International Trade Theory and Policy
by Steven M. Suranovic

Trade 120-3

Free Trade and the Distribution of Income

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. Lionel Robbins (?) once wrote that the objective of the economics discipline is to determine how to allocate scarce resources towards production and consumption. Economics describes 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 which 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 for compensation to work, 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. A 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 which, 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.(1) The simple way to eliminate this problem, conceptually, is to suggest that the redistribution take place as a "lump-sum" redistribution. A lump-sum redistribution 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.

What all of this implies is 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 resistence to free trade and trade liberalization. This resistence is perfectly valid. Afterall, 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 which 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 special benefits are being eliminated for those groups. On the other hand, those groups that benefit from free trade are the same one's 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, the difficulty of identifying who lost and who gained and by how much would be virtually impossible to achieve thus making this compensation scheme equally unworkable.

1. It has been shown that under some conditions it is possible to specify a tax and subsidy policy which would guarantee an increase in aggregate economic efficiency with free trade. (See for example Dixit and Norman (1980)). Go Back

International Trade Theory and Policy - Chapter 120-3: Last Updated on 2/17/07