possible is that because of the improvement in
aggregate efficiency, the sum of the gains to the winners exceeds the
sum of the losses to the losers. This implies that it is theoretically
possible for the potential winners from free trade to bribe the losers
and leave everyone better off as a result of free trade. This allows
economists to argue that free trade, coupled with an appropriate
compensation package, is preferable to some degree of protectionism.
One
major practical problem with compensation, however, is the difficulty
of implementing a workable compensation package. In order to achieve
complete compensation, one must be able to identify not only who the
likely winners and losers will be but also how much they will win and
lose and when in time the gains and losses will accrue. Although this is
relatively simple to do in the context of a single trade model, such as
the Heckscher-Ohlin model, it would be virtually impossible to do in
practice given the complexity of the real world. The real world consists
of tens of thousands of different industries producing millions of
products using thousands of different factors of production. The sources
of trade are manifold, including differences in technology, endowments,
and demands, as well as the presence of economies of scale. Each source
of trade, in turn, stimulates a different pattern of income
redistribution when trade liberalization occurs. In addition, the
pattern of redistribution over time is likely to be affected by the
degree of mobility of factors between industries as the adjustment to
free trade occurs. This was seen in the context of simple trade models,
from the immobile factor model to the specific factor model to the
Heckscher-Ohlin model.
Even in the context of simple trade
models, a workable compensation mechanism is difficult to specify. An
obvious solution would seem to be for the government to use taxes and
subsidies to facilitate compensation. For example, the government could
place taxes on those who would gain from free trade (or trade
liberalization) and provide subsidies to those who would lose. However,
if this were implemented in the context of many trade models, then the
taxes and subsidies would change the production and consumption choices
made in the economy and would act to reduce or eliminate the efficiency
gains from free trade. The government taxes and subsidies, in this case,
represent a policy-imposed distortion that, by itself, reduces
aggregate economic efficiency. If the compensation package reduces
efficiency more than the movement to free trade enhances efficiency,
then it is possible for the nation to be worse off in free trade when
combined with a tax/subsidy redistribution scheme. The simple way to eliminate this
problem, conceptually, is to suggest that the redistribution take place
as a "lump-sum" redistribution. A lump-sum redistribution is one that
takes place after the free trade equilibrium is reached - that is, after
all production and consumption decisions are made but before the actual
consumption takes place. Then, as if in the middle of the night when
all are asleep, goods are taken away from those who have gained from
free trade and left at the doors of those who had lost. Lump-sum
redistributions are analogous to Robin Hood stealing from the rich and
giving to the poor. As long as this redistribution takes place after the
consumption choices have been made and without anyone expecting a
redistribution to occur, then the aggregate efficiency improvements from
free trade are still realized. Of course, although lump-sum
redistributions are a clever conceptual or theoretical way to "have your
cake and eat it too," it is not practical or workable in the real
world.
This implies that although compensation can solve the
problem of income redistribution at the theoretical level, it is
unlikely that it will ever solve the problem in the real world. Although
some of the major gains and losses from free trade may be identifiable
and quantifiable, it is unlikely that analysts would ever be able to
identify all who would gain and lose in order to provide compensation
and assure that everyone benefits. This means that free trade is
extremely likely to cause uncompensated losses to some individuals in
the economy. To the extent that these individuals expect these losses
and can measure their expected value (accurately or not), then there
will also likely be continued resistance to free trade and trade
liberalization. This resistance is perfectly valid. After all, trade
liberalization involves a government action that will cause injury to
some individuals for which they do not expect to be adequately
compensated. Furthermore, the economic efficiency argument will not go
very far to appease these groups. Would you accept the argument that
your expected losses are justifiable because others will gain more than
you lose?
One final argument concerning the compensation issue is
that compensation to the losers may not even be justifiable. This
argument begins by noting that those who would lose from free trade are
the same groups who had gained from protectionism. Past protectionist
actions represent the implementation of government policies that had
generated benefits to certain selected groups in the economy. When trade
liberalization occurs, then, rather than suggesting that some
individuals lose, perhaps it is more accurate to argue that the special
benefits are being eliminated for those groups. On the other hand, those
groups that benefit from free trade are the same ones that had suffered
losses under the previous regime of protectionism. Thus their gains
from trade can be interpreted as the elimination of previous losses.
Furthermore, since the previous protectionist actions were likely to
have been long lasting, one could even argue that the losers from
protection (who would gain from free trade) deserve to be compensated
for the sum total of their past losses. This would imply that upon
moving to free trade, a redistribution ought to be made not from the
winners in trade to the losers but from the losers in trade to the
winners. Only in this way could one make up for the transgressions of
the past. As before, though, identifying who lost and who gained and by
how much would be virtually impossible to achieve, thus making this
compensation scheme equally unworkable.
Key Takeaways
- One major problem with movements to free trade is the redistribution of income described in many trade models. This means that although some individuals will benefit from free trade, many others will lose.
- One way to deflect the redistribution concern is to argue that economic analysis provides the positive results of trade policies and is not intended to answer the normative questions of what should be done.
- Another way to deflect the concern about income redistribution is to support compensation from the winners to the losers to assure that all parties benefit from free trade.
- Because compensation requires an enormous amount of information about who wins and loses from trade, how much they win and lose, and when they win and lose, it is impractical to impossible to completely compensate the losers from free trade in a real-world setting.
Exercise
- 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?"
- A principle that, if applied in practice, could eliminate the
negative impacts of income redistribution that may arise with free
trade.
- This is what many trade models show will happen to national income because of trade liberalization.
- This type of compensation can avoid affecting consumption and production decisions.
- The compensation using these two government policies is likely to affect production and consumption decisions.
- The name of the mythical character best associated with lump-sum compensation.
- Of a little or a lot, this is how much information the government needs to make compensation effective.
- A principle that, if applied in practice, could eliminate the
negative impacts of income redistribution that may arise with free
trade.