Chapter 6: Market Failures
2nd Edition, Published 2026. Jennifer Brogee, editor. See Contributing Authors section for original authors. License: 
Attribution-NonCommercial-ShareAlike CC BY-NC-SA
What are market failures?
Most models showing the advantages of international trade and the costs associated with protection assume that the world is perfectly competitive. The problem is that for a variety of reasons markets are usually not perfectly competitive, at least not completely so. Economists use the term “market imperfections” to describe situations that deviate from perfect competition. And when such deviations occur, interesting things happen.
For example, it is valid to say that in a world with market imperfections, free trade may not be the best policy to maximize national welfare; instead, some type of trade protection may be better. This chapter illustrates a series of examples with models that incorporate market imperfections to demonstrate this result. However, application of another theory in economics, the theory of the second best, and some other issues are shown to mitigate this result. In other words, even though trade policies can be used to raise a nation’s welfare, there may be a better way to achieve a superior result.
6.1 Chapter Overview
Learning Objectives
Understand that the presence of market imperfections or distortions in a trade model changes the potential outcomes of trade policies.
Learn the basic terminology used in discussing the theory of the second best.
Most of the models previously discussed incorporate a very standard economic assumption: namely, that markets are perfectly competitive. This was true in the Ricardian model, the Heckscher-Ohlin model, the specific factor model, and all the partial equilibrium analyses of trade and domestic policies using supply and demand curves in specific markets. The only deviation from perfect competition was in the discussion of economies-of-scale models and monopolistic competition. This is important because almost all the results concerning the effects of trade and trade policies presume that markets are perfectly competitive. But what if they’re not?
Many critics of the economic conclusions about trade argue that the assumptions of perfect competition are unrealistic and that as a result standard trade theory misses some of the important impacts of trade found in the real world. There is much truth to this. By default, perfect competition models include many assumptions that are unrealistic. However, in defense, that is the nature of model building. Simplification is necessary to make the models tractable and solvable. If we were to try to create a model that included many or most of the complexities that we can imagine are present in real-world markets, we would no doubt quickly be overwhelmed with the model’s intractability and might find it impossible to even identify an equilibrium solution. Indeed, in the real world, being in “equilibrium” might even be a rare occurrence.
Criticisms of economic theory along these lines, however, fail to recognize that economic analysis includes many attempts to incorporate market realities. Although it remains difficult to include many complexities simultaneously, it is possible to study them in a piecemeal way: one at a time.
The all-encompassing terms economists use to describe these complexities are market imperfections, or market failures, and market distortions. These cases are worthy of study because it is clear that markets rarely satisfy all the assumptions made under perfect competition. These cases offer compelling arguments for protection, including the infant industry argument, the optimal tariff argument, strategic trade policy arguments, and arguments concerning national security.
Market imperfections or market distortions
Any situation that deviates from the explicit or implicit assumptions of perfect competition., generally, are any deviations from the assumptions of perfect competition. These include monopoly and oligopoly markets, production with increasing returns to scale, markets that do not clear, negative and positive externalities in production and consumption, and the presence of public goods.
When imperfections or distortions are present in a trade model, it is usually possible to identify a trade policy that can raise aggregate economic efficiency. In this chapter many cases are demonstrated in which trade policies improve national welfare. These welfare-improving policies, although detrimental to national welfare when used in a perfectly competitive setting, act to correct the imperfections or distortions present in the market. As long as the welfare impact of the correction exceeds the standard welfare loss associated with the trade policy, the policy will raise welfare.
Trade policies with market imperfections and distortions represent applications of the theory of the second best
Describes the class of models that consider policy implications in the presence of market imperfections and distortions., formalized by Richard G. Lipsey and Kelvin Lancaster.See R. G. Lipsey and K. Lancaster, “The General Theory of the Second Best,” Review of Economic Studies 24 (1956): 11–32. When imperfections or distortions are present in an international trade model, we describe the resulting equilibrium as second best. In this case, the standard policy prescriptions to maximize national welfare in a first-best or nondistorted economy will no longer hold true. Also, the implementation of what would be a detrimental policy in a first-best world can become a beneficial policy when implemented within a second-best world. For example, tariffs applied by a small country in the presence of domestic distortions can sometimes raise national welfare.
In 1971, Jagdish Bhagwati presented a general theory of distortions in trade situations. See J. N. Bhagwati, “The Generalized Theory of Distortions and Welfare,” in Trade, Balance of Payments and Growth, ed. J. N. Bhagwati, R. W. Jones, R. A. Mundell, and J. Vanek (Amsterdam: North-Holland Publishing Co., 1971). He characterized many of the distortions that can occur and considered which policies could be used to correct each distortion and raise national welfare. He considered not only trade policies but also domestic tax or subsidy policies. He showed that for most distortions, a trade policy is inferior (in terms of the extent to which it can raise national welfare) to other purely domestic policies.
The most appropriate or first-best policy
The policy that raises welfare to the highest level possible; with market imperfections or distortions present, the policy that most directly corrects the distortion or imperfection., in general, would be the policy that most directly corrects the distortion or imperfection present in the market. This chapter provides numerous examples of policy rankings and applications of this general rule.
In one case, a trade policy does prove to be first best. This is the case of a large import or export country in international markets. In this case, the first-best policy is the optimal tariff or the optimal export tax.
Thus the results of this section are somewhat schizophrenic. On the one hand, these models offer some of the most compelling arguments supporting protection. For example, one can easily use these models to justify protection when national defense is a concern, when unemployment may arise in a market, when trade causes environmental degradation, or when there are infant industries in a country. On the other hand, in almost all of these cases, a trade policy is not the most effective policy tool available to correct the problems caused by the distortion or imperfection.
Finally, when more complex markets are considered, as when there are multiple distortions or imperfections present simultaneously, our ability to identify welfare-improving policies rapidly diminishes. The theory of the second best states that correcting one distortion in the presence of many may not improve welfare even if the policy makes perfect sense within the partial equilibrium framework containing the one distortion. The reason is that correcting one distortion may have unintentional (and probably immeasurable) impacts in other sectors due to the presence of other distortions. For example, suppose a trade policy is implemented to correct an environmental problem. One might be able to measure the welfare costs of the trade policy and the environmental benefits that would accrue to society and conclude that the benefits exceed the costs. However, the trade policy will have an impact on prices and resource allocation, potentially spreading across numerous sectors. Suppose one other sector, adversely affected, generates positive spillover effects that act to raise well-being for some groups. Then it is conceivable that the loss of the positive spillover effects would more than outweigh the net benefit accruing to society due to the environmental improvement. This means that the well-intentioned and reasonably measured environmental trade policy could result in an unintentional welfare loss for the nation. The more complex is the economy and the more distortions and imperfections that are present, the more likely it is that we simply cannot know what the national effects of trade policies will be.
