ECO328Y INTERNATIONAL ECONOMICS

F.R. Casas

PART I INTERNATIONAL TRADE THEORY AND POLICY

2. THE EFFECTS OF INTERNATIONAL TRADE
We will analyze the effect of free trade on the domestic distribution of income as well as its effect on the aggregate level of income.

(a) Trade and Income Distribution in the Short and in the Long Run
In the short run, capital is assumed to be SECTOR SPECIFIC (immobile) while labour is intersectorally mobile. Trade results in an increase in the relative price of the exportable good, which, in turn, causes the output of the exportable good to expand while the output of the import-competing good declines. As labour moves from the import-competing sector to the export sector, the marginal product of labour in the export sector falls, implying that the real wage in terms of the export good also falls. However, the marginal product of labour in the import-competing sector increases, as does the real wage in terms of that good. The net effect on the real wage rate is indeterminate: some workers may be better off and some worse off depending on their preferences in consumption. As for capital, the real return to capital increases in the export sector but declines in the import-competing sector. Over time, this causes capital to be reallocated to the export sector. In the long run, as both factors are reallocated to the export sector, the effect on the real wage rate and the real rental rate depends on the factor intensity ranking of these two commodities. In particular, the STOPLERSAMUELSON THEOREM predicts that free trade will benefit the factor used relatively intensively in the export sector and will hurt the other factor. If the Heckscher-Ohlin theorem holds, we could then predict that free trade will benefit a countrys abundant factor (by increasing the demand for the product using it relatively intensively) and will hurt the scarce factor. Free trade never benefits everyone, which explains why calls for free trade are always supported by some domestic groups and opposed by others. A closely related result is the FACTOR PRICE EQUALIZATION THEOREM which predicts that free trade will result in the equalization of real wages (as well as the equalization of rates of return to capital) in all trading countries. This means that trade in commodities is a substitute for international factor mobility.
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(b) International Trade and Aggregate Welfare

The opening of trade results in changes in commodity prices, in the allocation of resources and in domestic production and consumption levels. Regardless of the basis for trade and the pattern of trade, real aggregate income (or the aggregate level of utility) increases. We can distinguish two sources for these gains from trade: CONSUMPTION (EXCHANGE) GAINS even if output levels remained unchanged (as they would in the very short run), trading countries benefit from the opportunity to exchange goods. Whenever the MARGINAL RATES OF SUBSITUTION in consumption differ in two countries (as they will if price ratios differ), we can show that both sides can be made better off through an exchange of goods. In other words, trade results in a more efficient distribution of world production among consumers in different countries. PRODUCTION (SPECIALIZATION) GAINS whenever RATES OF PRODUCT TRANSFORMATION differ in two countries (as they will if price ratios differ), we can show that world production of at least one good can be increased without sacrificing any of the other good by reallocating resources within the two countries. In other words, trade results in a more efficient allocation of resources worldwide and increased world production and real incomes.

ECO328Y INTERNATIONAL ECONOMICS

F.R. Casas

(c) The Gains from Trade in the Presence of Market Imperfections Establishing the existence of gains from trade becomes more difficult in the presence of imperfections (such as monopoly) and/or distortions (such as taxes or externalities) in product or factor markets. In such cases, market prices no longer reflect marginal costs. In particular, we can distinguish three possible scenarios (in each case below, we assume that the domestic price Pd exceeds the marginal cost MC as a result of a production tax): 1) UNDERSPECIALIZATION IN THE RIGHT COMMODITY For example, assume that the price under free trade Pft is higher than the domestic autarkic price: Pft > Pd > MC. This product will be exported and would have been exported in the absence of the tax. However, the domestic output and consequently the level of exports will be smaller than would have been the case in the absence of the tax. It can be shown that in these circumstances, the country will still benefit from trade (there will be both consumption and production gains). A similar result would occur if the domestic output of the import-competing good is higher than the perfectly competitive level (e.g. a subsidy). 2) SPECIALIZATION IN THE WRONG COMMODITY This will happen if, for example, Pd > Pft > MC. Here, the good is imported because it is cheaper in other countries but the import price is higher than the domestic cost: the country ends up importing a good that it can produce at a lower cost (a parallel case would be where a subsidized good is exported even though the domestic cost exceeds the world price). Despite this paradox, the country may or may not gain from free trade as it will experience a consumption gain that may offset the production loss. 3) OVERSPECIALIZATION IN THE RIGHT COMMODITY This would happen if, for example, Pd > MC > Pft. The product is imported and would have been imported in the absence of the tax. However, the tax reduces the domestic output and results in an excessive level of imports. The same would occur if the domestic output of the exportable good is excessive (e.g., subsidy). Whether the country will benefit from trade is difficult to establish: while there will be consumption gains, there may be production gains or losses. Since market imperfections and distortions are prevalent, this analysis suggests that the widely held belief that a country gains from free trade needs to be approached with a healthy dose of scepticism. The fact that
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free trade redistributes income domestically also raises difficult questions.