CU Justifying a Primer on Trade and Inequality Economics Question
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Justify your answers for full credit.
1. (15 points) In a recent article by Dani Rodrik titled A Primer on Trade and Inequality, the author
summarizes a few of his takeaways from research on the links between trade and inequality. Choose
one of the first three of his takeaways and briey summarize the takeaway you choose in your own
words. Your answer should be a maximum of 200 words. On the Econ 425 website in the Supplementary
Materials Module, I have added a link to Dani Rodricks website and you may download the paper from
there.
(2.) This is a computational question on the Classical model of trade.
The economy has two countries, home (H) and foreign (F); two goods, wheat (W) and cloth (C); and
one factor of production, labour (L). Adopt the assumptions and the notation of this model that I have
used in lectures.
The production functions in each country for each good are as follows:
Home:
H
QH
W = 14LW
Foreign:
F
QF
W = 2LW
H
QH
C = 21LC .
F
QF
C = 8LC .
There are many households in each country and each household has 1 unit of labour. There are 100
households in Country H (LH = 100) and 900 households in Country F (LF = 900).
Every household has the following utility function:
?
?2
U (dW , dC ) = (dW )0.5 + (dC )0.5 .
The Marshallian demand functions associated with this utility function are as follows:
dW (pW , pC , I) =
?
1+
I
pW
?
?
pW
pC
?
dC (pW , pC , I) =
?
1+
I
pC
?
?
pC
pW
?.
I derive these demand functions in the Supplementary Material on the last two pages of this assignment.
The trading equilibrium between H and F is characterized by each country specializing in production of
only one of the goods.
1
Recall that aggregate real income in a country equals aggregate real GNP in a country. Now, an
appropriate way to measure real GNP in Country j, RGN P j , with the utility function in this example
economy is as follows:
RGN P j = GN P j ? DEF j ,
where
DEF j =
1
pjW
+
1
pjC
!
.
Here DEF j is a utility-based price deator in Country j. For interested students, I demonstrate this in
the Supplementary Material on the last two pages of this assignment but you can ignore that derivation
if you like and just use this fact. So we have
j
RGN P = GN P
j
1
pjW
+
=
pjW
!
pjC
or
RGN P j =
!
1
1+
pjC
?
pjW QjW
QjW
+
+
pjC QjC
pjC
!
pjW
?
1
pjW
+ 1 QjC .
+
1
pjC
!
(1)
To calculate per capita real GNP in Country j, P CRGN P j , we divide real GNP by the number of
households in that country:
P CRGN P j =
RGN P j
.
Lj
(2)
A PRIMER ON TRADE AND INEQUALITY
Dani Rodrik1
Revised, August 2021
Economists have generally underplayed until recently globalizations role in exacerbating inequality in
the advanced economies. But in the public imagination globalizations adverse effects have loomed
much larger, significantly contributing to the backlash against the political mainstream and the rise of
far-right populism. The literature on trade and inequality is in fact exceptionally rich, with important
theoretical insights as well as extensive empirical findings covering recent experience. In these
comments I will summarize a few key takeaways.
Redistribution is the flip side of the gains from trade
Economic theory provides a natural starting point. Received theory suggests the redistributive effects of
opening up to trade are large and permanent. Both of these implications the magnitude and
permanence of redistribution are baked in trade theory and are its immediate implications. The gains
from trade derive from the difference in relative prices that prevail in the world economy, on the one
hand, and in the pre-trade (autarky) domestic economy, on the other. As an economy opens up to trade,
domestic relative prices change, producing income redistribution alongside gains from trade. The
identities of gainers and losers depend on the nature of social stratification in society (class, occupation,
skills, education, gender, region, etc.) and on which side of the change in relative prices each group
stands.
The famous Stolper-Samuelson (1941) theorem produces one particular, and especially stark result in a
highly stylized model. It shows that trade creates absolute losses for a segment of society, and not just
relative losses. The assumptions behind the theorem are extreme: only two factors of production, two
goods, and perfect mobility of factors across goods. But the logic of the Stolper-Samuelson generalizes
to a much broader set of economic environments. In a competitive economy, and as long as the home
economy does not specialize completely (i.e., it continues to produce the goods that are imported),
opening to trade must leave at least one factor of production worse off — regardless of the numbers of
goods and factors and the degree of factor mobility (see Rodrik 2018a for a sketch of the proof).