Key Takeaways
In the presence of market imperfections or distortions, free trade may no longer be the best policy, even for a small open economy.
Although trade policies can sometimes generate national welfare improvements, trade policies are often second-best policies, meaning that there are other nontrade policies that are superior (called first-best policies).
The first-best policy is the policy that targets and corrects the market imperfection as directly as possible.
Exercise
Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
The term describing any assumption that represents a deviation from the standard assumptions of perfect competition.
The term describing a policy that most directly corrects the market imperfection or distortion in a market.
The name of the theory describing the class of models that consider policy implications in the presence of market imperfections and distortions.
6.2 Market Failures Defined
Learning Objectives
Identify the various types of market failures.
Recognize that market imperfections and distortions are widespread in real-world markets.
Market imperfections and distortions, generally, are any deviations from the assumptions of perfect competition. Many of the assumptions in a perfectly competitive model are implicit rather than explicit—that is, they are not always stated.
Below are descriptions of many different types of imperfections and distortions. Perfect competition models assume the absence of these items.
Monopoly, Duopoly, and Oligopoly
Perhaps the most straightforward deviation from perfect competition occurs when there are a relatively small number of firms operating in an industry. At the extreme, one firm produces for the entire market, in which case the firm is referred to as a monopoly. A monopoly has the ability to affect both its output and the price that prevails on the market. A duopoly consists of two firms operating in a market. An oligopoly represents more than two firms in a market but less than the many, many firms assumed in a perfectly competitive market. The key distinction between an oligopoly and perfect competition is that oligopoly firms have some degree of influence over the price that prevails in the market.
Another key feature of these imperfectly competitive markets is that the firms within them make positive economic profits. The profits, however, are not sufficient to encourage entry of new firms into the market. In other words, free entry in response to profit is not possible. The typical method of justifying this is by assuming that there are relatively high fixed costs. High fixed costs, in turn, imply increasing returns to scale. Thus most monopoly and oligopoly models assume some form of imperfect competition.
Large Countries in International Trade
Surprisingly, “large” importing countries and “large” exporting countries have a market imperfection present. This imperfection is more easily understood if we use the synonymous terms for “largeness,” monopsony and monopoly power. Large importing countries are said to have “monopsony power in trade... Another term to describe a large importing country—that is, a country whose policy actions can affect international prices.,” while large exporting countries are said to have “monopoly power in trade... Another term to describe a large exporting country—that is, a country whose policy actions can affect international prices..” Let’s first consider monopoly power.
When a large exporting country implements a trade policy, it will affect the world market price for the good. That is the fundamental implication of largeness. For example, if a country imposes an export tax, the world market price will rise because the exporter will supply less. An export tax set optimally will cause an increase in national welfare due to the presence of a positive terms of trade effect. This effect is analogous to that of a monopolist operating in its own market. A monopolist can raise its profit (i.e., its firm’s welfare) by restricting supply to the market and raising the price it charges its consumers. In much the same way, a large exporting country can restrict its supply to international markets with an export tax, force the international price up, and create benefits for itself with the terms of trade gain. The term monopoly “power” is used because the country is not a pure monopoly in international markets. There may be other countries exporting the product as well. Nonetheless, because its exports are a sufficiently large share of the world market, the country can use its trade policy in a way that mimics the effects caused by a pure monopoly, albeit to a lesser degree. Hence the country is not a monopolist in the world market but has “monopoly power” instead.
Similarly, when a country is a large importer of a good, we say that it has “monopsony power.” A monopsony represents a case in which there is a single buyer in a market where there are many sellers. A monopsony raises its own welfare or utility by restricting its demand for the product and thereby forcing the sellers to lower their price. By buying fewer units at a lower price, the monopsony becomes better off. In much the same way, when a large importing country places a tariff on imports, the country’s demand for that product on world markets falls, which in turn lowers the world market price. An import tariff set optimally will raise national welfare due to the positive terms of trade effect. The effects in these two situations are analogous. We say that the country has monopsony “power” because the country may not be the only importer of the product in international markets, yet because of its large size, it has “power” like a pure monopsony.
Externalities
Externalities: Economic actions that have effects external to the market in which the action is taken. are economic actions that have effects external to the market in which the action is taken. Externalities can arise from production processes (production externalities) or from consumption activities (consumption externalities). The external effects can be beneficial to others (positive externalities) or detrimental to others (negative externalities). Typically, because the external effects impact someone other than the producer or consumers, the producer and the consumers do not take the effects into account when they make their production or consumption decisions. We shall consider each type in turn.
Positive Production Externalities
Positive production externalities occur when production has a beneficial effect in other markets in the economy. Most examples of positive production externalities incorporate some type of learning effect.
For example, manufacturing production is sometimes considered to have positive spillover effects, especially for countries that are not highly industrialized. By working in a factory, the production workers and managers all learn what it takes to operate the factory successfully. These skills develop and grow over time, a process sometimes referred to as learning by doing. The skills acquired by the workers, however, are likely to spill over to others in the rest of the economy. Why? Because workers will talk about their experiences with other family members and friends. Factory managers may teach others their skills at local vocational schools. Some workers will leave to take jobs at other factories, carrying with them the skills that they acquired at the first factory. In essence, learning spillovers are analogous to infectious diseases. Workers who acquire skills in one factory in turn will infect other workers they come into contact with and will spread the skill disease through the economy.
A similar story is told concerning research and development (R&D). When a firm does R&D, its researchers learn valuable things about production that in turn are transmitted through the rest of the economy and have positive impacts on other products or production processes.
Negative Production Externalities
Negative production externalities occur when production has a detrimental effect in other markets in the economy. The negative effects could be felt by other firms or by consumers. The most common example of negative production externalities involves pollution or other environmental effects.
When a factory emits smoke into the air, the pollution will reduce the well-being of all the individuals who must breathe the polluted air. The polluted air will also likely require more frequent cleaning by businesses and households, raising the cost incurred by them.
Water pollution would have similar effects. A polluted river cannot be used for recreational swimming or at least reduces swimmers’ pleasures as the pollution rises. The pollution can also eliminate species of flora and fauna and change the entire ecosystem.
Positive Consumption Externalities
Positive consumption externalities occur when consumption has a beneficial effect in other markets in the economy. Most examples of positive consumption externalities involve some type of aesthetic effect.
