The Gains from Free Trade

Most propositions on the gains from trade with many consumers consider only lump-sum transfers as redistributive tools. It is widely believed that nothing can be said unless such transfers are possible. In this note we show that such a belief, and the consequent pessimism concerning the applicability of welfare propositions in trade theory, are groundless. Indirect consumer taxes are sufficient to make free trade Pareto-superior to restricted trade under the same consitions that would make free trade better than restricted trade in the one-consumer case, i.e. that there be no terms-of-trade gain from trade restrictions. This extends some earlier work in Dixit and Norman (1980, ch.3). The essence of our argument is simple. Suppose the government can levy taxes on all commodities entering individual consumers' utility functions, i.e. on all goods and all factors. Then, by appropriate choices of tax rates, the government can leave all consumer prices unchanged when moving from restricted trade to free trade. That will leave all consumer demands and utility levels unchanged. If such a scheme is feasible, in the sense that it gives non-negative government revenue, it means that all consumers can be made as well off with free trade as with restricted trade, thus proving weak Pareto-superiority of free trade. If government revenue is strictly positive under such a scheme, free trade can be made strongly superior simply by lowering the consumption tax rate on some good that all consumers demand in a positive quantity.