Free Trade and the Distribution of Income
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. Lionel Robbins (?) once wrote that the objective of the economics discipline is to
determine how to allocate scarce resources towards production and consumption. Economics
describes 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 which 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 for compensation to work, 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. A 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 which, 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.(1) 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.
What all of this implies is 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 resistence to free trade and trade liberalization.
This resistence is perfectly valid. Afterall, 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 which 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 special benefits are being eliminated for those
groups. On the other hand, those groups that benefit from free trade are the same one's 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, the difficulty of identifying
who lost and who gained and by how much would be virtually impossible to achieve thus making
this compensation scheme equally unworkable.
1. It has been shown that under some conditions it is possible to specify a tax and subsidy
policy which would guarantee an increase in aggregate economic efficiency with free trade. (See
for example Dixit and Norman (1980)). Go Back
International Trade Theory and Policy - Chapter 120-3: Last
Updated on 2/17/07