Importantly, this result implies that the consumer price effects of trade can never fully compensate the
losers. This is a consequence of the fact that in a neoclassical production system changes in factor prices
must bracket changes in goods prices. This produces the conclusion that there will be at least one factor
of production whose wages fall more than the price of the good with the steepest price drop. So even if
less skilled workers tend to heavily consume importables, they are still left worse off when such goods
are intensive in the use of less skilled workers.
These theoretical results are important because they run counter to many of the arguments in the
public debate that trade benefits most or all people, that even if trade creates some losers, these are
merely transitory adjustment costs, or that consumer price effects outweigh losses. Essentially, it is
1
Prepared for the IFS-Deaton Review: Inequalities in the Twenty First Century. I am grateful to Penny Goldberg,
other participants at the review meeting, and especially Angus Deaton for comments and suggestions.
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theoretically inconsistent to argue for significant gains from trade without accepting that there will be
sharp distributional consequences. No pain, no gain!
Tracing out these distributional effects empirically requires that we identify accurately the relevant
factors of production. Labor clearly differs from capital, and less-educated workers cannot quickly
transform themselves into educated professionals. Early empirical work focused on these broad
demarcations labor versus capital, skilled versus less skilled workers but these were probably too
aggregate to be very revealing. Employer- or industry-specific skills create an additional, more finegrained distributional margin between the winners and losers from trade. More importantly, spatial
immobility of workers produces distributional effects across regions. The research reviewed by Dorn and
Levell (2021) for this volume identifies significant adverse local labor market consequences of NAFTA (in
the U.S.) and the China trade shock (in both U.S. and Europe) in regions heavily reliant on jobs that
compete with imports. See in particular Autor, Dorn, and Hanson (2013) on the China trade shock and
Hakobyan and McLaren (2016) on NAFTA. These studies show that regions that were heavily impacted
by trade and workers and industries most directly competing with China and Mexico suffered
significant and long-term income losses.
Redistribution looms larger in advanced stages of globalization
Another important, but less well recognized, implication of trade theory is that the gains from removing
trade barriers become smaller relative to the induced redistribution as the barriers in question become
smaller. In other words, the redistributive component of trade looms larger relative to the overall gains
as globalization advances.
This result follows straightforwardly from standard economic theory. The efficiency costs of a tax on
trade, as with all taxes, rise with the square of the tax. Reducing a tariff that is half the size creates a
gain at the margin that is only a quarter as large. The distributive effects, meanwhile, are roughly linear
in relative price changes and do not depend on the magnitude of the tax (or where we are in
globalization).
To see the practical significance of this, consider the following question: how many dollars of income are
shuffled across different income groups per dollar of gains from trade? The answer to this question is
given by what I have called the political cost-benefit ratio (PCBR) of trade liberalization (Rodrik 1994).
The numerator of PCBR is the sum of the absolute values of gains and losses across identifiable groups,
divided by two (to ensure there is no double-counting). The denominator is the standard efficiency gains
produced by trade liberalization. We can compute this indicator using textbook partial- or generalequilibrium models of trade with benchmark parameter values (for elasticities in the former case and
factor shares in the latter case). In both cases, the ratio of redistribution to net gains rises from around 5
when tariffs are initially at 40% to more than 20 when tariffs are at 10% or below (Rodrik, 1994, 2018a)
In other words, the magnitude of redistribution is quite dramatic at low levels of trade barriers relative
to gains from trade that are generated. Nor is this merely a theoretical possibility. Empirical analyses of
NAFTA (Romalis, 2007; Caliendo and Parro, 2015) have found that the gains from trade reaped by the
U.S. economy are minute compared to distributive effects highlighted, for example, by Hakobyan and
McLaren (2016).
These considerations offer an important perspective on the political economy of globalization. Once
national markets have become fairly open, attempts to push globalization further will seem to be
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motivated primarily by the objective to enrich certain groups rather than expand the size of the overall
pie and with good reason! I would hazard the guess that advanced economies had already reached
that stage by the late 1990s, if not earlier.
