Pareto Inferior Trade

Abstract

The paper shows that between two competitive but risky economies with no insurance markets, free trade may be Pareto inferior to no trade. The model is simple enough to show clearly the role prices play in transferring and sharing risk when there is an incomplete set of markets, but rich enough to exhibit the resulting inefficiencies dramatically. The belief that free trade is Pareto optimal is one of the few tenets of economics which, at least until recently, would have received almost universal assent. The object of this paper is to demonstrate that this belief may not be well founded. We construct a simple model which lacks a complete set of risk markets but which in all other respects satisfies the conventional assumptions of a competitive economy, and show that free trade may be Pareto inferior to no trade. The basic idea behind our model is simple. There are two countries (regions) both of which grow a risky agricultural crop and a safe crop. The output in the two regions is perfectly negatively correlated. (The model can easily be extended to cases where the correlation is zero or even positive, so long as the correlation is not perfect.) In the absence of trade, price rises whenever outpurt falls. If demand functions have unitary price elasticity the price variations provide perfect income insurance for the farmer. With free trade the variations in the output of the risky crop offset each other and stabilize the price, which no longer varies to offset output variations. Consequently, the revenue from the risky crop now varies and the risk faced by the farmers is increased. This induces farmers to shift production away from the risky crop, raising its average price. Since consumers have unit price elasticity and thus spend a constant amount on both crops, the mean income of the farmers remains constant with the opening of trade while its riskiness increases. Consequently, farmers welfare necessarily decreases, as shown in Figure 1. Whereas before trade was opened, consumers bore all the risk, with free trade they bear none, and, other things being equal, this would make them better off. However, the increased riskiness of the risky crop induces farmers to shift their production to the safe crop, and the consequent rise in the average price of the risky crop can make consumers worse off. Near autarky, the risk benefit dominates this allocation effect, as shown in Figure 1, but near free trade the opposite is the case. If the change in supplies and prices is sufficiently large (which it will be if producers are sufficiently risk averse), and if the consumer risk benefits are sufficiently small (which they will be if consumers are not very risk averse), then consumers will be made worse off by opening trade. Since producers are necessarily worse off (in this model), it follows that free trade is Pareto inferior to autarky. The reconciliation of our results with the standard theorems of Welfare Economics in which free trade is Pareto efficient is straightforward-the conventional argument