National Welfare Arguments Against Free Trade
Most tariffs, import quotas, and other trade policy measures are undertaken primarily to
protect the income of particular interest groups. Politicians often claim, however, that the
policies are being undertaken in the interest of the nation as a whole, and sometimes they
are even telling the truth. Although economists often argue that deviations from free trade
reduce national welfare, there are, in fact, some theoretical grounds for believing that
activist trade policies can sometimes increase the welfare of the nation as a whole.
CHAPTER 10 The Political Economy of Trade Policy 225
The Terms of Trade Argument for a Tariff
One argument for deviating from free trade comes directly out of cost-benefit analysis:
For a large country that is able to affect the prices of foreign exporters, a tariff lowers the
price of imports and thus generates a terms of trade benefit. This benefit must be set
against the costs of the tariff, which arise because the tariff distorts production and consumption
incentives. It is possible, however, that in some cases the terms of trade benefits
of a tariff outweigh its costs, so there is a terms of trade argument for a tariff.
The appendix to this chapter shows that for a sufficiently small tariff, the terms of trade
benefits must outweigh the costs. Thus at small tariff rates, a large country’s welfare is
higher than with free trade (Figure10-2). As the tariff rate is increased, however, the costs
eventually begin to grow more rapidly than the benefits and the curve relating national
welfare to the tariff rate turns down. A tariff rate that completely prohibits trade ( in
Figure 10-2) leaves the country worse off than with free trade; further increases in the
tariff rate beyond have no effect, so the curve flattens out.
At point 1 on the curve in Figure 10-2, corresponding to the tariff rate , national welfare
is maximized. The tariff rate that maximizes national welfare is the optimum tariff.
(By convention, the phrase optimum tariff is usually used to refer to the tariff justified by
a terms of trade argument rather than to the best tariff given all possible considerations.)
The optimum tariff rate is always positive but less than the prohibitive rate that would
eliminate all imports.
What policy would the terms of trade argument dictate for export sectors? Since an
export subsidy worsens the terms of trade, and therefore unambiguously reduces national
welfare, the optimal policy in export sectors must be a negative subsidy, that is, a tax on
exports that raises the price of exports to foreigners. Like the optimum tariff, the optimum
export tax is always positive but less than the prohibitive tax that would eliminate exports
completely.
The policy of Saudi Arabia and other oil exporters has been to tax their exports of
oil, raising the price to the rest of the world. Although oil prices have fluctuated up and
down over the years, it is hard to argue that Saudi Arabia would have been better off
under free trade.
The terms of trade argument against free trade has some important limitations, however.
Most small countries have very little ability to affect the world prices of either their
(tp)
to
to
tp
tp
National welfare
Optimum
tariff, to
Prohibitive
tariff rate, tp
Tariff rate
1
Figure 10-2
The Optimum Tariff
For a large country, there is an
optimum tariff at which the
marginal gain from improved terms
of trade just equals the marginal
efficiency loss from production
and consumption distortion.
to
226 PART TWO International Trade Policy
imports or their exports, and thus the terms of trade argument is of little practical importance
to them. For big countries like the United States, the problem is that the terms of
trade argument amounts to an argument for using national monopoly power to extract
gains at other countries’ expense. The United States could surely do this to some extent,
but such a predatory policy would probably bring retaliation from other large countries.
A cycle of retaliatory trade moves would, in turn, undermine the attempts at international
trade policy coordination described later in this chapter.
The terms of trade argument against free trade, then, is intellectually impeccable but of
doubtful usefulness. In practice, it is more often emphasized by economists as a theoretical
proposition than actually used by governments as a justification for trade policy.
The Domestic Market Failure Argument Against Free Trade
Leaving aside the issue of the terms of trade, the basic theoretical case for free trade rested
on cost-benefit analysis using the concepts of consumer and producer surplus. Many
economists have made a case against free trade based on the counterargument that these
concepts, producer surplus in particular, do not properly measure costs and benefits.
