American Economic Association

The Optimality of Free Trade: Science or Religion?

Author(s): Rachel McCulloch
Source: The American Economic Review, Vol. 83, No. 2, Papers and Proceedings of the
Hundred and Fifth Annual Meeting of the American Economic Association (May, 1993), pp.
367-371
Published by: American Economic Association
Stable URL: http://www.jstor.org/stable/2117692
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 The Optimality of Free Trade: Science or Religion?
By RACHEL MCCULLOCH*
Ominous trends in America's interna-
tional position and overall economic perfor-
mance have generated increasing public dis-
satisfaction with the nation's laissez-faire
approach to trade. Recent academic re-
search has meanwhile cast new doubt on
the theoretical case for free trade, espe-
cially where high-technology industries are
concerned. As a consequence of these par-
allel developments, much of both academic
and public debate over appropriate trade
policy now centers on the practical implica-
tions of the modeling approach known as
the new trade theory. Some look to the new
theory for a better understanding of trade
policy's potential role in improving overall
economic performance; others seek theoret-
ical justification of policies from which they
themselves expect to benefit.
I. The Eroding Consensus on Free Trade
Until the mid-1980's, the doctrine of free
trade enjoyed broad popular support in the
United States. The nation emerged from
World War II a staunch crusader for liberal-
ization of global trade, notwithstanding oc-
casional lapses from its own stated ideals.
For most firms, neither exports nor compet-
ing imports played an important role in
overall profitability. If a few industries had
grievances about foreign competition,
America as a whole seemed to prosper along
with, and because of, the steady expansion
of its trade. In any case, the translation into
actual policy of the American free-trade
doctrine remained a pragmatic mixture of
measures to open international markets with
measures to accommodate the mercantilis-
tic impulses of governments.
* Department of Economics, Brandeis University,
Waltham, MA 02254. Gary Chamberlain, Douglas A.
Irwin, Peter A. Petri, and J. David Richardson pro- their mark by proving the improbable"
vided helpful comments.
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The past decade, however, has not been
friendly to American proponents of a liberal
trade policy. With help from a strong dollar
in the mid-1980's, firms abroad challenged
U.S. producers in a widening range of in-
dustries. Trading partners with activist pol-
icy regimes enjoyed prosperity fueled by
export surpluses, while employment and
wages sagged in America's own manufactur-
ing sector. U.S. exports continued to grow,
but imports grew faster. The resulting trade
deficits were startling in size and seemingly
resistant to the usual remedies. Of still
greater concern was the perceived nature of
foreign competition. Where lost market
share had once been concentrated in ma-
ture industries such as apparel and footwear,
powerful rivals (some bankrolled by foreign
governments) began to contest U.S. domi-
nance even in advanced high-technology
sectors. Innovative products, including ones
based on U.S. research, seemed as likely to
come to the American market from foreign
as from domestic producers.
Rising concern about U.S. economic per-
formance has promoted new skepticism re-
garding the merits of a laissez-faire ap-
proach to trade. This in turn has created
new interest in whatever rationale economic
theory can provide for trade-policy activism.
The resulting debate has created the im-
pression even among economists that the
new theory represents the first serious intel-
lectual challenge to a previously airtight
theoretical case for free trade.
In fact, nothing could be further from the
truth. Theoretical challenges to the optimal-
ity of free trade have always been the bread
and butter of international economics. Like
the new theory, older arguments for inter-
vention are predicated on departures from
the paradigm of perfect competition. The
new theory is thus solidly in an old tradi-
tion: "Ingenious economists properly make
(Jagdish Bhagwati, 1991 p. 5). While the
367
 368 AEA PAPERS AND
new theory does broaden the set of theoret-
ical exceptions to the conventional wisdom,
its emphasis on scale economies also serves
to underscore the potential gains from open
international markets.
II. Traditional Theory and New Arguments
The theoretical case for the optimality of
free trade rests on the same logic as the
case for unfettered competition in domestic
markets: given suitable conditions, private
profit-seeking behavior ensures an efficient
allocation of resources (for a concise discus-
sion, see Anne 0. Krueger [19901). As in
domestic markets, these conditions are not
always satisfied. Throughout the 20th cen-
tury and even before, economists have
probed not only the theoretical benefits of
free trade but also the multitude of circum-
stances (e.g., monopoly and monopsony, in-
creasing returns, externalities, labor-market
distortions) in which maximization of na-
tional income requires policy intervention.