Thus when homeowners landscape their properties and plant beautiful gardens, it benefits not only themselves but also neighbors and passersby. In fact, an aesthetically pleasant neighborhood where yards are neatly kept and homes are well maintained would generally raise the property values of all houses in the neighborhood.
One could also argue that a healthy lifestyle has positive external effects on others by reducing societal costs. A healthier person would reduce the likelihood of expensive medical treatment and lower the cost of insurance premiums or the liability of the government in state-funded health care programs.
Negative Consumption Externalities
Negative production externalities occur when consumption has a detrimental effect in other markets in the economy. Most examples of negative consumption externalities involve some type of dangerous behavior.
Thus a mountain climber in a national park runs the risk of ending up in a precarious situation. Sometimes climbers become stranded due to storms or avalanches. This usually leads to expensive rescue efforts, the cost of which is generally borne by the government and hence the taxpayers.
A drunk driver places other drivers at increased risk. In the worst outcome, the drunk driver causes the death of another. A smoker may also put others at risk if secondhand smoke causes negative health effects. At the minimum, cigarette smoke surely bothers nonsmokers when smoking occurs in public enclosed areas.
Public Goods
Public goods: Goods that are nonrival (the consumption or use of a good by one consumer does not diminish the usefulness of the good to another) and nonexcludable (once the good is provided, it is exceedingly costly to exclude nonpaying customers from using it). have two defining characteristics: nonrivalry and nonexcludability.
Nonrivalry
A situation in which consumption or use of a good by one consumer does not diminish the usefulness of the good to another. means that the consumption or use of a good by one consumer does not diminish the usefulness of the good to another.
Nonexcludability
A situation in which once the good is provided, it is exceedingly costly to exclude nonpaying customers from using it. means that once the good is provided, it is exceedingly costly to exclude nonpaying customers from using it. The main problem posed by public goods is the difficulty of getting people to pay for them in a free market.
The classic example of a public good is a lighthouse perched on a rocky shoreline. The lighthouse sends a beacon of light outward for miles, warning every passing ship of the danger nearby. Since two ships passing are equally warned of the risk, the lighthouse is nonrival. Since it would be impossible to provide the lighthouse services only to those passing ships that paid for the service, the lighthouse is nonexcludable.
The other classic example of a public good is national security or national defense. The armed services provide security benefits to everyone who lives within the borders of a country. Also, once provided, it is difficult to exclude nonpayers.
Information has public good characteristics as well. Indeed, this is one reason for the slow start of electronic information services on the World Wide Web. Once information is placed on a Web site, it can be accessed and used by millions of consumers almost simultaneously. Thus it is nonrival. Also, it can be difficult, although not impossible, to exclude nonpaying customers from accessing the services.
Nonclearing Markets
A standard assumption in general equilibrium models is that markets always clear—that is, supply equals demand at the equilibrium. In actuality, however, markets do not always clear. When markets do not clear, for whatever reason, the market is distorted.
The most obvious case of a nonclearing market occurs when there is unemployment in the labor market. Unemployment could arise if there is price stickiness in the downward direction, as when firms are reluctant to lower their wages in the face of restricted demand. Alternatively, unemployment may arise because of costly adjustment when some industries expand while others contract. As described in the immobile factor model, many factors would not immediately find alternative employment after being laid off from a contracting industry. In the interim, the factors must search for alternative opportunities, may need to relocate to another geographical location, or may need to be retrained. During this phase, the factors remain unemployed.
Imperfect Information
One key assumption often made in perfectly competitive models is that agents have perfect information. If some of the participants in the economy do not have full and complete information in order to make decisions, then the market is distorted.
For example, suppose entrepreneurs did not know that firms in an industry were making positive economic profits. Without this information, new firms would not open to force economic profit to zero in the industry. As such, imperfect information can create a distortion in the market.
Policy-Imposed Distortions
Another type of distortion occurs when government policies are set in markets that are perfectly competitive and exhibit no other distortions or imperfections. These were labeled policy-imposed distortions by Jagdish Bhagwati since they do not arise naturally but rather via legislation.
Thus suppose the government of a small country sets a trade policy, such as a tariff on imports. In this case, the equilibrium that arises with the tariff in place is a distorted equilibrium.
Key Takeaways
An implicit assumption of perfect competition models is that there are no market imperfections or distortions in place.
Among some of the most common market imperfections are monopolies, oligopolies, large countries in trade, externalities, public goods, nonclearing markets, imperfect information, and government tax and subsidy policies.
Externality effects can arise from production or consumption activities.
Externalities can be positive or negative in their effects.
Exercise
Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
The term used to describe the favorable effect that a production activity can have in another market.
The term used to describe the detrimental effect that a consumption activity can have on another person.
The two characteristics that identify “public goods.”
The term used to describe the type of distortion that occurs when governments implement taxes, subsidies, or regulations in otherwise perfectly competitive markets.
The type of power a large importing country is said to have.
The type of power a large exporting country is said to have.
6.3 The Theory of the Second Best
Learning Objectives
Understand the key features of the theory of the second best.
Distinguish between first-best and second-best equilibria.
Distinguish between first-best and second-best policies.
The theory of the second best was formalized by Richard Lipsey and Kelvin Lancaster in 1956. The primary focus of the theory is what happens when the optimum conditions are not satisfied in an economic model. Lipsey and Lancaster’s results have important implications for the understanding of not only trade policies but also many other government policies.
In this section, we will provide an overview of the main results and indicate some of the implications for trade policy analysis. We will then consider various applications of the theory to international trade policy issues.
First of all, one must note that economic models consist of exercises in which a set of assumptions is used to deduce a series of logical conclusions. The solution of a model is referred to as an equilibrium. An equilibrium is typically described by explaining the conditions or relationships that must be satisfied in order for the equilibrium to be realized. These are called the equilibrium conditions. In economic models, these conditions arise from the maximizing behavior of producers and consumers. Thus the solution is also called an optimum.
For example, a standard perfectly competitive model includes the following equilibrium conditions: (1) the output price is equal to the marginal cost for each firm in an industry, (2) the ratio of prices between any two goods is equal to each consumer’s marginal rate of substitution between the two goods, (3) the long-run profit of each firm is equal to zero, and (4) supply of all goods is equal to demand for all goods. In a general equilibrium model with many consumers, firms, industries, and markets, there will be numerous equilibrium conditions that must be satisfied simultaneously.
