TRADE AND WELFARE

Basic debate → Protectionism Vs. Non – Protectionism

1. Smith, Ricardo → 19th century

2. Bickerdike → Infant industry
3. Theory of Domestic Distortions – Meade “Trade & Welfare’, Bhagwati & Ramaswamy, Batra & Pattanaik
4. Recent development in trade theory
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Propositions:-
a) Free trade is optimal – small country
b) Large country – tariff retaliation
c) Intervention – domestic distortions
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d) Some trade > N.T. (generally true)
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Manoj Pant (Indian Institute of Foreign Trade)
TRADE AND WELFARE
……(Contd.) Let n = 2, r = 3
Xi = Fi (Ki, Li, Ni) …… i = 1, 2
OPTIMALITY aK1 = paK2
bL1 = pbL2
Model
cN1= pcN2
Max u = u (D1,………..,Dn) L1 + L2 =
such that Xi = F (K, L………) …..(1) K1 + K2 =
Factor market equilibrium …..(2) N1+ N2 =
Full employment …..(3) dX1 = aK1dk1 + bL1dL1 + cN1 dN1
D1 + P2D2 + …. + PnDn = X1+ P2X2 + …. + PnXn …..(4) = - paK2dK2 – pbL2dL2 – pcN2dN2

(Country budget constraint) = - pdX2

∴, dX1 + PdX2 = 0

Look at (1) – (3) ⇒ domestic production constraint

Q. For n = 3, r = 3; dX1 + P2dX2 + P3dX3 = 0
Q. For n = 2, r = 2; dX1 + P2dX2 = 0
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Manoj Pant (Indian Institute of Foreign Trade)
TRADE AND WELFARE
……(Contd.)
• , the model is:
∴
Max u = u (D1, D2) ……………….. (1)
such that dX1 + pdX2 = 0 ……………….. (2)
D1 + pD2 = X1 + pX2 ……………….. (3)

∴, = dX1 + pdX2 = 0
⇒ Free Trade is Optimal for small country (Why?)

• Tarif versus consumption tax – subsidy SMALL

COUNTRY
• Tarif versus production tax – subsidy

How do these afect (1) – (3)?

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Manoj Pant (Indian Institute of Foreign Trade)
 TRADE AND
WELFARE
Model (with tarifs) ……(Contd.)
• u = u (D1, D2) …… (1) For production subsidy ‘s’, =-ps<0
s.t. dX1 + p (1+t) dX2 = 0 …… (2) …… (5)
(+)
D1 + pD2 = X1 + pX2 …… (3)
Q. Why not in 3? For consumption tax ‘c’, =pc <0
…… (6) (+)
= + p (1+t)
Equivalence:-
From (3) ,
= =
+p = +p
From (2),
Q. Show that: (4) – (5) < 0
+p =-tp
(4) – (6) < 0
∴, =-tp +tp
Q. What about (5) – (6)?
=tp <0 …… (4)
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Manoj Pant (Indian Institute of Foreign Trade)
TRADE AND WELFARE
……(Contd.)
• Tarif Vs. Production Subsidy • Tarif vs. Consumption Tax

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Manoj Pant (Indian Institute of Foreign Trade)
 TRADE AND WELFARE
……(Contd.)

Optimum
• tarif and retaliation
u = u (D1, D2)
Imports: Z2 ≡ D2 – X2 & Z1* = X1 – D1

∴, u = u (X1 – Z1*, X2 + Z2)

And,
du = - = 0

=0
Beggar thy
⇒ = >0
neighbour policy

Manoj Pant (IIFT) 6

 TRADE AND WELFARE
Gains ……(Contd.)
• from trade with a domestic distortion
Modification of two sector model.
Q. What happen to S-S and Rybczynski theorem?
=-βp
Production constraint α > 1 ⇒ β <1
∴, <p
=p
α (f1 – k1) = p (f2-k2) ⇒ α FL1 = p FL2
=
=
=-pβ
And, α > or < 1 ⇒ β < or > 1
After trade, price of
= - [ p + β] X1 increases ⇒ p ↓es

• Positive supply function does not necessarily imply < 0. Q. Does it matter from
FT to NT via tariff?
• Transformation curve could be strictly concave

Manoj Pant (IIFT) 7

 TRADE AND WELFARE
(i) ……(Contd.)
• FT > NT if after trade, production ↑ in the commodity which
is paying the wage differential. FT → NT

(ii) FT is not optimal.

du = dX1 + p dX2 = dX2 [ + p]
= p dX2 [1 - β] ≠ 0 if β ≠ 1
Bhagwati & Ramaswami – suggestion → Equate in both
industries

α =1 → First best
Second best?
Policy for which
α>1⇒β<1
> 0 iff dX2 > 0 → production subsidy
= dX2 (
∴ tax cum subsidy such that = -p
Manoj Pant (IIFT) 8
TRADE AND WELFARE
……(Contd.)
References:
• Theory of wage differentials: Welfare and immiserising Growth – Batra and Scully, JIB, 1.1971.
• Corden →Trade and welfare (Introduction)
• Factor market imperfection, the terms of trade and welfare – Batra and Pattanaik, AER, Dec’ 1971
• Domestic Distortion, Tariffs and the theory of optimum subsidy, JPE, Dec’ 1969

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Manoj Pant (Indian Institute of Foreign Trade)