However, an international context opens
one new issue: maximizing national income
is not the same as maximizing global in-
come. Traditional theory shows that a large
country can benefit from limiting the vol-
ume of its trade; the tariff rate that maxi-
mizes national welfare is called the opti-
mum tariff. However, gains come entirely at
the expense of foreigners; the optimizing
country in effect grabs a larger slice of a
smaller global pie. Emulation or retaliation
by trading partners changes the likely out-
come to losses for all.' The new theory's
analysis of rent-grabbing by oligopolistic
global competitors is similar in both struc-
ture and implications.
1The most important practical application of this
logic concerns trade liberalization. Because of adverse
effects on its terms of trade, a large country's unilateral
liberalization may raise world welfare yet lower its
own. The apparently mercantilistic resort to reciprocal
trade liberalization in multilateral negotiations pro-
vides needed assurance that each participant will cap-
ture part of the gains from the resulting increase in
global efficiency.
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PROCEEDINGS MAY 1993
Postwar theorists formalized and ex-
tended long-established critiques of free
trade (the optimum tariff and infant-
industry protection were much debated
by 19th-century economists; see Douglas A.
Irwin, 1991) and also developed a wide-
ranging literature on departures from per-
fect competition. One standard graduate
text on traditional (i.e., pre-new) trade the-
ory (Bhagwati and T. N. Srinivasan, 1983)
devotes no less than 11 chapters to situa-
tions where free trade is suboptimal. In fact,
traditional theory offers so many plausible
reasons why intervention can raise national
and sometimes even world welfare that the
theme of this literature is perhaps better
described as the nonoptimality of free trade.
Departures from perfect competition are
likewise the focus of the new trade theory,
so in some respects the new theory simply
carries on a centuries-old tradition. Yet the
new theory is new in its modeling tech-
niques, which yield formal results concern-
ing aspects of economic reality that had
previously stymied trade theorists. Drawing
on tools recently developed by industrial-
organization (10) theorists, the new trade
theory offers fresh insights into policy's im-
pact in markets characterized by scale
economies, oligopoly, and externalities. Al-
though these conditions had been analyzed
earlier, traditional tools limited their theo-
retical depiction. For example, the extensive
traditional literature on scale economies
considered mainly external economies at the
industry level, with individual firms assumed
to experience constant returns and zero
profits. This approach precludes a role for
firms' strategic behavior, which is central to
the new models. (Paul Krugman [1992] re-
views the new theory's key innovations.)
One reason why the new models are par-
ticularly relevant today is that they apply
best to high-technology industries, where
spending for research and development cre-
ates significant scale economies internal to
the individual firm. Learning-by-doing and
knowledge spillovers are also important, and
the number of competitors in a given mar-
ket is often small. As public officials search
for the best way to nurture high-tech indus-
VOL. 83 NO. 2 FREE TRADE: A LOSS OF (THEORETICAL) NERVE? 369
tries, the new trade theory appears to bol-
ster the case for policy activism.
III. From Theory to Policy: The Leap of Faith
The gap between traditional and new
trade theory is less in the nature of the
theory itself than in the public perception of
what the findings imply for policy. In fact,
both bodies of theory abound with demon-
strations that government intervention can,
under plausible conditions, raise national
and perhaps even world welfare. Yet to go
from theory (whether new or traditional) to
policy (whether activist or laissez-faire) re-
quires a substantial leap of faith. Activists
eager to translate the new theory into policy
believe that traditional analysts place too
much faith in the wisdom of the market and
are thus too ready to ignore aspects of real-
ity that do not conform to the competitive
paradigm. For their part, traditional
economists believe that policy activists in-
spired by new 10-based theory place too
much faith in the robustness of theoretical
results and the feasibility of identifying and
carrying out policies that actually improve
social welfare.