Lipsey and Lancaster’s analysis asks the following simple question: What happens to the other optimal equilibrium conditions when one of the conditions cannot be satisfied for some reason? For example, what happens if one of the markets does not clear—that is, supply does not equal demand in that one market? Would it still be appropriate for the firms to set the price equal to the marginal cost? Should consumers continue to set each price ratio equal to their marginal rate of substitution? Or would it be better if firms and consumers deviated from these conditions? Lipsey and Lancaster show that, generally, when one optimal equilibrium condition is not satisfied, for whatever reason, all the other equilibrium conditions will change. Thus if one market does not clear, it would no longer be optimal for firms to set the price equal to the marginal cost or for consumers to set the price ratio equal to the marginal rate of substitution.
First-Best versus Second-Best Equilibria
Consider a small perfectly competitive open economy that has no market imperfections or distortions, no externalities in production or consumption, and no public goods. This is an economy in which all resources are privately owned, the participants maximize their own well-being, firms maximize profit, and consumers maximize utility—always in the presence of perfect information. Markets always clear and there are no adjustment costs or unemployment of resources.
The optimal government policy in this case is laissez-faire. With respect to trade policies, the optimal policy is free trade. Any type of tax or subsidy implemented by the government under these circumstances can only reduce economic efficiency and national welfare. Thus with a laissez-faire policy, the resulting equilibrium would be called first best. It is useful to think of this market condition as economic nirvana since there is no conceivable way of increasing economic efficiency at a first-best equilibriumA market equilibrium that arises in the absence of any market imperfections or distortions; in other words, under the standard assumptions of perfect competition..
Of course, the real world is unlikely to be so perfectly characterized. Instead, markets will likely have numerous distortions and imperfections. Some production and consumption activities have externality effects. Some goods have public good characteristics. Some markets have a small number of firms, each of which has some control over the price that prevails and makes positive economic profit. Governments invariably set taxes on consumption, profit, property and assets, and so on. Finally, information is rarely perfectly and costlessly available.
Now imagine again a small, open, perfectly competitive economy with no market imperfections or distortions. Suppose we introduce one distortion or imperfection into such an economy. The resulting equilibrium will now be less efficient from a national perspective than when the distortion was not present. In other words, the introduction of one distortion would reduce the optimal level of national welfare.
In terms of Lipsey and Lancaster’s analysis, the introduction of the distortion into the system would sever one or more of the equilibrium conditions that must be satisfied to obtain economic nirvana. For example, suppose the imperfection that is introduced is the presence of a monopolistic firm in an industry. In this case, the firm’s profit-maximizing equilibrium condition would be to set its price greater than the marginal cost rather than equal to the marginal cost as would be done by a profit-maximizing perfectly competitive firm. Since the economic optimum obtained in these circumstances would be less efficient than in economic nirvana, we would call this equilibrium a second-best equilibriumA market equilibrium that arises in the presence of one or more market imperfections or distortions.. Second-best equilibria arise whenever all the equilibrium conditions satisfying economic nirvana cannot occur simultaneously. In general, second-best equilibria arise whenever there are market imperfections or distortions present.
Welfare-Improving Policies in a Second-Best World
An economic rationale for government intervention in the private market arises whenever there are uncorrected market imperfections or distortions. In these circumstances, the economy is characterized by a second-best rather than a first-best equilibrium. In the best of cases, the government policy can correct the distortions completely and the economy would revert back to the state under economic nirvana. If the distortion is not corrected completely, then at least the new equilibrium conditions, altered by the presence of the distortion, can all be satisfied. In either case, an appropriate government policy can act to correct or reduce the detrimental effects of the market imperfection or distortion, raise economic efficiency, and improve national welfare.
It is for this reason that many types of trade policies can be shown to improve national welfare. Trade policies, chosen appropriate to the market circumstances, act to correct the imperfections or distortions. This remains true even though the trade policies themselves would act to reduce economic efficiency if applied starting from a state of economic nirvana. What happens is that the policy corrects the distortion or imperfection and thus raises national welfare by more than the loss in welfare arising from the application of the policy.
Many different types of policies can be applied, even for the same distortion or imperfection. Governments can apply taxes, subsidies, or quantitative restrictions. They can apply these to production, to consumption, or to factor usage. Sometimes they even apply two or more of these policies simultaneously in the same market. Trade policies, like tariffs or export taxes, are designed to directly affect the flow of goods and services between countries. Domestic policies, like production subsidies or consumption taxes, are directed at a particular activity that occurs within the country but is not targeted directly at trade flows.
One prominent area of trade policy research focuses on identifying the optimal policy to be used in a particular second-best equilibrium situation. Invariably, this research has considered multiple policy options in any one situation and has attempted to rank order the potential policies in terms of their efficiency-enhancing capabilities. As with the ranking of equilibria described above, the ranking of policy options is also typically characterized using the first-best and second-best labels.
Thus the ideal or optimal policy choice in the presence of a particular market distortion or imperfection is referred to as a first-best policy. The first-best policy will raise national welfare, or enhance aggregate economic efficiency, to the greatest extent possible in a particular situation.
Many other policies can often be applied, some of which would improve welfare. If any such policy raises welfare to a lesser degree than a first-best policy, then it would be called a second-best policyA policy whose best effect is inferior to another policy.. If there are many policy options that are inferior to the first-best policy, then it is common to refer to them all as second-best policies. Only if one can definitively rank three or more policy options would one ever refer to a third-best or fourth-best policy. Since these rankings are often difficult, third-best (and so on) policies are not commonly denoted.
Trade Policies in a Second-Best World
In a 1971 paper, Jagdish Bhagwati provided a framework for understanding the welfare implications of trade policies in the presence of market distortions.See J. N. Bhagwati, “The Generalized Theory of Distortions and Welfare,” in Trade, Balance of Payments and Growth, ed. J. N. Bhagwati, R. W. Jones, R. A. Mundell, and J. Vanek (Amsterdam: North-Holland Publishing Co., 1971). This framework applied the theory of the second best to much of the welfare analysis that had been done in international trade theory up until that point. Bhagwati demonstrated the result that trade policies can improve national welfare if they occur in the presence of a market distortion and if they act to correct the detrimental effects caused by the distortion. However, Bhagwati also showed that in almost all circumstances a trade policy will be a second-best rather than a first-best policy choice. The first-best policy would likely be a purely domestic policy targeted directly at the distortion in the market. One exception to this rule occurs when a country is “large” in international markets and thus can affect international prices with its domestic policies. In this case, as was shown with optimal tariffs, quotas, voluntary export restraints (VERs), and export taxes, a trade policy is the first-best policy.