Why might producer surplus not properly measure the benefits of producing a good?
We consider a variety of reasons in the next two chapters: These include the possibility
that the labor used in a sector would otherwise be unemployed or underemployed, the
existence of defects in the capital or labor markets that prevent resources from being transferred
as rapidly as they should be to sectors that yield high returns, and the possibility of
technological spillovers from industries that are new or particularly innovative. These can
all be classified under the general heading of domestic market failures. That is, in each of
these examples, some market in the country is not doing its job right—the labor market is
not clearing, the capital market is not allocating resources efficiently, and so on.
Suppose, for example, that the production of some good yields experience that will
improve the technology of the economy as a whole but that the firms in the sector cannot
appropriate this benefit and therefore do not take it into account in deciding how much to
produce. Then there is a marginal social benefit to additional production that is not
captured by the producer surplus measure. This marginal social benefit can serve as a
justification for tariffs or other trade policies.
Figure 10-3 illustrates the domestic market failure argument against free trade.
Figure 10-3a shows the conventional cost-benefit analysis of a tariff for a small country
(which rules out terms of trade effects). Figure 10-3b shows the marginal benefit from
production that is not taken account of by the producer surplus measure. The figure shows
the effects of a tariff that raises the domestic price from to . Production rises
from to , with a resulting production distortion indicated by the area labeled a.
Consumption falls from to , with a resulting consumption distortion indicated by the
area b. If we considered only consumer and producer surplus, we would find that the costs
of the tariff exceed its benefits. Figure 10-3b shows, however, that this calculation overlooks
an additional benefit that may make the tariff preferable to free trade. The increase
in production yields a social benefit that may be measured by the area under the marginal
social benefit curve from to , indicated by c. In fact, by an argument similar to that
in the terms of trade case, we can show that if the tariff is small enough, the area c must
always exceed the area and that there is some welfare-maximizing tariff that yields
a level of social welfare higher than that of free trade.
The domestic market failure argument against free trade is a particular case of a more
general concept known in economics as the theory of the second best. This theory states
that a hands-off policy is desirable in any one market only if all other markets are working
properly. If they are not, a government intervention that appears to distort incentives in one
a + b
S1 S2
D1 D2
S1 S2
PW PW + t
CHAPTER 10 The Political Economy of Trade Policy 227
market may actually increase welfare by offsetting the consequences of market failures
elsewhere. For example, if the labor market is malfunctioning and fails to deliver full
employment, a policy of subsidizing labor-intensive industries, which would be undesirable
in a full-employment economy, might turn out to be a good idea. It would be better to
fix the labor market by, for example, making wages more flexible, but if for some reason
this cannot be done, intervening in other markets may be a “second-best” way of alleviating
the problem.
When economists apply the theory of the second best to trade policy, they argue that
imperfections in the internal functioning of an economy may justify interfering in its
external economic relations. This argument accepts that international trade is not the
source of the problem but suggests nonetheless that trade policy can provide at least a
partial solution.
How Convincing Is the Market Failure Argument?
When they were first proposed, market failure arguments for protection seemed to undermine
much of the case for free trade. After all, who would want to argue that the real economies we
live in are free from market failures? In poorer nations, in particular, market imperfections
seem to be legion. For example, unemployment and massive differences between rural and
urban wage rates are present in many less-developed countries (Chapter 11). The evidence that
markets work badly is less glaring in advanced countries, but it is easy to develop hypotheses
suggesting major market failures there as well—for example, the inability of innovative firms
to reap the full rewards of their innovations. How can we defend free trade given the likelihood
that there are interventions that could raise national welfare?
Price, P
Quantity, Q
S
D
PW + t
PW
(b)
D2 D1
S1 S2
Dollars
Marginal
social
benefit
Quantity, Q
(a)
S1 S2
a b
c
Figure 10-3
The Domestic Market Failure
Argument for a Tariff
If production of a good yields
extra social benefits (measured in
panel (b) by area c) not captured
as producer surplus, a tariff can
increase welfare.
