International Trade Theory and Policy
by Steven M. Suranovic

Trade 60-13

Trade 60-13


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The Compensation Principle

The Heckscher-Ohlin model generates the following conclusions for a country that moves from autarky to free trade:

Aggregate national welfare rises - this is displayed as achieving a higher level of utility on a set of national indifference curves.

Income is redistributed among individuals within the economy - this is shown by applying the magnification effect for prices to the price changes that arise in moving from autarky to free trade. It is shown that the real income of a country's relatively abundant factor rises while a the real income of a country's relatively scarce factor falls.

A reasonable question at this juncture, then, is whether the gains to some individuals exceed the losses to others, and if so whether it is possible to redistribute income to ensure that everyone is absolutely better off with trade than they were in autarky.

In other words, is it possible for the winners from free trade to compensate the losers in such a way that everyone is left better off than they were in autarky?

The answer to this is yes in most circumstances. The primary reason is that the move to free trade improves production and consumption efficiency which can make it possible for the country to consume more of both goods with trade compared to autarky.

Consider the adjoining diagram. Point A on the PPF represents the autarky production and consumption point for this economy. The shaded region represents the set of consumption points which provide at least as much of one good and more of the other relative to the autarky equilibrium. Suppose that in free trade production moves to P1 and consumption moves to C1. Since C1 lies within the shaded region, the country consumes more clothing and more steel in the aggregate than it had consumed in autarky. However, in moving from autarky to free trade some factors have experienced increases in income while others have suffered losses. This means that some individuals consume less of both goods in free trade while others consume more of both goods.

However, since there is more of both goods in the aggregate it is conceivable that government intervention which takes some of the extra goods away from the winners could sufficiently compensate the losers and leave everyone better off in trade.

The possibility of an effective redistribution depends in some circumstances on the way in which the redistribution is implemented. For example, taxes and subsidies could redistribute income from winners to losers but would simultaneously affect the domestic prices of the goods, which would affect consumption decisions etc. With the secondary effects of taxes and subsidies it becomes uncertain whether a redistribution policy would work. For this reason, economists will often talk about making a lump sum redistribution or transfer. Lump sum transfers are analogous to the transfers from rich to poor made by the infamous character Robin Hood. Essentially, goods must be stolen away from the winners, after they have made their consumption choices, and given to the losers, also after they have made their consumption choices. Furthermore, the winners and losers must not know or expect that a redistribution will be made, lest that knowledge affect their consumption choices. Thus, a lump-sum redistribution is exactly what Robin Hood achieves. He steals from the wealthy, after they've purchased their goods, and gives to the poor, who were not expecting such a gift.

Compensation may not always be as straightforward as shown in the above example, however. Another possible outcome in a free trade equilibrium is for more of one good to be consumed but less of another relative to autarky. In other words the free trade consumption point may occur at a point like C1 in the adjoining figure. In this case it would not be possible to compensate everyone with as much steel as they had in autarky since the economy is consuming less steel in the free trade equilibrium. However, even in this case it is potentially possible to arrange a redistribution scheme. The reason is that the economy could potentially choose a consumption point along the pink line segment, as at point C2. Since the pink segment lies in the range in which more of both goods are available, compensation to make everyone better off with trade remains a possibility.

Thus it is always conceivably possible to find a free trade consumption point and an appropriate lump-sum compensation scheme such that everyone is at least as well off with trade as they had been in autarky.

International Trade Theory and Policy - Chapter 60-13: Last Updated on 7/31/06