Since Bhagwati’s paper, international trade policy analysis has advanced to include market imperfections such as monopolies, duopolies, and oligopolies. In many of these cases, it has been shown that appropriately chosen trade policies can improve national welfare. The reason trade policies can improve welfare, of course, is that the presence of the market imperfection means that the economy begins at a second-best equilibrium. The trade policy, if properly targeted, can reduce the negative aggregate effects caused by the imperfection and thus raise national welfare.
Summary of the Theory of the Second Best
In summary, the theory of the second best provides the theoretical underpinning to explain many of the reasons that trade policy can be shown to be welfare enhancing for an economy. In most (if not all) of the cases in which a trade policy is shown to improve national welfare, the economy begins at an equilibrium that can be characterized as second best. Second-best equilibria arise whenever the market has distortions or imperfections present. In these cases, it is relatively straightforward to conceive of a trade policy that corrects the distortion or imperfection sufficiently to outweigh the detrimental effects of the policy itself. In other words, whenever market imperfections or distortions are present, it is always theoretically or conceptually possible to design a trade policy that would improve national welfare. As such, the theory of the second best provides a rationale for many different types of protection in an economy.
The main criticism suggested by the theory is that rarely is a trade policy the first-best policy choice to correct a market imperfection or distortion. Instead, a trade policy is second best. The first-best policy, generally, would be a purely domestic policy targeted directly at the market imperfection or distortion.
In the remaining sections of this chapter, we use the theory of the second best to explain many of the justifications commonly given for protection or for government intervention with some form of trade policy. In each case, we also discuss the likely first-best policies.
Key Takeaways
A first-best equilibrium occurs in a perfectly competitive market when no imperfections or distortions are present.
A second-best equilibrium arises whenever a market includes one or more imperfections or distortions.
A first-best policy is that policy that can improve national welfare to the greatest extent when beginning in a second-best equilibrium.
A second-best policy is one whose best national welfare effect is inferior to a first-best policy when beginning in a second-best equilibrium.
As a general rule of thumb, beginning in a second-best equilibrium, the first-best policy will be a policy that attacks the market imperfection or distortion as directly as possible.
As a general rule of thumb, domestic policies are usually first-best policies, whereas trade policies are usually second-best policies.
One exception to the previous rule of thumb is that a trade policy is the first-best policy choice to correct the imperfection of a large country in international markets.
Exercise
Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
The term used to describe an equilibrium that arises in the presence of market imperfections and distortions.
The term used to describe a policy action that can raise economic efficiency to the greatest extent possible.
The names of the economists who first formalized the theory of the second best.
The term used to describe an equilibrium that arises in the absence of market imperfections and distortions.
The term used to describe a policy action whose best effect is inferior to another policy option.
6.4 Public Goods and National Security
Learning Objectives
Learn that public goods, which have the features of being nonrival and nonexcludable in consumption, are a type of market imperfection.
Recognize that a trade policy can be used to correct for a public good imperfection.
Learn the first-best and second-best policy options to correct for a public good imperfection.
One of the oldest and most common arguments supporting protection is the “national security argument,” also called the “national defense argument.” This argument suggests that it is necessary to protect certain industries with a tariff to assure continued domestic production in the event of a war. Many products have been identified as being sufficiently important to warrant protection for this reason. Perhaps the most common industry identified is agriculture. Simply consider the problems that would arise if a nation did not have an adequate food supply when it was at war with the outside world. Low food stocks may induce severe hardships and even famine. A simple solution to avoid this potential problem is to maintain a sufficiently high tariff in order to keep cheap foreign goods out and, in turn, maintain production of the domestic goods.
Similar problems may arise in many other industries. Consider the potential problems for a country’s national security if it could not produce an adequate amount of steel, aluminum, ships, tanks, planes, fuel, and so on in the event of a war. The number of products that could be added to this list is enormous. Indeed, at one time or another in most countries’ histories, it has been argued that almost every product imaginable is important from a national security perspective and thus is deserving of protection. One of the most interesting arguments ever described is that made by the embroidery industry, which once argued for a protective tariff in the United States because embroidered patches on soldiers’ uniforms are essential in maintaining the morale of the troops. Thus it was clear, to them at least, that the embroidery industry needed to be protected for national security reasons.
National Security and Public Goods
We can make better sense of the national security argument if we classify it in the context of the theory of the second best. In this case, we must note that the national security argument is actually incorporating a market imperfection into the story to justify the use of a protective tariff. The market imperfection here is a public good. National security is a public good and public goods are excluded from the standard assumptions of perfect competition. Thus, whenever a product has public good characteristics, we can say that a market imperfection is present. Traditionally, the literature in economics refers to concerns such as national security as noneconomic objectives. The effects that food production may have on the nation’s sense of security, for example, were thought to fall outside the realm of traditional economic markets.
In general, public goods have the following two consumption characteristics: they are nonexcludable and they are nonrival. Nonexcludability means that once the product is produced, it is impossible to prevent people from consuming it. Nonrivalry means that many people can consume the produced product without diminishing its usefulness to others. Here are a few examples to explain the point. First, consider a nonpublic good: soda. A soda is excludable since the producer can put it into a can and require you to pay for it to enjoy its contents. A can of soda is also a rival good. That’s because if you consume the can of soda, there is no way for anyone else to consume the same can. This implies that a can of soda is not a public good. On the other hand, consider oxygen in the atmosphere. (This is an odd example because oxygen in the air is not formally produced, but let’s ignore that for a moment.) Atmospheric oxygen is nonexcludable because once it is there, everyone has free access to its use. It is impossible (or at least very difficult) to prevent some people from enjoying the benefits of the air. Atmospheric oxygen is also nonrival because when one person takes a breath, it does not diminish the usefulness of the atmosphere for others. Thus, if atmospheric oxygen did need to be formally produced, it would be a classic example of a pure public good.
The typical examples of public goods include national security, clean air, lighthouse services, and commercial-free television and radio broadcasts. National security is the public good we are most concerned with in international trade. It is a public good because, once provided, (1) it is difficult to exclude people within the country from the safety and security generated and (2) multiple individuals can enjoy the added safety and security without limiting that received by others.
We know from the theory of the second best that when market imperfections are present, government policies can be used to improve the national welfare. In most cases, trade policies can be used as well. It is well known in economic theory that when a good has public good characteristics, and if private firms are free to supply this good in a free market, then the public good will not be adequately supplied. The main problem occurs because of free ridership. If a person believes that others may pay for a good and if its subsequent provision benefits all people—due to the two public good features—then that person may avoid paying for the good in a private marketplace. If many people don’t pay, then the public good will be insufficiently provided relative to the true demands in the country. It is well known that government intervention can solve this problem. By collecting taxes from the public, and thus forcing everyone to pay some share of the cost, the public good can be provided at an adequate level. Thus national welfare can be increased with government provision of public goods.