228 PART TWO International Trade Policy
There are two lines of defense for free trade: The first argues that domestic market failures
should be corrected by domestic policies aimed directly at the problems’ sources; the
second argues that economists cannot diagnose market failure well enough to prescribe
policy.
The point that domestic market failure calls for domestic policy changes, not international
trade policies, can be made by cost-benefit analysis modified to account for any
unmeasured marginal social benefits. Figure 10-3 showed that a tariff might raise welfare,
despite the production and consumption distortions it causes, because it leads to additional
production that yields social benefits. If the same production increase were achieved via a
production subsidy rather than a tariff, however, the price to consumers would not increase
and the consumption loss b would be avoided. In other words, by targeting directly the particular
activity we want to encourage, a production subsidy would avoid some of the side
costs associated with a tariff.
This example illustrates a general principle when dealing with market failures: It is
always preferable to deal with market failures as directly as possible, because indirect
policy responses lead to unintended distortions of incentives elsewhere in the economy.
Thus, trade policies justified by domestic market failure are never the most efficient
response; they are always “second-best” rather than “first-best” policies.
This insight has important implications for trade policy makers: Any proposed trade policy
should always be compared with a purely domestic policy aimed at correcting the same
problem. If the domestic policy appears too costly or has undesirable side effects, the trade
policy is almost surely even less desirable—even though the costs are less apparent.
In the United States, for example, an import quota on automobiles has been supported on
the grounds that it is necessary to save the jobs of autoworkers. The advocates of an import
quota argue that U.S. labor markets are too inflexible for autoworkers to remain employed
either by cutting their wages or by finding jobs in other sectors. Now consider a purely
domestic policy aimed at the same problem: a subsidy to firms that employ autoworkers. Such
a policy would encounter massive political opposition. For one thing, to preserve current levels
of employment without protection would require large subsidy payments, which would
either increase the federal government’s budget deficit or require a tax increase. Furthermore,
autoworkers are among the highest-paid workers in the manufacturing sector; the general
public would surely object to subsidizing them. It is hard to believe an employment subsidy
for autoworkers could pass Congress. Yet an import quota would be even more expensive,
because while it would bring about the same increase in employment, it would also distort
consumer choice. The only difference is that the costs would be less visible, taking the form
of higher automobile prices rather than direct government outlays.
Critics of the domestic market failure justification for protection argue that this case is
typical: Most deviations from free trade are adopted not because their benefits exceed their
costs but because the public fails to understand their true costs. Comparing the costs of
trade policy with alternative domestic policies is thus a useful way to focus attention on
just how large these costs are.
The second defense of free trade is that because market failures are typically hard to
identify precisely, it is difficult to be sure what the appropriate policy response should be.
For example, suppose there is urban unemployment in a less-developed country; what is
the appropriate policy? One hypothesis (examined more closely in Chapter 11) says that a
tariff to protect urban industrial sectors will draw the unemployed into productive work
and thus generate social benefits that would more than compensate for the tariff’s costs.
However, another hypothesis says that this policy will encourage so much migration to
urban areas that unemployment will, in fact, increase. It is difficult to say which of these
hypotheses is right. While economic theory says much about the working of markets that
function properly, it provides much less guidance on those that don’t; there are many ways
CHAPTER 10 The Political Economy of Trade Policy 229
in which markets can malfunction, and the choice of a second-best policy depends on the
details of the market failure.
The difficulty of ascertaining the correct second-best trade policy to follow reinforces
the political argument for free trade mentioned earlier. If trade policy experts are highly
uncertain about how policy should deviate from free trade and disagree among themselves,
it is all too easy for trade policy to ignore national welfare altogether and become
dominated by special-interest politics. If the market failures are not too bad to start with, a
commitment to free trade might in the end be a better policy than opening the Pandora’s
box of a more flexible approach.
This is, however, a judgment about politics rather than about economics. We need to
realize that economic theory does not provide a dogmatic defense of free trade, even
though it is often accused of doing so.
