Who Wins and Who Loses from a Country Opening Up to Free Trade - Literature review Example

Name: Subject: Course: Supervisor: Submission date: Free Trade Analysis Krugman (1979) Economists have strongly advocated free trade for many years. In the mid eighteenth century, many mercantilist thought that free trade was both a national, and everyone’s interest. However, during the19th and 20th centuries, this food of thought was again revised and found that free trade was not every nation or person’s interest. Such arguments under this umbrella did include the strategic trade, income redistribution, terms of trade and infant industry arguments. These arguments were thought to weaken the free trade idea. However, examinations of each one of the arguments rather than weakening free trade counterarguments that favor the position of free trade were developed. Dixit & Norman (1980) among the counterarguments include: the democratic system allowing lobbying, the imperfect or incomplete information, the second best theory and retaliation potential. Today there exist sophisticated modern arguments. This argument puts forth that, free trade is everyone’s best interest. The modern argument does not classify the arguments of exception as illogical or invalid. However, it argues that the exception calls for government intervention in terms of trade policy, in addition, puts a challenge to implementation problems which are likely to cause impracticality to the policy Torrens (1844). The economic theory, however, is not without criticism regarding free trade regardless of modern argument. Such kind of disapproval supports that free trade is not a simple measure as some theories say, and that is why not everyone benefits from free trade. Therefore, according to real world experience and trade theory there are losers and winners. Modern argument is actually based on realistic assumption that leads to realistic conclusion. This is because it is built on outcome analysed from different trade model. The considerations of all trade models actually offer realistic features of the globe at large. Jointly, trade theory model, puts into considerations realistic features, joint production, imperfect information, consumption, externalities in production, effects of trade dynamism and imperfectly competitive markets. It is good to note that; these features are not all present in a particular model; rather, they are present in extended model which has been used to argue the realistic nature of free trade. Support of free trade Consumption and positive production efficiency effects offer a fundamental support for free trade. As shown in every trade model when a country’s economy opens to free trade consumption and production efficiency improves considerably. In other words, national welfare also increases. This outcome was clearly demonstrated by the monopolistic competition, the simple economies-of-scale, the Heckscher-Ohlin, the specific factor, the immobile factor and Ricardian models. Each models shows that a country practicing free trade is likely to have a positive impact on the available consumption choices and greater national output. Production efficiency Young (1991) Production efficiency improvement it is using same resources available to produce more services and goods. Meaning, productivity increases only on the amount of production resources available. Production efficiency improvement is achieved only through shifting resources within the economy and between industries. Different trade stimuli are emphasized by different models of trade. Ricardian model for example, puts emphasizes on technological differences experienced between countries as trade basis. A country with exemplary technology will be better placed to specialize in product that the technology favors. That is, production is shifted to country’s that are capable and use abundant factors in industries most intensively. In other cases, production can be shifted to countries with less demand when compared to other nations or production may as well shift to product(s) that houses sufficient wealth economies of scale potential. Any of these reasons or combinations of several reasons can lead to shift in production. Consequently, trade models shows that the total production rises as well. The best indicator for such shift is noted in Gross Domestic Product (GDP) of a country. Therefore, free trade in this case would lead to increase in national income and output in a given country. Ricardian model: This trade model assumes production is viable only by using a single input factor (labor) to produce constant returns. To demonstrate this, the model takes assumption in: a) There is free labor movement between sectors in a country (both sectors offer same wage). b) It is impossible to move labor between countries (different countries offer different wages), and there is perfect competition between agents. For example using countries x and Y Table 1: requirement of labor labor requirement Unit Good 1 Good 2 Country X aX1=1 aX2=1 Country Y aY1=3 aY2=6 Both countries produce good 1 and good 2, superscript is the country X and Y, the subscript is commodity 1 and 2. Assuming that only one unit is required by country X to produce one output. Therefore, from the table to produce both goods will require less labor in country X than in country Y. Country X, therefore, has absolute advantage over country Y. However, in trade, gains are not in any way related to absolute advantage. A country will only benefit in trading only if the relative prices in equilibrium autarkic differ from the relative trading prices. From the table above, country X is reproductive than Y, and therefore, it is more advantageous over country Y. However, both countries will still benefit from trade. In this particular case it is fundamental if one country specializes because of the difference in the relative production cost. The best way to arrive at this fact is calculating the opportunity cost. Country X opportunity cost of Good 1 = aX1/aX2=1/1 > Country Y opportunity cost of Good 1= aY1/aY2=3/6. Country