A similar logic explains why a trade policy can be used to raise a country’s welfare in the presence of a public good. It is worth pointing out, though, that the goods highlighted above, such as agricultural products and steel production, are not themselves public goods. The public good one wishes to provide in greater abundance is “national security.” And it is through the production of certain types of goods locally that more security can be provided. For example, suppose it is decided that adequate national security is possible only if the nation can provide at least 90 percent of its annual food supplies during wartime. Suppose also that under free trade and laissez-faire domestic policies, the country produces only 50 percent of its annual food supply and imports the remaining 50 percent. Finally, suppose the government believes that it would be very difficult to raise domestic production rapidly in the event that imported products were ever cut off, as might occur during a war. In this case, a government may decide that its imports are too high and thus pose a threat to the country’s national security.
A natural response in this instance is to put high tariffs in place to prevent imports from crowding out domestic production. Surely, a tariff exists that will reduce imports to 10 percent and subsequently cause domestic production to rise to 90 percent. We know from tariff analysis that in the case of a small country, a tariff will cause a net welfare loss for the nation in a perfectly competitive market. These same gains and losses and net welfare effects can be expected to prevail here. However, because of the presence of the public good characteristics of national security, there is more to the story. Although the tariff alone causes a net welfare loss for the economy, the effect is offset with a positive benefit to the nation in the form of greater security. If the added security adds more to national welfare than the economic losses caused by the tariff, then overall national welfare will rise. Thus protectionism can be beneficial for the country.
The national security argument for protection is perfectly valid and sound. It is perfectly logical under these conditions that protectionism can improve the nation’s welfare. However, because of the theory of the second best, many economists remain opposed to the use of protectionism, even in these circumstances. The reason is that protectionism turns out to be a second-best policy option.
Recall that the first-best policy response to a market imperfection is a policy that is targeted as directly as possible at the imperfection itself. Thus, if the imperfection arises because of some production characteristic, a production subsidy or tax should be used. If the problem is in the labor market, a tax or subsidy in that market would be best, and if the market imperfection is associated with international trade, then a trade policy should be used.
In this case, one might argue that the problem is trade related, since one can say that national security is diminished because there are too many imports of, say, agricultural goods. Thus an import tariff should be used. However, this logic is wrong. The actual problem is maintaining an adequate food supply in a time of war. The problem is really a production problem because if imports were to be cut off in an emergency, the level of production would be too low. The most cost-effective way, in this situation, to maintain production at adequate levels will be a production subsidy. The production subsidy will raise domestic production of the good and can be set high enough to assure that an adequate quantity is produced each year. The subsidy will cost the government money and it will generate a net production efficiency loss. Nevertheless, the efficiency loss from a tariff, one that generates the same level of output as a production subsidy, will cause an even greater loss. This is because an import tariff generates both a production efficiency loss and a consumption efficiency loss. Thus, to achieve the same level of production of agricultural goods, a production subsidy will cost less overall than an import tariff. We say, then, that an import tariff is a second-best policy. The first-best policy option is a production subsidy.
Another Case in Which a Trade Policy Is First Best
There is one case in which a trade policy, used to protect or enhance national security, is the first-best policy option. Consider a country that produces goods that could be used by other countries to attack or harm the first country. An example would be nuclear materials. Some countries use nuclear power plants to produce electricity. Some of the products used in this production process, or the knowledge gained by operating a nuclear facility, could be used as an input in the production of more dangerous nuclear weapons. To prevent such materials from reaching countries, especially materials that may potentially threaten a country, export bans are often put into place. The argument to justify an export ban is that preventing certain countries from obtaining materials that may be used for offensive military purposes is necessary to maintain adequate national security.
In the United States, export bans are in place to prevent the proliferation of a variety of products. Many other products require a license from the government to export the product to certain countries. This allows the government to monitor what is being exported to whom and gives them the prerogative to deny a license if it is deemed to be a national security threat. In the United States, licenses are required for goods in short supply domestically; goods related to nuclear proliferation, missile technology, and chemical and biological weapons; and other goods that might affect regional stability, crime, or terrorist activities. In addition, the United States maintains a Special Designated Nationals list, which contains names of organizations to which sales of products are restricted, and a Denied Persons list, which contains names of individuals with whom business is prohibited. In recent years the United States has maintained export bans to several countries, including Cuba, Iran, Syria, and Sudan.
In this case, the export control policy is the first-best policy to enhance national security. This is because the fundamental problem is certain domestic goods getting into the hands of certain foreign nations, groups, or individuals. The problem is a trade problem best corrected with a trade policy. Indeed, there is no effective way to control these sales, and thus to enhance national security, using a purely domestic policy.
Key Takeaways
The preservation of national security is a common justification for the use of protection.
The preservation of national security is a type of noneconomic objective.
Protection can help maintain an adequate domestic supply of materials critical in the event of war, including food, steel, military equipment, and petroleum.
Export bans can be used to prevent the proliferation of materials that may eventually prove to be threatening to a nation’s security.
Import tariffs can raise national welfare when increased production of the protected product enhances national security.
Because national security is a public good and also an imperfection, trade protection can sometimes be beneficial for a country.
A production subsidy can achieve the same level of production at a lower cost.
A production subsidy is the first-best policy when increased production of a good enhances national security.
An import tariff is a second-best policy option.
An export ban can raise a nation’s welfare when the export of a product reduces national security.
The export ban, a trade policy, is the first-best policy option when export of a product reduces national security.
Exercise
Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
The term used to describe policy intentions that are not economic in nature.
This is a common justification for import protection of food, steel, shipping, and many other things thought necessary under certain circumstances.
This policy is first best if a product in the hands of foreigners could threaten one’s national security.
Of a production subsidy or an import tariff, this policy is likely to be first best to protect a nation’s agricultural production.
The term describing a “good” like national security that is both nonexcludable and nonrival in consumption.
6.5 Economic Integration: Free Trade Areas, Trade Creation, and Trade Diversion
Learning Objectives
Distinguish the different types of economic integration.
Learn the effects of trade creation and trade diversion.
Understand how free trade area formation can make a country worse off in terms of the theory of the second best.
