International Trade Theory and Policy
by Steven M. Suranovic

Trade 100-0

Trade Policies with Market Imperfections and Distortions

Most arguments for protection arise when markets have either imperfections or distortions present. These cases are worthy of study because it is clear that markets rarely satisfy all of the assumptions made under perfect competition. These cases offer compelling arguments for protection including the infant industry argument, the optimal tariff argument, strategic trade policy arguments and arguments concerning national security.

Market imperfections and distortions, generally, mean any deviation from the assumptions of perfect competition. This includes monopoly and oligopoly markets, production with increasing returns to scale, markets that do not clear, negative and positive externalities in production and consumption and the presence of public goods.

When imperfections or distortions are present in a trade model, it is usually possible to identify a trade policy that can raise aggregate economic efficiency. Many cases are demonstrated in this chapter in which trade policies improve national welfare. These welfare improving policies, although detrimental to national welfare when used in a perfectly competitive setting, act to correct the imperfections or distortions present in the market. As long as the welfare impact of the correction exceeds the standard welfare loss associated with the trade policy, the policy will raise welfare.

Trade policy with market imperfections and distortions represent applications of the General Theory of the Second Best formalized by Lipsey and Lancaster. When imperfections or distortions are present in an international trade model we describe the resulting equilibrium as second-best. In this case the standard policy prescriptions to maximize national welfare in a first-best or non-distorted economy will no longer hold true. Also the implementation of what would be a detrimental policy in a first-best world can become a beneficial policy when implemented within a second-best world. For example, tariffs applied by a small country in the presence of domestic distortions can sometimes raise national welfare.

In 1971 Jagdish Bhagwati presented a general theory of distortions in trade situations. In this paper he characterized many or most of the distortions that can occur and considered which policies could be used to correct each distortion and raise national welfare. He considered not only trade policies, but also domestic tax or subsidy policies as well. He showed that for most distortions, trade policy is inferior (in terms of the extent to which it can raise national welfare) to other purely domestic policies. A general rule to identify the most appropriate (or first-best) policy, would be that policy which most directly corrects the distortion or imperfection present in the market. This chapter provides numerous examples of policy rankings and applications of this general rule.

In one case trade policy does prove to be first-best. This is the case of a large import or export country in international markets. In this case the first-best policy is the optimal tariff or the optimal export tax.

Thus the results of this section are somewhat schizophrenic. On the one hand, these models offer some of the most compelling arguments supporting protection. For example, one can easily use these models to justify protection for national defense reasons, or when unemployment is a serious concern in a market, or when trade causes environmental degradation, or when there are infant industries in a country. On the other hand, in almost all of these cases trade policy is not the most effective policy tool available to correct the problems caused by the distortion or imperfection.

Finally when more complex markets are considered, as when there are multiple distortions or imperfections present simultaneously, our ability to identify welfare improving policies rapidly diminishes. The theory of the second-best states that correcting one distortion in the presence of many may not improve welfare even if the policy makes perfect sense within the partial equilibrium framework containing the one distortion. The reason is that correcting one distortion may have unintentional (and probably unmeasurable) impacts in other sectors due to the presence of other distortions. For example, suppose a trade policy is implemented to correct an environmental problem. One might be able to measure the welfare costs of the trade policy and the environmental benefits that would accrue to society and conclude that the benefits exceed the costs. However, the trade policy will have an impact upon prices and resource allocation potentially spreading across numerous sectors. Suppose one other sector, adversely affected, generates positive spillover effects which act to raise well-being to some groups. Then it is conceivable that the loss of the positive spillover effects would more than outweigh the net benefit accruing to society due to the environmental improvement. This means that the well-intentioned, and reasonably measured environmental trade policy could result in an unintentional welfare loss for the nation. The more complex is the economy and the more distortions and imperfections that are present, the more likely it is that we simply cannot know what the national effects of trade policies will be.

International Trade Theory and Policy - Chapter 100-0: Last Updated on 12/11/97