Compensation is problematic
Trade induces income redistribution, but it need not aggravate inequality if the beneficiaries are the less
fortunate in society. Theory and empirics both suggest, however, that redistribution went in the wrong
direction in the advanced economies. The losers were poorer workers with less education, and regions
that were already adversely impacted by de-industrialization and the concomitant loss of jobs. The
income losses were in turn magnified by rising mortality rates and other social costs (Case and Deaton,
2020).
The standard response by economists and trade policy makers to such concerns is that trade
agreements need to be accompanied by compensation for the losers. In the U.S., compensation is often
explicitly built into trade policy in the form of Trade Adjustment Assistance (TAA). In Europe,
compensation is not directly targeted at workers affected by trade, but social insurance and active labor
market programs addressing job losses in general tend to be more generous than in the U.S. In neither
case is compensation provided for earning losses per se, unless workers are thrown into unemployment
or fall under income thresholds that trigger public assistance. It is fair to say that compensation is
incomplete and imperfect.
There are good reasons why compensation never quite works in practice. First, there are informational
problems that impede targeting the losers. It is not clear how well governments can identify workers
whose earnings would have been higher in the absence of trade liberalization. In practice, this problem
is solved by making public assistance conditional on an observable trade shock such as job loss due
to trade. But this misses workers who have to accept lower wages either as they change jobs or in their
existing employment. In general, imperfect information rules out lump-sum transfers, which means that
compensation must create by-product inefficiencies.
This brings us to the second problem. Since compensation is costly, the deadweight loss of
compensation could easily eat up an important chunk of the gains from trade. This would make the
aggregate gains from trade liberalization-cum-compensation much smaller, and could even turn those
gains into losses. Antràs et al. (2017) show that the relevant magnitudes can be significant in a
quantitative trade model: the uncompensated rise in inequality produced by trade can make a sizable
dent in social welfare; and the distortionary taxation deployed to moderate inequality can in turn
reduce the gains from trade. In this study, trade liberalization is modeled as a reduction in iceberg
trade costs, which ignores the loss in government tariff revenues. When government revenues are
added in, the requisite compensation is larger.
Consider a back-of-the envelope calculation based on the Rodrik (1994, 2018a) results cited earlier.
Assume the excess burden of tax-transfer policies is as low as $0.10. In other words, for every $1 dollar
of redistribution 10 cents of deadweight loss is generated. Assume further that the PCBR (at the margin)
of trade liberalization is 10, which is not an extreme number when economies are already highly open
(as discussed previously). Then, compensating the losers fully would produce a deadweight loss that
exhausts all the gains from trade. A PCBR larger than 10 and/or excess burden greater than 0.10 would
produce net losses to society from trade liberalization-cum-compensation. Particular groups (export-3-
oriented interests) might still gain — and gain a lot. But the losses incurred by the rest of society would
be larger.
I have so far considered the economic arguments for why compensation may be problematic, and
incomplete at best. The assumption was that there is a social welfare function that takes income
distribution into account and which political authorities want to maximize. But there are also political
reasons that can stand in the way of compensation. If globalizations beneficiaries are powerful enough
to get the trade agreements they want, they might be also powerful enough to block redistributive
policies. And even if they need a broad enough coalition at the outset, they can wiggle themselves out
of their commitments down the line.
A particular version of this argument is based on the time inconsistency of the promise to compensate
the losers. Suppose signing a trade agreement requires that at least some of the potential losers be on
board. In advanced countries, these groups are likely to represent workers in declining industrial
regions. To get their agreement, the government will want to promise compensation. In the U.S.
context, this takes the form of enhanced Trade Adjustment Assistance. Once the agreement is signed,
however, and as long as the trade agreement cannot be easily reversed, there will be little incentive to
ensure the compensation is undertaken. More generally, promises to redistribute ex-post are timeinconsistent when the trade deal undermines the power of veto players (Fernandez and Rodrik, 1991).
Indeed, TAA has generally been under-funded and its effectiveness has been limited (DAmico and
Schochet, 2012).
In short, the fact that globalizations losers have not seen much compensation in practice is not
surprising from either an economic or a political standpoint.