For a variety of reasons, it often makes sense for nations to coordinate their economic policies. Coordination can generate benefits that are not possible otherwise. If countries cooperate and set zero tariffs against each other, then both countries are likely to benefit relative to the case when both countries attempt to secure short-term advantages by setting optimal tariffs. This is just one advantage of cooperation. Benefits may also accrue to countries that liberalize labor and capital movements across borders, that coordinate fiscal policies and resource allocation toward agriculture and other sectors, and that coordinate their monetary policies.
Any type of arrangement in which countries agree to coordinate their trade, fiscal, or monetary policies is referred to as economic integrationAny type of arrangement in which countries agree to coordinate their trade, fiscal, or monetary policies.. There are many different degrees of integration.
Preferential Trade Agreement
A preferential trade agreement (PTA) is perhaps the weakest form of economic integration. In a PTA, countries would offer tariff reductions, though perhaps not eliminations, to a set of partner countries in some product categories. Higher tariffs, perhaps nondiscriminatory tariffs, would remain in all other product categories. This type of trade agreement is not allowed among World Trade Organization (WTO) members, who are obligated to grant most-favored nation (MFN) status to all other WTO members. Under the MFN rule, countries agree not to discriminate against other WTO member countries. Thus, if a country’s low tariff on bicycle imports, for example, is 5 percent, then it must charge 5 percent on imports from all other WTO members. Discrimination or preferential treatment for some countries is not allowed. The country is free to charge a higher tariff on imports from non-WTO members, however. In 1998, the United States proposed legislation to eliminate tariffs on imports from the nations in sub-Saharan Africa. This action represents a unilateral preferential trade agreement since tariffs would be reduced in one direction but not the other. (Note that a PTA is also used more generally to describe all types of economic integration since they all incorporate some degree of “preferred” treatment.)
Free Trade Area
A free trade area (FTA)A situation in which a group of countries agrees to eliminate tariffs among themselves but maintain their own external tariff on imports from the rest of the world. occurs when a group of countries agrees to eliminate tariffs among themselves but maintain their own external tariff on imports from the rest of the world. The North American Free Trade Agreement (NAFTA) is an example of an FTA. When NAFTA is fully implemented, tariffs of automobile imports between the United States and Mexico will be zero. However, Mexico may continue to set a different tariff than the United States on automobile imports from non-NAFTA countries. Because of the different external tariffs, FTAs generally develop elaborate “rules of origin.” These rules are designed to prevent goods from being imported into the FTA member country with the lowest tariff and then transshipped to the country with higher tariffs. Of the thousands of pages of text that make up NAFTA, most of them describe rules of origin.
Customs Union
A customs union occurs when a group of countries agrees to eliminate tariffs among themselves and set a common external tariff on imports from the rest of the world. The European Union (EU) represents such an arrangement. A customs union avoids the problem of developing complicated rules of origin but introduces the problem of policy coordination. With a customs union, all member countries must be able to agree on tariff rates across many different import industries.
Common Market
A common market establishes free trade in goods and services, sets common external tariffs among members, and also allows for the free mobility of capital and labor across countries. The EU was established as a common market by the Treaty of Rome in 1957, although it took a long time for the transition to take place. Today, EU citizens have a common passport, can work in any EU member country, and can invest throughout the union without restriction.
Economic Union
An economic union typically will maintain free trade in goods and services, set common external tariffs among members, allow the free mobility of capital and labor, and also relegate some fiscal spending responsibilities to a supranational agency. The EU’s Common Agriculture Policy (CAP) is an example of a type of fiscal coordination indicative of an economic union.
Monetary Union
A monetary union establishes a common currency among a group of countries. This involves the formation of a central monetary authority that will determine monetary policy for the entire group. The Maastricht treaty, signed by EU members in 1992, proposed the implementation of a single European currency (the Euro) by 1999.
Perhaps the best example of an economic and monetary union is the United States. Each U.S. state has its own government that sets policies and laws for its own residents. However, each state cedes control, to some extent, over foreign policy, agricultural policy, welfare policy, and monetary policy to the federal government. Goods, services, labor, and capital can all move freely, without restrictions among the U.S. states, and the nation sets a common external trade policy.
Multilateralism versus Regionalism
In the post–World War II period, many nations pursued the objective of trade liberalization. One device used to achieve this was the General Agreement on Tariffs and Trade (GATT) and its successor, the WTO. Although the GATT began with less than 50 member countries, the WTO now claims 153 members as of 2010. Since GATT and WTO agreements commit all member nations to reduce trade barriers simultaneously, the agreements are sometimes referred to as a multilateral approach to trade liberalization.
An alternative method used by many countries to achieve trade liberalization includes the formation of preferential trade arrangements, free trade areas, customs unions, and common markets. Since many of these agreements involve geographically contiguous countries, these methods are sometimes referred to as a regional approach to trade liberalization.
The key question of interest concerning the formation of preferential trade arrangements is whether these arrangements are a good thing. If so, under what conditions? If not, why not?
One reason supporters of free trade may support regional trade arrangements is because they are seen to represent movements toward free trade. Indeed, Section 24 of the original GATT allows signatory countries to form free trade agreements and customs unions despite the fact that preferential agreements violate the principle of nondiscrimination. When a free trade area or customs union is formed between two or more WTO member countries, they agree to lower their tariffs to zero between each other but will maintain their tariffs against other WTO countries. Thus the free trade area is a discriminatory policy. Presumably, the reason these agreements are tolerated within the WTO is because they represent significant commitments to free trade, which is another fundamental goal of the WTO.
However, there is also some concern among economists that regional trade agreements may make it more difficult, rather than easier, to achieve the ultimate objective of global free trade.
The fear is that although regional trade agreements will liberalize trade among their member countries, the arrangements may also increase incentives to raise protectionist trade barriers against countries outside the area. The logic here is that the larger the regional trade area relative to the size of the world market, the larger will be that region’s market power in trade. The more market power, the higher would be the region’s optimal tariffs and export taxes. Thus the regional approach to trade liberalization could lead to the formation of large “trade blocs” that trade freely among members but choke off trade with the rest of the world. For this reason, some economists have argued that the multilateral approach to trade liberalization, represented by the trade liberalization agreements in successive WTO rounds, is more likely to achieve global free trade than the regional or preferential approach.
Much has been written on this subject recently. Here we have merely scratched the surface.
In what follows, we present the economic argument regarding trade diversion and trade creation. These concepts are used to distinguish between the effects of free trade area or customs union formation that may be beneficial and those that are detrimental. As mentioned, preferential trade arrangements are often supported because they represent a movement in the direction of free trade. If free trade is economically the most efficient policy, it would seem to follow that any movement toward free trade should be beneficial in terms of economic efficiency. It turns out that this conclusion is wrong. Even if free trade is most efficient, it is not true that a step in that direction necessarily raises economic efficiency. Whether a preferential trade arrangement raises a country’s welfare and raises economic efficiency depends on the extent to which the arrangement causes trade diversion versus trade creation.
