Risk-aversion explains resistance to freer trade (and explains protectionism during a recession)
Drafted March 1989, published March 2009
Author’s Note March 19 2009: This small note has remained unpublished in my files for more than 20 years. Some stylistic improvements have been made to the original.
Textbook economics suggests world trade improves material welfare: consumers are better off when imports may compete freely in the home-market. Yet from Adam Smith’s critique of mercantilism to modern theories of rent-seeking, domestic producers in import-competing industries have been described as trying to restrict international trade by tariffs or other means. How is it producers so often succeed in persuading governments of the social costs of imports? Why are there not (or not as many, or not as powerful) consumer lobbies? Certainly there are high costs of organizing consumer lobbies relative to producer lobbies, but leaving that aside, is it possible consumers are ignorant and irrational? J. Michael Finger (1982, 1983/84) argued that in this respect consumers are in fact ignorant of their own best interests.
Roy (1983/84) suggested that a simple Keynesian observation offers a different explanation. A domestic household may be definitely better off by trade-liberalization on the expenditure side of its budget but the increased competitiveness of the economy accompanying liberalization may so decrease the expected value of its income that a risk-averse household would prefer the trade-protected status quo and have no incentive to lobby for trade-liberalization. Conversely, in a recession when the expected value of a household’s income declines, households have an incentive to lobby for trade-protection despite this worsening the expenditure side of their budgets.
The simplest of examples suffices to show all this. Let x1 be a non-traded domestic good, and x2 an imported good, and let a domestic household have preferences
U (x1, x2) = x1α . x2β
α + β < 1; 0 < α, β < 1 (1)
Let x1 be numeraire, p’ and p be the world and domestic prices of x2 respectively, and t be the tariff-rate on x2 such that p = (1 + t). p’. Let the household’s expected income be ya in the trade-protected state and yb in the trade-liberalized state, so its budget constraint is either
ya = x1 + (1 + t).p’. x2 in the trade-protected stated (2a)
yb = x1 + p’. x2 in the trade-liberalized state (2b).
Maximizing (1) subject to (2a) gives a “final utility” in the trade-protected state, Ua*. Maximizing (1) subject to (2b) gives a “final utility” in the trade-liberalized state, Ub*.
Hence Ua* > Ub* as
[ya/yb] (α + β)/β > 1 + t where (α + β)/β > 1.
If income is certain in the trade-protected state but uncertain in the trade-liberalized state, a household’s risk-aversion will require loss in the expected utility of income in the trade-liberalized state to be offset by a gain in final utility that it receives as a consumer due to tariff-reduction.
E.g., let α = β = ½ and let the household have a certain income in the trade-protected state of $20,000; let it place a subjective probability of 1/4 on being unemployed with zero income in the trade-liberalized state, and 3/4 on maintaining the same income of $20,000. Then Ua* > Ub* as [4/3]2 > 1 + t.
I.e., for any tariff-rate less than about 78% with these particular data, the household may rationally think itself better off in the trade-protected state than in the trade-liberalized state, and hence have no incentive to lobby for the latter.
Cooper (1987) remarked: “There should of course be a strong appeal to consumers of imported goods for removing restrictions. For a variety of reasons, political mobilization of consumers has been difficult in most countries. Many of these consumers also are employed in producing tradable goods, and they worry more about their jobs than about the purchasing power of a given wage. But most goods that move in international trade are not consumer goods. They are capital goods and intermediate products, and it should be easier to appeal to buyers of these intermediate products for import liberalization, because such buyers would enjoy a reduction in their costs.” The sentence italicized above may be consonant with the simple point made here.
Richard N. Cooper “Why liberalization meets resistance” in J. Michael Finger (ed.), The Uruguay Round, A Handbook on the Multilateral Trade Negotiations, World Bank, November 1987.
J. Michael Finger, “Incorporating the gains from trade into policy”, The World Economy, 5, December 1982, 367-78.
“The political economy of trade policy”, Cato Journal, 3, Winter 1983/84.
Subroto Roy, “The political economy of trade policy: comment”, Cato Journal, 3, Winter 1983/84.