Given the enormous energy international
economists devote to theoretical demonstra-
tions of the nonoptimality of free trade, it
may seem incongruous that as a group they
have been for centuries and today remain
free-traders, virtually unanimous in reject-
ing most trade intervention. Intimately
familiar with the leaky and incomplete
theoretical case for the optimality of free
trade, traditional international economists
nonetheless share a faith in what might be
termed the practical case: that, as a real-
world choice, free trade is almost always
optimal. Even the most prolific contributors
to both old and new theories of optimal
trade intervention are notably reluctant to
translate their research findings into pre-
scriptions for real-world policies.
IV. Policy in Practice
In contrast to the traditional theoretical
case for free trade, with intellectual roots in
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David Ricardo's discussion of comparative
advantage, the traditional practical case
draws also on Adam Smith and Joseph
Schumpeter. Integration of national mar-
kets provides benefits from scale economies
(the division of labor is limited by the extent
of the market) and from intensified pro-
ducer rivalry. Such effects, often termed the
dynamic benefits of trade, are notoriously
hard to formalize and measure, yet many
economists believe they are of far greater
importance than the more theoretically
tractable static benefits from Ricardian
comparative advantage. For example, Bela
Balassa's (1967) classic evaluation of the
potential gains from liberalized trade among
industrial economies concludes that result-
ing trade expansion and static welfare gains
would be small but that larger markets could
produce substantial additional gains through
scale economies and increased innovation.
Canadian support for a free-trade agree-
ment with the United States has likewise
rested mainly on presumed efficiency gains
from a greatly enlarged market.
Indeed, international economists' strong
belief in the importance of larger markets
helps explain their generally optimistic as-
sessment of regional free-trade initiatives,
despite the ambiguous welfare conclusions
of traditional customs-union theory. The
theoretical ambiguity arises because gains
from increased trade among partners can be
offset by losses from trade diversion (sub-
stitution of partner imports for lower-cost
goods produced elsewhere). However, even
selective trade liberalization means a larger
market and associated dynamic benefits. The
new 10-based theory supports this conven-
tional wisdom, and recent empirical studies
confirm that welfare gains from regional
liberalization can be far greater when mar-
kets are imperfectly competitive (for refer-
ences and evaluation, see J. David Richard-
son [1989] and Robert E. Baldwin [1992]).
The practical case for free trade also rec-
ognizes the formidable obstacles to translat-
ing theoretically optimal intervention into
real-world welfare gains. Real-world poli-
cies are chosen not by omniscient social-
welfare-maximizing technocrats, but by
370 AEA PAPERS AND
incompletely informed government officials
vulnerable to influence from interested par-
ties. Trade policy's impact on national wel-
fare is the net effect of much larger gains
and losses within the domestic economy. An
industry can benefit handsomely from pro-
tection that has a negligible or even a nega-
tive effect on national welfare.2 Moreover,
implementation of optimizing intervention
requires detailed information on industry
cost and demand-future as well as current.
The most reliable sources (but far from
neutral ones) are the industries themselves.
A related problem is that the theoretical
standard against which optimality is mea-
sured in both traditional and newer IO-
based models is maximization of aggregate
national income or its present discounted
value. No notice is taken of effects on distri-
bution; the implicit assumption is that unin-
tended redistribution can be reversed cost-
lessly through ideal lump-sum transfers and
that required government funding can be
obtained costlessly through ideal lump-sum
taxes. In fact, neutralization of policy-
induced redistribution is the rare exception,
and a policy's distributive consequences are
always considered along with its impact on
aggregate performance. Significant redistri-
bution implies large political costs and thus
a strong bias in favor of the status quo.
(Dani Rodrik [1992] uses this observation to
explain why less-developed countries seem
to liberalize trade only under crisis condi-
tions.)
The traditional interpretation of the in-
fant-industry argument for protection is typ-
ical in its reluctance to make the leap of
faith from theory to policy. The theory
hinges on the dynamic nature of compara-
tive advantage: through learning-by-doing,
protection today yields benefits tomorrow
when an erstwhile infant becomes interna-
tionally competitive. Despite its antiquity,
this argument has a decidedly modern fla-
2The growing literature on rent-seeking and the
political economy of trade policy formalizes and mea-
sures these influences; see Krueger (1990) for discus-
sion and references. A pioneering contribution is
Gordon Tullock (1967).
