By Shreya Deora

Edited by, Madhavi Roy, Senior Editor, The Indian Economist

“Trade theory does not say, as sometimes claimed, that international trade is necessarily and always good for everyone. On the contrary, the theory of comparative advantage identifies both winners and losers from international trade, and the subtlety of the argument, much like many applications of benefit-cost analysis, consists of quantifying and comparing the gains and losses.”

Alan Deardorff , the John W. Sweetland Professor of International Economics and a Professor of Economics and Public Policy at the University of Michigan, Ann Arbor, goes on to explain that in a partial equilibrium analysis, the direction of trade depends on whether the domestic price is lesser or more than the world price. If it is below the world price, then the good is exported. This benefits the suppliers, both the employers and workers. But this harms the domestic demanders who are forced to pay more for the good. But the theory shows that the benefits of trade exceed the harms, and so much so that the beneficiaries can help and compensate the losers and vice versa. A standard benefit-cost analysis of international trade yields an unambiguous result: benefits are greater than costs.

In a general equilibrium framework, apart from the effects that accrue in a partial equilibrium analysis, there are also effects on factor prices. Specific factors gain or lose depending on the whether the industry they are used in are exporting or importing. Factors that are mobile within industries do not get affected by the performance of a particular industry per se, but by how their factor market as a whole is getting affected by trade. This theory is derived from the famous Stolper Samuelson Theorem. The general equilibrium models of trade theory also establish, however, that whatever some factor owners may lose from trade, other factor owners must gain even more. Therefore again, the benefits outweigh the costs from trade.

The Role of Distortions

 All the results so far require certain assumptions- perfect competition, market clearing requirement, no government intervention, no externalities etc. But in reality this is not the case.

Any deviation from these assumptions or a ‘distortion’ lowers economic welfare. This means that the economy might end up bearing additional costs or benefits from trade, depending on the industry and flow of trade.

In case of imperfect competition (when the domestic firms enjoy significant market power) trade can compel these large domestic firms to compete with foreign firms, thus undermining their market power. This forces them to behave more like competitive firms and cut prices to the benefit of the demanders. But this also comes at the cost of loss in profits to the monopoly owners. An extra benefit is that large domestic firms can earn monopoly profits abroad, and the extra cost is just the opposite, local demanders might have to face monopoly power of foreign firms.

Another assumption that is coupled with perfect competition is the homogeneity of the products. But in real world products tend to be differentiated. The producers of such differentiated goods automatically have market power and with that come the aforementioned benefits and costs. Also, demanders get to choose from a larger variety of products to suit their needs.

In case of market disequilibrium, especially in cases of recession, a deficiency in aggregate demand with downward stickiness of wages causes excess supply in the labor market. In such a case the effect of trade depends on the kind of good the country trades and their labor intensities. An expansion of trade will tend to increase aggregate employment in a country whose exports are more labor intensive than its imports and will tend to reduce employment in countries facing the opposite pattern. In a lot of centrally planned economies making the transition to market economies, more effects follow. Trade obviously relieves shortages. But in centrally planned economies, there is a tendency to find cases of smuggling to meet these shortages, considering the vast potential for profits it has. Thus the additional cost is that trade may undermine the additional profits being made by those who exploit market disequilibrium

Externalities are also a case scenario where trade may affect the potential benefits and costs of a nation. If the activities of producers and consumers have affects on others in the economy that the decision maker has not internalized, then such effects may led to more benefits or costs depending on the pattern of trade. For example, in the case of pollution as an externality, with increase in exports pollution may increase, and with an increase in imports, domestic output may fall and pollution will decrease. If these polluters are optimally regulated, then such pollution will no longer cause an externality as it will internalize the benefits and costs. Pollution policies may also lead to creation of ‘pollution havens’. If environmental policies differ across countries not because the true costs differ but because of differences in the effectiveness of governments, then the costs of creating pollution havens may exceed their benefits.

A type of positive externality is technology spillovers which occur when products between firms are exchanged and workers move along employers. Exports increase production, and thus such spillovers, while imports restrict them. Thus it implies that countries might benefit from interfering in trade to guide the evolution of industries towards sectors that it will benefit from. But technological spillovers are difficult to observe, and even if they aren’t, such policies need to be placed before they occur.

Like any other distortions, those created by government intervention can also be made worse or better by international trade, just depending on the nature of the distortion and the direction of the trade.

So distortions coupled with trade can harm an economy further. Distortions may indeed create situations in which restricting trade could be beneficial. Jagdish Bhagwati on the contrary has showed that in all such cases there exists at least one better policy than restricting trade, a policy that would offset the distortion more directly and avoid some of the costs of restricting trade.

Other Effects of Trade 

One of the greatest environmental benefits of trade is that it can, by allowing pollution havens, concentrate polluting activities to areas where they do the least harm. But it is also argued that international trade will lead to a ‘race to the bottom’ in terms of environmental regulations as firms would want to cut costs to compete with foreign markets. Statistics prove that there exists a causal relationship between rising trade and increasing national income. Thus increase in incomes can help countries fight environmental concerns better. But trade indirectly also leads to extinction and endangering of various animals and wildlife species.

International trade is also seen as a threat to culture as it homogenises what people consume. American consumerism for example, has spread across the globe. This may undermine cultural identities.

Trade has allowed the diffusion of technology from one part of the globe to the others where they can be used more efficiently. On the other hand it has also allowed piracy and counterfeiting to become easier, thus allowing people to exploit the technology, and the owner of the intellectual property may not get proper compensation.

In conclusion, international trade has several monumental benefits offset by severe harms to the world. It has serious effects on income inequalities, environment and seems to work perfectly only under a whole lot of assumptions. Given the realistic world, where such assumptions fail to work, international trade needs to be viewed more critically. Deardorff in his literature mentions the final benefit of international trade as being world peace. More free trade leads to more interdependence between nations. Currently in the global context, the possibility of war between nations seems like a costly affair. And hence any political issues are resolved by other means. In the past, international trade routes have actually been the very reasons for widespread war. But he hopes that in the contemporary world, with more complex trade patterns, international relations and politics can help avoid this problem.

But the debate on free trade and protectionism is a complex one. Keeping in account aforementioned costs, countries might opt for protecting certain industries and sectors of their economies. But then the age old question arises, are the costs offset by the benefits of such trade? If yes, then the world should adopt more trade liberalization. And this seems to be the result that trade theory has reached, and ergo the emergence and need for institutions like GATT and WTO can be justified.

Posted by The Indian Economist | For the Curious Mind