Most tariffs, import quotas, and other trade policy measures are undertaken primarily to
protect the income of particular interest groups. Politicians often claim, however, that the
policies are being undertaken in the interest of the nation as a whole, and sometimes they
are even telling the truth. Although economists often argue that deviations from free trade
reduce national welfare, there are, in fact, some theoretical grounds for believing that
activist trade policies can sometimes increase the welfare of the nation as a whole.
CHAPTER 10 The Political Economy of Trade Policy 225
The Terms of Trade Argument for a Tariff
One argument for deviating from free trade comes directly out of cost-benefit analysis:
For a large country that is able to affect the prices of foreign exporters, a tariff lowers the
price of imports and thus generates a terms of trade benefit. This benefit must be set
against the costs of the tariff, which arise because the tariff distorts production and consumption
incentives. It is possible, however, that in some cases the terms of trade benefits
of a tariff outweigh its costs, so there is a terms of trade argument for a tariff.
The appendix to this chapter shows that for a sufficiently small tariff, the terms of trade
benefits must outweigh the costs. Thus at small tariff rates, a large country’s welfare is
higher than with free trade (Figure10-2). As the tariff rate is increased, however, the costs
eventually begin to grow more rapidly than the benefits and the curve relating national
welfare to the tariff rate turns down. A tariff rate that completely prohibits trade ( in
Figure 10-2) leaves the country worse off than with free trade; further increases in the
tariff rate beyond have no effect, so the curve flattens out.
At point 1 on the curve in Figure 10-2, corresponding to the tariff rate , national welfare
is maximized. The tariff rate that maximizes national welfare is the optimum tariff.
(By convention, the phrase optimum tariff is usually used to refer to the tariff justified by
a terms of trade argument rather than to the best tariff given all possible considerations.)
The optimum tariff rate is always positive but less than the prohibitive rate that would
eliminate all imports.
What policy would the terms of trade argument dictate for export sectors? Since an
export subsidy worsens the terms of trade, and therefore unambiguously reduces national
welfare, the optimal policy in export sectors must be a negative subsidy, that is, a tax on
exports that raises the price of exports to foreigners. Like the optimum tariff, the optimum
export tax is always positive but less than the prohibitive tax that would eliminate exports
completely.
The policy of Saudi Arabia and other oil exporters has been to tax their exports of
oil, raising the price to the rest of the world. Although oil prices have fluctuated up and
down over the years, it is hard to argue that Saudi Arabia would have been better off
under free trade.
The terms of trade argument against free trade has some important limitations, however.
Most small countries have very little ability to affect the world prices of either their
(tp)
to
to
tp
tp
National welfare
Optimum
tariff, to
Prohibitive
tariff rate, tp
Tariff rate
1
Figure 10-2
The Optimum Tariff
For a large country, there is an
optimum tariff at which the
marginal gain from improved terms
of trade just equals the marginal
efficiency loss from production
and consumption distortion.
to
226 PART TWO International Trade Policy
imports or their exports, and thus the terms of trade argument is of little practical importance
to them. For big countries like the United States, the problem is that the terms of
trade argument amounts to an argument for using national monopoly power to extract
gains at other countries’ expense. The United States could surely do this to some extent,
but such a predatory policy would probably bring retaliation from other large countries.
A cycle of retaliatory trade moves would, in turn, undermine the attempts at international
trade policy coordination described later in this chapter.
The terms of trade argument against free trade, then, is intellectually impeccable but of
doubtful usefulness. In practice, it is more often emphasized by economists as a theoretical
proposition than actually used by governments as a justification for trade policy.
The Domestic Market Failure Argument Against Free Trade
Leaving aside the issue of the terms of trade, the basic theoretical case for free trade rested
on cost-benefit analysis using the concepts of consumer and producer surplus. Many
economists have made a case against free trade based on the counterargument that these
concepts, producer surplus in particular, do not properly measure costs and benefits.
Why might producer surplus not properly measure the benefits of producing a good?