Fairness versus inequality: trade differs from other market exchanges
But why should governments try to undo the redistributive effects of trade and globalization in the first
place? Market-based economies undergo continuous changes, much of which have implications for
relative prices and for income distribution. Changes in demand conditions, new technologies and a
variety of other idiosyncratic shocks buffet economies without necessarily giving rise to concern about
inequality or calls for compensation. Moreover, it is not clear that trade is the most important factor
behind the distributional woes of advanced societies in recent decades: rising wage inequality, deindustrialization, regional decline, middle-class squeeze, increasing top incomes, and falling income
shares of labor. There is broad consensus within the economics profession that technology and broad
institutional changes (such as the decline in unionization or labor power) have played a larger role. Yet
somehow the adverse effects of trade and globalization have become politically salient in a way that
many of the other determinants have not. A large body of empirical literature shows that globalization
shocks have played a causal and significant role in the rise of right-wing populist movements (Rodrik
2021).
The outsized effects of trade shocks in shaping public attitudes are demonstrated in an experiment that
Rafael di Tella and I ran on U.S. respondents (di Tella and Rodrik, 2020). In a large-scale online survey,
we presented subjects with a newspaper article on the impending closure of a garment plant. Our
subjects were divided randomly into different treatment groups, with each group presented with a
different scenario as to the reason for the plant closure. The scenarios covered a negative demand
shock, the introduction of labor-saving technology, management mistakes, and different types of
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international outsourcing (trade). The respondents were then asked about their preference for various
types of government policy: they could choose to do nothing, provide government transfers to the
displaced workers, or impose trade protection.
In general, the scenarios elicited an increase in support for government action compared to the control
scenario (with no job losses). But the main take away was that people do not treat different types of job
loss uniformly. They distinguish among labor market shocks according to what produces them. While
non-trade disruptions such as technology and demand shocks did increase the demand for protection,
trade shocks elicited a much more drastic protectionist response, doubling or tripling the share of
respondents who sought trade restrictions. Moreover, our subjects were especially sensitive to trade
with a developing nation. Simply changing the name of the country to which production is outsourced,
from France to Cambodia, increased the demand for import protection significantly (by more than half
the baseline level of demand for trade protection).
These results suggest that people view trade shocks as being inherently different from other kinds of
shocks. Our respondents views on the desirability of government action of some kind (and trade
protection in particular) depended not just on prospective outcomes the job losses but also on the
causal channels. People seem to have preferences over distributive mechanisms as well.
Angus Deaton, among others, has argued that public reactions to economic trends are shaped less by
inequality per se than by perceptions of unfairness. As Deaton (2017) writes, inequality is not the same
thing as unfairness
it is the latter that has incited so much political turmoil in the rich world today.
Some of the processes that generate inequality are widely seen as fair. But others are deeply and
obviously unfair, and have become a legitimate source of anger and disaffection. Foreign trade is
particularly prone to charges of unfairness, because it entails economic transactions between entities
that operate under different sets of rules and regulations.
Consider the difference between a market exchange that is domestic and one that crosses national
borders. In the first case, all firms operating in a given industry are subject to identical rules and
regulations established by the national government and the expectation is that the state does not
favor one over the other. In other words, there is a level playing field. In the second case,
circumstances facing different firms may be quite dissimilar. A firm in country A might be subsidized
(explicitly or implicitly) by its government, may face much weaker environmental and labor standards
than prevail in country B, and even if regulations on the books are similar, may be allowed to evade
them. From a formal economic standpoint, the resulting variation in comparative costs across countries
are no different from those that arise from differences in relative factor endowments or productivity,
and hence may even be the source of additional gains from trade. But the opportunities to trade that
arise from such unevenness in playing field have a rather different feel and smack of unfairness.
Economists have traditionally resisted bringing such fairness concerns in discussions of trade policy. If
labor standards are weak or non-existent in low-income countries, why should that not count as just
another source of comparative advantage? Besides, would the workers displaced from sweatshops if
trade of this kind were to be restricted not be even worse off in the absence of the trade opportunities?
Does it not make economic sense to move pollution-intensive activities to jurisdictions where the
demand for cleaner air is lower and hence environmental regulations are weaker?