Y will undergo a loss of ½ for good 2 in order to produce 1 unit of good1. On the other hand, country X will have to make a loss of one unit good 1 to make for one unit of good 2. Therefore, country Y has a lower opportunity for good 1.Country Y will benefit from investing on good 1 Krugman (1979), on condition that the technology and labor are relative cheaper as compared to production of good 2. Consumption efficiency This is a situation where consumers of given nation are able to consume goods and services that are quite satisfying as a result of relative change in price. Price of services and goods do alter significantly the consumer’s choice and, therefore, consumer efficiency indicates there are varied satisfying choices available for consumers. As indicated in Monopolistic competition model, when goods of varied categories are available the consumer on the other hand gets the opportunity to consume and purchase variety according to his choices and money power. Income distribution Bourguignon & Morrisson (1991) Free trade has been criticized in regard to distribution of income. However, most models indicate there is substantial raise in economy efficiency when it comes to free trade; there are no indications of an individual benefits coming from the trade. Moreover, most study models clearly illustrate that in free trade there is redistribution of income. That is to mean some participants will gain while other will lose in free trade. Such models which support this illustration include The Trade Liberalization Partial Equilibrium Analysis Model, The Heckscher-Ohlin, The Specific Factor and Immobile Factor Model. Income distribution issue has been argued by economist in two general ways. Some do argue determining the best efficiency policy is the sole objective of the economist. On the other hand, others argue that economic as a discipline aims at finding out how scarce resources can be efficiently allocated toward consumption and production. Resource allocation is optimal if at all it achieves the highest level of aggregate economic efficiency. Economic analysis is also said to be “positive” in nature. When economists talk about positive economy they do regard to the working of different things in economy and their subsequent effects. Positive economic analysis explain how distribution “should be”, rather than how “should be done”. In international trade, if this reasoning is applied, appropriate income distribution in this case go beyond the discipline and call for philosophers, government officials and policy makers to argue and determine the fate. Most economists have contributed to the issue of income distribution and saw that compensation principle is ideal for the losers. This is because, free trade leads to economic efficiency, and it is possible to consider the loser and redistribute the winners’ income. Therefore, the loser as the winner all benefits at the end. The main reason to this is that, in the aggregate efficiency improvement, winners’ sum of gain exceeds the losers’ sum of losses. Therefore, the synergy shows that the winner in free trade is left with substantial benefit such that he can bribe the loser, therefore, benefiting all participants in a free trade. According to most economists, free trade can be protected if it is accompanied with appropriate compensation package. The challenge of compensation package comes in that it is difficult to find out how compensation should be done. This is because a person needs to identify the loser as well as the winner. In addition, they need to know how much will the loser lose and the winner gain. This can be easily illustrated using a single trade model like Heckscher-Ohlin. However, the practical application still will remain a challenge because the world is indeed complex. Production is carried by thousand and thousands number of industries which produce different factors of production (capital, labor and land). In addition, there are various trade sources, technology, economies of scale, demands and endowments. Therefore, income distribution is stimulated differently by each trade source. In addition, the occurrence of trade liberation calls for different income distribution patterns. Moreover, these patterns of redistribution are likely to be affected by other factors of mobility between different industries in the event of free trade adjustment. This fact was indicated by Heckscher-Ohlin, Specific Factor, Immobile Factor, and Simple Trade Models. Using Heckscher-Ohlin as an example, in trade, Falvery & Kierzkowski (1987) there is involvement of many factors intertwined such as capital, labor and land. International trade exchange involves transfer of immobile factors of production where they are scarce. This form of trade is known as indirect factor arbitrage. The indirect arbitrage in reality can eliminate factor-price indifference completely. As from HO indication, a local market can transform into an international market through opting to sell factor services externally. As a result there is elasticity in input demands enforcing similarity of income across countries. According to HO model, the uneven productive resources distribution geographically, is compensated through international commerce. For example, labor rich countries than land will in turn export labor intensive products of agriculture. Following trade the wage levels in such case will be more or less equal to the countries with labor-scarce factor. For example assuming a country produces two intra-industry goods x1, x2 and one extra industry good y and assuming there is an identical technology across the country in x2 and y, with a small productivity difference in x1, and that intra-industry goods (x1, x2) relative to y are capital intensive. Then Country one: X1=AF (K X1, L X1) X2=F (K X2, L X2) Y=G (KY, LY) Country two: X1=F (K X1, L X1) X2=F (K X2, L X2) Y=G (KY, LY) Where A>1 From this example country one’s technology is the only reliable factor in production of good X1. The intra-industry goods have a constant transformation marginal rate. Therefore