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PROCEEDINGS MAY 1993
vor. However, traditional discussions usually
stress that strong theoretical conditions are
required for infant-industry protection to
improve welfare; that most governments lack
the expertise to single out appropriate in-
dustries and the political will to reject pleas
from others; that even economically justi-
fied infant-industry protection raises costs
and thus harms prospects of downstream
sectors; and finally, that no grown-up for-
mer infant relinquishes favorable treatment
without a fight. The dismal track record in
most countries of interventions based on
the infant-industry argument speaks for it-
self (see Rodrik, 1992).3
An additional complication is that most
theoretical arguments, old and new, over-
state the benefits of change by comparing
alternative equilibria without considering
costs of moving between them.4 Yet real-
world discussions of trade policy often cen-
ter precisely on problems of adjustment.
Adjustment costs not only temper the theo-
retical case for change, but are also crucial
at the practical level. Displaced resources
that remain idle for an extended period are
both costly in terms of forgone output and
politically troublesome.
Despite a widespread impression to the
contrary, practitioners of the new trade the-
ory are no different from traditional ana-
lysts in their reluctance to translate theory
into practice. While some (e.g., Krugman,
1992) profess to a stance of "cautious ac-
tivism," all emphasize the same real-world
difficulties as traditional analysts. In fact,
the leap of faith from theoretical model to
policy prescription is even more hazardous
for the new theory than for the old. The
3Even apparent successes-former infant industries
now competitive in world markets-may not represent
the result of optimal policies, since today's benefits
must be compared with earlier costs. The impressive
growth performance of Japan and Korea owes much to
policies inspired by infant-industry logic, yet no re-
search has demonstrated net social benefits even for
these conspicuously successful cases of policy-guided
development.
4In Richardson's (1980) folksy analogy, we could be
better off at our lakeside cabin on a hot summer day,
yet worse off going there.
VOL. 83 NO. 2 FREE TRADE: A LOSS OF (THEORETICAL) NERVE? 371
new theory's results usually hinge on as-
sumptions about optimizing behavior of
large individual firms, but economics is best
at modeling the actions of many agents,
worst when it comes to just a few. Conclu-
sions are highly sensitive to assumptions
concerning competitors' behavior in
oligopolistic industries; what seems to be
the case for a government subsidy under
one assumption can become the case for a
tax under a second and equally plausible
assumption (Gene Grossman, 1986).
V. That Old Free-Trade Religion
The noneconomist's stock discourse on
trade policy begins, "Of course free trade is
best in theory, but...," where what follows
reveals scant familiarity with the content of
the theory thus dismissed. International
economists, however, appear to have exactly
the opposite view: that free trade is subopti-
mal in theory yet optimal in practice. The
theoretical suboptimality of free trade is the
product of science; the belief in the practi-
cal suboptimality of most intervention re-
flects an appreciation of what lies beyond
the narrow limits of that science. Although
the new trade theory has significantly ex-
tended the domain of science, it has done
nothing to erode economists' traditional
skepticism concerning the prospects for
translating scientific possibility into real-
world results.
REFERENCES
Balassa, Bela, Trade Liberalization Among In-
dustrial Countries: Objectives and Alterna-
tives, New York: Council on Foreign Re-
lations, 1967.
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Baldwin, Robert E., "Are Economists' Tradi-
tional Trade Policy Views Still Valid?"
Journal of Economic Literature, June 1992,
30, 804-29.
Bhagwati, Jagdish N., The World Trading Sys-
tem at Risk, Princeton, NJ: Princeton
University Press, 1991.
and Srinivasan, T. N., Lectures on
International Trade, Cambridge, MA: MIT
Press, 1983.
Grossman, Gene M., "Strategic Export Pro-
motion: A Critique," in Paul R. Krug-
man, ed., Strategic Trade Policy and the
New International Economics, Cambridge
MA: MIT Press, 1986, pp. 47-68.
Irwin, Douglas A., "Challenges to Free
Trade," Journal of Economic Perspectives,
Spring 1991, 5, 201-7.
Krueger, Anne 0., "The Political Economy of
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Krugman, Paul, "Does the New Trade The-
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Richardson, J. David, Understanding Interna-
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Rodrik, Dani, "The Rush to Free Trade in
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Why Now? Will It Last?" National Bu-
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