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But lets look at these concerns from the standpoint of the affected groups, particularly labor, in the
importing country. After long political struggles workers in most advanced countries have achieved a
significant expansion of social rights, including labor standards such as freedom of collective bargaining
and prohibition of forced and child labor. A key feature of these labor standards is that they make it
illegal (and illegitimate) for firms to compete on the basis of cost advantages derived by violating these
standards. A firm cannot outcompete another firm by employing workers who are willing to exempt
themselves from national labor regulations even if those workers are willing to do so voluntarily.
But international trade renders what is illegal (and illegitimate) in a national setting to be suddenly legal
(and, in the eyes of many economists and technocrats, fully legitimate). A firm cannot import child
workers and put them to work at home; but it is perfectly able to do so when it employs those child
workers abroad (directly, or through a subcontractor). An economist looks at this, and sees gains from
trade. For the labor advocate and social reformer, however, what is taking place is an undercutting of
domestic labor standards. Effectively, domestic workers are told: If you want to compete with imports,
you need to sacrifice your hard-earned labor rights.
In some cases, international trade laws recognize the need to pay at least lip service to considerations of
fairness. That is why export subsidies and dumping (selling below cost) on the part of exporters are
generally punishable by trade remedies (i.e., import tariffs) even though the purely economic case for
doing so is weak. Prison labor was left outside trade rules in the original GATT (allowing countries to
restrict imports made with such labor). A similar exception was not made formally for goods made with
slave labor, though presumably few would object today to trade prohibitions in this case. But what
about child labor, exploitative work practices, or blatant repression of collective bargaining rights? In all
these cases, there is a strong argument that such trade is open to charges of unfairness. Yet current
trade rules generally do not allow countries to restrict imports on the basis of such considerations
(outside a few bilateral or regional trade agreements). Prohibiting or restricting imports because of labor
rights violations in exporting nations would violate WTO rules and could be met with retaliation on the
part of affected exporters.
Regulatory differences across countries need not be always problematic. They can be based on
differences in circumstances or preferences, and need not reflect clear-cut violations of social rights. For
example, an exporting country may have a comparatively low minimum wage reflecting a depressed
levels of labor productivity. Clearly, this would not be a source of downward arbitrage on working
conditions in importing countries, and should not raise concerns about unfair trade (though in practice it
often does). In other cases, countries may choose weaker social and labor protections because of
perceived tradeoffs with other social objectives (e.g., higher levels of employment). Arbitrage
considerations will then still enter, even if there are no rights violations in the low-standard country.
This is one of the considerations that weighed heavily in the EUs negotiation with Britain on Brexit.
Fairness considerations in trade do not call for uniformity in labor or social rules. Regulatory diversity is
a value in itself. But in general, the more complete and deeper the integration, the greater will be the
demand for harmonizing regulations. Within the EU, divergence in labor rules between some of the
countries in the periphery (e.g., Poland) and the more advanced nations (e.g., France) has often created
tensions. In the Brexit agreement, the EU received assurances from Britain that its industries would not
be undercut by weaker labor and environmental rules in the latter (and reserved the right to restrict
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trade if changes in UK labor, social, or environmental policies produce material impacts on trade or
investment between the parties).2
Economic integration comes with a tradeoff between the gains from trade, on the one hand, and the
gains from regulatory diversity, on the other. It is impossible in general to maximize on both fronts. The
deeper we go into integration, the more we must sacrifice regulatory diversity either de jure, or de
facto through arbitrage. (I discuss regulatory harmonization further in the next section.) Without
claiming to resolve such issues, economists might nevertheless acknowledge that trade does indeed
raise thorny questions of fairness under such conditions.
Deep integrations benefits are ambiguous
Economists typically think of international trade policy in terms of tariffs and quotas. But as the
discussion above suggests, over the years trade policy has become less and less about such textbook
frictions and more about so-called behind-the-border barriers that raise the costs of accessing
domestic markets. The idea was that as traditional barriers came down, further gains from trade could
be reaped by removing the transaction costs created by policies or regulations that were traditionally
considered to be domestic policies. Agriculture, services, subsidies, health and sanitary rules, intellectual
property regulations were some of the new areas that were incorporated into the World Trade
Organization in 1994. Subsequent trade agreements negotiated bilaterally or regionally went even
further in these domains and entered additional areas such as banking, finance, and labor regulations.
