This is “Free Trade and the Distribution of Income”, section 11.3 from the book Policy and Theory of International Economics (v. 1.0). For details on it (including licensing), click here.

For more information on the source of this book, or why it is available for free, please see the project's home page. You can browse or download additional books there. You may also download a PDF copy of this book (29 MB) or just this chapter (114 KB), suitable for printing or most e-readers, or a .zip file containing this book's HTML files (for use in a web browser offline).

Has this book helped you? Consider passing it on:
Creative Commons supports free culture from music to education. Their licenses helped make this book available to you.
DonorsChoose.org helps people like you help teachers fund their classroom projects, from art supplies to books to calculators.

11.3 Free Trade and the Distribution of Income

Learning Objectives

  1. Recognize that a movement to free trade will cause a redistribution of income within the country.
  2. Understand how compensation can relieve the problems caused by income redistribution.

A valid criticism of the case for free trade involves the issue of income distribution. Although most trade models suggest that aggregate economic efficiency is raised with free trade, these same models do not indicate that every individual in the economy will share in the benefits. Indeed, most trade models demonstrate that movements to free trade will cause a redistribution of income between individuals within the economy. In other words, some individuals will gain from free trade while others will lose. This was seen in the immobile factor model, the specific factor model, the Heckscher-Ohlin model, and the partial equilibrium analysis of trade liberalization.

There have been two general responses by economists concerning the income distribution issue. Some have argued that the objective of economics is solely to determine the most efficient policy choices. Introductory textbooks often suggest that the objective of the economics discipline is to determine how to allocate scarce resources toward production and consumption. Economists describe an allocation as “optimal” when it achieves the maximum level of aggregate economic efficiency. Put in these terms, economic analysis is “positive” in nature. Positive economics refers to studies that seek to answer questions pertaining to how things work in the economy and the subsequent effects. Positive economic analysis does not intend to explain what “should” be done. Issues pertaining to income distribution are commonly thought of as “normative” in nature, in that the concern is often over what the distribution “should” be. If we apply this reasoning to international trade, then, issues such as the appropriate income distribution are beyond the boundaries of the discipline and should be left to policymakers, government officials, or perhaps philosophers to determine.

Perhaps a more common response by economists concerning the income distribution issue is to invoke the compensation principle. A substantial amount of work by economists has been done to show that because free trade causes an increase in economic efficiency, it is generally possible to redistribute income from the winners to the losers such that, in the end, every individual gains from trade. The basic reason this is possible is that because of the improvement in aggregate efficiency, the sum of the gains to the winners exceeds the sum of the losses to the losers. This implies that it is theoretically possible for the potential winners from free trade to bribe the losers and leave everyone better off as a result of free trade. This allows economists to argue that free trade, coupled with an appropriate compensation package, is preferable to some degree of protectionism.

One major practical problem with compensation, however, is the difficulty of implementing a workable compensation package. In order to achieve complete compensation, one must be able to identify not only who the likely winners and losers will be but also how much they will win and lose and when in time the gains and losses will accrue. Although this is relatively simple to do in the context of a single trade model, such as the Heckscher-Ohlin model, it would be virtually impossible to do in practice given the complexity of the real world. The real world consists of tens of thousands of different industries producing millions of products using thousands of different factors of production. The sources of trade are manifold, including differences in technology, endowments, and demands, as well as the presence of economies of scale. Each source of trade, in turn, stimulates a different pattern of income redistribution when trade liberalization occurs. In addition, the pattern of redistribution over time is likely to be affected by the degree of mobility of factors between industries as the adjustment to free trade occurs. This was seen in the context of simple trade models, from the immobile factor model to the specific factor model to the Heckscher-Ohlin model.