Px1=1/A (both goods have positive production). Py (relative price) is provided by the general equilibriums giving rise to factor intensities k x1 = kx2 > kY, and factor price ratio w/r is established. Then, the determination of how factors should be allocated in various production sectors is carried out. Having v-world factor endowment, (VI, V2) = [(K1, L1), (K2, L2)] as partition. Let Factors in Sector i integrated equilibrium be v (i) = [(K (i), L (I))]; and shares of country j of good i in the equilibrium production is λij In this case FPE (Factor Price Equalization) FPE = {(VI, V2)IƎ λX21, λ X22, λY1, λY2,≥0 Therefore, λX21+λ X22=1, λY1+ λY2=1, λX11=1, λX12=0 V1=Σλi1 v(i) V2=Σλi2 v(i)} Hence FPE is a collection of world factor endowments partitions, and using integrated equilibrium techniques: Since X2 and Y goods are produced under identical technologies can therefore be distributed among the countries Since Country one has technical advantage of X1can produce overall integrated supply If the two counties employ fully factors of production, FPE will be consisted. It has not been a simple task to specify the best compensation plan. However, policy makers can as well come up with taxes and subsidies imposition to facilitate compensation. This will involve, for example, the government taxing the winners and subsidizing on the losers. This fact was not implemented on trade models so that the consumption and production choices remain unchanged. In addition, efficiency gained in free trade is likely to be eliminated. Krueger (1978) Subsidies and taxes are forms of policy imposed distortion. The effect is that, there is reduction on the aggregate economic efficiency. A nation using subsidy/taxes is likely to worsen in free trade if there is reduction in efficiency using compensation package more than the rate at which free trade enhances efficiency. To eliminate this challenge “lump-sum” income redistribution is another option. This takes places once the equilibrium is reached. All the gains by the winners are taken and given to the loser. This is quite ideal thought in the real world and is quite unworkable and impractical. From these findings, compensation is a solution to income redistribution problem. However, this is quite theoretical and the feasibility of the issue in the real world is still unforeseen. It is possible to quantify and identify some major free trade loses or gains. However, it is not possible to get all the profit and lose beneficiaries so as to provide compensation and ensure everyone benefits. Therefore, trading freely might not offer compensation to some losers in the economy. Trade liberalization and free trade will remain being resisted by those individual who are able to estimate total loses. Such a resistance is actually valid. Government action is required in trade liberalization. This kind of involvement is likely to hurt some individual who do not get full compensation, and therefore, the economic efficiency does not really favor this individual. Another argument regarding compensation is that is not possible to justify compensation principle to the losers. Therefore, Krueger (1978) in trade liberalization instead of counting loses incurring to some individuals, it might be argued that special benefit are just eliminated from such people like loses that occurred in the past. Therefore, income redistribution is not only taken from the winners, but also from the losers. This will ensure loses accrued in the past are recovered. Selected protection Graham (1923) Protectionism is preferred in areas where there is market distortion, imperfectly competitive market or both. It is only in such situation where it is possible to indicate that selected protection (trade policy) is able to uplift the economic efficiency aggregate. This is to say if a country has to maximize national welfare free trade is not only the best policy option. Economists have found that, in some circumstances applying selected protectionism raises national welfare. However, trade models do not certainly support this argument. This is because trade models works in an assumption that the market is perfect and not faced with market distortions. Generally, the real world faces market distortion and imperfections. The situation is caused by international market being faced with national market power, distorted government regulations and policies, lack of common information, availability of public goods, issues of unemployment, unclear market, presence of oligopolistic or monopolistic production firms making positive profits, dynamic and static external forces leading to consumption and production that may be negative or positive or both. If these features are given consideration in the standard trade models the best trade policy will be identified to amend the distortion and imperfect market hence raising the aggregate efficiency. An example of such a policy of protection is an optimal quota or tariff supported by terms of trade argument. Terms of trade argument puts forward that; if a country is known to import a lot of goods in the international market, it can take advantage of its monopolistic trade power and increase national economy. Like in import, a country that has large proportion in the international trade can as well impose Voluntary Export Retraint (VER) or Optimal Export Tax. This will ensure it takes advantages of its monopolistic trade power and builds its economy. Tariff imposition in order to safeguard import-competing industries from being strained by foreign imports will in turn reduce unemployment factors experienced in the industries. This will be possible if the effect of tariff on the standard net national welfare is less than the affected workers unemployment. In this case, then, the tariff will have positive improvement on the welfare of a country. Krueger (1978) A tariff can be imposed on imports goods coming from stable foreign firms. This may stimulate the domestic industries to have humble time of gaining learning instrument for production in turn increasing production that