The trouble is that domestic policies in these domains often served important distributive roles or were
the outcome of historical social bargains. When they became part of trade negotiations, the result was
the perception (often accurate) that trade agreements were being hijacked by specific groups and
lobbies seeking to overturn long-standing social contracts. Trade agreements became more divisive and
contentious.
But this is not merely a question of perceptions. The political backlash against deep integration does
have reasonable economic underpinnings. International agreements that constrain domestic regulatory
autonomy produce aggregate economic benefits that are far more ambiguous than is the case for
lowering traditional border barriers. They may well reduce trade costs and boost increases in the
volume of trade and cross-border investment. But their welfare and efficiency impacts are
fundamentally uncertain. I discuss the issues more fully in Rodrik (2018b); see also Maggi and Ossa
(2020).
Consider the case of regulatory standards (designed to promote consumer safety, the environment, or
health). The harmonization of such regulatory standards lies at the center of todays trade agreements.
The justification is that reducing regulatory differences among nations reduces the transaction costs
associated with doing business across borders. Demanding regulatory standards that may impede
market access by foreign producers are sometimes labeled non-tariff barriers. And there is little
question that governments sometimes do deploy regulations to favor domestic producers over foreign
ones. But, as I discussed earlier, these differences often reflect dissimilar consumer preferences or
2
See U.K. Explores Reform of Workers Rights That Would Break From EU, Bloomberg News, January 14, 2021,
https://www.bloomberg.com/news/articles/2021-01-14/u-k-explores-reform-of-workers-rights-that-would-breakfrom-eu?utm.
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divergent regulatory styles. European bans on GMOs and hormone-fed beef, for example, are rooted
not in protectionist motives the same bans apply to domestic producers as well but in pressures
from consumer groups at home. The US government considers these as protectionist barriers, and
dispute-settlement panels of the World Trade Organization have often agreed (Rodrik 2018b).
The trouble is that unlike in the case of tariffs and quotas, there is no natural benchmark that allows us
to judge whether a regulatory standard is excessive or protectionist. Different national assessments of
risk safety, environmental, health — and varying conceptions of how business should relate to its
stakeholders employees, suppliers, consumers, local communities will produce different standards,
none obviously superior to others. In the language of economics, regulatory standards are public goods
over which nations (and groups within nations) can have different preferences. Nations need to trade
off the benefits of expanding market integration (by reducing regulatory diversity) against the costs of
excessive harmonization. The resulting decisions are inherently political and distributional. And they
remain contested as preferences and political coalitions shift.
The European Acquis Communautaire represents the apex of regulatory harmonization. The European
single market is the self-conscious result of pursuing not just free trade, but deep integration, which in
turn has required an extensive and detailed body of laws and regulations going so far as prescribing,
for example, the size of cages for egg-producing hens — that apply, for the most part, to all member
states. These trade-offs featured heavily in the British debate on Brexit. One (perhaps charitable) way to
understand the pro-Brexit case is that it was a demand for such decisions to remain in the hands of
domestic politicians and policy makers (rather than European technocrats). Continued membership in
the EU implied that the relevant tradeoffs would be made in Brussels, relatively distant from
democratically elected leaders, and would likely favor the single market rather than national difference.
This was perhaps a different kind of distributional conflict, revolving less around material interests and
more around values and broader social/political preferences. For those with significant commercial,
economic, or professional stakes in accessing the European market, it was natural that material interests
would predominate. For others, for whom the economic prospects were less bright, political and
regulatory autonomy could rise to the surface.
Dynamic gains from trade are uncertain
The standard gains from trade are static, level effects that are the result of a more efficient allocation
of domestic resources, given trade possibilities. It is possible to envisage also dynamic growth effects or
productivity benefits that go beyond standard allocative efficiency gains. In particular, freer trade could
produce an increase in the underlying rate of productivity growth of the economy instead of a one-time
increase in consumption possibilities. The advocates of trade agreements often rely on such growth or
productivity effects to claim large economic gains. Many of the distributional issues I have discussed
would not loom as large in the presence of a sustained increase in economic growth. A continuously
rising tide is much more likely to eventually lift all (or most) boats.
The growth effects could arise either from an increase in capital accumulation or a faster rate of
innovation and its dissemination. Note first that an increase in medium- or long-run growth need n