Trade Creation and Trade Diversion
In this section, we present an analysis of trade diversion and trade creation. The analysis uses a partial equilibrium framework, which means that we consider the effects of preferential trade liberalization with respect to a representative industry. Later in the section we consider how the results from the representative industry cases can be extended to consider trade liberalization that covers all trade sectors.
We assume in each case that there are three countries in the world: Countries A, B, and C. Each country has supply and demand for a homogeneous good in the representative industry. Countries A and B will form a free trade area. (Note that trade diversion and creation can occur regardless of whether a preferential trade agreement, a free trade area, or a customs union is formed. For convenience, we’ll refer to the arrangement as a free trade area [FTA].) The attention in this analysis will be on Country A, one of the two FTA members. We’ll assume that Country A is a small country in international markets, which means that it takes international prices as given. Countries B and C are assumed to be large countries (or regions). Thus Country A can export or import as much of a product as desired with Countries B and C at whatever price prevails in those markets.
We assume that if Country A were trading freely with either B or C, it would wish to import the product in question. However, Country A initially is assumed not to be trading freely. Instead, the country will have an MFN-specific tariff (i.e., the same tariff against both countries) applied on imports from both Countries B and C.
In each case below, we will first describe an initial tariff-ridden equilibrium. Then, we will calculate the price and welfare effects that would occur in this market if Countries A and B form an FTA. When the FTA is formed, Country A maintains the same tariff against Country C, the non-FTA country.
Trade Diversion
In general, trade diversion is a situation in which a free trade area diverts trade away from a more-efficient supplier outside the FTA toward a less-efficient supplier within the FTA. means that a free trade area diverts trade away from a more-efficient supplier outside the FTA and toward a less-efficient supplier within the FTA. In some cases, trade diversion will reduce a country’s national welfare, but in some cases national welfare could improve despite the trade diversion. We present both cases below.
Trade diversion can be harmful to a country that joins an FTA. If conditions were different, however, the national welfare change could be positive. In some cases, formation of an FTA that causes a trade diversion may have a positive net national welfare effect. Thus a trade diversion may be, but is not necessarily, welfare reducing.
Generally speaking, the larger the difference between the nondistorted prices in the FTA partner country and in the rest of the world, the more likely it is that trade diversion will reduce national welfare.
Trade Creation
In general, trade creation is a situation in which a free trade area creates trade that would not have existed otherwise. means that a free trade area creates trade that would not have existed otherwise. As a result, supply occurs from a more-efficient producer of the product. In all cases, trade creation will raise a country’s national welfare.
Aggregate Welfare Effects of a Free Trade Area
The analysis above considers the welfare effects on participants in one particular market in one country that is entering into a free trade area. However, when a free trade area is formed, presumably many markets and multiple countries are affected, not just one. Thus, to analyze the aggregate effects of an FTA, one would need to sum up the effects across markets and across countries.
The simple way to do that is to imagine that a country entering an FTA may have some import markets in which trade creation would occur and other markets in which trade diversion would occur. The markets with trade creation would definitely generate national welfare gains, while the markets with trade diversion may generate national welfare losses. It is common for economists to make the following statement: “If the positive effects of trade creation are larger than the negative effects of trade diversion, then the FTA will improve national welfare.” A more succinct statement, though also somewhat less accurate, is that “if an FTA causes more trade creation than trade diversion, then the FTA is welfare improving.”
However, the converse statement is also possible—that is, “if an FTA causes more trade diversion than trade creation, then the FTA may be welfare reducing for a country.” This case is actually quite interesting since it suggests that a movement to free trade by a group of countries may actually reduce the national welfare of the countries involved. This means that a movement in the direction of a more-efficient free trade policy may not raise economic efficiency. Although this result may seem counterintuitive, it can easily be reconciled in terms of the theory of the second best.
Free Trade Areas and the Theory of the Second Best
One might ask, if free trade is economically the most efficient policy, how can it be that a movement to free trade by a group of countries can reduce economic efficiency? The answer is quite simple once we put the story of FTA formation into the context of the theory of the second best. Recall that the theory of the second best suggested that when there are distortions or imperfections in a market, then the addition of another distortion (like a trade policy) could actually raise welfare or economic efficiency. In the case of an FTA, the policy change is the removal of trade barriers rather than the addition of a new trade policy. However, the second-best theory works much the same in reverse.
Before a country enters an FTA, it has policy-imposed distortions already in place in the form of tariff barriers applied on imports of goods. This means that the initial equilibrium can be characterized as a second-best equilibrium. When the FTA is formed, some of these distortions are removed—that is, the tariffs applied to one’s FTA partners. However, other distortions remain—that is, tariffs applied against the nonmember countries. If the partial tariff removal substantially raises the negative effects caused by the remaining tariff barriers with the non-FTA countries, then the efficiency improvements caused by free trade within the FTA could be outweighed by the negative welfare effects caused by the remaining barriers outside the FTA, and national welfare could fall.
This is, in essence, what happens in the case of trade diversion. Trade diversion occurs when an FTA shifts imports from a more-efficient supplier to a less-efficient supplier, which by itself causes a reduction in national welfare. Although the economy also benefits through the elimination of the domestic distortions, if these benefits are smaller than the supplier efficiency loss, then national welfare falls. In general, the only way to assure that trade liberalization will lead to efficiency improvements is if a country removes its trade barriers against all countries.
Key Takeaways
Countries can integrate by reducing barriers to trade under multilateral arrangements like the WTO or by entering into regional arrangements, including preferential trade agreements, free trade agreements, customs unions, common markets, or monetary unions.
The formation of a free trade area can lead to trade creation or trade diversion.
Trade creation involves new trade that would not exist without the FTA and is always beneficial for the countries in terms of national welfare.
Trade diversion involves the shifting of trade away from one country toward one’s free trade partner and is sometimes detrimental to the countries in terms of national welfare.
Losses caused by trade diversion can be understood in terms of the theory of the second best; because one market distortion remains when another is removed, welfare can fall.
Exercise
Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
An arrangement in which a group of countries agrees to eliminate tariffs among themselves but maintain their own external tariff on imports from the rest of the world.
The term used to describe a change in the pattern of trade in response to trade liberalization in which a country begins to import from a less-efficient supplier.
The term used to describe a change in the pattern of trade in response to trade liberalization in which a country begins to import from a more-efficient supplier.
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