Nontraded Goods, Variable Returns to Scale and Welfare

Abstract

The implications of variable returns to scale (VRS) for the theory of international trade have been extensively studied by trade theorists. [5; 7; 8; 11; 14] It is, however, notable that no attempt has been made to ascertain the role of VRS in conjunction with nontraded goods. Some of the major trade theorems have been examined by Komiya [12] in an extended Heckscher-Ohlin-Samuelson (H.O.S.) model with a nontraded good. Despite its pioneering contribution, Komiya's analysis is confined to the production side of a small open economy. More recently, Batra [2] has investigated the welfare effects of several trade policies in a nontraded goods model by incorporating the presence of factor market distortions. The purpose of this paper is to explore the welfare implications of a change in the terms of trade and the rate of tariff, as well as the relative effectiveness of some trade policy instruments in the three-commodity (two traded and one nontraded) and two-factor trade model allowing the presence of VRS. The issue is important for two reasons. First, the existence of nontraded goods is an indisputable phenomenon characterizing the real world.' Second, to the extent that VRS have impacts on commercial policy, its implication in the presence of nontraded goods must be thoroughly examined. Several significant results are obtained from this analysis. For example, free trade may turn out to be the first best policy (optimum optimorum) even when returns to scale are divergent among industries. When the industries in an economy operate under identical returns to scale, with constant returns to scale (CRS) as a special case, an improvement in the terms of trade necessarily enhances welfare, but a higher rate of tariff may not result in a lower welfare. Unlike the result derived by Bhagwati [3] from the standard two-commodity (H.O.S.) model with production externalities, a consumption subsidy (tax), rather than a production tax-cum-subsidy, may turn out to be the optimum optimorum in our nontraded good model; this occurs specifically when VRS distortions exist in the nontraded good industry only. Under divergent returns to scale among industries, the output elasticities of