Income Distribution and the Gains from Trade

Income Distribution and the Gains from Trade
We have seen how production possibilities are determined by resources and technology;
how the choice of what to produce is determined by the relative price of cloth; how
changes in the relative price of cloth affect the real incomes of different factors of production;
and how trade affects both relative prices and the economy’s response to those price
changes. Now we can ask the crucial question: Who gains and who loses from international
trade? We begin by asking how the welfare of particular groups is affected, and then
how trade affects the welfare of the country as a whole.
To assess the effects of trade on particular groups, the key point is that international trade
shifts the relative price of the goods that are traded. We just saw in the previous section that
opening to trade will increase the relative price of the good in the new export sector. We can
link this prediction with our results regarding how relative price changes translate into
changes in the distribution of income. More specifically, we saw that the specific factor in
the sector whose relative price increases will gain, and that the specific factor in the other
sector (whose relative price decreases) will lose. We also saw that the welfare changes for
the mobile factor are ambiguous.
The general outcome, then, is simple: Trade benefits the factor that is specific to the
export sector of each country but hurts the factor specific to the import-competing sectors,
with ambiguous effects on mobile factors.
Do the gains from trade outweigh the losses? One way to try to answer this question
would be to sum up the gains of the winners and the losses of the losers and compare
them. The problem with this procedure is that we are comparing welfare, an inherently
subjective thing. A better way to assess the overall gains from trade is to ask a different
question: Could those who gain from trade compensate those who lose and still be better
off themselves? If so, then trade is potentially a source of gain to everyone.
In order to show that there are aggregate gains from trade, we need to state some basic
relationships among prices, production, and consumption. In a country that cannot trade,
the output of a good must equal its consumption. If is consumption of cloth and
consumption of food, then in a closed economy, and . International
trade makes it possible for the mix of cloth and food consumed to differ from the mix
DC = QC DF = QF
DC DF
(PC/PF)2
(PC/PF)1 (PC/PF)2
(PC/PF)1
(PC/PF)2
3In the figure, we assumed that there were no differences in preferences across countries, so we have a single relative
demand curve for each country and the world as a whole.
4We describe how changes in relative prices affect a country’s pattern of trade in more detail in Chapter 6.
64 PART ONE International Trade Theory
produced. While the amounts of each good that a country consumes and produces may
differ, however, a country cannot spend more than it earns: The value of consumption
must be equal to the value of production. That is,
(4-7)
Equation (4-7) can be rearranged to yield the following:
(4-8)
is the economy’s food imports, the amount by which its consumption of food
exceeds its production. The right-hand side of the equation is the product of the relative
price of cloth and the amount by which production of cloth exceeds consumption, that is,
the economy’s exports of cloth. The equation, then, states that imports of food equal
exports of cloth times the relative price of cloth. While it does not tell us how much the
economy will import or export, the equation does show that the amount the economy can
afford to import is limited, or constrained, by the amount it exports. Equation (4-8) is
therefore known as a budget constraint.5
Figure 4-11 illustrates two important features of the budget constraint for a trading economy.
First, the slope of the budget constraint is minus , the relative price of cloth. The
reason is that consuming one less unit of cloth saves the economy ; this is enough to purchase
extra units of food. In other words, one unit of cloth can be exchanged on
world markets for units of food. Second, the budget constraint is tangent to the production
possibility frontier at the chosen production point (shown as point 1 here and in
Figure 4-5). Thus, the economy can always afford to consume what it produces.
PC/PF
PC/PF
PC
PC/PF
DF - QF
DF - QF = 1PC/PF2 * 1QC - DC2.
PC * DC + PF * DF = PC * QC + PF * QF.
5The constraint that the value of consumption equals that of production (or, equivalently, that imports equal
exports in value) may not hold when countries can borrow from other countries or lend to them. For now we
assume that these possibilities are not available and that the budget constraint (equation (4-8)) therefore holds.
International borrowing and lending are examined in Chapter 6, which shows that an economy’s consumption
over time is still constrained by the necessity of paying its debts to foreign lenders.
Consumption of food, DF
Output of food, QF
Consumption of
cloth, DC
Output of
cloth, QC
PP
1
Budget constraint
(slope = – PC/PF )
2
QC
1
QF
1
Figure 4-11
Budget Constraint for a Trading
Economy and Gains from Trade
Point 1 represents the economy’s
production. The economy can
choose its consumption point
along its budget constraint (a line
that passes through point 1 and
has a slope equal to minus the relative
price of cloth). Before trade,
the economy must consume what
it produces, such as point 2 on the
production possibility frontier
. The portion of the budget
constraint in the colored region
consists of feasible post-trade
consumption choices, with consumption
of both goods higher
than at pretrade point 2.
1PP2
CHAPTER 4 Specific Factors and Income Distribution 65
To illustrate that trade is a source of potential gain for everyone, we proceed in three
steps:
1. First, we notice that in the absence of trade, the economy would have to produce what
it consumed, and vice versa. Thus the consumption of the economy in the absence of
trade would have to be a point on the production possibility frontier. In Figure 4-11, a
typical pretrade consumption point is shown as point 2.
2. Next, we notice that it is possible for a trading economy to consume more of both goods
than it would have in the absence of trade. The budget constraint in Figure 4-11 represents
all the possible combinations of food and cloth that the country could consume
given the world relative price of cloth. Part of that budget constraint—the part in the colored
region—represents situations in which the economy consumes more of both cloth
and food than it could in the absence of trade. Notice that this result does not depend on
the assumption that pretrade production and consumption is at point 2; unless pretrade
production is at point 1, so that trade has no effect on production at all, there is always a
part of the budget constraint that allows the consumption of more of both goods.
3. Finally, observe that if the economy as a whole consumes more of both goods, then it
is possible in principle to give each individual more of both goods. This would make
everyone better off. This shows, then, that it is possible to ensure that everyone is better
off as a result of trade. Of course, everyone might be even better off if they had less
of one good and more of the other, but this only reinforces the conclusion that everyone
has the potential to gain from trade.
The fundamental reason why trade potentially benefits a country is that it expands the
economy’s choices. This expansion of choice means that it is always possible to redistribute
income in such a way that everyone gains from trade.6
That everyone could gain from trade unfortunately does not mean that everyone actually
does. In the real world, the presence of losers as well as winners from trade is one of
the most important reasons why trade is not free.