International Trade Theory and Policy
by Steven M. Suranovic

Trade 80-5D

The Costs of Free Trade under Monopolistic Competition

There are two potential costs of free trade in this model. The first cost involves the potential costs of adjustment in the industry. The second cost involves the possibility that more varieties will increase transactions costs. Each cost requires modification of the basic assumptions of the model in a way that conforms more closely with the real world. However, since these assumption changes are not formally included in the model the results are subject to interpretation.

1) The movement to free trade requires adjustment in the industry in both countries. Although firm output rises, productive efficiency rises as well. Thus it is possible that each firm will need to lay off resources - labor and capital - in moving to free trade. Even if each firm did not reduce resources it is possible (indeed likely) that some firms will be pushed out of business in moving to the long-run free trade equilibrium. Now it is impossible to identify which country's firms would close, however, it is likely to be those firms who lose more domestic customers than they gain of foreign customers, or firms that are unable or unwilling to adjust the characteristics of their product to serve the international market rather than the domestic market alone. For firms that close, all of the capital and labor employed will likely suffer through an adjustment process. The costs would involve the opportunity cost of lost production, unemployment compensation costs, search costs associated with finding new jobs, emotional costs of being unemployed, costs of moving, etc. Eventually these resources are likely to be re-employed in other industries. The standard model assumption is that this transition occurs immediately and without costs. In reality, however, the adjustment process is likely to be harmful to some groups of individuals.

2) A second potential cost of free trade arises if one questions the assumption that more variety is always preferred by consumers. Consider for a moment a product in which consumers seek their ideal variety. A standard (implicit) assumption in this model is that consumers have perfect information about the prices and characteristics of the products they consider buying. In reality, however, consumers must spend time and money to learn about the products available in a market. For example, when a consumer considers the purchase of an automobile, part of the process involves a search for information. One might visit dealerships and test drive selected cars, one might purchase magazines that offer evaluations, one might talk to friends about their experiences with different autos. All of these activities involve expending resources - time and money - and thus represent, what we could call, a transactions cost to the consumer.

Before we argued, that because trade increase the number of varieties available to each consumer, each consumer is more likely to find a product which is closer to her ideal variety. In this way more varieties may increase aggregate welfare. However, the increase in the number of varieties also increases the cost of searching for one's ideal variety. More time will now be needed to make a careful evaluation. One could reduce these transactions costs by choosing to evaluate only a sample of the available products. However, in this case there might also arise a psychological cost because of the inherent uncertainty about whether the best possible choice was indeed made. Thus in welfare would be diminished among consumers to the extent that there are increased transactions costs because of the increase in the number of varieties to evaluate.

International Trade Theory and Policy - Chapter 80-5D: Last Updated on 2/15/07