We consider a variety of reasons in the next two chapters: These include the possibility
that the labor used in a sector would otherwise be unemployed or underemployed, the
existence of defects in the capital or labor markets that prevent resources from being transferred
as rapidly as they should be to sectors that yield high returns, and the possibility of
technological spillovers from industries that are new or particularly innovative. These can
all be classified under the general heading of domestic market failures. That is, in each of
these examples, some market in the country is not doing its job right—the labor market is
not clearing, the capital market is not allocating resources efficiently, and so on.
Suppose, for example, that the production of some good yields experience that will
improve the technology of the economy as a whole but that the firms in the sector cannot
appropriate this benefit and therefore do not take it into account in deciding how much to
produce. Then there is a marginal social benefit to additional production that is not
captured by the producer surplus measure. This marginal social benefit can serve as a
justification for tariffs or other trade policies.
Figure 10-3 illustrates the domestic market failure argument against free trade.
Figure 10-3a shows the conventional cost-benefit analysis of a tariff for a small country
(which rules out terms of trade effects). Figure 10-3b shows the marginal benefit from
production that is not taken account of by the producer surplus measure. The figure shows
the effects of a tariff that raises the domestic price from to . Production rises
from to , with a resulting production distortion indicated by the area labeled a.
Consumption falls from to , with a resulting consumption distortion indicated by the
area b. If we considered only consumer and producer surplus, we would find that the costs
of the tariff exceed its benefits. Figure 10-3b shows, however, that this calculation overlooks
an additional benefit that may make the tariff preferable to free trade. The increase
in production yields a social benefit that may be measured by the area under the marginal
social benefit curve from to , indicated by c. In fact, by an argument similar to that
in the terms of trade case, we can show that if the tariff is small enough, the area c must
always exceed the area and that there is some welfare-maximizing tariff that yields
a level of social welfare higher than that of free trade.
The domestic market failure argument against free trade is a particular case of a more
general concept known in economics as the theory of the second best. This theory states
that a hands-off policy is desirable in any one market only if all other markets are working
properly. If they are not, a government intervention that appears to distort incentives in one
a + b
S1 S2
D1 D2
S1 S2
PW PW + t
CHAPTER 10 The Political Economy of Trade Policy 227
market may actually increase welfare by offsetting the consequences of market failures
elsewhere. For example, if the labor market is malfunctioning and fails to deliver full
employment, a policy of subsidizing labor-intensive industries, which would be undesirable
in a full-employment economy, might turn out to be a good idea. It would be better to
fix the labor market by, for example, making wages more flexible, but if for some reason
this cannot be done, intervening in other markets may be a “second-best” way of alleviating
the problem.
When economists apply the theory of the second best to trade policy, they argue that
imperfections in the internal functioning of an economy may justify interfering in its
external economic relations. This argument accepts that international trade is not the
source of the problem but suggests nonetheless that trade policy can provide at least a
partial solution.
How Convincing Is the Market Failure Argument?
When they were first proposed, market failure arguments for protection seemed to undermine
much of the case for free trade. After all, who would want to argue that the real economies we
live in are free from market failures? In poorer nations, in particular, market imperfections
seem to be legion. For example, unemployment and massive differences between rural and
urban wage rates are present in many less-developed countries (Chapter 11). The evidence that
markets work badly is less glaring in advanced countries, but it is easy to develop hypotheses
suggesting major market failures there as well—for example, the inability of innovative firms
to reap the full rewards of their innovations. How can we defend free trade given the likelihood
that there are interventions that could raise national welfare?
Price, P
Quantity, Q
S
D
PW + t
PW
(b)
D2 D1
S1 S2
Dollars
Marginal
social
benefit
Quantity, Q
(a)
S1 S2
a b
c
Figure 10-3
The Domestic Market Failure
Argument for a Tariff
If production of a good yields
extra social benefits (measured in
panel (b) by area c) not captured
as producer surplus, a tariff can
increase welfare.
