Brad DeLong, prices, and trade

Brad picks up the discussion on trade and prices, and says he is confused by it. He writes  in relation to an earlier post of mine:

Yes, prices of exportables rise and prices of importables fall [as a result of free trade]. But importables have a higher weight in consumption than in production (that's why we import them). And exportables have a lower weight in consumption than in production (that's why we export them). So if the average price of production stays the same--and incomes stay the same, because everything paid to buy our production winds up as somebody's income--then the average price of consumption falls.

I think we do agree on the economics, which is not rocket science after all. Under the usual conditions, trade does increase aggregate real incomes, and whether that is because the numerator  (nominal income) rises or the denominator (price level) falls is immaterial--and in fact something that micro-economic theory cannot shed light on.

But this discussion has never been about the aggregate gains from trade, and that is why Brad is confused I think. I started on this particular thread to make a point about distributional effects. The argument on prices is often presented as if it is an add-on to the income-side effects of trade, and one that can override otherwise important distributional consequences. "Yes, these workers might lose their jobs, but look how much the rest of us benefit on account of lower prices."  See for example the post by Dan Drezner that started me off. My point  was that the "but..." part of the argument is irrelevant or need not hold. In particular:

(a) In our workhorse model of trade (the HOS model), certain groups will lose out from trade, regardless of price movements.

(b) And in other models (such as those with some sector-specific factors), whether any particular group of workers gains from the price effects of trade depends on how their consumption basket relates to traded goods.  If you are a worker who consumes a lot of the export good (my Argentine example), you will be worse off, regardless of the aggregate relationships discussed by Brad (i.e., even though exportables may have a smaller share in consumption than in production in aggregate).

I should add that because of these distributional effects, the median (i.e., typical) consumer can also end up worse off, to the extent that her income sources and budget shares differ from those of the average. So before you take too much comfort about all the cheap prices at Wal-Mart, these are some of the things you have to worry about.

So my earlier summary of these issues is still pretty good, I think.

Comments

[spencer]

I have no trouble following the discussions about trade if the country's trade is in rough balance. But how does it impact the arguments and gains or loses when the country run a large and significant trade deficit as the US is doing? Excluding the impact through the interest rate side of the model does the fact that the import side is much larger then the export side change the cost-benefit calculations?

[Brad DeLong]

Aha. Price effects as an add-on to gains-from-trade is clearly a non-starter...

Somebody else, somewhere, suggested a model in which increased trade decreased local market power, and in a model with menu costs led to decreased inflation. But I'm not sure it was coherent...

Brad

[Justin Rietz]

What about the differences between the short run and the medium / long run? Is there any disagreement that in the long run opening up markets to free trade is beneficial to all parties?

In the short run, there is an increase in domestic unemployment and a decrease in wage levels caused by lower priced imports. However, the new markets for exports creates an increase in demand for exported goods, causing the domestic prices of these goods to increase. Businesses in the exporting industries, faced with lower wage levels and higher prices for their goods, hire more workers and increase production - basic MR = MC equilibrium. Moreover, lower wage levels will also entice businesses not directly involved in trade to hire more workers and expand production.

The result: wage levels bounce back, the domestic price of exported goods drops, and general production increases (with the possible result of an across the board increase in consumer purchasing power).

Obviously this takes some time to occur. Therefore, the trade policy that would follow from this would be: continue to open up markets to free trade and provide short-term support (unemployment benefits, retraining stipends) for workers impacted directly by cheaper imports. We can consider the costs of these short term safety net measures as "punishment" for having protectionist policies in the first place. Eventually, all markets (domestic) will be open to free trade and we won't have anything to blog about ;-)

[DRR]

I'm confused.

I don't know if it can "override" dsitributional issues. My guess is for someone who lost their job to overseas competition, cheaper consumer goods don't make up for their loss of welfare, that being said, the change in the relative price of imports as a result of free trade (for the rest of us), IS an "add on" to the separate comparative advantage restructuring benefits of liberalization, is it not?

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