Even in the context of simple trade models, a workable compensation mechanism is difficult to specify. An obvious solution would seem to be for the government to use taxes and subsidies to facilitate compensation. For example, the government could place taxes on those who would gain from free trade (or trade liberalization) and provide subsidies to those who would lose. However, if this were implemented in the context of many trade models, then the taxes and subsidies would change the production and consumption choices made in the economy and would act to reduce or eliminate the efficiency gains from free trade. The government taxes and subsidies, in this case, represent a policy-imposed distortion that, by itself, reduces aggregate economic efficiency. If the compensation package reduces efficiency more than the movement to free trade enhances efficiency, then it is possible for the nation to be worse off in free trade when combined with a tax/subsidy redistribution scheme.Dixit and Norman (1980) showed that under some conditions it is possible to specify a tax and subsidy policy that would guarantee an increase in aggregate economic efficiency with free trade. See A. Dixit and V. Norman, Theory of International Trade: A Dual General Equilibrium Approach (Cambridge: Cambridge University Press, 1980). The simple way to eliminate this problem, conceptually, is to suggest that the redistribution take place as a “lump-sum” redistribution. A lump-sum redistributionA redistribution of income that takes place after the free trade equilibrium is reached—that is, after all production and consumption decisions are made but before the actual consumption takes place. is one that takes place after the free trade equilibrium is reached—that is, after all production and consumption decisions are made but before the actual consumption takes place. Then, as if in the middle of the night when all are asleep, goods are taken away from those who have gained from free trade and left at the doors of those who had lost. Lump-sum redistributions are analogous to Robin Hood stealing from the rich and giving to the poor. As long as this redistribution takes place after the consumption choices have been made and without anyone expecting a redistribution to occur, then the aggregate efficiency improvements from free trade are still realized. Of course, although lump-sum redistributions are a clever conceptual or theoretical way to “have your cake and eat it too,” it is not practical or workable in the real world.

This implies that although compensation can solve the problem of income redistribution at the theoretical level, it is unlikely that it will ever solve the problem in the real world. Although some of the major gains and losses from free trade may be identifiable and quantifiable, it is unlikely that analysts would ever be able to identify all who would gain and lose in order to provide compensation and assure that everyone benefits. This means that free trade is extremely likely to cause uncompensated losses to some individuals in the economy. To the extent that these individuals expect these losses and can measure their expected value (accurately or not), then there will also likely be continued resistance to free trade and trade liberalization. This resistance is perfectly valid. After all, trade liberalization involves a government action that will cause injury to some individuals for which they do not expect to be adequately compensated. Furthermore, the economic efficiency argument will not go very far to appease these groups. Would you accept the argument that your expected losses are justifiable because others will gain more than you lose?

One final argument concerning the compensation issue is that compensation to the losers may not even be justifiable. This argument begins by noting that those who would lose from free trade are the same groups who had gained from protectionism. Past protectionist actions represent the implementation of government policies that had generated benefits to certain selected groups in the economy. When trade liberalization occurs, then, rather than suggesting that some individuals lose, perhaps it is more accurate to argue that the special benefits are being eliminated for those groups. On the other hand, those groups that benefit from free trade are the same ones that had suffered losses under the previous regime of protectionism. Thus their gains from trade can be interpreted as the elimination of previous losses. Furthermore, since the previous protectionist actions were likely to have been long lasting, one could even argue that the losers from protection (who would gain from free trade) deserve to be compensated for the sum total of their past losses. This would imply that upon moving to free trade, a redistribution ought to be made not from the winners in trade to the losers but from the losers in trade to the winners. Only in this way could one make up for the transgressions of the past. As before, though, identifying who lost and who gained and by how much would be virtually impossible to achieve, thus making this compensation scheme equally unworkable.

Key Takeaways

  • One major problem with movements to free trade is the redistribution of income described in many trade models. This means that although some individuals will benefit from free trade, many others will lose.
  • One way to deflect the redistribution concern is to argue that economic analysis provides the positive results of trade policies and is not intended to answer the normative questions of what should be done.
  • Another way to deflect the concern about income redistribution is to support compensation from the winners to the losers to assure that all parties benefit from free trade.
  • Because compensation requires an enormous amount of information about who wins and loses from trade, how much they win and lose, and when they win and lose, it is impractical to impossible to completely compensate the losers from free trade in a real-world setting.

Exercise

  1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”

    1. A principle that, if applied in practice, could eliminate the negative impacts of income redistribution that may arise with free trade.
    2. This is what many trade models show will happen to national income because of trade liberalization.
    3. This type of compensation can avoid affecting consumption and production decisions.
    4. The compensation using these two government policies is likely to affect production and consumption decisions.
    5. The name of the mythical character best associated with lump-sum compensation.
    6. Of a little or a lot, this is how much information the government needs to make compensation effective.