228 PART TWO International Trade Policy
There are two lines of defense for free trade: The first argues that domestic market failures
should be corrected by domestic policies aimed directly at the problems’ sources; the
second argues that economists cannot diagnose market failure well enough to prescribe
policy.
The point that domestic market failure calls for domestic policy changes, not international
trade policies, can be made by cost-benefit analysis modified to account for any
unmeasured marginal social benefits. Figure 10-3 showed that a tariff might raise welfare,
despite the production and consumption distortions it causes, because it leads to additional
production that yields social benefits. If the same production increase were achieved via a
production subsidy rather than a tariff, however, the price to consumers would not increase
and the consumption loss b would be avoided. In other words, by targeting directly the particular
activity we want to encourage, a production subsidy would avoid some of the side
costs associated with a tariff.
This example illustrates a general principle when dealing with market failures: It is
always preferable to deal with market failures as directly as possible, because indirect
policy responses lead to unintended distortions of incentives elsewhere in the economy.
Thus, trade policies justified by domestic market failure are never the most efficient
response; they are always “second-best” rather than “first-best” policies.
This insight has important implications for trade policy makers: Any proposed trade policy
should always be compared with a purely domestic policy aimed at correcting the same
problem. If the domestic policy appears too costly or has undesirable side effects, the trade
policy is almost surely even less desirable—even though the costs are less apparent.
In the United States, for example, an import quota on automobiles has been supported on
the grounds that it is necessary to save the jobs of autoworkers. The advocates of an import
quota argue that U.S. labor markets are too inflexible for autoworkers to remain employed
either by cutting their wages or by finding jobs in other sectors. Now consider a purely
domestic policy aimed at the same problem: a subsidy to firms that employ autoworkers. Such
a policy would encounter massive political opposition. For one thing, to preserve current levels
of employment without protection would require large subsidy payments, which would
either increase the federal government’s budget deficit or require a tax increase. Furthermore,
autoworkers are among the highest-paid workers in the manufacturing sector; the general
public would surely object to subsidizing them. It is hard to believe an employment subsidy
for autoworkers could pass Congress. Yet an import quota would be even more expensive,
because while it would bring about the same increase in employment, it would also distort
consumer choice. The only difference is that the costs would be less visible, taking the form
of higher automobile prices rather than direct government outlays.
Critics of the domestic market failure justification for protection argue that this case is
typical: Most deviations from free trade are adopted not because their benefits exceed their
costs but because the public fails to understand their true costs. Comparing the costs of
trade policy with alternative domestic policies is thus a useful way to focus attention on
just how large these costs are.
The second defense of free trade is that because market failures are typically hard to
identify precisely, it is difficult to be sure what the appropriate policy response should be.
For example, suppose there is urban unemployment in a less-developed country; what is
the appropriate policy? One hypothesis (examined more closely in Chapter 11) says that a
tariff to protect urban industrial sectors will draw the unemployed into productive work
and thus generate social benefits that would more than compensate for the tariff’s costs.
However, another hypothesis says that this policy will encourage so much migration to
urban areas that unemployment will, in fact, increase. It is difficult to say which of these
hypotheses is right. While economic theory says much about the working of markets that
function properly, it provides much less guidance on those that don’t; there are many ways
CHAPTER 10 The Political Economy of Trade Policy 229
in which markets can malfunction, and the choice of a second-best policy depends on the
details of the market failure.
The difficulty of ascertaining the correct second-best trade policy to follow reinforces
the political argument for free trade mentioned earlier. If trade policy experts are highly
uncertain about how policy should deviate from free trade and disagree among themselves,
it is all too easy for trade policy to ignore national welfare altogether and become
dominated by special-interest politics. If the market failures are not too bad to start with, a
commitment to free trade might in the end be a better policy than opening the Pandora’s
box of a more flexible approach.
This is, however, a judgment about politics rather than about economics. We need to
realize that economic theory does not provide a dogmatic defense of free trade, even
though it is often accused of doing so.
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