will at the end have a positive impact on domestic firm allowing them to also compete in the international trade with foreign firms in future regardless of whether the protection policy is in place or not. The learning instruments that include cost-cutting procedures, management techniques, and organizational methodologies with time will spread to other industries stimulating efficiency improvement. The GDP is also likely to improve impacting generally on the national welfare. Tariff if imposed on goods that require high technology in domestic production will as well affect the development and research centers leading to timely innovations on subsequent products. The firms will in turn enjoy profits that accompany original innovators if at all these industries evolve to be among the best. National welfare will rise so long as the protectionism cost is outweighed by the long-term profits. Torrens (1844) Application of import tariff to a foreign monopoly supplier will shift benefits to the domestic market effectively and consequently the government. Although the domestic price is likely to go up the national welfare will experience a positive change. If the government on the other hand provides export subsidies to domestic firms which are in competition with other foreign firms on oligopoly market, the domestic profit is likely to rise by far as compared to cost of subsidy. This will be felt greatly if the profit shifts away from the foreign industries. These examples of optimal tariff just give insight of how protectionism raises the national welfare. However, for the protection to be felt on the aggregate economic efficiency, there should be a specific objective, and should aim at a particular firm or industry. The cases argued above in regard to protectionism are valid. They are based on the assumption that in real world the market is generally full of distortions and imperfections. The trade policy are therefore, considered due to their ability to reduce the imperfection and distortion in the current markets. In addition to elimination of the market misgivings, the trade policy benefits in the economy outweigh the losses incurred in implementing the policy. Harry 1953, the trade policies chosen faces some challenges that are likely to render the different form of income protection a second best choice. When a country chooses to use tariff, it does so at trade partner’s expense. In that, it will improve its gains as the partners achieve loses. The partners are likely to make a copy of the trade policy to their partners; a form of retaliation. This way, the profits gained will go down. This problem is much felt when the international market is flooded with large countries. On the other hand, finding a purely domestic policy should be the top priority; trade policy protection in economy is actually the second best. Moreover, a country has to sufficiently carry out the efficiency (pros and cons) of a particular trade policy before the implementation and the impact expected on the national economy. This is actually time consuming and sometimes small firms may not have resources to invest through information research. In addition, there is generally lack of sufficient information worldwide. Therefore, there is possibility of choosing the wrong protection. Trade policy is prone to leaking through special interest parties during the lobbying process among the representative democracies. This fact makes it difficult to achieve maximum national welfare. Following the challenges facing trade policies, although free trade is actually not technically optimal it is still the best of all; unlike other policies it is likely to take the economic efficiency to the highest level possible. Conclusion From the theory models, Krugman (1987) free trade might not be the best option a country can take. However, it remains the most pragmatic choice that a country can follow. As analysed through different models, positive consumption and production efficiency are the key elements that arise in countries involved in free trade. Income redistribution Bourguignon & Morrisson (1991) is a major challenge for countries moving to free trade. It is actually true as countries move to free trade their will be beneficiaries and losers. Income redistribution can be done through trade policy development or supporting compensation plan for all individuals to benefit. The settings in real world do not really embrace compensation issue due to its impracticality and unworkable nature. This is because compensation calls for sufficient information regarding when, who and by how much did the beneficiary of lose and profit get. The market unlike the assumption made by trade model it is not perfect. It faces distortion and imperfection. Free trade, therefore, is not the only optimal icon that can increase the national economy. Protectionism in addition, can however, raise the national welfare. References Bourguignon F. & Morrisson C. (1991) External trade and income distribution, paris; OECD Dixit A. & Norman V. (1980) Theory of International Trade: A dual general equilibrium approach. Cambridge: Cambridge university press Falvery R.E. & Kierzkowski H. (1987) product quality, intra-industry trade and (im)perfect competition, in Kierzkowski H., ed, protection and competition in international trade New York: Basil Blackwell 143-161 Graham F. (1923) Some Aspects of Protection Further Considered, the quarterly journal of economics 37 (2)199-227 Harry G.J. (1953) Optimum Tariffs and Retaliation, review of economic studies 21(2) 142-153 Krueger A. (1978) Liberalization Attempts and Consequences Cambridge: Ballinger Krugman P.R. (1979) Increasing returns, monopolistic competition and international trade, journal of international economics 9:4, 469-479 Krugman P. (1987) “is free trade passé?” journal of economic perspectives 1(2):131-144 Torrens R. (1844).The budget: on commercial and colonial policy. London: smith Young A. (1991) Learning by doing and the dynamic effects of international trade, quarterly journal of economics 106:2,369-405 Read More