International Trade Theory and Policy
by Steven M. Suranovic
Trade 60-13
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The Compensation PrincipleThe 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.
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.
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 |