Pareto inferior trade and optimal trade policy
Newbery, David M.; Stiglitz , Joseph E.
One of the basic tenets of liberal economics is that everyone could be made better off by reducing restrictions on trade. Even though some groups in the population may be made initially worse off, those who gain as a result of trade liberalization can more than afford to compensate those who suffer. The paper shows that in a competitive but risky economy, free trade may be Pareto inferior to no trade, and under fairly general conditions a restriction in trade from the free-trade position will constitute a Pareto improvement. One result consistent with traditional beliefs is that there exists some form of liberalization from the no-trade situation which constitutes a Pareto improvement. This paper is divided into three parts. In Part I the basic model is developed and the conditions derived under which free trade is Pareto inferior to no trade. In Part II a more general model is used to analyze trade policy. In Part III it is shown that the results are more robust than the simple model developed in Parts I and II. Critical assumptions are discussed, an alternative interpretation of the model presented, and extensions suggested to the analysis.
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